PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 15 DECEMBER 2010

(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 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 on the answer sheet with a horizontal line 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 written test questions must begin on a new page. Ensure that each question is
clearly numbered. Use both sides of the paper in your answer booklet.

7. The examiner will take account of the way in which material is presented in the written test
questions

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 you
information and must NOT be removed MUST enter your candidate number in this box
from the examination hall.

DO NOT TURN OVER UNTIL YOU ARE

INSTRUCTED TO BEGIN WORK

The Institute of Chartered Accountants in England and Wales 2010 Page 1 of 5

1. In December 2010 Oxidian plc (Oxidian) successfully completed the development of a new product,
the SeaGuard, a mobile alarm for use with yachts and small boats. The development costs of this
new product have totalled 120,000, of which half has already been paid and half is due to be paid on
31 December 2010, although the amount of this second instalment will fall to 40,000 if the SeaGuard
is not launched onto the market. All development costs attract tax relief in the year in which the
payment is made.

The firms marketing director has indicated that a market research report (previously commissioned at
a cost of 3,500, payable in 2011) indicates that the SeaGuard should have a life of four years. The
report has confirmed that the superior functionality of the SeaGuard, compared to existing products,
means that it is highly likely to be a commercial success, but that this success will lead to lost sales
for Oxidians current product for the yacht market, the Mobilok.

In light of the market research report, the marketing director has estimated that the loss of Mobilok
sales revenue will equate to 30% of the projected sales revenue of the SeaGuard in each year of the
SeaGuards life. Mobilok will generate a contribution of 60p per 1 of sales during those four years.

Production and sales of the SeaGuard could start on 1 January 2011, with sales expected to be as
follows:

Units
Year ending 31 December 2011 7,500
2012 12,000
2013 15,000
2014 7,500

The projected selling price will be 100 per unit with a contribution of 55 per unit.

Product management of the SeaGuard will be undertaken by two managers at a total annual
employment cost of 45,000 each. Both of these managers are currently due to leave the company
on 31 December 2010, but have expressed a willingness to manage the product and will leave the
company four years later. Were they to leave at the end of 2010 they would each be entitled to
receive, at that time, redundancy payments from the company of 30,000. By the end of 2014, this
will have increased to 40,000 each. Redundancy payments are fully allowable for corporation tax in
the year in which the expenditure is incurred. These management costs have not been included in
calculating the SeaGuards unit contribution figure above.

Oxidian always budgets for a working capital requirement for all of its products at the rate of 10% of
annual sales revenue and the company ensures that this is in place at the start of each year. Working
capital will have no tax impact and will be released in full at the end of the SeaGuards estimated life.

The launch of the SeaGuard will require investment on 31 December 2010 in new production
machinery at a cost of 900,000. This will be expected to have a market value of 150,000 on
disposal at the end of the project, although the directors are uncertain whether it will be most
advantageous for Oxidian to dispose of the machinery on 31 December 2014 or 1 January 2015.

The companys 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 year to which they relate. The directors are also
assuming that the new machinery will attract full capital allowances at 20% pa on a reducing balance
basis commencing in the year of purchase and continuing throughout the companys ownership of the
machinery. A balancing charge or allowance will arise on disposal of the new equipment.

In appraising the SeaGuard the directors are assuming that all operating revenues and expenses
arise on 31 December of the year concerned and that the companys cost of capital is 10% pa.

The Institute of Chartered Accountants in England and Wales 2010 Page 2 of 5

Requirements

(a) Prepare capital allowance calculations for the SeaGuard production machinery on the following
two bases:

(i) disposal of the machinery on 31 December 2014;

(ii) disposal of the machinery on 1 January 2015;

and, without undertaking any further calculations, state whether Oxidian would be best advised
to sell this machinery on 31 December 2014 or on 1 January 2015. (5 marks)

(b) Taking account of the decision reached in (a), produce a schedule of annual net cash flows and
use it to indicate whether, on the basis of their net present value at 31 December 2010,
production of the SeaGuard should proceed. (14 marks)

(c) Identify the areas in which conflicts of interest might occur between the directors and
shareholders of Oxidian. (6 marks)

(25 marks)

NOTES: Ignore inflation

Work to the nearest .

The Institute of Chartered Accountants in England and Wales 2010 Page 3 of 5

2. Lipton plc (Lipton) is a listed company which operates in the pharmaceutical sector, manufacturing a
broad range of drugs under licence in a number of countries. Around 75% of the book value of
Liptons non-current assets comprises factories situated across Europe. In recent years the company
has grown organically but a proposal has now been put forward by the companys investment bank
that the company might consider the acquisition of a smaller firm, Becal Ltd (Becal), as a route to both
further expansion and diversification of the companys activities.

Becal is involved in a different area of the pharmaceutical sector from Lipton as it is primarily a
research-driven company involved in the development of new drugs arising from the latest academic
research, often working with research departments of universities and teaching hospitals to turn the
research into commercial reality.

The majority of Becals shares are owned by members of the three founding families, many of whom
still work for the company. They are now considering selling Becal if a suitable price can be agreed.

The following financial information has been obtained for Lipton, along with comparative information
for Becal:

Lipton Becal
Forecast earnings in next financial year ( million) 7.50 2.00
Shares in issue (million) 12.50 0.75
Current earnings per share (pence) 56.25 76.50
Current dividend per share (pence) 25.30 50.00
Share price (pence) 618.50 n/a
Book value of equity ( million) 175.00 22.50
Gearing ratio (debt as a % of market value) 25.00 0
Forecast dividend growth rate pa 3% 6%
Cost of equity 7% n/a

Becal does not calculate a cost of equity, but the average for listed companies operating in the same
sector is 8%. At this stage, the directors of Lipton have identified either a rights issue or a floating rate
term loan as the most likely method by which they might finance the purchase of Becal.

Requirements

(a) In your role as a corporate finance manager at Lipton, prepare a report to Liptons directors
which provides valuations of Becal using:
(i) net assets;
(ii) dividends;
(iii) current and forecast earnings (using Liptons current price-earnings ratio),
and, for each valuation calculated, identify any specific reservations or other issues that you
might wish to bring to the attention of Liptons directors. (16 marks)

(b) Evaluate (without undertaking any calculations) the two potential methods of financing the
purchase of Becal. (8 marks)

(c) Discuss the relative advantages of organic growth and growth by acquisition. (6 marks)

(30 marks)

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3(a) Springfield plc (Springfield) wishes to borrow 20 million for five years to finance the purchase of new
non-current assets. The preference of the companys directors is that these funds are borrowed at a
fixed rate of interest. The companys long-term debt is currently rated BBB, meaning that Springfield
would have to pay 6.50% pa for fixed rate borrowing. Alternatively, Springfield could borrow at a
floating rate of LIBOR + 2.25% pa at the present time.

The directors of Springfield have recently been informed by its bank that Faversham plc (Faversham)
is also currently looking to borrow 20 million for five years at a floating rate of interest and its AA
rating gives it access to floating rate borrowing at LIBOR + 1.50% pa. Faversham would pay 5.50%
pa for fixed rate borrowing at the present time.

Requirements

(i) State five reasons that a company might have for entering into an interest rate swap. (5 marks)

(ii) Show how an interest rate swap could be used to the equal benefit of both companies
assuming that the terms of the swap agreement are such that Springfields swap payment to
Faversham is to be 5.50% fixed pa. (5 marks)

(iii) Identify, with a supporting explanation, which of the two companies would be disadvantaged if
LIBOR were to fall consistently over the five year term of the interest rate swap. (2 marks)

(iv) Identify two risks that the two companies both face should they decide to enter into the interest
rate swap agreement. (2 marks)

(b) Woodhouse plc (Woodhouse) is planning to borrow 6 million at a fixed rate of interest in March for
six months and wishes to protect itself against interest rates rising above 4.75% pa. It is now
15 December and the current interest rate is 4% pa. The following data has been obtained by the
companys finance director:

Traded options on 3-month futures contracts (contract size 500,000)

Strike Price Calls Puts

March June September March June September
95.25 0.14 0.17 0.19 0.12 0.90 1.60
95.50 0.03 0.04 0.05 0.26 1.13 1.83
95.75 0.01 0.02 0.03 0.47 1.37 2.08

Option premiums are in annual % terms.

Requirements

Demonstrate the outcome of a traded interest rate options hedge (indicating the effective rate of
interest achieved by the company on its borrowing) if the interest rate and futures prices on the date
the company draws down the loan from its bank are:

(i) 5.4% pa and 94.30 respectively;

(ii) 3.1% pa and 96.70 respectively. (11 marks)

(25 marks)

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