Financial Management - Professional Stage December 2012

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 7 7 0

2 4 3 1

3 4 2 2

Total 15 12 3

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

Details of the questions with a facility of less than 40% are shown here:

1. Provided with a share price and a range of probabilities for that same shares future price,
candidates were required to calculate an expected value for profit from having one call option and
one put option on the share given a particular premium cost.
2. Provided with the original purchase cost of a raw material, its current market value (for buying or
selling) and the anticipated present value of the cash flows that would arise from using it in
production, candidates were required to calculate the change in the deprival value if the present
value of using the raw material in production was to increase by a certain amount.
3. Provided with details of a firms inventory position with regard to a particular raw material and the
probability of its future use, its replacement cost in future, its anticipated future disposal proceeds
and its holding costs, candidates were required to calculate the expected relevant cost of the raw
material for investment appraisal purposes.

The nature of these three low-scoring OT questions suggests that relevant costs and probabilities/expected
values were significant weaknesses among the cohort that sat this paper.

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 Financial Management - Professional Stage December 2012

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: 31

General comments
As has been flagged up consistently with the tutoring firms (at arenas such as the Annual Tutor
Conference), since the last syllabus review there can be no guarantee that WT1 will automatically consist
of the standard NPV question with all the usual ingredients, which traditionally candidates are well drilled
for and, consequently, tend to score very well on.

(a)(i)
Net asset valuation:
Intangibles 900,000
Freehold land and property 4,500,000
Plant and equipment 3,600,000
Investments 1,350,000
Inventory 540,000
Receivables 1,080,000
Cash 180,000
12,150,000

Less
Current liabilities 1,080,000
Preference shares 648,000
Debentures 1,980,000
8,442,000
8,442,000/3,600,000 = 2.345 per share

Dividend yield valuation:

Dividend in 2012 = 180,000
Number of shares = 3,600,000
Dividend per share = 0.05
Average dividend yield of other two quoted firms: 3.7% (or the minimum 3.4%)
Valuation = 0.05 / 0.037 = 1.35 (or 0.05 / 0.034 = 1.47)
Less discount to reflect non-marketability (25% - any % will suffice) = 0.34 or 0.37
Valuation = 1.01 per share (or 1.10 per share)
Price/earnings valuation:
Average PBIT = (1,080+440+1,800)/3 = 1,106,667
Less interest 180,000 and tax 259,467 (926,667 x 28%) = PAIT 667,20043,200 = 624,000
EPS = 624,000/3,600,000 = 0.1733
Average price-earnings ratio of the other two quoted firms: 8.3 (or the minimum 7)
Valuation = 0.1733 x 8.3 = 1.44 (or 1.21)
Less discount to reflect non-marketability (25%) = 0.36 (any % deduction will suffice)
Valuation = 1.08 per share (or 0.91)

(ii) (maximum 4 marks)

In addition to a discussion of basic elements surrounding the weaknesses of net asset valuation (historic
cost, omission of internally-generated intangibles) and dividend yield and price/earnings valuations
(comparator statistics, unrepresentative annual figures), the following areas were worthy of comment in
this specific scenario:
The erratic profits in recent years suggests the earnings value may be somewhat unreliable
Purchasers may prefer a valuation based on the present value of forecast future cash-flows

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 Financial Management - Professional Stage December 2012

Given the dividend yield and price/earnings valuations, Cerns directors may prefer to sell off the firm on a
break-up basis rather than as a going concern.
Is the discount for non-marketability reasonable?
(iii) (maximum 4 marks)
Synergy: the 2+2=5 effect
Risk reduction via diversification
Removal of a competitor
Vertical integration: safeguard Fentons position by acquiring a supplier or distributor
Access a new market (possibly overcoming barriers to entry)
The acquisition of skills/knowledge
Speed compared to organic growth
Asset-stripping
Whilst there were many strong responses to the valuation questions, less well-prepared candidates were
undoubtedly exposed by the question and were particularly weak in dealing with the technicalities of both
the dividend yield and price/earnings valuation techniques. In the second section, whilst many candidates
were able to list classic text-book commentary on the respective valuation techniques, far fewer were able
to augment this basic analysis with insightful commentary on the relevance of the techniques to the
specific scenario set out in the question. The third and final section of the first part of the paper, on take-
over motives, was, however, generally very well answered across the board.
Total possible marks 27
Maximum full marks 21

(b)
Maximum annual production/sales (units) 300,000 285,000 270,000 255,000
Annual revenue @ 12 per unit () 3.60m 3.42m 3.24m 3.06m
Annual variable costs @ 8 per unit 2.40m 2.28m 2.16m 2.04m
Annual contribution 1.20m 1.14m 1.08m 1.02m

One-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 320,000
Maintenance costs (12,000)
Contribution 1,200,000
Net cash flow (480,000) 1,508,000
NPV (480,000) + (1,508,000 x 0.909) = 890,772/0.909 = 979,947

Two-year replacement cycle:

Purchase price (480,000)
Scrap value 200,000
Maintenance costs (12,000) (14,000)
Contribution 1,200,000 1,140,000
Net cash flow (480,000) 1,188,000 1,326,000
NPV (480,000) + (1,188,000 x 0.909) + (1,326,000 x 0.826) = 1,695,168/1.736 = 976,479

Three-year replacement cycle:

Purchase price (480,000)
Scrap value 80,000
Maintenance costs (12,000) (14,000) (16,000)
Contribution 1,200,000 1,140,000 1,080,000
Net cash flow (480,000) 1,188,000 1,126,000 1,144,000
NPV (480,000) + (1,188,000 x 0.909) + (1,126,000 x 0.826) + (1,144,000 x 0.751) = 2,389,112/2.487 =
960,640

Four-year replacement cycle:

Purchase price (480,000)
Scrap value 10,000
Maintenance costs (12,000) (14,000) (16,000) (18,000)
Contribution 1,200,000 1,140,000 1,080,000 1,020,000
Net cash flow (480,000) 1,188,000 1,126,000 1,064,000 1,012,000
NPV (480,000) + (1,188,000 x 0.909) + (1,126,000 x 0.826) + (1,064,000 x 0.751) + (1,012,000 x 0.683)
= 3,020,228/3.170 = 952,753

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 Financial Management - Professional Stage December 2012

Therefore, the directors should change their existing policy of replacing the processing machine every
three years to replacing it every year, as that gives the greatest annual equivalent net revenue
The second part of the question was, again, very well answered by the stronger candidates but
performance was somewhat polarised as those candidates who had clearly banked on there being a
traditional NPV question found their lack of a firm grasp of the replacement methodology exposed. Even
some candidates who scored well on the calculations themselves arrived at incorrect conclusions as a
result of treating the calculated figures as equivalent annual costs rather than net revenues.
Total possible marks 10
Maximum full marks 10

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 Financial Management - Professional Stage December 2012

Question 2

Total Marks: 23

General comments
It had been thought by the examining team that this relatively straightforward cost of capital question
would provide some comfort for those who had found the unexpected nature of WT1 something of a
challenge.

(a)
Cost of equity:
Current price per share cum-dividend 4.58
Dividend per share (1,134,000/4.2m) (0.27)
Current price per share ex-dividend 4.31

ke = d0 (1 + g) + g
P0

We cannot calculate g using the average growth in dividends as we have not been provided with sufficient
information. So the Gordon Growth Model (g = r x b) must be used:

r = 2,106,000/(13,359,000 972,000) = 0.17

b = 972,000/2,106,000 = 0.46
Therefore g = 0.17 x 0.46 = 7.8%

Therefore ke = 0.27 x 1.078 + 0.078

4.31

Cost of equity = 14.6%

Cost of loan stock:

df5% PV df10% PV
t0 (85.10) 1 (85.10) 1 (85.10)
t1 - t10 7(1 0.28) 7.722 38.92 6.145 30.97
t10 105 0.614 64.47 0.386 40.53
18.29 (13.60)

Cost of loan stock = 5% + 18.29/(18.29 + 13.60) x (10 5)% = 7.87%

The weighted average cost of capital - MVs are (4.2m x 4.31) and (1.819m x 0.851):

(18,102,000 x 0.146) + (1,547,969 x 0.0787) = 14%

(18,102,000 + 1,547,969)
The opening part of the question was generally well-answered although weaker candidates made common
mistakes in mis-calculating the constituent elements (r and b) of the Gordon growth model. However,
overall performance here was strong.
Total possible marks 10
Maximum full marks 10

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 Financial Management - Professional Stage December 2012

(b)
1. The Gordon Growth Model:
In its use of ARR, it relies upon accounting profit figures as opposed to cash-flows
It assumes that both r and b will remain constant
ARR can be distorted by inflation if assets remain valued at historic cost
The model assumes all new finance comes from equity (or gearing remains constant)
2. The Dividend Valuation Model:
The model assumes that the value of shares derives solely from dividends, which is untrue
The model assumes either that dividends do not grow or will grow at a constant rate
The model assumes share prices are constant, but they are subject to constant fluctuation
The model ignores future income growth
In this second part of the question, either through a lack of attention to the precise question being asked
or, more probably we suspect, an inability to answer that precise question, a good number of candidates
simply chose to write about the assumptions and weaknesses in calculating a WACC rather than the
assumptions and weaknesses in calculating the cost of equity as the question precisely called for. Many
weaker candidates consequently lost a good number of marks on a part of the question which carried just
over one third of the total marks for the question.
Total possible marks 8
Maximum full marks 8

(c)
The dividend growth rate might change in future
All projects have different business risk so each should have a risk-specific discount factor
Market values might change in future
The tax rate might change in future
The gearing ratio might change in future
Other sources of finance might emerge in future
Overall performance here was strong.
Total possible marks 6
Maximum full marks 5

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 Financial Management - Professional Stage December 2012

Question 3
Total Marks: 26

General comments
Following its introduction into the syllabus at the last review, this subject area was initially very challenging
for many candidates. However, at this sitting and in a reflection of an emerging trend on the paper in more
recent sittings, candidates grasp of the material appears to get stronger and stronger, so much so that it
was this question, rather than the traditional NPV question, that provided many candidates with the basis
of their pass on the paper.

(a)
Sunbeam requires an option to sell a December put option with an exercise price of 5,000

Portfolio value = 5.6m Spot value = 5,000

Value of one contract = 5,000 x 10 = 50,000
Number of contracts required = 5.6m/50,000 = 112 contracts
Premium: 70 points x 10 per point x 112 contracts = 78,400

If the index rises to 5,900, the put option gives Sunbeam the right to sell @ 5,000, so the option would be
abandoned (with zero value)

Overall position:
Value of portfolio 6,608,000
Gain on option -
Less premium (78,400)
6,529,600

If the index falls to 4,100, the put option gives Sunbeam the right to sell @ 5,000, so the option would be
exercised (value = 9,000 {900 x 10} x 112 contracts = 1,008,000)

Overall position:
Value of portfolio 4,592,000
Gain on option 1,008,000
Less premium (78,400)
5,521,600
Most candidates performed strongly on this question, although where errors were made they primarily
related to incorrect calculation of the number of contracts and the premium.
Total possible marks 8
Maximum full marks 8

(b)(i)
Sunbeam needs to sell a 3-month contract
Number of contracts = 4m/0.5m x 9/3 = 24 contracts

Futures outcome:
Selling at the opening rate of 96 and buying at the closing rate of 95 yields a gain of 1%
Therefore 1% x 0.5m x 3/12 x 24 = 30,000

Net outcome:
Spot market 4m x 4.5% x 9/12 = (135,000) plus the futures receipt of 30,000 = (105,000)
Effective interest rate 105,000/4m x 12/9 = 3.5%

Hedge efficiency:
Increase in spot rate = 1.5% so increase in interest = 60,000 (1.5% x 4m) x 9/12 = 45,000
So the hedge efficiency = 30,000/45,000 x 100 = 66.7%

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 Financial Management - Professional Stage December 2012

(ii)
Traded interest rate options on futures:
Sunbeam requires a March put option with a strike price of 96.25 (100 3.75)
The number of contracts required = 4m/0.5m x 9/3 = 24 contracts @ 0.18%
So the premium = 24 x 0.18% x 0.5m x 3/12 = 5,400

Case 1:
Spot price 4.4%
Futures price 95.31
Strike price 96.25
Exercise? Yes
Gain on future 0.94% therefore 0.94% x 0.5m x 3/12 x 24 = 28,200
Borrowing cost at spot 132,000
Option (28,200)
Premium 5,400
Effective interest rate 109,200/4m x 12/9 = 3.64%

Case 2:
Spot price 2.1%
Futures price 97.75
Strike price 96.25
Exercise? No
Gain on future -
Borrowing cost at spot 63,000
Option -
Premium 5,400
Effective interest rate 68,400/4m x 12/9 = 2.28%

(iii)
1.The time period to expiry of the option the longer the time to expiry, the more the time value of the
option will be

2.The volatility of the underlying security price the more volatile, the greater the chance of the option
being in the money, which increases the time value of the option

3.The general level of interest rates (the time value of money) the time value of an option reflects the
present value of the exercise price
The only real areas of weakness in most candidates responses were in their being unable to effectively
calculate hedge efficiency (many candidates simply did not even make an attempt to do so) and in the
mis-calculation of time-period adjustments and, consequently, premiums. However, overall candidate
strength in this area of the syllabus is pleasing to see.
Total possible marks 18
Maximum full marks 18

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