Financial Management - Professional Stage – June 2010

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.
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.

Question 1 Total Marks: 27

General comments
With an average mark of 71.9%, it is clear that most candidates were well prepared for this standard
question on the investment appraisal section of the syllabus.
(a)
Option 1: Introduce the Diamond and drop the RotoEdge
31 December 2010 2011 2012 2013 2014 2015
Unit sales 12,000 18,000 24,000 18,000 12,000
(£)
Contribution (72/unit) 864,000 1,296,000 1,728,000 1,296,000 864,000

Redundancy (144,000)

Fixed costs (300,000) (300,000) (300,000) (300,000) (300,000)

Net cash flow (144,000) 564,000 996,000 1,428,000 996,000 564,000

Tax (28%) 40,320 (157,920) (278,880) (399,840) (278,880) (157,920)

Working capital (W1) (144,000) (72,000) (72,000) 72,000 72,000 144,000

Investment (1,500,000)

Cap. Allowances (W2) 84,000 67,200 53,760 43,008 34,406 137,626

Net cash flow (1,663,680) 401,280 698,880 1,143,168 823,526 687.706

df (10%) 1 0.909 0.826 0.751 0.683 0.621

PV (1,663,680) 364,764 577,275 858,519 562,468 427,065

NPV 1,126,411

Omission of the outstanding committed cost of £100,000

Workings:
W1:
31/12 2010 2011 2012 2013 2014 2015
Sales 1,440,000 2,160,000 2,880,000 2,160,000 1,440,000
Working capital 144,000 216,000 288,000 216,000 144,000 -
Incremental effect (144,000) (72,000) (72,000) 72,000 72,000 144,000
W2:
WDV Tax saved (28%)
31.12.2010 Cost 1,500,000
31.12.2010 WDA 300,000 84,000
1,200,000
31.12.2011 WDA 240,000 67,200
960,000
31.12.2012 WDA 192,000 53,760
768,000
31.12.2013 WDA 153,600 43,008
614,400
31.12.2014 WDA 122,880 34,406
31.12.2015 Bal.All 491,520 137,626

© The Institute of Chartered Accountants in England and Wales 2010 Page 1 of 7

 Financial Management - Professional Stage – June 2010

(b)
Option 2: Introduce the Diamond and retain the RotoEdge

31/12 2010 2011 2012 2013 2014 2015

Unit sales:
RotoEdge 4,800 3,600 2,400
Diamond 9,600 16,200 22,800 18,000 12,000

(£)
Contribution:
RotoEdge (42/unit) 201,600 151,200 100,800
Diamond (72/unit) 691,200 1,166,400 1,641,600 1,296,000 864,000

Redundancy (60,000) (48,000) (48,000) (24,000)

Fixed costs (320,000) (320,000) (320,000) (300,000) (300,000)

Net cash flow (60,000) 524,800 949,600 1,398,400 996,000 564,000

Tax (28%) 16,800 (146,944) (265,888) (391,552) (278,880) (157,920)

Working capital (W1) (161,280) (67,680) (67,680) 80,640 72,000 144,000

Investment (1,500,000)

Cap. Allowances 84,000 67,200 53,760 43,008 34,406 137,626

Net cash flow (1,620,480) 377,376 669,792 1,130,496 823,526 687,706

df (10%) 1 0.909 0.826 0.751 0.683 0.621

PV (1,620,480) 343,035 553,248 849,003 562,468 427,065

NPV 1,114,339

Workings – W1:
31/12 2010 2011 2012 2013 2014 2015
Sales 1,612,800 2,289,600 2,966,400 2,160,000 1,440,000
Working capital 161,280 228,960 296,640 216,000 144,000 -
Incremental effect (161,280) (67,680) (67,680) 80,640 72,000 144,000

The recommendation, therefore, should be that Option 1 be pursued.

In the opening section of the question the majority of candidate responses scored highly, although weaker
scripts were characterised by errors in the following areas:

1. A failure to omit irrelevant costs, which included the costs to which the firm in the two scenarios was
already committed;
2. Accurate calculation of the working capital impact of the investment proposals;
3. Confusion regarding the correct treatment of fixed costs in the second of the two scenarios outlined in
the question.

Total possible marks 19

Maximum full marks 19

© The Institute of Chartered Accountants in England and Wales 2010 Page 2 of 7

 Financial Management - Professional Stage – June 2010

(c )
1. The firm’s shareholders may not be diversified, as assumed by the CAPM.
2. The shareholders are not the only stakeholders in the firm, as assumed by the CAPM – directors and
employees will struggle to be persuaded that they should be unconcerned if the new project has an
adverse effect on the risk/return profile of the firm.
In the second section of the question, there was some polarisation of performance between those
candidates with a clear knowledge of the relevant area of the learning materials and those with none. In
addition, many candidates made reference to the issue of a beta calculation, but this was a difficulty
associated with the methodology rather than an assumption underpinning its use to calculate a discount
factor for investment appraisal purposes.

Total possible marks 2

Maximum full marks 2
(d)
1. Increase the rate of growth of sales (use of marketing)
2. Increase the operating profit margin (increase selling price/decrease variable costs)
3. Reduce the investment in non-current assets (acquire for less than £1.5m)
4. Reduce the investment in working capital (less than 10%)
5. Reduce the firm’s cost of capital (change capital structure)
6. Extend the life of the project (use of marketing)

In the final section of the question, the vast majority of candidates were able to list many, if not all, the
value drivers, although the frequent references to the idea that the firm could simply reduce the rate of
corporation tax scored no marks as this is not a variable the firm can directly influence even if the firm can
seek to minimise the amount of tax it pays in absolute terms. Another key characteristic of weaker
candidates was their failure to follow up the identification of value drivers with an explanation of how
improvements in shareholder value might actually be achieved in practice.
Total possible marks 6
Maximum full marks 6

© The Institute of Chartered Accountants in England and Wales 2010 Page 3 of 7

 Financial Management - Professional Stage – June 2010

Question 2 Total Marks: 27

Performance on this second question was also good, although the average mark of 65.6% indicates that
candidates did not find it as much to their liking as the opening question.

(a)
Forecast Income Statement for the years ending 31 December:
31 March 2011 31 March 2012

Revenue 65,059 70,264

Operating costs (excluding depreciation) 51,480 53,539
Depreciation 875 875
Operating profit 12,704 15,850
Finance costs 1,200 1,200
Profit before tax 11,504 14,650
Tax (W1) 3,018 3,989
Profit after tax 8,486 10,661
Dividends 2,951 3,128
Retained profit 5,535 7,533

W1 Tax:
Profit before tax 11,504 14,650
Add back depreciation 875 875
Less capital allowances (1,600) (1,280)
Taxable profits 10,779 14,245
Tax @ 28% 3,018 3,989

Forecast Balance Sheets as at 31 December:

31 March 2011 31 March 2012
ASSETS
Non-current assets 35,975 35,100
Inventories 9,922 9,922
Receivables 9,759 10,540
Cash (balancing figure) - 5,751
TOTAL ASSETS 55,656 61,313

EQUITY AND LIABILITIES

Ordinary share capital 16,700 16,700
Retained earnings 18,017 25,550
Debentures 8,000 8,000
Payables 7,629 7,935
Bank overdraft (balancing figure) 2,359 -
Dividends 2,951 3,128
TOTAL EQUITY AND LIABILITIES 55,656 61,313

Forecast Cash Flow Statements for the years ending 31 December:

31 March 2011 31 March 2012
Profit before tax 11,504 14,650
Depreciation 875 875
Increase in inventories (902) -
Increase in receivables (723) (781)
Increase in payables 293 306
Purchase of non-current assets (8,000) -
Tax paid (3,018) (3,989)
Dividends paid (2,784) (2,951)
Net cash flow (2,755) 8,110
Cash balance brought forward 396 (2.359)
Cash balance carried forward (2,359) 5,751

© The Institute of Chartered Accountants in England and Wales 2010 Page 4 of 7

 Financial Management - Professional Stage – June 2010

In the first section of the question the main errors made by weaker candidates were in the following areas:

1. An inability to correctly calculate the tax figure in the Income Statement – very often weaker candidates
simply calculated 28% of the profit before tax rather than taking account of both the depreciation and the
capital allowances in the calculation;
2. A failure to use the cash/overdraft figure as the balancing item in the Balance Sheet – it was also
surprising how many candidates chose to put an overdraft in the current assets section of the Balance
Sheet;
3. Incorrect calculation of the payables figure due to misinterpretation of the available information;
4. Failure to include, on many occasions, tax and dividends in the Cash Flow Statement.

It seemed that weaker candidates had failed to prepare themselves adequately for a question on this new
aspect of the syllabus and had placed too much reliance on their knowledge from earlier papers rather
than studying the Financial Management learning materials closely which would have rendered this
question quite straightforward as it mirrored closely the style of question used in the learning materials.

Total possible marks 21

Maximum full marks 21
(b)
1. Management buy-out: a new company acquires either the trade and assets or the shares of the
subsidiary to be sold, with the purchase usually funded by a mix of debt and equity provided by the
managers (equity), venture capital providers (debt and equity) and other financiers (debt)

2. Management buy-in: as above, but with purchase by a group of external managers

3. Spin-off (demerger): shareholders are given shares in the new entity pro rata to their shareholdings in
the parent company – there is no change in ownership; with separate legal identities established; used
to avoid the problems of the conglomerate discount; sometimes used as a defence against takeover of
the entire business

4. Sale of shares/assets to a third party.

Most candidates coped well with the demands of the second part of the question, although weaker
candidates too often simply listed a number of divestment options without actually describing the nature of
the options in each case.
Total possible marks 6
Maximum full marks 6

© The Institute of Chartered Accountants in England and Wales 2010 Page 5 of 7

 Financial Management - Professional Stage – June 2010

Q uestion 3 Total Marks: 26

The average mark of 65.8% seen on this question was much in line with that of WT2. One pleasing aspect
was that there was less polarisation in performance apparent in the responses to the question than has
been evident at previous sittings – candidates are clearly more comfortable overall with this area of the
syllabus than has previously been the case.

(a)(i)
1. Costs (direct and implicit)
2. Materiality of the exposure
3. Attitude to risk may lead the firm to decide to leave the upside potential open
4. Portfolio effect
5. If shareholders are fully diversified, their exposure to systematic risk will not be affected, so there will be
no benefits for them from hedging

(a)(ii)
1. 8,000,000/1.1980 = £6,677,796
2. 8,000,000/1.1420 = £7,005,254

Forward contract: Forward rate €1.1608

8,000,000/1.1608 = £6,891,799

OTC Option:
Need to sell €so a put option is required at a premium of £1.25 per €100 = £100,000
1. If spot is €1.1980/£, exercise the option – 8,000,000/1.1750 = £6,808,511, net £6,708,511
2. If spot is €1.1420/£, let the option lapse – 8,000,000/1.1420 = £7,005,254, net £6,905,254

(a)(iii)
1. Appropriate choice of invoice currency
2. Matching payments and receipts (eg. Creating payables and receivables in same currency)
3. Matching assets and liabilities (eg. Creating overdraft borrowing in respect of a receivable)
4. Leading and lagging payments
5. Maintaining currency accounts
6. Use of a money market hedge
In the opening section of the question most candidates coped well with the identification of reasons why a
firm may choose not to hedge its foreign exchange exposure, although attitude to risk was the most
frequently omitted item by weaker candidates.

The majority of candidates clearly had a firm grasp of the workings of both forward and option contracts
(although there was evidence of continuing confusion amongst weaker candidates of the distinction
between a put option and a call option). Most candidates also had a good knowledge of the operational
techniques available to a firm to hedge its foreign exchange exposure.

Total possible marks 17

Maximum full marks 16

© The Institute of Chartered Accountants in England and Wales 2010 Page 6 of 7

 Financial Management - Professional Stag

(b)(i)
Futures price $1.6436/£ Contract size £62,500 Current spot $1.6520/£
So needs to buy £20,000,000/62,500 = 320 contracts

Scenario 1:
Buy 320 contracts @ 1.6436
In 6 months sell 320 contracts @ 1.6610
Gain per £ 0.0174
Total gain (320 x 62.500 x 0.0174) $348,000
Purchase of £20m in 6 months $33,260,000 (20m x 1.6630)
Net cost $32,912,000
Scenario 2:
Buy 320 contracts @ 1.6436
In 6 months sell 320 contracts @ 1.6400
Loss per £ 0.0036
Total loss (320 x 62,500 x 0.0036) ($72,000)
Purchase of £20m in 6 months $32,840,000 (20m x 1.6420)
Net cost $32,912,000

(b)(ii)
1. Hedge inefficiency caused by basis risk
2. The fact that the buyer of the contract is tied into buying the £ even if the purchase does not proceed
(which appears to be a real possibility) – a currency option would appear to be a much better option in this
scenario
Not surprisingly, weaker candidates found the second section of the question more challenging, with
common errors arising in the following areas:

1. Failure to calculate correctly the precise number of futures contracts required in the scenario outlined in
the question;
2. Confusion regarding whether the futures contracts would be bought or sold;
3. Confusion between whether gains or losses would arise on the futures contracts;
4. Failure to recognise that the firm still needs to buy sterling in the spot market at the conclusion of the
transaction.

Each of these failings relates to fundamental knowledge in this area of the syllabus and whilst there was a
welcome improvement in overall performance on this topic, it is clear that the weakest candidates tend not
to have mastered these basics at all and so struggle to pick up marks.

Total possible marks 10

Maximum full marks 10

© The Institute of Chartered Accountants in England and Wales 2010 Page 7 of 7