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CAP2 SFMA S13 23/04/2013

CA Proficiency 2


PAPER 2 STRATEGIC FINANCE &
MANAGEMENT ACCOUNTING


SUMMER 2013 (Thursday 27
th
June 2013 - 9.30 a.m. to 1.20 p.m.)




INSTRUCTIONS TO CANDIDATES


1. The first 20 minutes of this examination is dedicated to reading time. During this time, candidates may refer
to their materials and make notes on this examination paper or in their own note book.


Candidates are NOT permitted to open their answer books until instructed to do so.


2. Answer Question 1 in Section A.

Answer ANY TWO of THREE Questions in Section B.


3. Candidates should indicate clearly whether they are answering the paper in accordance with the law and
practice of Northern Ireland or the Republic of Ireland.


4. Candidates should deem each monetary amount shown with the / symbol to be stated in their relevant
currency.


5. All workings should be shown.


6. Answers should be illustrated with examples where appropriate.


7. Section A begins on Page 2 overleaf.



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CAP2 SFMA S13 23/04/2013
SECTION A

CASE STUDY
Answer Question 1 (Compulsory)

QUESTION 1 (Compulsory)

Background
Bourne plc (BOURNE) is an Irish based company operating in the pharmaceutical sector and was established by
Ms. Olive Barry over twenty years ago. Olive currently occupies the position of Chair of BOURNEs Board of
Directors. BOURNE specialises in the research, development, production and sale (on a global basis) of a range of
medications targeting certain neurological conditions.

As a result of the expensive nature of the industry in which BOURNE competes, coupled with continual downward
price pressures (e.g. repeated Government demands for cheaper medicines), cost control is of critical importance
for BOURNE in achieving the companys annual financial targets. Consequently, BOURNEs newly appointed
Managing Director, Mr. Ken Walsh, has been heavily incentivised by BOURNEs Board of Directors to ensure that
BOURNE achieves its 2014 profit target of / 3,500,000.

Performance Measurement
BOURNE is organised on a divisional basis in accordance with each of the three main neurological conditions it
specialises in, i.e. Alpha, Beta and Charlie. Each of BOURNEs divisions is treated as an investment centre
and divisional management are encouraged by the Board of Directors to pursue projects which align with
BOURNEs overall long-term strategic goals one of which is profit maximisation. Certain divisional decisions, such
as, capital investment and debt financing over a predetermined monetary threshold, must be agreed in advance
with the Board of Directors (via Ken as an intermediary).

In terms of evaluating the annual performance of each division, BOURNE uses a combination of the following
measures: return on capital employed (ROCE) and residual income (RI). Each division has recently submitted
some initial 2014 budgetary data to Ken for approval. See Appendix I for the relevant budgetary data.

Since the data in Appendix I was accumulated, the management of the Beta division have requested that Ken
seek the Board of Directors approval for a major clinical trial of a new form of medication which would commence
at the end of 2014; and if successful, could potentially generate significant profits for BOURNE from 2018 onwards.
However, as Ken has some concerns about the proposed scale of the trial, coupled with the potential impact on his
ability to achieve his annual bonuses over the next few years, he has requested that BOURNEs Board of Directors
reject the Beta divisions request.

Transfer Pricing Proposal
At a recent meeting of BOURNEs Board of Directors, it was suggested that BOURNE seriously examine the
feasibility of establishing an additional division on a particular Caribbean island noted for its low rate of corporation
tax. According to the Director who made the suggestion, by using the new division to license and distribute
BOURNEs output internationally, BOURNE could potentially reduce their overall corporation tax liability, which
would in turn allow BOURNE to generate additional profits for re-investment.

Financial Analysis
Ken has met with BOURNEs Financial Director, Mr. Ted Moles, to discuss a proposal to acquire Dexcon Limited
(DEXCON), a rival company, also in the pharmaceutical industry. DEXCON is attractive because its products
would complement those manufactured by BOURNE. Following preliminary discussions with DEXCONs Board of
Directors, BOURNE has been provided with financial information on DEXCON (See Appendix II). Ted has informed
Ken that he has some concerns about the financial performance and the management of working capital in
DEXCON and wants to investigate these issues further before making any recommendation regarding the potential
acquisition of the company. In order to assist Ted with his recommendations he has collected financial performance
data for BOURNEs Charlie division (See Appendix II). The financial performance of the Charlie division is very
similar to the other divisions in BOURNE and Ted feels this information would prove useful in analysing DEXCONs
financial performance.

Raising Capital
BOURNE intends to raise additional capital to fund investment in several projects over the next year. Part of this
financing plan involves a rights issue, to raise a total of / 1,500,000. The issue will be announced next week on
the following terms: 1 new share for 6 existing shares at a discount of 30% of BOURNEs current share price.
BOURNEs shares are currently trading at / 3.45. Ken has held preliminary discussions with BOURNEs larger
shareholders over the last few weeks about BOURNEs plan to raise additional equity capital. Terry Neil,
BOURNEs largest shareholder, with a 9% interest in BOURNE, has told Ken he would not be in a position to
subscribe to a rights issue.
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CAP2 SFMA S13 23/04/2013
QUESTION 1 (Contd)


Requirement:

(a) For each of BOURNEs three divisions, calculate the 2014 budgeted return on capital employed (ROCE) and
residual income (RI). See Appendix I for the relevant data.

Assume that BOURNE expects all three divisions to generate a minimum return of 9% per annum. State clearly
any assumptions that you make.
6 Marks

(b) Suggest (with reasons) what improvements you would make to BOURNEs current system of divisional
performance evaluation.
8 Marks

(c) Outline the potential negative consequences for BOURNE as a result of Kens decision to recommend the
rejection of the Beta divisions request for a major clinical trial of a new form of medication.
7 Marks

(d) Outline FOUR potential limitations for BOURNE associated with the transfer pricing proposal as suggested by
a member of BOURNEs Board of Directors.
8 Marks

(e) Calculate the 2012 Cash Conversion Cycle for DEXCON (using the data provided in Appendix II) and briefly
explain the significance of this number.
5 Marks

(f) Using the data provided in Appendix II, analyse the financial performance of DEXCON.
10 Marks

(g) Based on your analysis in part (f), suggest and describe FOUR actions which BOURNE should take to remedy
any areas of underperformance evident in DEXCON should BOURNE proceed with the acquisition.
8 Marks

(h) Calculate the theoretical ex-rights share price and outline the options open to Terry Neil if BOURNE proceeds
with the rights issue.
6 Marks
Total Marks: 58 Marks















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CAP2 SFMA S13 23/04/2013
SECTION B
Answer ANY TWO of THREE Questions in this Section
QUESTION 2

Crystal Limited (CRYSTAL) (a user of standard costing) is an award winning firm that designs, produces and sells
hand-crafted crystal ornaments globally through a network of independent retailers and via their website. As a
result of ever-increasing competition mainly from low-cost producers located in the Far East, CRYSTALs newly
appointed Production Manager, Mr. Joe Flynn, is eager to ensure that CRYSTALs production process (which is
primarily labour based) is as efficient and cost effective as possible, whilst simultaneously maintaining CRYSTALs
quality ethos.

As a first step, Joe has accumulated the following 2012 budgeted and actual labour related information pertaining
to one of CRYSTALs most popular ornaments, Harp, during which time 2,500 units (i.e. ornaments) were
produced. (Note: all units of Harp produced by CRYSTAL require the input of all three types of labour prior to
completion.)

2012 - Budgeted Information (based on 2,500 units)
Type 1 Labour 5,000 hours / 25.00 per hour
Type 2 Labour 2,000 hours / 35.00 per hour
Type 3 Labour 3,000 hours / 18.00 per hour

2012 - Actual Information (based on 2,500 units)
Type 1 Labour 4,800 hours / 27.50 per hour
Type 2 Labour 2,100 hours / 34.00 per hour
Type 3 Labour 3,250 hours / 17.75 per hour

Joe has since discovered that as a result of an accounting error, the standard rate of pay per hour in 2012 for all
Type 2 Labour employees used in the production of Harp should have been / 32.50.

Additionally, due to an intensive in-house training programme held at the end of 2011 for all Type 2 Labour
employees involved in the production of Harp, the standard amount of Type 2 Labour hours required to produce
each unit of Harp in 2012 should have been 0.75 hours.

Requirement:

(a) In relation to CRYSTALs production of Harp in 2012 calculate the total labour mix variance and the total
labour yield variance. 6 Marks

(b) From the perspective of CRYSTALs use of Type 2 Labour during the production of Harp in 2012,
calculate the following variances (all workings should be clearly shown.);
(i) Labour rate variance (before adjusting for planning & operational issues)
(ii) Labour efficiency (usage) variance (before adjusting for planning & operational issues)
(iii) Labour rate planning variance
(iv) Labour rate operational variance
(v) Labour efficiency (usage) planning variance
(vi) Labour efficiency (usage) operational variance 9 Marks

(c) Joe is concerned that although the hourly Type 2 Labour rate increased from / 32.50 to / 34.00 in
2012, labour efficiency did not improve. Consequently, Joe has suggested that the hourly labour rate be
cut to / 30.00 until the expected labour efficiency gains are realised.

Critically evaluate Joes proposal as outlined above.
6 Marks
Total Marks: 21 Marks
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CAP2 SFMA S13 23/04/2013
QUESTION 3

Mr. Jim Starling, the Managing Director of Starling Products Limited (STARLING), has become increasingly
stressed recently due to the rapid expansion of the company. STARLING, which manufactures cleaning products,
has grown from a small domestically focussed producer to a major player in the European market. Sales to the US
and Asian markets were also increasing for STARLING.

STARLING had been founded by Jims father, Mike Starling, in 1979 and for the first twenty five years of its
existence sold all of its output to supermarket chains and hardware shops in Ireland. In 2004, Jims nephew Paul
Neilson, developed a new chemical for cleaning windows which was dramatically more effective than any other
product on the market. Jim saw an opportunity and offered Paul a 25% shareholding in STARLING in return for the
sole rights to manufacture and sell this new chemical. Paul had acquired a European patent on the product at this
stage.

Revenues had grown from / 1,600,000 in 2004 to / 17,500,000 in 2012 but in many ways STARLING had not
changed as it grew. Its management structure was the same in 2012 as it had been in 2000. Jims wife, Ellen, was
STARLINGs only other director and worked part-time in STARLING with a responsibility for credit control and
general working capital management. Ellen was struggling to deal with all of STARLINGs new debtors, many of
whom were overseas. Jim also felt he no longer had a sense for how STARLING was performing as it had grown
so big and complex.

The priority right now for Jim was expanding production capacity. STARLING currently manufactures its products in
a factory in the West of Ireland which is operating at maximum capacity. An adjacent site has been acquired for a
new factory and Jim has now to secure funding for this new factory. Jims intention is to use debt to fund the factory
as STARLING is currently an all equity financed company, however Jim is worried about interest rate increases in
the future. Jim has read a newspaper article recently saying that interest rates were at an all-time low and could
only go in one direction. STARLING would need to borrow / 8,000,000. The 3 month Libor/Euribor rate is
currently 4.5%. STARLINGs bank was very keen to lend the money and offered two financing alternatives to Jim.
The two financing alternatives are detailed below.

Alternatives proposed by STARLINGs bank:

1. Fixed rate, interest only, loan of / 8,000,000 for 5 years. With capital repayable in 5 years.
Interest rate of 6.75%. Payments would be made annually in arrears. An arrangement fee of
/ 100,000 would be payable immediately.

2. Variable rate, interest only, loan of / 8,000,000 for 5 years. Variable rate will be adjusted on a
weekly basis. With capital repayable in 5 years. Interest rate of 3 month Libor/Euribor + 1.5%.
This can be hedged using a swap contract where STARLING would pay a fixed rate of 6.35% and
would receive 3 month Libor/Euribor + 1.5%. Payments would be made annually in arrears. A fee
of 1% of the principal amount is payable immediately for arranging a swap.


Other Relevant Information
- You should ignore any interest rate exposure after the first year.
- You should ignore the impact of taxation.
- You should ignore the time value of money.

Requirement

(a) Other than the interest rate risk associated with the proposed new borrowing, identify FOUR key risks facing
STARLING and outline how STARLING should address each of these risks.
8 Marks

(b) Outline the cumulative cash-flows which will arise in the first year from each of the two financing alternatives
proposed by STARLINGs bank assuming that:
(i) immediately after borrowing Libor/Euribor falls to 2.5% and then remains unchanged
thereafter, and
(ii) immediately after borrowing Libor/Euribor rises to 6% and then remains unchanged thereafter.
9 Marks

(c) Advise STARLING on which of the two financing alternatives it should choose. In your answer outline the
factors you considered in making your decision.
4 Marks
Total Marks: 21 Marks
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CAP2 SFMA S13 23/04/2013
QUESTION 4

The Board of Directors of Hexagon Limited (HEXAGON) has just had a stormy meeting, where the future
direction of HEXAGON was discussed at length, with no agreement reached. The Board comprises three directors;
Bill O Brien and Michael Melvin, the founders of HEXAGON, each of whom own 33% of the equity in HEXAGON
and the remaining 34% of the equity is owned by Tony Long, an investor who had bought shares in HEXAGON
when it was expanding several years ago.

Tony was pushing for a stock market flotation as he has always considered his investment in HEXAGON to be a
medium term one. HEXAGON had grown strongly since Tonys investment and Tony saw the current buoyancy of
the stock market as an opportunity to cash-out. Tony also argued that the three directors had all of their wealth tied
up in HEXAGON and that this was not sensible. Bill, however, strongly believed that HEXAGON was going to grow
rapidly over the next few years and couldnt see the sense in sharing that growth with new investors that would buy
shares at an Initial Public Offering (IPO). Hexagon wouldnt need any funding for the foreseeable future, in fact it
was generating significant profits every year, more than enough to finance any investments required. Bill saw a
stock market listing as an unnecessary expense and argued that, after the listing, the three directors would no
longer be able to pursue their chosen strategy for HEXAGON they would have to satisfy the market, which was
obsessed with the next years earnings.

Michael could see merits in the proposal to float HEXAGON but had some concerns. Michael was not convinced
the directors could get a fair price for any shares sold to new investors in an IPO and was also concerned about
losing control of HEXAGON and any conflict with new shareholders. The Directors agreed that they would perform
a valuation of HEXAGON using the information in Appendix I below before making a decision on a stock market
flotation.

Appendix I - Forecasted financial performance and investment requirements for the next five years.
30 June
2014
/ 000
30 June
2015
/ 000
30 June
2016
/ 000
30 June
2017
/ 000
30 June
2018
/ 000
Sales 3,600 3,850 3,900 4,550 4,900
EBIT 900 883 1,362 1,408 1,421
Interest 285 310 310 325 350
Tax 68 60 153 198 155

Additional Information
Use the following definition of Free Cash Flow (FCF).
FCF = EBIT Tax + Depreciation Increase in net working capital Increase in capital investment
Depreciation is expected to be / 285,000 in each of the years 2014 to 2018.
Net working capital is currently / 1,120,000, which equates to 35% of 2013 sales. It is expected that this
ratio of working capital to sales will be required in the future.
Annual capital investment has historically averaged 15% of annual sales.
The three directors believe a growth rate of 4% in FCF could be maintained indefinitely from 2018.
HEXAGON pays corporation tax at a rate of 20%.
HEXAGON is financed by ordinary equity and traded bonds.
The bonds were issued eight years ago at a nominal value of / 100. They currently trade at / 106.55.
The bonds pay an annual coupon of 7.5%. This coupon will be paid in two weeks and the bonds are
currently trading cum-interest. These bonds are irredeemable.
Octagon plc. (OCTAGON) is a publicly traded company, which is very similar to HEXAGON in most
respects. OCTAGON has just paid a dividend of / 0.09 per share and analysts expect OCTAGONs
dividends to grow at an annual rate of 4.5% in the future. OCTAGONs share price closed at / 1.24
yesterday.
HEXAGONs most recent Statement of Financial Position reports values of / 1,857,000 and
/ 2,355,000 for long term debt and equity respectively.

Requirement
(a) Estimate the Weighted Average Cost of Capital (WACC) of HEXAGON. (Explain any assumptions you make.)
6 Marks

(b) Estimate the value of HEXAGON using a Free Cash Flow approach. (Explain any assumptions you make.)
9 Marks

(c) Critically assess the arguments each of shareholders have made for and against HEXAGON seeking a listing
on the stock market. 6 Marks
Total Marks: 21 Marks