PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 7 DECEMBER 2011

(2 hours)

FINANCIAL MANAGEMENT
This paper is made up 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 ball point 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 FIFTEEN 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
information and must NOT be removed
from the examination hall.

Place your label here. If you do not have a label

you MUST enter your candidate number in this
box.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN WORK

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Page 1 of 6

1.

Assume it is 31 December 2011. You work as a finance manager for Caldene Financial plc
(Caldene), a publicly quoted company that operates in the UK professional education market.
Caldene is currently financed by a mixture of debt and equity. You have been asked to
calculate an after-tax weighted average cost of capital (WACC) for use in assessing the
viability of a major investment in a new training business in India.
The companys balance sheet at 31 December 2011 showed the following long-term sources
of finance:
60 million ordinary shares of 25p each
Reserves
5% irredeemable preference shares of 100 each
9% redeemable loan stock (nominal value)

m
15
25
25
20

On 31 December 2011, the ordinary shares are quoted at 242p cum-dividend, with a dividend
of 10.4p per share due to be paid early in 2012. Over recent years, dividends have increased
in line with the companys target dividend growth rate of 4% pa.
The current market price of the 5% irredeemable preference shares is 103.50 (ex-dividend).
The 9% redeemable loan stock is redeemable at par on 31 December 2018. Its current
market price is 117 per 100 nominal (ex-interest). Interest on debt is payable annually on
31 December.
Caldenes directors would like you to assume that the rate of corporation tax will be 28% for
the foreseeable future.
Upon redemption of the existing loan stock on 31 December 2018, Caldene expects to
replace it with a much larger loan stock issue, part of which will be used to buy back the
irredeemable preference shares.
Requirements
(a)

(i)

Calculate Caldenes after-tax WACC at 31 December 2011.

(7 marks)

(ii)

Discuss the limitations of the dividend valuation model as a means of calculating

the cost of equity.
(3 marks)

(b)

Explain why it may not be suitable to use the WACC calculated in part (a) as a discount
factor when assessing the investment in India.
(4 marks)

(c)

Explain the benefits to managers of knowing the cost of equity capital of their
companies.
(4 marks)

(d)

Explain how, both in theory and in practice, the proposed loan stock issue in 2018 will
affect the WACC calculated in part (a) above.
(6 marks)
(24 marks)

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Page 2 of 6

2.

Ocean Train plc (Ocean) is considering establishing a premium, high-speed ferry service
between Liverpool and the Isle of Man, which lies around 70 miles off the coast of the UK.
Ocean has been researching the viability of this new service with a consultancy firm,
Skudder Brothers (SB). The service would be branded the Manx Link and would commence
on 1 January 2013. SB has advised Ocean to appraise the project over a three-year
investment horizon.
SB has drawn up the following estimates for the new ferry service:

Total number of ferry crossings

Average number of passengers per ferry crossing

Year to
31/12/2013
540
100

Year to
Year to
31/12/2014 31/12/2015
720
720
125
150

SB has also made the following estimates at 31 December 2012 prices:

- the average ticket price per passenger will be 90;
- there will be port charges of 1,100 per ferry crossing;
- administration costs will be 2 per passenger;
- labour costs for all on-board and port employees will be 600,000 pa;
- Ocean will have to spend 120,000 pa advertising the Manx Link service;
- Ocean will have to spend 100,000 pa on servicing and maintenance.
Given the environmentally-friendly nature of sea travel relative to air travel, the UK
government has stated that it would subsidise Oceans proposed service from its launch date
by making a payment to Ocean of 5% of annual sales revenue at the end of each calendar
year. However, this subsidy will only cover the first two years of the service. The subsidy will
have no tax impact.
To operate the service, Ocean would need to purchase a new ship from an Italian firm which
has confirmed that delivery could be made in time to start the service on 1 January 2013.
The purchase price would be 8 million, payable on 31 December 2012.
SB has looked into the likely residual value of the ship and feels that Ocean could expect to
realise 4 million on 31 December 2015 if it were to sell the ship at that time.
Oceans directors believe that the ship will attract full capital allowances at 20% pa on a
reducing balance basis commencing in the year of purchase and continuing throughout
Oceans ownership of the ship, except in the year of disposal when either a balancing charge
or allowance will arise. They also believe that Ocean would pay UK corporation tax at a rate
of 28%, payable at the end of the year to which profits relate.
Oceans finance director has estimated that loan interest charges of 168,000 pa will be
incurred by the company as a direct result of the Manx Link investment and has also
advised Oceans board of directors that SBs consultancy fee of 36,000 will be payable on
31 December 2012 whether or not Ocean decides to proceed with the investment.
Oceans directors currently use a real discount rate of 10% for investment appraisal. It can be
assumed that, unless otherwise stated, all cash flows take place on the last day of Oceans
accounting year (31 December).

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Page 3 of 6

Except for the purchase price and anticipated residual value of the ship, all costs and
revenues are expected to be subject to an annual inflation rate of 3%.
One director has requested that the sensitivity of the projects net present value be
investigated in respect of two key variables sales revenue and the residual value of the new
ship. However, another director has suggested that simulation would be a much better way
of appraising whether the company should proceed with the Manx Link investment.
Requirements
(a)

Calculate the net present value of the Manx Link proposal at 31 December 2012 and
advise Oceans board of directors whether it should proceed with the investment.
(17 marks)

(b)

Advise Oceans board of directors of the sensitivity of the net present value of the
Manx Link investment to:
(i)
(ii)

(c)

changes in sales revenue;

changes in the residual value of the new ship.

(3 marks)
(3 marks)

Explain the advantages and limitations of using simulation to appraise an investment

such as that being undertaken by Ocean.
(5 marks)
(28 marks)

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Page 4 of 6

3.

Assume throughout this question that the current date is 31 December 2011

(a)

Dayton plc (Dayton) is a UK manufacturer of thermal insulation products and does a

significant amount of business in mainland Europe. The company has just delivered a major
export order to a customer in Luxembourg at a price of 35 million payable in six months
time and as the companys finance director you are concerned about the potential impact of
currency volatility on the profitability of this particular order. You have obtained the following
exchange rate and interest rate data at the close of business today:
Spot rate (/)
6-month forward rate
Annual interest rates:
UK
Eurozone

1.1735 - 1.1760
0.34 cent - 0.26 cent premium
Deposit
Borrowing
2.25%
2.50%
1.75%
2.00%

Daytons bank has quoted a premium of 100,000 (payable up-front) for a 35 million sixmonth over-the-counter currency put option with an exercise price of 1.17/. Dayton has the
100,000 available on deposit at the current time and would leave it on deposit for the next
six months if it was not used to purchase the currency put option.
Requirements
(i)

Calculate the unhedged sterling value of the 35 million receivable if, in six months
time, sterling has depreciated by 5%.
(2 marks)

(ii)

Calculate the hedged sterling value of the 35 million receivable if Dayton chooses to
use a forward exchange contract.
(2 marks)

(iii)

Calculate the hedged sterling value of the 35 million receivable if Dayton chooses to
use a money market hedge and calculate the effective forward exchange rate achieved.
(2 marks)

(iv) Calculate the hedged sterling value of the 35 million receivable if Dayton chooses to
use an over-the-counter currency put option and the spot exchange rate in six months
time is:
(1)
1.14/;
(2)
1.20/.
(3 marks)
(v)

Discuss how the principle of interest rate parity explains the difference between the
spot and forward rates of exchange quoted above.
(3 marks)

(vi) With regard to a firms exposure to exchange rate movements, distinguish between
economic exposure and translation exposure.
(2 marks)
(vii) Discuss the long-term strategies a firm may adopt to hedge its economic exposure.
(4 marks)

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Page 5 of 6

(b)

Daytons employee pension fund currently holds a portfolio of FTSE 100 shares with a value
of 48 million. The pension fund trustees are worried that by the end of September 2012,
when they plan to liquidate much of the portfolio, share prices will have fallen. They are
considering the use of FTSE 100 index futures to hedge against the risk of capital loss. The
current value of the FTSE 100 index is 5,000. The index value for contracts to be completed
at the end of September 2012 is 4,900 and the price of futures is 10 per full index point.
Requirements

(c)

(i)

Assuming that at the end of September 2012 the portfolio value has dropped to
46.98 million, and the September 2012 future is quoted at 4,800, illustrate how a
FTSE 100 index futures hedge could protect the pension fund against a drop in
share prices, showing the value of each contract and the required number of contracts
to effect the hedge.
(4 marks)

(ii)

Calculate and explain the hedge efficiency achieved by the FTSE 100 index futures
hedge.
(2 marks)

Dayton has a subsidiary, Fulton Energy Ltd (Fulton), a manufacturer of domestic heating
products. Fultons business tends to be highly seasonal. From September to March the
business tends to be highly cash generative but in the other six months of the year the
business needs to borrow to cover its outgoings.
At the end of March 2012 Fulton will move into its six-month borrowing period and will need
to borrow 3m for the entire six months. Fultons directors are concerned that interest rates
are expected to increase over the next few months. Annual interest rates and forward rate
agreements (FRAs) are currently quoted as follows:
Spot
3-6 FRA
3-9 FRA

2.50 2.25%
2.57 2.34%
2.69 2.39%

Requirement
By calculating the interest cash flows, demonstrate the result of using a forward rate
agreement and state the effective loan rate achieved if on 31 March 2012 the relevant spot
interest rate has moved to:
(i)
(ii)

3.5%;
1.5%.

(4 marks)
(28 marks)

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