PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 15 JUNE 2011

(2½ hours)

FINANCIAL MANAGEMENT
This paper consists of FIFTEEN objective test (OT) questions (20 marks) and THREE written
test questions (80 marks).

1. Ensure your candidate details are on the front of your answer booklet.

2. Answer each question in black pen only.

Objective Test Questions (1 – 15)

3. Record your OT responses on the separate answer sheet provided: this must not be
folded or creased. Your candidate details are printed on the sheet.

4. For each of the 15 OT questions there are four options: A, B, C, D. Choose the
response that appears to be the best and indicate your choice in the correct box, as
shown on the answer sheet.

5. Attempt all questions: you will score equally for each correct response. There will be
no deductions for incorrect responses or omissions.

Written Test Questions (1 – 3)

6. Answers to each written test question must begin on a new page and must be clearly
numbered. Use both sides of the paper in your answer booklet.

7. The examiner will take account of the way in which answers are presented.

A Formula Sheet and Discount Tables are provided with this examination paper.

IMPORTANT

Question papers contain confidential Place your label here. If you do not have a label
information and must NOT be you MUST enter your candidate number in this box
removed from the examination hall.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN
WORK

© The Institute of Chartered Accountants in England and Wales 2011 Page 1of 6
1. Southsea plc (Southsea) manufactures high specification stretchers for its sole customer,
HealthTrans plc (HealthTrans), which supplies ambulances and ancillary products to the
UK National Health Service and a range of private hospitals and firms.

HealthTrans is currently experiencing rapid growth in business levels. As a result,

Southsea has recently been offered a new five-year contract with HealthTrans which will
start on 1 January 2012. Under this contract HealthTrans would guarantee to buy its entire
stretcher requirements from Southsea, assuming that Southsea were able to supply all of
its needs.

Demand from HealthTrans under the existing contract in the year ending 31 December
2011 is expected to be 1,000 stretchers. However, HealthTrans forecasts that this demand
will rise at a compound rate of 10% pa over the five years of the new contract.

At the present time Southsea has a production capacity of 1,050 stretchers pa, but the
company is considering making an investment in production facilities that would see its
annual capacity rise to 1,500 stretchers pa. However, the new contract with HealthTrans
will go ahead, using existing production facilities, whether or not Southsea decides to
increase its production capacity. In any one year, Southsea will only ever produce
sufficient stretchers to meet that year’s annual demand ie, it will not hold inventory.

In the year ending 31 December 2011, the price per stretcher is £2,500, but the contract on
offer contains a commitment from HealthTrans to accept an increase in this price over the
period of the contract at the UK rate of inflation, which is expected to be 2% pa up to
31 December 2014 and 3% pa thereafter.

The total cost of the component parts of each stretcher during the year ending
31 December 2011 is £1,200. Due to the highly competitive nature of the market for these
component parts, this cost will not be subject to annual inflation, but rather is expected to
fall at a compound rate of 1% pa over the life of the contract due to the economies of scale
that would arise from the increased levels of production.

Labour costs are also expected to be subject to efficiency gains which will be sufficient to
cancel out the effect of any wage inflation. The cost of labour is therefore expected to
remain constant over the life of the contract at £300 per stretcher.

Anticipated efficiency gains associated with the increased production levels also mean that
the impact on working capital requirements and fixed costs will be negligible and can be
ignored.

In order to achieve the proposed increase in production capacity, investment in production

facilities of £2 million would be required and this would take place on 31 December 2011.
The new facilities would have an estimated useful life of five years at the end of which they
are estimated to have no residual value.

The company’s corporation tax rate is expected to be 28% for the foreseeable future, and it
can be assumed that tax payments occur at the end of the accounting year to which they
relate. The directors are also assuming that the new facilities will attract full capital
allowances at 20% pa on a reducing balance basis commencing in the year of purchase
and continuing throughout the company’s ownership of the new facilities. A balancing
charge or allowance will arise on disposal of the new facilities which can be assumed to be
on 31 December 2016. Sufficient profits are available for the firm to claim all such tax
allowances in the year they arise.

© The Institute of Chartered Accountants in England and Wales 2011 Page 2 of 6

The company’s real after-tax cost of capital is 7% pa, and its accounting year end is
31 December. Assume that all annual operating cash flows arise at the year end.

As the relationship between Southsea and HealthTrans has developed, directors of both
companies have increasingly considered the possibility of a merger between the two
companies.

Requirements

(a) Calculate the net present value at 31 December 2011 of the proposed investment in
increased production facilities and, on the basis of your calculation, state whether or not
Southsea should proceed. (16 marks)

(b) Identify and explain the type of real option that might be most relevant to Southsea’s
consideration of its investment decision. (3 marks)

(c) Outline in general terms the potential advantages of a merger between Southsea and
HealthTrans. (3 marks)

(22 marks)

PLEASE TURN OVER

© The Institute of Chartered Accountants in England and Wales 2011 Page 3 of 6

2. Havant Hall Ltd (HH) is a small private company that runs a residential activity centre from a
stately home, Havant Hall, and its 125-acre estate in southern England. The company’s client
base comprises principally of local government bodies who send groups of disadvantaged
children for residential stays at the estate and private firms who send employees on people
development programmes centred on all aspects of leadership, team-building and
management development.

Since HH was established almost 15 years ago, all of its shares have been owned by
members of the Elliot family. In addition, the residential courses on offer and the range of
activities included in them have been restricted by the level of accommodation available in
Havant Hall itself and by the fact that HH has never used long-term external finance to
invest in developing the available facilities.

However, following the recent appointment of Andrew Elliot as chief executive in

succession to his father, John Elliot, who has retired, the family is now keen to expand
both the accommodation on the estate and the range of activities on offer to clients. A
recently commissioned report by a firm of management consultants has estimated that
HH’s proposed expansion plans will cost £2.8 million.

The most recent management accounts for HH can be summarised as follows:

Income Statement for the year ended 31 May 2011

£’000
Revenue 11,024

Profit from operations 1,281

Tax (359)
Profit after tax 922
Dividends (433)
Retained profit for the year 489

Balance Sheet as at 31 May 2011

£’000
Non-current assets 4,228
Current assets 616
Current liabilities (594)
4,250

Share capital (ordinary £1 shares) 2,000

Retained profits 2,250
4,250

Returns on invested funds and the proportion of profits retained are consistent with
previous years. Within its current assets HH has only a small cash balance and within its
current liabilities it has no borrowings.

Upon his retirement, the former chief executive, John Elliot, sold his shares to other
members of the family. At the time, the consideration paid for these shares was based on
an estimated valuation provided by HH’s auditors of £4 per share.

© The Institute of Chartered Accountants in England and Wales 2011 Page 4 of 6

There has been much debate among the directors regarding the source of finance for the
firm’s proposed expansion, with some directors wishing to continue with the policy of no
long-term debt and others believing that debt finance should be the preferred option.

Requirements

(a) Calculate HH’s cost of capital, stating and justifying the assumptions and methodology
you employ. (7 marks)

(b) Discuss the advantages and disadvantages of a rights issue to fund the proposed
expansion, and, as an alternative to a rights issue, whether a listing on the Alternative
Investment Market (AIM) would be appropriate, given HH’s particular circumstances.
(8 marks)

(c) If debt finance were to be used:

(i) explain the benefits that might accrue to HH if the proposed expansion was
financed by convertible loans rather than an ordinary bank loan; and

(ii) explain the implicit assumptions underlying the use of HH’s resultant weighted
average cost of capital as a discount factor in appraising the proposed expansion.
(7 marks)

(d) Without using calculations, identify the methods that the company’s auditors might
have used to value HH’s shares. (6 marks)

(28 marks)

PLEASE TURN OVER

© The Institute of Chartered Accountants in England and Wales 2011 Page 5 of 6

3.(a) Fratton plc (Fratton) trades extensively in Europe. The firm is due to receive €2,960,000 in
three months’ time. The following information is available:

(1) The spot exchange rate is currently €1.1845 - 1.1856/£.

(2) The three-month forward rate of exchange is currently at a 0.79 - 0.59 cent premium.

(3) The prices of three-month sterling traded option contracts (premiums in cents per £ are
payable up front, with a standard contract size of £62,500) are as follows:

Exercise price Calls Puts

€1.18 2.40 3.60

(4) Annual interest rates at the present time are as follows:

Deposit Borrowing
UK 1.15% 2.40%
Eurozone 0.75% 1.60%

Requirements

(i) Calculate the net sterling receipt that Fratton can expect in three months’ time if it
hedges its foreign exchange exposure using:

- the forward market;

- the money market; and,
- the options market, assuming the spot exchange rate in three months is:
(1) €1.1185 - 1.1200/£;
(2) €1.1985 - 1.2000/£. (14 marks)

(ii) Discuss the advantages and disadvantages of using futures contracts as opposed to
forward contracts when hedging foreign currency exposure. (7 marks)

3.(b) In addition, in three months’ time Fratton will be drawing down a three-month £2.5 million
loan facility which is granted each year by its bank to see the firm through its peak borrowing
period. The following information is available:

(1) The quotation for a ‘3-6’ forward rate agreement is currently 2.60 – 1.35.

(2) The spot rate of interest today is 2.40% pa and the relevant three-month sterling interest
rate futures contract (standard contract size £500,000) is currently trading at 97.20.

Requirements

(i) Explain how Fratton could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months’ time, the
spot rate of interest is 3% pa. (4 marks)

(ii) Explain how Fratton could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months’ time, the spot rate of interest is
3% pa and the price of the interest rate futures contract has fallen to 97. (5 marks)

(30 marks)

© The Institute of Chartered Accountants in England and Wales 2011 Page 6 of 6