PART 3

WEDNESDAY 13 DECEMBER 2006

QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A

BOTH questions are compulsory and MUST be

answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 8, 9, 10 and 11

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination
hall

The Association of Chartered Certified Accountants

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

Stanzial plc is a UK based telecommunications company listed on the FTSE 250 index. The company is considering
the purchase of Besserlot Ltd, an unlisted company that has developed, patented and marketed a secure, medium
range, wireless link to broadband. The wireless link is expected to increase Besserlots turnover by 25% per year for
three years, and by 10% per year thereafter. Besserlot is currently owned 35% by its senior managers, 30% by a
venture capital company, 25% by a single shareholder on the board of directors, and 10% by about 100 other private
investors.
Summarised accounts for Besserlot for the last two years are shown below:
Profit and loss accounts for the years ended 31 March (000)
2006
2005
Turnover
22,480
20,218

Operating profit before exceptional items

1,302
820
Exceptional items
(2,005)

Interest paid (net)

(280)
(228)

Profit before taxation

(983)
592
Taxation
(210)
(178)
Dividend
(200)
(100)

Retained earnings
(1,393)
314

Balance sheets as at 31 March (000)

2006
Fixed assets (net)
Tangible assets
Goodwill
Current assets
Stocks
Debtors falling due within one year
Debtors falling due after more than one year
Cash at bank and in hand
Creditors
Amounts falling due within one year
Net current assets
Net assets
Capital and reserves:
Called up share capital (25 pence par)
Profit and loss account
Other reserves
Total equity shareholders funds

2005

5,430
170

5,048
200

3,400
2,658
100
48

2,780
2,462
50
48

5,520
686

6,286

4,823
517

5,765

2,000
3,037
1,249

6,286

1,000
4,430
335

5,765

Other information relating to Besserlot:

(i)
Non-cash expenses, including depreciation, were 820,000 in 20056.
(ii) Corporate taxation is at the rate of 30% per year
(iii) Capital investment was 1 million in 20056, and is expected to grow at approximately the same rate as
turnover.
(iv) Working capital, interest payments and non-cash expenses are expected to increase at the same rate as
turnover.
(v) The estimated value of the patent if sold now is 10 million. This has not been included in fixed assets.
(vi) Operating profit is expected to be approximately 8% of turnover in 20067, and to remain at the same
percentage in future years.
(vii) Dividends are expected to grow at the same rate as turnover.

(viii) The realisable value of existing stocks is expected to be 70% of its book value.
(ix) The estimated cost of equity of Besserlot is 14%
Information regarding the industry sector of Besserlot:
(i)
The average PE ratio of listed companies of similar size to Besserlot is 30:1
(ii) Average earnings growth in the industry is 6% per year
Required:
(a) Estimate the value of Besserlot Ltd using:
(i)
(ii)
(iii)
(iv)

Asset based valuation

PE ratios
Dividend based valuation
The present value of expected future cash flows

Discuss the potential accuracy of each of the methods used and recommend, with reasons, a value, or range
of values that Stanzial might bid for Besserlot.
State clearly any assumptions that you make.
Approximately 16 marks are available for calculations and 11 marks for discussion.

(27 marks)

(b) Discuss how the shareholder mix of Besserlot and type of payment used might influence the success or
failure of the bid.
(8 marks)
(c) Assuming that the bid was successful, discuss other factors that might influence the medium term financial
success of the acquisition.
(5 marks)
(40 marks)

[P.T.O.

Several months ago FNDC plc, a television manufacturer, agreed to offer financial support to a major sporting event.
The event will take place in seven months time, but an expenditure of 45 million for temporary facilities will be
necessary in five months time. FNDC has agreed to lend the 45 million, and expects the loan to be repaid at the
time of the event. At the time the support was offered, FNDC expected to have sufficient cash to lend the
45 million from its own resources, but new commitments mean that the cash will have to be borrowed. Interest rates
have been showing a rising trend, and FNDC wishes to protect itself against further interest rate rises when it takes
out the loan. The company is considering using either interest rate futures or options on interest rate futures.
Assume that it is now 1 December and that futures and options contracts mature at the relevant month end.
LIBOR is currently 4%. FNDC can borrow at LIBOR plus 125%
Euronext.LIFFE
December
March
June

STIR 500,000 three month sterling futures. Tick size 001%, tick value 1250
9604
9577
9555

Euronext.LIFFE options on three month 500,000 sterling futures. Tick size 0005%, tick value 625. Option
premiums are in annual %.

9400
9450
9500
9550
9600

December
1505
1002
0502
0252
0002

CALLS
March
1630
1130
0630
0205
0025

June
1670
1170
0685
0285
0070

December

0060
0200

PUTS
March

0115
0450

June

0015
0165
0710

Required:
(a) Discuss the relative merits of using short-term interest rate futures and market traded options on short-term
interest rates futures to hedge short-term interest rate risk.
(6 marks)
(b) If LIBOR interest rates were to increase by 05% or to decrease by 05% estimate the expected outcomes
from hedging using:
(i) an interest rate futures hedge; and
(ii) options on interest rate futures.
Briefly discuss your findings.
Note: In the futures hedge the expected basis at the close-out date should be estimated, but basis risk may
be ignored.
(16 marks)
(c) Calculate and discuss the outcome of a collar hedge which would limit the maximum interest rate paid by
the company to 575%, and the minimum to 525%. (These interest rates do not include any option
premium.)
(5 marks)
(d) The company has been advised that it can increase income by writing (selling) options. Discuss whether or
not this is correct, and provide a reasoned recommendation as to whether or not FNDC plc should adopt this
strategy.
(3 marks)
(30 marks)

Section B TWO questions ONLY to be attempted

3

The financial management team of Tampem plc is discussing how the company should appraise new investments.
There is a difference of opinion between two managers.
Manager A believes that net present value should be used as positive NPV investments are quickly reflected in
increases in the companys share price.
Manager B states that NPV is not good enough as it is only valid in potentially restrictive conditions, and should be
replaced by APV (adjusted present value).
Tampem has produced estimates of relevant cash flows and other financial information associated with a new
investment. These are shown below:
000
Year
1
2
3
4
Investment pre-tax operating cash flows
1,250
1,400
1,600
1,800
Notes:
(i) The investment will cost 5,400,000 payable immediately, including 600,000 for working capital and
400,000 for issue costs. 300,000 of issue costs is for equity, and 100,000 for debt. Issue costs are not tax
allowable.
(ii) The investment will be financed 50% equity, 50% debt which is believed to reflect its debt capacity.
(iii) Expected company gearing after the investment will change to 60% equity, 40% debt by market values.
(iv) The investment equity beta is 15.
(v) Debt finance for the investment will be an 8% fixed rate debenture.
(vi) Capital allowances are at 25% per year on a reducing balance basis.
(vii) The corporate tax rate is 30%. Tax is payable in the year that the taxable cash flow arises.
(viii) The risk free rate is 4% and the market return 10%.
(ix) The after tax realisable value of the investment as a continuing operation is estimated to be 15 million
(including working capital) at the end of year 4.
(x) Working capital may be assumed to be constant during the four years.
Required:
(a) Calculate the expected NPV and APV of the proposed investment.

(10 marks)

(b) Discuss briefly the validity of the views of the two managers. Use your calculations in (a) to illustrate and
support the discussion.
(5 marks)
(15 marks)

[P.T.O.

You have been asked to investigate the dividend policy of two companies, Forthmate plc and Herander plc. Selected
financial information on the two companies is shown below.

2001
2002
2003
2004
2005

2001
2002
2003
2004
2005

Earnings after
Tax (000)
24,050
22,345
26,460
32,450
35,890

Forthmate plc
Issued ordinary
Free cash flow
shares (m)
to equity (000)
100
11,400
100
12,200
100
(3,500)
130
(2,600)
130
9,200

Dividend per
share (pence)
48
45
53
50
55

Earnings after
Tax (000)
8,250
5,920
9,140
10,350
8,220

Herander plc
Issued ordinary
Free cash flow
shares (m)
to equity (000)
50
6,100
50
(4,250)
50
10,300
50
4,400
50
3,140

Dividend per
share (pence)
100
100
103
105
105

A colleague has suggested that companies should try to pay dividends that are a constant percentage of a companys
free cash flow to equity.
Required:
(a) Analyse and contrast the dividend polices of Forthmate plc and Herander plc. Include in your analysis
estimates of dividends as a percentage of free cash flow, and any other relevant calculations.
Discuss possible reasons why the companies dividend policies differ.

(8 marks)

(b) Discuss whether or not a company should pay dividends that are equal to the free cash flow to equity.
(4 marks)
(c) In both of the last two years Herander plc has had more potential investments with positive NPV than it actually
undertook.
Required:
Discuss the implications of your findings in (a) above for the financial strategy of Herander plc.

(3 marks)
(15 marks)

Kandover plc, a UK company, has recently established a subsidiary in another country, Petronia. An essential
component that is produced in the UK by Kandover plc will need to be provided to the subsidiary in Petronia. The
finance team are discussing what transfer price should be set for sales between the parent company and subsidiary.
Three suggestions have been made:
(i) Use the estimated UK market price of the component as the transfer price. This is 18 per unit.
(ii) Use fixed cost per year plus variable cost per unit.
(iii) Use a negotiated price of UK total cost plus 25%
The following is a break down of the cost structure of an important component that must be sent between parent
company and the overseas subsidiary. Annual sales are 50,000 units.
Parent company costs
Variable costs
Fixed cost

13 per unit
120,000

Once received by the subsidiary the component undergoes further processing and is sold locally at P$250 per unit.
Costs in Petronia
Local variable costs
Local fixed cost

P$
82
351,000

The current exchange rate is P$78/.

The corporate tax rate in Petronia is 25%, and in the UK 30%.
A 15% withholding tax is levied on all dividend payments in Petronia.
A bilateral tax treaty exists between the UK and Petronia. This allows tax paid on income and distributions in one
country to be credited against a tax liability on the same income in the other country.
Assume that all available profits in Petronia are to be remitted back to the UK.
Required:
(a) Calculate the expected after tax profits that would result from each of the three transfer pricing methods.
(9 marks)
(b) Discuss the advantages and disadvantages of each of the methods.

(6 marks)
(15 marks)

Two multinational companies have recently published their objectives:

Company A:
Our companys objective is to focus on the maximisation of global shareholder wealth. We will use sophisticated
measures to maximise cash flow in each country in which we operate. We will also extensively outsource
internationally in order to increase profitability.
Company B:
Our companys primary objectives are to enhance our customers satisfaction and to grow our business. We aim to
supply our customers with the highest quality products and provide outstanding levels of sales and delivery service,
incapable of being matched by our competitors, and thereby increasing our market share.
Required:
Discuss and contrast these objectives. Comment upon any possible ethical implications of the objectives.
(15 marks)

[P.T.O.

Formulae Sheet

E( r j ) = r f + E( rm ) r f j

Ke (i)

D1
+g
P0

(ii)

WACC Keg

E
D
+ Kd (1 t )
E+D
E+D

Dt
or Keu 1

E + D
2 asset
portfolio

p = a2 x 2 + b2 (1 x ) 2 + 2 x (1 x ) p ab a b
Purchasing
power parity

a = e

i f i uk
1 + i uk

D(1 t )
E
+ d
E + D(1 t )
E + D(1 t )

Call price for a European option = Ps N( d1) Xe rT N( d 2 )

d1 =

1n ( Ps / X ) + rT

+ 0.5 T

d 2 = d1 T
Put call parity PP = PC PS +XerT

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10

Standard normal distribution table

000

001

002

003

004

005

006

007

008

009

00
01
02
03
04

00000
00398
00793
01179
01554

00040
00438
00832
01217
01591

00080
00478
00871
01255
01628

00120
00517
00910
01293
01664

00160
00557
00948
01331
01700

00199
00596
00987
01368
01736

00239
00636
01026
01406
01772

00279
00675
01064
01443
01808

00319
00714
01103
01480
01844

00359
00753
01141
01517
01879

05
06
07
08
09

01915
02257
02580
02881
03159

01950
02291
02611
02910
03186

01985
02324
02642
02939
03212

02019
02357
02673
02967
03238

02054
02389
02703
02995
03264

02088
02422
02734
03023
03289

02123
02454
02764
03051
03315

02157
02486
02794
03078
03340

02190
02517
02823
03106
03365

02224
02549
02852
03133
03389

10
11
12
13
14

03413
03643
03849
04032
04192

03438
03665
03869
04049
04207

03461
03686
03888
04066
04222

03485
03708
03907
04082
04236

03508
03729
03925
04099
04251

03531
03749
03944
04115
04265

03554
03770
03962
04131
04279

03577
03790
03980
04147
04292

03599
03810
03997
04162
04306

03621
03830
04015
04177
04319

15
16
17
18
19

04332
04452
04554
04641
04713

04345
04463
04564
04649
04719

04357
04474
04573
04656
04726

04370
04484
04582
04664
04732

04382
04495
04591
04671
04738

04394
04505
04599
04678
04744

04406
04515
04608
04686
04750

04418
04525
04616
04693
04756

04429
04535
04625
04699
04761

04441
04545
04633
04706
04767

20
21
22
23
24

04772
04821
04861
04893
04918

04778
04826
04864
04896
04920

04783
04830
04868
04898
04922

04788
04834
04871
04901
04925

04793
04838
04875
04904
04927

04798
04842
04878
04906
04929

04803
04846
04881
04909
04931

04808
04850
04884
04911
04932

04812
04854
04887
04913
04934

04817
04857
04890
04916
04936

25
26
27
28
29

04938
04953
04965
04974
04981

04940
04955
04966
04975
04982

04941
04956
04967
04976
04982

04943
04957
04968
04977
04983

04945
04959
04969
04977
04984

04946
04960
04970
04978
04984

04948
04961
04971
04979
04985

04949
04962
04972
04979
04985

04951
04963
04973
04980
04986

04952
04964
04974
04981
04986

30

04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

This table can be used to calculate N(di), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above
from 05.

End of Question Paper

11