Diploma in Financial Management

Paper DB1 Incorporating subject areas: Financial Strategy Risk Management

Tuesday 7 June 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This paper is divided into three sections: Section A Section B and Section C ALL 20 questions are compulsory and MUST be attempted THREE questions in total to be attempted Candidates MUST attempt ONE question from Section B, ONE question from Section C and ONE further question from either Section B or Section C

Present Value Rates are on page 2. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Module B

The net present value of $1 receivable at the end of n years at x% x= n 0 1 2 3 4 8% 100 093 086 079 074 15% 100 087 076 066 057

Section A ALL 20 questions are compulsory and MUST be attempted Please use the space provided on the inside cover of the Candidate Answer Booklet to indicate your chosen answer to each multiple choice question. Each question in this section is worth 2 marks. 1 Saur Co has issued $40 million convertible bonds at $106 per $100 nominal value. The bonds may be converted into ordinary shares in four years time at the rate of 12 shares for every $100 of convertible bonds. The ordinary shares are currently trading at a price of $8 per share. What is the conversion premium as a percentage of the bond value? A B C D 1042% 1000% 417 % 400%

Pindar Co is an airport operator that is quoted on the Stock Exchange. Recently, the board of directors agreed to change the companys depreciation policy concerning airport runways. In future, these assets will be written off over 100 years rather than 50 years. This change is solely designed to increase reported profits over the next 50 years and thereby create a better impression to investors of company performance. What is the maximum level of market efficiency that the board of directors is assuming that would be consistent with such behaviour? A B C D Strong-form efficiency Semi-strong form efficiency Weak-form efficiency No form of efficiency

Kangra Co has recently made a tender offer of shares and has received the following tenders: Share price Number of shares tendered at each share price (000s) 850 950 1,100 1,200

$400 $325 $250 $175

What striking price is required to maximise receipts from the issue? A B C D $400 $325 $250 $175

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When appraising investment projects using discounted cash flow methods, two approaches to dealing with inflation could be used. These are: 1. 2. to exclude inflation from the estimated future cash flows and to apply a discount rate based on the money cost of capital. to include inflation in the estimated future cash flows and to apply a discount based on the real cost of capital.

Which ONE of the following combinations (true/false) concerning the above statements is correct? A B C D Statement 1 True True False False Statement 2 True False True False

Chamba Co has 50 million $050 ordinary shares in issue with a total market capitalisation of $150 million. For the year just ended, after-tax profits were $20 million and are expected to rise by 25% in the forthcoming year. Chamba Co has a constant dividend payout ratio of 40% and intends to increase the dividend by 5% per year after payment of the forthcoming years dividend. Which ONE of the following is the expected rate of return from the ordinary shares? A B C D 507% 1033% 1167% 1505%

Which ONE of the following statements concerning the issue of shares is correct? A B C D A placing of shares involves an offer of shares to selected investors rather than to the general public. An offer for sale is an invitation to the general public to subscribe for shares not yet in issue. An offer for subscription is an invitation to the general public to subscribe for shares already in issue. A bonus issue raises finance through an offer of shares to existing shareholders.

Indus Co holds an item of inventory for which the demand is 40,000 units per year. The cost of holding one unit of the item is $250 per year and the cost of placing an order for the item is $20. Demand for the item is even throughout the year. Indus Co employs the economic order quantity (EOQ) model to derive the optimal order quantity for the item. What is the combined annual cost of holding and ordering this item? A B C D $8,250 $8,125 $3,000 $2,000

Consider the following statements. 1. 2. Darma Co has an operating cash cycle of 40 days and has decided to issue shares to pay off its bank overdraft. Shimla Co is highly geared and has decided to make a one-for-three bonus issue of ordinary shares.

What will happen (increase/decrease) to the operating cash cycle of Darma Co and to the debt/equity ratio of Shimla Co if these decisions are implemented? Operating cash cycle of Darma Co Increase Increase No effect Decrease Debt/equity ratio of Shimla Co Decrease No effect No effect Increase

A B C D

Napa Co has 100 million $025 ordinary shares in issue with a current market value of $120 per share. The cost of ordinary shares is estimated at 12%. The company also has $100 million 6% irredeemable loan notes in issue that are currently quoted at $60 per $100 nominal value. The tax rate is 20%. What is the weighted average cost of capital for Napa Co? A B C D 113% 106% 88% 72%

10 Pecking order theory states that, when financing new investment opportunities, a business will prefer to use: 1. 2. internal finance rather than external finance. equity rather than debt.

Which ONE of the following combinations (true/false) concerning the above statements is correct? A B C D Statement 1 True True False False Statement 2 True False True False

11 The following exchange rates of UK sterling () against the Australian dollar (A$) have been quoted. Spot Six months forward 1 = A$17574 1 = A$17245

The interest rate in Australia is 5% per year for a six-month deposit or borrowing. What is the annual interest rate for a six-month deposit or borrowing in the UK? A B C D 445% 700% 890% 995%

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12 The UK Corporate Governance Code states that 1. 2. a chief executive should not go on to be chairman of the same company. non-executive directors should be appointed for specified terms.

Which ONE of the following combinations (true/false) concerning the above statements is correct? A B C D Statement 1 True True False False Statement 2 True False True False

13 Narmada Co is a UK business that has purchased goods from a German supplier. This involves a payment of 200,000 in three months time. The company will take out an option at a strike price of 1 = 11226 to hedge the currency risk. A call option costs 060 per 100 and a put option costs 045 per 100. These options relate to the purchase or sale of euros. What is the maximum amount that will have to be paid if the spot rate in three months time is 1 = 11025? A B C D 179,058 179,358 182,306 182,606

14 The UK Corporate Governance Code states that: 1. 2. for larger companies, at least one-third of the board, excluding the chairman, should be independent non-executive directors. for smaller companies, there should be at least two independent non-executive directors.

Which ONE of the following combinations (true/false) is correct? A B C D Statement 1 True True False False Statement 2 True False True False

15 Johar Co has earnings per share of $080 and a constant annual dividend payout ratio of 25%. Its equity shares have a beta of 12. The risk-free rate of return is 5% and the market rate of return is 8%. What is the expected cost and predicted value of an equity share in Johar Co? A B C D Expected cost 206% 86% 86% 36% Predicted value $388 $233 $930 $556

16 Imphal Co is a US importer that recently purchased goods from Nubra Co, a Thai exporter. Imphal Co was invoiced in US$ and during the thirty-day credit allowed under the terms of sale, the US$ weakened against the Thai baht. If neither Imphal Co nor Nubra Co hedge against foreign exchange risk, what is the foreign exchange gain or loss for each company arising from this transaction? A B C D Imphal Co No gain or loss Gain No gain or loss Loss Nubra Co Gain No gain or loss Loss No gain or loss

17 The shares of Derwent Co and Plym Co have beta values of 05 and 12 respectively. The expected rate of return for Derwent Co investors is 9% and the expected returns to the market are 12%. Using the Capital Asset Pricing Model, what is the expected rate of return for investors in Plym Co? A B C D 72% 108% 132% 216%

18 Consider the following statements concerning risk measurement. 1. 2. Value at Risk (VaR) is a measure of the most likely loss that a portfolio of financial assets will suffer over a particular time period. Stress testing assesses the vulnerability of a business to exceptional and implausible economic shocks.

Which ONE of the following combinations (true/false) is correct? A B C D Statement 1 True True False False Statement 2 True False True False

19 A UK company was owed $10 million from a US customer and hedged the currency risk by entering into a forward arrangement at a price of 1 = $16450. The spot price on settlement was 1 = $16510. Did the UK company enter into a forward arrangement to buy or sell US$ to hedge the exposure and was there a gain or loss from the hedging transaction? A B C D Buy or sell Buy Sell Buy Sell Gain or loss Gain Loss Loss Gain

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20 Consider the following statements concerning financial derivatives. 1. 2. Interest rate swaps are a form of over-the-counter derivative. A European-style option will give the right to buy or sell at any time up to and including the expiry date.

Which ONE of the following combinations (true/false) is correct? A B C D Statement 1 True True False False Statement 2 True False True False (40 marks)

This is a blank page. Section B begins on page 10.

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Section B Candidates MUST attempt ONE question from Section B, ONE question from Section C and ONE further question from either Section B or Section C. 1 Puster Co has invested $35 million over the past two years in developing a cellular phone that can be recharged using solar energy. The company recently commissioned a marketing survey, at a cost of $05 million, which reveals a healthy demand for the phone in the Middle East, South East Asia and parts of Africa at the proposed selling price of $150 per phone. The cellular phone project is expected to have a life of four years, at the end of which time a new model will be launched. Using the marketing survey results and the companys own estimated cost data, the finance department has prepared the following forecast income statements for the new cellular phone: Year Sales revenue Cost of sales Gross profit Variable overheads Fixed overheads Profit/(loss) 1 $m 125 (46) 79 (21) (36) 22 2 $m 158 (82) 76 (29) (36) 11 3 $m 112 (58) 54 (19) (36) (01) 4 $m 65 (33) 32 (10) (36) (14)

The operations director is disappointed with the results and has decided to recommend to the board that the proposed launch of the cellular phone be aborted. The following additional information is available: (i) New equipment will be required immediately to produce the new phone. This will cost $120m and will be sold at the end of the production period for $40m. Puster Co adopts the straight-line method of depreciation for non-current assets and depreciation charges are included in the fixed overhead figures shown above.

(ii) If the new phone is produced, additional working capital of $30m will be required immediately. This will be released at the end of the production period. (iii) The fixed overheads include an apportionment of general overheads to the product of $10m per year. (iv) Puster Co has an estimated cost of capital of 8%. Required: (a) Prepare calculations that show: (i) the net present value, and (ii) the approximate internal rate of return of the project. (b) Comment on the decision of the operations director. (12 marks) (2 marks)

(c) Compare the two methods of investment appraisal in (a) above and explain which, if any, is superior. (6 marks) (20 marks)

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Itria Co operates an airline throughout Europe. The company is highly profitable and is committed to achieving future growth through diversification. To this end, the company has been in negotiations with Leen Co, which operates a budget hotel chain. The two boards of directors have reached an agreement that Itria Co would acquire all the shares of Leen Co at a premium of 20% above their current market value. The bid consideration would take the form of shares in Itria Co. Financial information relating to each company is as follows. Income statement extracts for the year ended 31 May 2011 Itria Co $m 9864 2992 592 2400 800 200 Leen Co $m 5435 1506 256 1250 500 80

Revenue Profit before taxation Tax Profit for the year Other information Number of ordinary shares in issue (millions) Price/earnings ratio (times)

It has been estimated that the acquisition will lead to the following savings: Fuel and depreciation costs Staff costs Total savings before taxation Taxation Total savings after taxation $m 265 245 510 110 400

The boards of directors are convinced that the takeover will benefit the shareholders of both companies. They are concerned, however, that there will not be a positive response from the market. It is estimated that the price/earnings ratio of Itria Co will fall by 15% following a successful takeover. There is also concern that the shareholders of Leen Co will be unwilling to accept a share-for-share exchange and will press for a cash offer from Itria Co. Required: (a) Outline the case for and against employing a strategy of diversification through mergers or acquisitions. (5 marks) (b) Assuming that the bid price mentioned is acceptable to the shareholders of Leen Co: (i) calculate the price per share that Itria Co will have to pay to acquire the shares of Leen Co; (ii) calculate the rate of exchange for the shares of the two companies and the total number of shares that must be issued by Itria Co to finance the takeover; (iii) calculate the market value per share of Itria Co following a successful takeover, assuming the forecast savings are achieved and the price/earnings ratio of Itria Co falls as expected. (11 marks) (c) Explain the advantages and disadvantages for the shareholders in Leen Co of receiving the bid consideration in the form of cash rather than shares. (4 marks) (20 marks)

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Eskdale Co operates a chain of childrens clothing stores. The most recent financial statements of the company are set out below: Statement of financial position as at 31 May 2011 $m ASSETS Non-current assets Property, plant and equipment Current assets Inventories Trade receivables Cash at bank

1455 254 46 127 427 1882

Total assets EQUITY AND LIABILITIES Equity Ordinary shares $050 Retained earnings

300 678 978 500 344 60 404 1882

Non-current liabilities Loan notes Current liabilities Trade receivables Taxation

Total equity and liabilities Income statement for the year ended 31 May 2011 Revenue Operating profit Loan interest payable Profit before taxation Tax (25%) Profit for the year

$m 3628 360 (40) 320 (80) 240

The company has decided to expand its operations by opening new stores at a cost of $400 million. This move is expected to increase operating profits by $100 million per year. To raise the necessary finance, the directors of Eskdale Co are considering either: (i) an issue of $050 ordinary shares at a premium of $20 per share, or (ii) an issue of $40 million 8% loan notes at their nominal value. To conserve funds for further expansion, the company will issue no dividends for the foreseeable future.

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Required: (a) For each financing option: (i) prepare a forecast income statement for the forthcoming year; (ii) calculate the expected earnings per share for the forthcoming year; (iii) calculate the expected level of gearing at the end of the forthcoming year.

(10 marks)

(b) Calculate the level of operating profit at which the earnings per share will be the same under each financing option. (4 marks) (c) Evaluate each financing option from the perspective of an existing shareholder. (6 marks) (20 marks)

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Section C Candidates MUST attempt ONE question from Section B, ONE question from Section C and ONE further question from either Section B or Section C. 4 Maurienne Co and Chepino Co manufacture agricultural machinery and have identical business and operating risk characteristics. The following financial information relates to each company: Maurienne Co $m 120 320 280 600 300 900 Chepino Co $m 180 350 1200 1550 1550

Profit before interest charges Equity and non-current liabilities $050 ordinary shares Retained earnings 8% Loan notes

The current market price of an ordinary share is $240 for Maurienne Co and $450 for Chepino Co. The loan notes of Maurienne Co are currently trading at $120 per $100 nominal. The directors of Maurienne Co believe that the current market value of the loan notes is at an equilibrium level. They are not so sure, however, about the current market value of the ordinary shares. They believe that the shares may be undervalued, while the shares of Chepino Co are in equilibrium. Assume a tax rate of 20%. Required: (a) Outline the Modigliani and Miller (excluding taxes) view concerning capital structure and company valuation and describe the effect of the introduction of taxation on this view. (8 marks) (b) Briefly state TWO limiting assumptions in the Modigliani and Miller (including taxes) viewpoint. (4 marks)

(c) Based on the Modigliani and Miller (including taxation) view, calculate the equilibrium price of an ordinary share in Maurienne Co and comment on the results. (8 marks) (20 marks)

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Farndale Co is a UK supermarket chain with subsidiaries in a number of different countries. Some years ago, the company entered the US market but the financial results proved to be disappointing. As a result, the company recently agreed to sell its US stores to a rival US supermarket chain for $250 million. An initial payment of $100 million has already been received and the balance is due to be received in three months time. The directors of Farndale Co have to decide whether, and if so how, to hedge against the foreign exchange risk arising from this balancing payment. They are considering three possible options: (i) To take out a forward exchange contract. Exchange rates are: /$ spot 3-months forward 1 = $15806 $15852 $00082 $00072 premium

(ii) To take out a currency option. A bank has offered an over-the-counter option at an exercise price of 1 = $160 and at a premium cost of 110 per $100. (iii) To do nothing. During their deliberations, the directors dismissed the idea of currency futures contracts as they were not clear as to how they could be employed for this particular hedging transaction. Required: (a) Show the effect of each of the three options being considered, assuming that the exchange rate has moved in three months time to: (i) 1 = $165; (ii) 1 = $150. (b) Discuss the results in (a) above. (8 marks) (4 marks)

(c) Describe the nature of currency futures contracts and explain how a currency futures contract should be arranged in order to hedge the currency exchange risk faced by Farndale Co. (8 marks) (20 marks)

It is often said that audit committees are an important instrument of corporate governance. Required: (a) Explain the role of the audit committee within a public listed company. (b) Discuss the issues and problems that may arise from establishing an audit committee. (8 marks) (12 marks) (20 marks)

End of Question Paper

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