Financial Management - Professional Stage – September 2011

PROFESSIONAL STAGE - FINANCIAL MANAGEMENT OT EXAMINER’S 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 6 6 0

2 3 3 0

3 6 4 2

Total 15 13 4

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

Details of the two questions with facilities of less than 40% are shown here:

1. Candidates were given a list of the costs (including lost contribution) for a company’s proposal to build a
new extension to its factory. They were also given the cost for the extension as per a quote from an external
contractor. They were asked to calculate the net gain or loss if the company did its own construction work.
The majority of those candidates who answered the question wrongly failed to deal correctly with the lost
contribution figure.

2. Candidates were given the details of two mutually exclusive three-year projects - initial investment in
equipment, scrap value of the equipment, cost of capital and NPV. They were asked to calculate the
sensitivity of the scrap value as regards which project to chose. Most candidates who answered the
question incorrectly failed to (i) deal with the impact of discounting correctly or (ii) tested the sensitivity of the
scrap value against the wrong variable.

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 Financial Management - Professional Stage – September 2011

MARK PLAN AND EXAMINER’S 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. In many cases,
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.

General point about candidates’ handwriting

There were a number of instances in the scripts where the markers found it extremely difficult to read
the candidates’ handwriting. Markers make every effort to read even the worst presentation, but if a
marker is unable to read what has been written then no marks can be awarded for the passage in
question.

Question 1

Total marks: 27

General comments
This question had the highest average mark on the paper and most candidates did very well.

It was a five-part question that tested the candidates’ understanding of the investment decisions element
of the syllabus.

The scenario was fairly standard and in part (a) for 12 marks candidates had to advise the directors of the
company in question whether to proceed with a planned investment in capital equipment, based on an
NPV calculation. Parts (b) and (c), which were worth 9 marks in total, asked candidates to calculate the
sensitivity of their calculations in part (a). To do well here, they would have had to show an understanding
of the impact of taxation, capital allowances and the discount rate on their original figures. Part (d) for 2
marks asked candidates to demonstrate their knowledge of theory by asking for explanations of their
treatment of interest in the NPV calculation. Part (e) for 4 marks required candidates to explain the theory
behind Shareholder Value Analysis (SVA) and how SVA could be applied to the scenario.

1(a)
2011 2012 2013 2014
£ £ £ £
Capital equipment cost (1,300,000) 600,000
Tax saved on equipment (W1) 72,800 58,240 46,592 18,368
Sales (W2) 2,310,000 2,668,050 3,081,598
Variable costs (W3) (1,296,000) (1,539,648) (1,829,102)
Fixed costs (W4) (442,800) (478,224) (516,482)
Taxation on extra profit (W5) (159,936) (182,050) (206,084)
Working Capital (W6) (231,000) (35,805) (41,355) 308,160
Total cash flows (1,458,200) 433,699 473,365 1,456,458
14% factor 1.000 0.877 0.769 0.675
PV (1,458,200) 380,354 364,018 983,109
NPV 269,281

The NPV is positive and so UGL’s management should proceed with the proposed investment as it will
enhance shareholder value.

Workings
W1 2011 2012 2013 2014
£ £ £ £
WDV b/f 1,300,000 1,040,000 832,000 665,600
WDA @ 20% (260,000) (208,000) (166,400) (65,600)
WDV/sale 1,040,000 832,000 665,600 600,000
Tax saving @ 28% 72,800 58,240 46,592 18,368

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 Financial Management - Professional Stage – September 2011

W2 2011 2012 2013 2014

£ £ £ £
Sales £2,200,000 x 1.05 2,310,000
£2,310,000 x 1.05 x 1.10 2,668,050
£2,668,050 x 1.05 x 1.10 3,081,598

W3
VC’s £1,200,000 x 1.08 1,296,000
£1,296,000 x 1.08 x 1.10 1,539,648
£2,668,050 x 1.08 x 1.10 1,829,102

W4
FC’s (£427,000 - £17,000) x 1.08 442,800
£442,800 x 1.08 478,224
£478,224x 1.08 516,482

W5
Sales (W2) 2,310,000 2,668,050 3,081,598
VC’s (W3) (1,296,000) (1,539,648) (1,829,102)
FC’s (W4) (442,800) (478,224) (516,482)
Extra profit 571,200 650,178 736,014

Tax on extra profit @ 28% 159,936 182,050 206,084

W6 - Working Capital
Total £2,310,000 x 10% 231,000
£2,668,050 x 10% 266,805
£3,081,598 x 10% 308,160
Change in working capital (231,000) (35,805) (41,355) 308,160
Here most candidates scored high marks and, because the markers apply the “follow through” rule, early
mistakes made were not unduly detrimental. The most common errors were (i) to ignore the volume
change for sales and variable costs or (ii) just the latter plus including the interest charge.

Total possible marks 12

Maximum full marks 12

1(b)
2012 2013 2014 PV
£ £ £ £
Sales 2,310,000 2,668,050 3,081,598 6,157,679
Variable costs (1,296,000) (1,539,648) (1,829,102) (3,555,225)
Contribution 1,014,000 1,128,402 1,252,496 2,602,454
less: Taxation (283,920) (315,953) (350,699) (728,687)
Net cash flow 730,080 812,449 901,797
Discount factor 0.877 0.769 0.675
Total PV 640,280 624,773 608,713 1,873,767

Sensitivity of sales volume is £269,281 = 14.4%

£1,873,767

So, ignoring the impact on working capital, if sales volumes are 14.4% lower than estimated, the NPV will
be negative and UGL should not proceed with the investment.

In this part many candidates scored full marks. Otherwise, forgetting to include the variable costs and
taxation were the most common errors.

Total possible marks 5

Maximum full marks 5

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 Financial Management - Professional Stage – September 2011

1(c)
Impact of scrap value of £100,000 £
Loss of scrap value (500,000)
Increase in balancing allowance (£500,000 x 28%) 140,000
Net decrease in cash flow (Y3) (360,000)

PV of loss of cash flow in 2014 (£360,000 x 0.675) 243,000

Thus the NPV of the proposed scheme would decrease by £243,000 and this means that the amended
NPV would be £26,281 – so a much more marginal decision for the UGL directors.
This was also generally done well, but in the poorer scripts candidates forgot to take account of the impact
of the balancing allowance on the new NPV figure.

Total possible marks 4

Maximum full marks 4

1(d)
The process of discounting takes account of the time value of money, e.g. interest paid on funds
borrowed. Thus the interest payments will be dealt with as part of the WACC and so, to avoid double
counting, it is necessary to ignore specific interest payments.
This was not done well and far too many candidates did not know why the interest charge should have
been excluded.

Total possible marks 2

Maximum full marks 2

1(e)
Shareholder Value Analysis (SVA) concentrates on a company’s ability to generate value and thereby
increase shareholder wealth. SVA is based on the premise that the value of a business is equal to the sum
of the present values of all of its activities. SVA posits that a business has seven value drivers:

1. Life of projected cash flows

2. Sales growth rate
3. Operating profit margin
4. Corporate tax rate
5. Investment in non-current assets
6. Investment in working capital
7. Cost of capital

The value of the business is calculated from the cash flows generated by drivers 1-6 which are then
discounted at the company’s cost of capital (driver 7).

In the case of UGL, all of the seven SVA value drivers are relevant and are used in the calculation. UGL’s
(three year) strategy of expanding its solar panel market will increase the value of the firm.
This part was answered reasonably overall, but candidates scored low marks if SVA was not adequately
explained or if SVA’s value drivers were not related to part (a).
Total possible marks 4
Maximum full marks 4

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 Financial Management - Professional Stage – September 2011

Question 2

Total marks: 27

General comments
This question had the lowest average mark on this paper and caused problems for a large number of
students

It was a five-part question that tested the sources of finance and cost of capital elements of the syllabus. It
was a good discriminator in that its structure will have caused candidates to plan their approach carefully.
In the scenario a shareholder is asking for an explanation of information given out at a company’s recent
AGM. In part (a) for 4 marks, rather than being asked to calculate the company’s WACC, candidates were
given that figure and asked to prove it. In part (b) for 5 marks candidates had to calculate the total annual
interest and dividends payable and reconcile this to the WACC calculation in part (a). For 4 marks in part
(c) candidates were asked to explain the meaning of WACC as a hurdle rate. Part (d) for 8 marks required
candidates to rebuild the company’s most recent Income Statement from the information available to them.
Finally, for 6 marks, in part (e) candidates had to explain the factors surrounding the company’s rate of
dividend growth.

2(a)
Type of Capital
Market Capitalisation (£)
Ordinary shares (50p) (£4m/£0.50) x £2 16,000,000
Preference shares (25p) (£0.8m/£0.25) x £0.80 2,560,000
Irredeemable debentures £1.4m x 110/100 1,540,000
20,100,000

Ordinary shares 10.50% x £16,000/£20,100 8.358%

Preference shares 8.75% x £2,560/£20,100 1.114%
Irredeemable debentures 3.60% x £1,540/£20,100 0.276%
Weighted Average Cost of Capital 9.748%

Most candidates scored full marks here, but a surprising minority could not calculate the number of shares
and debentures.

Total possible marks 4

Maximum full marks 4

2(b)
£
Ordinary dividends = £16m x 10.5% (or 0.105 = d/2; d = 0.21 x 8m) 1,680,000
Preference dividends = £2.56m x 8.75% (or 0.0875 = d/0.80; d = 0.07 x 3.2m) 224,000
Debenture interest = £1.54m x 3.6% (or 0.036 = I(1-t)/110; I(1-t) = 3.96 x 0.014m) 55,440
1,959,440
£1,959,440 / £20,100,000 = 9.748%
Part (b) was poorly done although a minority of candidates did secure full marks. The majority however
were unable to work to an unknown figure which isn't the cost of capital (as this was given in the question).
This was surprising as candidates would have learnt the formulae required or, in the case of the Dividend
Valuation Model, it was given in the formulae sheet. Also many OT’s in the learning materials require
candidates to work backwards towards an answer, as was required here.

Total possible marks 5

Maximum full marks 5

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 Financial Management - Professional Stage – September 2011

2(c)
The hurdle rate (WACC) is:
(a) the cost of funds that a company raises and uses, and the return that investors expect to be paid for
putting funds into the company and therefore is
(b) the minimum return that a company must make on its own investments, to earn the cash flows out of
which investors can be paid their return.

If the company does not achieve this hurdle rate on its investments then it will be investing in projects that
produce a negative net present value and the value of the company (and the wealth of the shareholders)
will decline.
In this part many candidates knew about the desirability and impact of positive NPV’s, but could not
explain what a WACC actually is, i.e. a required rate of return.

Total possible marks 5

Maximum full marks 4

2(d)
Earnings (see Workings below) £1,980,000
Ordinary shares in issue 8 million
Earnings per share (£1,980,000/8,000,000) £0.2475

Price earnings Ratio £2.00/£0.2475 8.08

Gearing ratio = Fixed Return Capital £2.56m + £1.54m 20.4%

Total Long term Capital £20.1m

Profit before interest and tax – see Workings below

Workings (working upwards) £

Profit before interest and tax 3,138,111
less: Interest (£1.54m x 3.6% / 0.72) (77,000)
Profit before tax 3,061,111
less: Corporation Tax (£2,204,000 x 28/72) (857,111)
Profit after tax 2,204,000
less: Preference dividends (£2.56m x 8.75%) (224,000)
Earnings 1,980,000
less: Ordinary dividends (£16m x 10.5%) (1,680,000)
Retained Profits (given) 300,000

This was in general answered very poorly indeed. Too many candidates treated retained earnings and
earnings as the same figure. A significant minority added ordinary and preference share prices for the P/E
calculation. The majority could not work backwards, up through the Income Statement, despite this
appearing in the learning materials.

Total possible marks 8

Maximum full marks 8

2(e)
Key points regarding dividend growth:
It should be future growth – forecasts, strategy, retentions etc – but often use past i.e.
Past dividends per share or
The Gordon growth model
0% growth means constant share price with no capital growth. The return is just dividend yield.
Here virtually no-one considered future forecasts. When past dividend growth rates and the Gordon model
were used few candidates noted the assumption that past growth = future growth. The significance of the
company’s 0% dividend growth rate was poorly answered. The question was couched in terms of returns
but few candidates spotted that there would be no capital return on the current share price.

Total possible marks 6

Maximum full marks 6

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 Financial Management - Professional Stage – September 2011

Question 3

Total marks: 26

General comments
This question had a good average mark and was generally done well.

It was a three-part question that tested the financial risk elements of the syllabus. The scenario was that of
a company (i) due a large receipt of foreign exchange and (ii) having a surplus of funds (sterling) to invest.
Candidates were asked to give advice. In part (a) for 10 marks candidates had to calculate the outcome of
employing four different forex hedging techniques. Part (b) was worth 8 marks and required candidates to
explain the issues that arose for the company’s management from the calculations made in part (a). In part
(c) for 8 marks candidates had to advise the company’s management as to the effectiveness of each of
four techniques for hedging interest rate risk.

3(a)
(i) Expected spot rates at 30 September 2012 9.230 x 10% 0.923
9.330 x 10% 0.933
9.430 x 40% 3.772
9.530 x 40% 3.812
Expected spot rate at 30 September 2012 (NK/£) 9.440

So sterling receipt if no hedging (i.e. spot rate at 30/9/12) 16.75m NK £1,774,364

9.440

(ii) Forward contract

Sterling receipt: 16.75m NK 16.75m NK £1,771,549
(9.325 + 0.13) 9.455

(iii) Money market hedge

NK borrowed now 16.75m NK 16.75m NK 15,712,945 NK
(1 + 6.6%) 1.066

Sterling receipt, converted at spot rate 15,712,945 NK £1,685,034

9.325

Sterling invested at 4.3% pa £1,685,034 x (1 + 4.3%) £1,757,490

(iv) Option
Put option (sell NK) exchange rate is 9.300 NK/£

Sterling receipt 16.75m NK 1,801,075

9.300
less: Premium cost £25,000 x 1.043 (assumed on deposit) (26,075)
Sterling receipt - net £1,775,000
Most students scored high marks in this part. However, the most common mistake was to use a call option
instead of a put option.
Total possible marks 10
Maximum full marks 10

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 Financial Management - Professional Stage – September 2011

3(b)
The directors’ attitude to risk will be an important factor.

Sterling receipt with current spot rate (9.325NK/£) 16.75m NK £1,796,246

9.325

The forward contract (assuming that there is no arrangement fee), produces a higher sterling receipt than
the money market hedge. Both of these hedging methods will produce a fixed sterling amount, known at
the start of the hedging period.

If the research paid for is accurate then it would be better to not hedge at all as the spot rate in twelve
months’ time will produce a sterling receipt of £1,774, 364. If the current spot rate remains constant
(unlikely bearing in mind the comparative interest rates in the UK and Norway) this would produce an even
higher sterling receipt of £1,796,246. However, if the future spot rate is 9.53 (as per the question) the
receipt is only £1,757,608 i.e. worse than the forward contract.

The put option at the strike price of 9.30NK/£ produces an attractive amount of sterling £1,775,000 and
management might consider paying the £25,000 premium and also have the chance to benefit from a low
exchange rate in September 2012. At a future spot rate of 9.23 (as per the question) the option would be
abandoned with a receipt of (£1,814,735 – 26,075) £1,788,660.
In part (b), although there were some very good answers, too few candidates were able to apply theory to
practice i.e. raise issues pertinent to the scenario.
Total possible marks 8
Maximum full marks 8

3(c)
(i) FRA – this would fix the rate of interest receivable by DDS. Upside potential is therefore removed. It can
be tailored to the exact amount to be invested by DDS.
(ii) Interest rate future – DDS would buy interest rate futures, but these are for standardised amounts,
which could be impractical.
(iii) Interest rate option – DDS would have the right to deal at an agreed interest rate at maturity date, i.e.
March 2012. DDS would buy traded call options, but these are for standardised amounts and may not
be suitable. So, for more flexibility, DDS could purchase a tailored over the counter (OTC) option.
(iv) Interest rate swap – it would be impractical as a long term hedge for a large deposit. The hedge is only
for six months. It would be difficult to find a counterparty.
Here the better answers identified what needed to be done with the FRA, the future and the option rather
than just describing them. Few candidates spotted that an interest rate swap would be inappropriate as it
is a long term strategy.

Total possible marks 9

Maximum full marks 8

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