ICAEW Professional Level Financial Management Question Bank - Twelfth Edition 2018

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The Institute of Chartered Accountants in England and Wales
FINANCIAL
MANAGEMENT
For exams in 2019
Question Bank
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Financial Management
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-50972-137-5
Previous ISBN: 978-1-78363-875-8 ฀
First edition 2007
Twelfth edition 2018
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system or transmitted in any form or by any means,
graphic, electronic or mechanical including photocopying, recording,
scanning or otherwise, without the prior written permission of the
publisher.
The content of this publication is intended to prepare students for the

ICAEW examinations, and should not be used as professional advice.
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library
Originally printed in the United Kingdom on paper obtained from

traceable, sustainable sources.
© ICAEW 2018
ii Financial Management: Question Bank ICAEW 2019

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Contents
The following questions are exam-standard. Unless told otherwise, these questions are the style,
content and format that you can expect in your exam.
Study Time Page

manual allocation
Title reference Marks Mins Question Answer
Objectives and investment

appraisal
1 Stoane Gayte Sounds plc (March
2013) 2, 7 29 43.5 3 119
2 Profitis plc (December 2001) 2 17 25.5 4 122
3 Horton plc (June 2009) 2 35 52.5 5 124
4 Broadham Hotels Ltd (December
2001) 2, 3 22 33 7 128
5 ProBuild plc (June 2013) 2, 3 29 43.5 8 130
6 Frome Lee Electronics Ltd
(September 2008) 2, 3, 5 26 39 9 133
7 Nuts and Bolts Ltd (March 2011) 2 24 36 11 135
8 Newmarket plc (Sample paper) 2, 3 35 52.5 12 139
9 Grimpen McColl International Ltd
(September 2012) 2, 3 30 45 13 142
10 Wicklow plc (December 2008) 2, 3, 6 35 52.5 15 145
11 Air Business Ltd (September 2013) 2, 3 35 52.5 17 149
12 Daniels Ltd (March 2007) 2 25 37.5 19 152
13 Adventurous plc (December 2013) 2, 3, 5, 6 35 52.5 20 155
14 Hawke Appliances Ltd (September
2014) 2, 3, 8 35 52.5 21 159
15 Alliance plc (December 2015) 2, 3 35 52.5 23 162
Finance and capital structure

16 Bradford Bedwyn Medical plc
(March 2014) 3, 5, 7 35 52.5 26 166
17 Penny Rigby Fashions plc
(September 2011) 5, 6, 7 27 40.5 27 169
18 Turners plc (June 2014) 2, 4, 5, 6 35 52.5 28 172
19 Middleham plc (Sample paper) 4, 5 35 52.5 29 175
20 Better Deal plc (March 2010) 5, 7 35 52.5 30 177
21 Puerto plc (December 2013) 5, 6 35 52.5 31 180
22 Abydos plc 2, 6 16 24 33 183
23 Biddaford Lundy plc (March 2012) 4, 6 35 52.5 34 185
24 Newspaper articles (September
2010) 6, 7 35 52.5 34 189
25 BBB Sports plc (December 2015) 4, 5, 6, 7 35 52.5 35 192
ICAEW 2019 Contents iii

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Study Time Page

manual allocation
Business valuations, plans,

dividends and growth
26 Cern Ltd (December 2012) 2, 8 31 46.5 37 196
27 Wexford plc (December 2008) 4, 6, 8 30 45 39 199
28 Loxwood (March 2014, amended) 2, 4, 8 40 60 41 202
29 Arleyhill Redland plc (September
2013) 4, 6, 8 35 52.5 42 206
30 Sennen plc (June 2014) 2, 3, 7, 8 35 52.5 44 209
31 Printwise UK plc (March 2010,
amended) 7, 8 34 51 45 212
32 Tower Brazil plc (September 2014) 4, 6, 7 35 52.5 47 215
33 Brennan plc 2, 8 20 30 48 218
Risk management
34 Fratton plc (June 2011) 9, 10 30 45 50 220
35 Sunwin plc (December 2012) 9 26 39 51 222
36 Padd Shoes Ltd (March 2014) 9, 10 30 45 52 225
37 Stelvio Ltd (June 2014) 9, 10 30 45 53 227
38 JEK Computing Ltd (September 2014) 10 30 45 54 230
39 Lambourn plc (Sample paper) 9, 10 30 45 55 232
40 American Adventures Ltd
(December 2013) 9, 10 30 45 57 235
41 Hammond Beamish Software Ltd
(September 2010) 9, 10 30 45 58 238
42 Bridge Engineering plc (December
2015) 9 30 45 59 240
March 2016 exam

43 Aranheuston Pharma plc 1, 2, 3 35 52.5 61 245
44 Oliphant Williams plc 4, 6 35 52.5 62 249
45 Tully Carlisle Ltd 9, 10 30 45 64 252
June 2016 exam

46 Zeus plc 2, 4, 8 35 52.5 65 256
47 Ross Travel plc 4, 5 35 52.5 66 259
48 Heaton Risk Management 9, 10 30 45 68 263
September 2016 exam

49 Northern Energy Ltd 9, 10 30 45 70 266
50 Roper Newey plc 2, 5, 6 35 52.5 71 269
51 Darlo Games Ltd 2, 8 35 52.5 72 272
iv Financial Management: Question Bank ICAEW 2019

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Study Time Page

manual allocation
December 2016 exam

52 Ribble plc 2, 3 35 52.5 75 275
53 Bristol Corporate Finance 4, 5, 6 35 52.5 76 278
54 Orion plc 9, 10 30 45 78 282
March 2017 exam

55 Sentry Underwood plc 4, 6, 7 35 52.5 80 285
56 White Rock plc 2, 3, 4 35 52.5 81 289
57 ST Leonard Foods 9, 10 30 45 83 294
June 2017 exam

58 Brighton plc 1, 2, 3 35 52.5 85 297
59 Easton plc 3, 4, 5, 6 35 52.5 86 300
60 Lake Ltd 9, 10 30 45 87 303
September 2017 exam

61 Merikan Media plc 8 35 52.5 89 306
62 Ramsey Douglas Motors plc 4, 5, 6 35 52.5 90 308
63 Jenson Grosvenor plc 9, 10 30 45 92 311
December 2017 exam

64 Innovative Alarms 1, 2, 3, 4 35 52.5 94 315
65 Peel Kitchens plc 3, 4, 5, 6, 7 35 52.5 96 318
66 Jewel House Investments Ltd 9, 10 30 45 97 322
March 2018 exam

67 Wells Bakers plc 1, 3, 4, 5 35 52.5 100 325
68 Hunt Trading plc 9, 10 30 45 101 328
69 Bishop Homes Ltd 2, 3 35 52.5 103 330
June 2018 exam

70 Helvellyn Corporate Finance 2, 8 35 52.5 105 334
71 Blackstar plc 1, 4, 6, 7 35 52.5 107 337
72 Tarbena plc 9, 10 30 45 109 340
September 2018 exam

73 Thomas Rumsey Group plc 2, 3 35 52.5 111 344
74 Heath Care plc 4, 5, 6 35 52.5 112 348
75 Eddyson Cordless Ltd 9, 10 30 45 114 352
ICAEW 2019 Contents v

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Appendix
Formulae and discount tables
vi Financial Management: Question Bank ICAEW 2019

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Question Bank topic finder

Set out below is a guide showing the Financial Management syllabus learning outcomes, topic
areas, and related questions in the Question Bank for each topic area. If you need to concentrate
on certain topic areas, or if you want to attempt all available questions that refer to a particular
topic, you will find this guide useful.
Syllabus Study
learning Manual
Topic area outcome(s) Question number(s) chapter(s)
Adjusted present 1g 10,13,18,22,50,59,65 6

value
Business valuation 3i 14,26,28,30,31,33,46,51,61,70 8
methods
Capital rationing 3g 3,12,15,56 2
CAPM 1h 16,18,19,20,21,25,47,50,53,59,65,67,74 3
Currency futures 2d 37,39,40,48,49,54,60,63,66,72,75 10
Currency options 2d 34,36,37,38,40,41,45,48,49,54,57,60,63,66, 10
68,72,75
Debenture issues 1j 16,22,24,29,47,53,62,65,71 6
Dividend policy 1i 1,20,32,44,55,65,71 7
Economic risk 2f 54,63,75 10
EMH/behavioural 1d 18,19,21,24,56,62,65 4
effects
Ethics 1c 25,28,30,32,44,46,51,52,55,58,62,64,67,71,73 1,4
Financial statements/ 1k 21,27,29,53,55 6
financing plans
Forward contracts 2d 34,36,37,38,39,40,41,45,48,49,54,57,60,63, 10
66,68,72,75
Forward rate 2c 34,40,49,57 9
agreements
Gearing 1g 24,29,32,65 6
Gordon growth 1f 16,17,18,25,74 5
model
Hedging advice 2a, 2b 36,37,38,40,41,54,57,60,63,66,68,72,75 9,10
Index options/futures 2c 35,48,66,75 9
Interest rate futures 2c 34,35,39,57,66,68 9
Interest rate options 2c 35,42,49,57,68 9
Interest rate parity 2c 37,38,54,72 9
Interest rate swaps 2c 37,41,45,49,66 9
Loan covenants 1e 21,24 4
ICAEW 2019 Question Bank topic finder vii

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Syllabus Study
learning Manual
Topic area outcome(s) Question number(s) chapter(s)
Management buy 3i 30,46,53,61 8

outs
Money market 2d 34,36,38,39,40,41,45,49,57,60,63,68,75 10
hedges
NPV – 3e 4,8,9 2
assumptions/strategic
factors
NPV calculations – 3b 4,5,6,7,9 2
inflation
NPV calculations – 3b 1,4,5,6,7,8,9,10,11,13,14,15,56,64,69,70,73 2
relevant cash flows
Overseas trading 2f; 3f 9,13,25,36,60,63,75 2,10
Real options 3e 5,8,13,52,58,64,69,73 2
Replacement 3h 2,12,26,64 2
decision/cycle
Rights issues 1j 23,24,29,32,53,55,65,71 6
Risk 3d 5,8,9,13,25,59 2,3
Sensitivity analysis 3c 10,11,13,14,15,43,52,58,64,69 3
Share buy back 1i 16,71 7
Share for share 3i 30,31 8
exchange
Share options 2e 42,48 9
Shareholder value 3a 11,28,33,43,51,58,61,70,73 2,8
analysis (SVA)
Sources of 1f; Ij 21,23,24,29,32,44,59,65,71,74 5, 6
finance/capital
structure
Stakeholder 1b 16,24,43,44,53,55,58,59,65,71 1
objectives and
conflict
Weighted average 1f 16,17,18,19,20,21,25,47,50,59,62,65,67,74 5
cost of capital
(WACC)
viii Financial Management: Question Bank ICAEW 2019

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Exam
Your exam will consist of:
3 questions 100 marks
Pass mark 55
Exam length 2.5 hours
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ICAEW 2019 Exam ix

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x Financial Management: Question Bank ICAEW 2019

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Question Bank

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฀
฀
2 Financial Management: Question Bank ICAEW 2019

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Objectives and investment appraisal
1 Stoane Gayte Sounds plc

Stoane Gayte Sounds plc (SGS) manufactures audio equipment and has a financial year end of
31 March. Its directors are considering making use of SGS's cash reserves to finance an
investment of £4.9 million in a new range of high specification audio speakers for cars, to be
marketed under the brand name of Inca. However, two of SGS's directors are of the opinion that
this money should be used for an ordinary dividend payment instead, as they feel that this
would help to increase the company's share price.
You work in SGS's finance team and have been asked to advise the SGS board. You have been
given the following information:
Sales
£80,000 of market research work for SGS has been done by Etchingham Tyce Marketing Ltd
(ETM) in the past two months and the payment for this work has yet to be made. The results of
the research suggest that, although it is a very competitive market, Inca speakers would be
popular amongst young drivers for at least three years. ETM's estimated figures for Inca sales
over the next four years, based on a selling price of £190 per unit (at 31 March 20X3 prices), are
shown below:
Units
Year to 31 March 20X4 65,000
As a result of these estimates SGS's directors are concerned about the riskiness of the proposal
and so wish to appraise the investment in Inca speakers over a three-year period only (ie, to
31 March 20X6).
Costs
The estimated variable costs (at 31 March 20X3 prices) of manufacturing one Inca unit are:
£
Raw materials 43
Variable overheads 45
Skilled labour (£9/hour) 18
Because of a lack of skilled labour, SGS will have to transfer all of the skilled production hours
required to manufacture the Inca away from the manufacture of another, lower specification
speaker, the Boom-Boom. Thus a proportion of the Boom-Boom production would have to
cease. Current production details for the Boom-Boom (at 31 March 20X3 prices) are shown
below:
Per unit
£
Selling price 99
Raw materials 28
Skilled labour (£9/hour) 9
SGS's directors estimate that the company's total fixed overheads are unlikely to change as a
result of manufacturing the Inca, but will nonetheless apportion a share of SGS's existing fixed
costs at a rate of £27 per Inca unit (at 31 March 20X3 prices). However this does not include the
depreciation charge (to be spread evenly over the three financial years ending 31 March 20X6)
that will be incurred as a result of the capital expenditure for the Inca (see details below).
ICAEW 2019 Objectives and investment appraisal 3

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Capital expenditure
In order to manufacture the Inca speakers, new machinery costing £4.9 million would be
purchased on 31 March 20X3. SGS's production director estimates that this could be sold on
31 March 20X6 for £980,000 (at 31 March 20X6 prices).
This machinery will attract 18% (reducing balance) capital allowances in the year of expenditure
and in every subsequent year of ownership by the company, except the final year. In the final
year, the difference between the machinery's written down value for tax purposes and its
disposal proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 as a balancing charge, if the disposal proceeds are more than the tax written down value.
Working capital
SGS's directors estimate that a net investment of £750,000 for additional working capital to
support the Inca will be required on 31 March 20X3 and that this will be fully recoverable on
31 March 20X6.
Inflation
Revenues, costs and working capital are all expected to increase in line with the general rate of
inflation, which is estimated at 3% pa.
Taxation
SGS's directors wish to assume that the corporation tax rate will be 17% pa for the foreseeable
future and that tax flows arise in the same year as the cash flows which gave rise to them.
Cost of capital
For investment appraisal purposes SGS uses a money cost of capital of 11% pa.
Other information
 SGS's ordinary dividends have been rising steadily over the past five years and in the
financial year to 31 March 20X2 they totalled £3.4 million.
 Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
Requirements
1.1 Calculate the net present value of the Inca proposal at 31 March 20X3 and, based on this
calculation alone, advise SGS's directors whether they should proceed with it. (17 marks)
1.2 Calculate the internal rate of return of the Inca proposal at 31 March 20X3 and advise SGS's
directors as to the usefulness of this figure. (6 marks)
1.3 Discuss, with reference to relevant theories, the view that SGS should, as an alternative to
the Inca proposal, pay an ordinary dividend in order to increase the company's share price.
(6 marks)
Total: 29 marks
2 Profitis plc
Profitis plc has a continuing need for a machine. At the level of intensity of use by the company,
after four years from new the machine is not capable of efficient working. It has been the
company's practice to replace it every four years. The production manager has pointed out that
in the fourth year the machine needs additional maintenance to keep it working at normal
efficiency. The question has therefore arisen as to whether to replace it after three years instead
of the usual four years.

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Relevant information is as follows.

(1) The machine costs £80,000 to buy new. If it is retained for four years, it will have a zero
scrap value at the end of the period. If it is retained for three years, it will have an estimated
disposal value of £10,000.
The machine will attract capital allowances. For the purposes of this analysis assume that it
will be excluded from the general pool. This means that it will attract a 18% (reducing
balance) tax allowance in the year of acquisition and in every subsequent year of being
owned by the company, except the last year. In the final year, the difference between the
machine's written down value for tax purposes and its disposal proceeds will be treated by
the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 balancing charge, if the disposal proceeds are more than the tax written down value.
Assume that the machine will be bought and disposed of on the last day of the company's
accounting year.
(2) The company's corporation tax rate is 17%. Tax is payable on the last day of the accounting
year concerned.
(3) During the first year of ownership the supplier takes responsibility for any necessary
maintenance work. In the second and third years maintenance costs average £10,000 a
year. During the fourth year these rise to £20,000. Maintenance charges are payable on the
first day of the company's accounting year and are allowable for tax.
(4) The company's cost of capital is estimated at 15%.
Requirements
2.1 Prepare calculations to show whether it would economically be more desirable to replace
the machine after three years or four years. (13 marks)
2.2 Discuss any other issues that could influence the company's replacement decision. This
should include any weaknesses in the approach taken in 2.1. (4 marks)
Total: 17 marks
3 Horton plc
3.1 The objective of the directors of Horton plc (Horton) is the maximisation of shareholder
wealth. The directors are currently considering Horton's capital investment strategy for
20Y0. Five potential investment projects have been identified, each one having an
expected life of four years. However, at this stage the directors are uncertain of the precise
financial situation the company will be in on 31 December 20X9 when it will actually make
its chosen investments. The company accountant has already undertaken net present value
calculations for each of the five potential investment projects as follows:
Initial Investment (31.12.X9) Net Present Value (31.12.X9)
£ £
Project 1 (2,400,000) 2,676,600
Project 2 (2,250,000) (461,700)
Project 3 (3,000,000) 4,111,500
Project 4 (2,630,000) 2,016,250
Project 5 (3,750,000) (45,250)
Whilst these net present value calculations include the impact of corporation tax, which the
company pays at 17%, they do not include the effect of capital allowances. Project 3 is the
only project that will attract capital allowances and these allowances will apply just to the
initial £3 million investment. The allowances will be at a rate of 18% per annum on a

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reducing balance basis, commencing in the year of initial investment, with either a
balancing charge or allowance arising in the final year of the project. The directors are
confident that the company will be able to use all capital allowances in full.
The company's cost of capital is 10%. The cashflows used by the company accountant to
calculate the original net present values of the projects were as follows:
T0 T1 T2 T3 T4
Project 1 (2,400,000) (750,000) 300,000 4,200,000 3,450,000
Project 2 (2,250,000) (750,000) 1,800,000 900,000 450,000
Project 3 (3,000,000) (1,500,000) 3,750,000 3,750,000 3,750,000
Project 4 (2,630,000) 750,000 1,650,000 2,100,000 1,500,000
Project 5 (3,750,000) 1,050,000 1,350,000 1,950,000 250,000
Project 3's T4 cashflow of £3.75 million includes disposal proceeds of £1 million relating to
the assets originally purchased on 31 December 20X9 for £3 million.
To reflect the uncertainty regarding Horton's financial position at the end of 20X9, four
potential scenarios have been identified for consideration:
Scenario 1: Horton will face no capital rationing and the five projects will be independent
and divisible.
Scenario 2: Horton's available capital for investment at T0 will be limited to £4.5 million;
the five projects will be independent and divisible and none of the projects
can be delayed.
Scenario 3: Horton's available capital for investment at T0 will not be limited, but its
available capital for investment at T1 will be limited to £0.3 million; the five
projects will be independent and divisible and none of the projects can be
delayed.
Scenario 4: Horton's available capital for investment at T0 will be limited to £5.25 million,
and whilst the five projects will be independent and none of the projects can
be delayed, they will be indivisible.
One director has indicated that he wishes to discuss the possibility of leasing some of the
assets that would be required as a result of these investment projects in preference to
outright purchase of the assets. He is, however, a little uncertain as to the leasing options
available to the company.
Requirements
(a) Calculate the revised net present value of Project 3 at 31.12.X9 taking account of the
capital allowances attributable to that project. (4 marks)
(b) For each of the four scenarios, prepare calculations which show the proportion of each
project that should be undertaken. (12 marks)
(c) Summarise the different characteristics of finance leases and operating leases and
discuss the potential attractions of lease finance over outright purchase of an asset.
(8 marks)
3.2 The managing director of one of Horton's subsidiary companies has approached Horton's
finance director for advice. On 31 December 20X9 the subsidiary company will be
replacing its three existing company cars with brand new vehicles. The managing director
wishes to know whether to replace these new vehicles every one, two or three years from
now on. He has provided the following background information:
(1) Each new car will cost £11,000.
(2) Resale values for each car (assumed to be received in cash on the last day of the year
to which they relate) are estimated to be £7,000 after one year, £4,200 after two years
and £1,800 after three years.

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(3) Annual running costs for each car (assumed to be paid on the last day of the year to
which they relate) are estimated at £6,600 in the first year of ownership, £7,600 in the
second year and £9,200 in the third year.
(4) The subsidiary company uses a discount rate of 10% in its appraisal of such
investments.
(5) For the purposes of the advice to be given to the managing director, taxation and
inflation can be ignored.
Requirements
(a) Using appropriate calculations, advise the managing director of the optimal
replacement policy for these new company cars. (5 marks)
(b) Outline the limitations of the method used in answering 3.2(a) above. (6 marks)
Total: 35 marks
4 Broadham Hotels Ltd

Broadham Hotels Ltd (BH) owns and manages a hotel in a major Midlands city. The hotel has
500 identical, twin-bedded rooms for which a standard rate of £50 per night is charged, whether
the room is occupied by one or two people. Occupancy rates have fallen below those which
were envisaged when the hotel was built five years ago.
Septo, a Japanese-owned business, which is shortly to open a local manufacturing plant, has
approached the hotel's management with a proposal that it takes over 100 of the rooms, in
effect the whole of the top two floors of the hotel, to accommodate its staff and guests when
they visit the plant. Septo wishes to take over the rooms for a five-year period starting on 1 July
20X2. Septo would employ its own staff to service and manage the rooms.
On the basis of past experience and taking account of future developments in the market, the
hotel's management believes that future average nightly demand will be as follows.
Rooms Probability (%)
380 20
400 20
420 30
440 20
460 10
The hotel is open for 360 nights each year.
It is estimated that the variable costs of having a room occupied is on average 10% of the room
rate. All staff costs are effectively fixed costs, and no staff cost savings are expected to be made
by the hotel should the Septo proposal be accepted. The total fixed costs of running the hotel
are estimated at £4 million a year.
Under the proposal Septo would pay a fixed fee annually on 1 July from 20X2 to 20X6 inclusive.
There is expected to be a general annual rate of inflation of 3% throughout the five-year period.
This will affect the room rate, the variable costs and the fixed costs, all of which are stated above
at 1 July 20X2 prices.
BH has a corporation tax rate of 17% and an accounting year ending on 30 June. Tax will be
payable on the last day of the accounting year in which the relevant transactions occur. You
should assume that all operating cash flows occur on the last day of the relevant accounting
year, except for any receipt from Septo, which will be received on the first day.
BH's cost of capital, in real terms, is 10% per annum.

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Requirements
4.1 Determine, on the basis of net present value and the information given in the question, the
minimum fixed annual payment that Septo must make so that BH is at least as valuable in
expected value terms as it would be without the Septo proposal.
Notes
1 Work in 'money' terms.
2 Assume for this requirement that neither Septo's new plant nor the proposal to BH
would affect the projected nightly demand figures given in the question. (13 marks)
4.2 State and explain any other items of information, not mentioned in the question, that should
have been brought into the determination of the minimum annual payment in 4.1. (4 marks)
4.3 Discuss briefly whether in principle from Septo's perspective the planned provision of
accommodation seems a good idea. (5 marks)
Total: 22 marks
5 ProBuild plc
ProBuild plc (ProBuild) runs a network of builders' merchants in northern England. The company
has a small subsidiary, Cabin Ltd (Cabin) that hires out various types of portable cabin used on
building sites. In recent years, Cabin's performance (relative to that of ProBuild's core business)
has been disappointing and the directors of ProBuild have decided that they should focus
resources on their core operations and dispose of Cabin.
Having advertised the business for sale, ProBuild has now been approached by the directors of
Brixham plc (Brixham) with an offer to buy Cabin on 31 December 20X3. Brixham has agreed, in
principle, to pay ProBuild the net present value (as at 31 December 20X3) of the projected
incremental net cash flows of Cabin over the four-year period to 31 December 20X7.
You have been asked by Brixham's directors to calculate an appropriate purchase price using
the following information which has been provided by ProBuild and verified by independent
accountants:
(1) All cash flows can be assumed to occur at the end of the relevant year unless otherwise
stated.
(2) Inflation is expected to average 2% pa for all costs and revenues.
(3) The real discount rates applicable to the appraisal of this investment are:
20X4: 5%
20X5: 6%
20X6: 7%
20X7: 7%
(4) During the past five years, Cabin's annual revenue (at 31 December 20X3 prices) has been
extremely volatile, having peaked at £2 million in one year, whilst falling to a low of
£1.2 million in another year.
(5) During the past five years, Cabin's variable costs have been similarly volatile, being as low
as 25% of annual revenue in one year, whilst having been as high as 30% of annual revenue
in another year. There has been no direct correlation between annual revenue and variable
costs during the past five years.
(6) It has been estimated that under Brixham's ownership, annual fixed costs will be
£0.6 million (at 31 December 20X3 prices), including a share of Brixham's existing head
office costs equal to £0.25 million.

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(7) Working capital equal to 8% of Cabin's annual revenue for that year must be in place by the
start of the year concerned and, for the purposes of the calculation of a purchase price, it
can be assumed to be released in full on 31 December 20X7.
(8) Cabin has an existing commitment (which Brixham would have to honour as a condition of
its purchase of Cabin) to make a substantial investment of £1.5 million in new plant and
equipment on 31 December 20X3. This equipment is expected to have a useful working life
of four years, at which time it is estimated that it will be disposed of for a sum of £100,000
(at 31 December 20X7 prices).
This new plant and equipment will attract capital allowances of 18% pa on a reducing balance
basis commencing in the year of purchase and continuing throughout Brixham's ownership of
the equipment. A balancing charge or allowance will arise on disposal of the equipment on
31 December 20X7.
It can be assumed that sufficient profits would be available for Brixham to claim all such tax
allowances in the year they arise. It can also be assumed that the corporation tax rate will be 17%
for the foreseeable future, and that tax payments will occur at the end of the accounting year to
which they relate.
Requirements
5.1 Using money cash flows, calculate the net present values at 31 December 20X3 of the
Cabin business for both the 'worst case' and 'best case' scenarios. (17 marks)
5.2 Distinguish between the terms 'uncertainty' and 'risk' in the context of investment decision-
making and describe how the directors of Brixham might adjust the calculations made in
5.1 from calculations made under conditions of uncertainty to calculations made under
conditions of risk. (6 marks)
5.3 Explain what is meant by the term 'real options' and suggest two real options that might be
relevant to Brixham's purchase of Cabin. (6 marks)
Total: 29 marks
6 Frome Lee Electronics Ltd

Frome Lee Electronics Ltd (Frome Lee) makes small portable radios. Frome Lee's board has
been considering the financial implications of launching a new radio, which it would call 'The
Pink 'Un'. You have recently been appointed on a short-term contract at Frome Lee following the
sudden resignation of the company's chief accountant and have received this memo from the
managing director:
To: A Newman
From: Diana Marshall
As you are aware, our chief accountant, John Smith, left Frome Lee earlier this week following a
disagreement over company policy.
As a result we desperately need financial advice from you. We are considering the purchase of
capital equipment for the manufacture of a new radio, The Pink 'Un. Our marketing team feels
that we would have a competitive advantage with this new radio for three years. Mr Smith had
prepared some estimated figures which we were going to consider at our next meeting on
Monday and he left some of them behind. You will find my summary of them (with some of my
notes) in the Appendix below. We would want to purchase the equipment at the end of our
financial year on 30 September, commence production very soon after and sell the equipment
at the end of September 20Y1.

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The board would like to consider a complete set of figures and your recommendations over the
weekend so that we can reach a prompt decision on Monday. Apologies for giving you so little
time, but we don't want to miss what could be a valuable investment opportunity for the
company.
Diana Marshall
Friday 5 September
Appendix – summary of information available

Year to 30 September 20X8 20X9 20Y0 20Y1
£'000 £'000 £'000 £'000
Equipment cost (400.000)
Equipment scrap value 60.000
Working capital increment (32.000) (Note 1) (3.000) 40.000
Direct material costs (52.000) (64.000) (70.000)
Other variable costs (12.000) (14.000) (16.000)
Incremental fixed costs (11.000) (11.800) (12.700)
Sales (Note 1) Figures to be calculated
Direct labour costs (Note 2) Figures to be calculated
Notes
1 As you can see, I don't know the estimated sales figures, but we always make sure that we
have sufficient working capital, based on 10% of the annual sales, in place at the beginning
of the relevant year. All working capital will be recovered at the end of September 20Y1.
We need to know the missing figures for (a) annual sales (for 20X9–20Y1) and (b) working
capital (for 20X9) from this information.
2 We always estimate labour costs at 50% of material costs.
3 When discounting, we use a real cost of capital figure of 5% and make adjustments for
inflation when necessary. The figures in the appendix above are all in money terms and I'd
like you to use the following annual rates of general price inflation when working out the
present values of the estimated cash flows:
%
Year to 30 September 20X9 3
Year to 30 September 20Y0 3
Year to 30 September 20Y1 4
I'm not sure how accurate our cost of capital is, but I did read the other day that if a business
uses the wrong cost of capital figure 'it destroys shareholder value'.
Capital allowances
The equipment would attract capital allowances, but would be excluded from the general pool.
Assume that this means that it attracts 18% (reducing balance) tax allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
In the final year, the difference between the equipment's written down value for tax purposes
and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value; or
The corporation tax rate can be assumed to be 17% over the next three years.

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Requirements
6.1 Calculate the net present value at 30 September 20X8 of proceeding with production of
The Pink 'Un and advise the board as to whether it should purchase the equipment.
(15 marks)
6.2 Explain your approach to the effects of inflation in your calculation in 6.1 above. (3 marks)
6.3 In response to Diana Marshall's Note (3), discuss the view that a business, by using the
wrong cost of capital figure, 'destroys shareholder value'. (4 marks)
6.4 Explain, in the context of the proposed investment, the nature and importance of follow-on
and abandonment real investment options. (4 marks)
Total: 26 marks
7 Nuts and Bolts Ltd

Nuts and Bolts Ltd (NBL) manufactures parts for motor cars and the majority of its customers are
UK-based. Its financial year end is 31 March. Its management team is considering the purchase
of machinery that would produce a new type of catalytic converter (model number NBL 1114).
However, NBL's management team, mindful of the current weakness of the UK economy, is
uncertain as to the level of demand for NBL 1114. As a result it commissioned a market research
report from Ashford Hume Research and that report showed two alternative overall levels of
demand for NBL 1114 – pessimistic throughout the project's life or optimistic throughout the
project's life. The report concluded that these alternative overall levels of demand were equally
likely to occur.
For each of the overall levels of demand (pessimistic or optimistic), demand for NBL 1114 varies
in the first year of the project as shown here in Table 1:
Table 1
Pessimistic Optimistic
Annual demand Probability Annual demand Probability
(units) (units)
6,000 25% 10,000 25%
10,000 50% 14,000 37.5%
14,000 25% 20,000 37.5%
Demand in each subsequent year of the project's life would remain at the first year's expected
level.
Financial information about the new machinery and NBL 1114 is shown here in Table 2:
Table 2
NBL 1114's period of competitive advantage (1 April 20X1 to 31 March 20X4) 3 years
Maximum annual output of new machinery (units of NBL 1114) 12,800
Cost of new machinery (payable on 31 March 20X1) £480,000
Scrap value of new machinery (at end of three year period, ie, 31 March 20X4) £nil
NBL 1114's contribution per unit (based on a selling price per unit of £65) £33
Additional annual fixed costs incurred (including annual depreciation charge of
£160,000) £300,000
Extra working capital required at 31 March 20X1 (recoverable in full on 31 March
20X4) £50,000
Working capital
The working capital requirement for each year must be in place at the start of the relevant year.

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Capital allowances
NBL's machinery and equipment attracts capital allowances, but is and will be excluded from the
general pool. The equipment attracts 18% (reducing balance) capital allowances in the year of
In the final year, the difference between the equipment's written down value for tax purposes
and its disposal proceeds will be treated by the company either as a:
Inflation
All of the above figures are stated at 31 March 20X1 prices. NBL's management is unsure of the
rate of inflation and would like to consider the impact of either 0% or 5% annual inflation.
Other relevant information:
(1) NBL's directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future and the tax will be payable in the same year as the cash flows to which it
relates.
(2) Unless otherwise stated all cash flows occur at the end of the relevant trading year.
(3) NBL uses a real post-tax cost of capital of 10% for appraising its investments.
Requirements
7.1 Assuming that the annual rate of inflation is zero, calculate the expected net present value
of the NBL 1114 project at 31 March 20X1 and advise NBL's management whether it should
purchase the new machinery. (18 marks)
7.2 Assuming that the annual rate of inflation is 5%, explain, with supporting calculations, what
the impact will be on the expected net present value at 31 March 20X1 of this proposed
investment if the effects of inflation on pre-tax contribution and working capital are taken
into account. (6 marks)
Total: 24 marks
8 Newmarket plc
Newmarket plc (Newmarket), a listed company, has recently developed a new lawnmower, the
NL500. Development of the NL500 was supported by market research which was undertaken by
an external agency who agreed that their £10,000 fee would only be payable if the NL500 was
actually launched, with payment due at the end of the NL500's first year on the market.
Newmarket's directors estimate that the market life of the NL500 will be five years but they
would be willing to launch the NL500 only if they were satisfied that the required investment
would generate a net present value of at least £300,000, using a discount factor of 10% pa.
Production and sale of the NL500 would commence on 1 July 20X3 and would require
investment by Newmarket in new production equipment costing £750,000, payable on 30 June
20X3. On 30 June 20X8 it is expected that this equipment could be sold back to the original
vendor for £50,000. Newmarket depreciates plant and equipment in equal annual instalments
over its useful life.
The company's directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future, and it can be assumed that tax payments would occur at the end of the
accounting year to which they relate. The directors are also assuming that the new production
facilities would attract capital allowances of 18% pa on a reducing balance basis commencing in
the year of purchase and continuing throughout the company's ownership of the equipment. A
balancing charge or allowance would arise on disposal of the equipment on 30 June 20X8. It
can be assumed that sufficient profits would be available for Newmarket to claim all such tax
allowances in the year they arise.

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Purchase of the new production equipment would be financed by a five-year fixed rate bank
loan which will be drawn down on 30 June 20X3 at an interest rate of 6% pa. Interest on the loan
would be payable annually, with repayment of the capital being made in full on 30 June 20X8.
Newmarket's marketing director has estimated annual demand for the NL500 to be 2,000 units
and on that basis the finance department has estimated the unit cost of the NL500 as follows:
£
Labour (4 hours @ £12 per hour) 48.00
Components 32.00
Loan interest 22.50
Depreciation 70.00
Variable energy costs 5.00
Share of Newmarket's fixed costs 20.00
197.50
If the NL500 is launched, a manager already employed by Newmarket would be moved from his
present position to manage production and sale of the NL500. This existing manager's position
would consequently have to be filled by a new recruit, specifically employed to replace him, on
a five-year contract at a fixed annual salary of £35,000. The launch of the NL500 would have a
negligible impact on both Newmarket's working capital requirements and on its fixed costs.
Newmarket's accounting year end is 30 June and it can be assumed that all cash flows would
occur at the end of the year to which they relate.
Requirements
8.1 Calculate (to the nearest £) the minimum price per unit that Newmarket should charge for
the NL500 if a net present value of at least £300,000 is to be achieved. (15 marks)
8.2 Identify and describe two quantitative techniques that Newmarket could use to assess and
adjust for the various risks to which launching the NL500 would expose the company.
(6 marks)
8.3 Distinguish between systematic risk and non-systematic risk and explain, using examples,
how each of these types of risk might apply to the launch of the NL500. (6 marks)
8.4 Identify and explain, in the context of the proposed investment in the NL500, the nature and
importance of the real options available to Newmarket. (8 marks)
Total: 35 marks
9 Grimpen McColl International Ltd

Grimpen McColl International Ltd (GMI) specialises in the construction of hydroelectric dams. It
has a financial year end of 31 December. GMI is currently negotiating with the government of a
South American country regarding a new dam that the government plans to build on a tributary
of the River Amazon. You work for GMI and have been asked to advise its directors during the
negotiations. The following information has been collected:

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Costs
GMI's estimated costs of constructing the dam (all at 31 December 20X2 prices except where
stated otherwise) are shown below:
31 December
20X2 20X3 20X4 20X5
£'000 £'000 £'000 £'000
Specialist machinery (Note 1) 30,000
Working capital (Note 2) 5,000
Materials and labour costs 7,000 8,000 9,000
Overheads (Note 3) 4,000 4,500 5,000
Lost contribution (Note 4) 4,000 4,000 4,000
Notes
1 GMI will need to purchase specialist machinery for the construction of the dam. This will
have an estimated resale value at the end of the construction period of £5 million (at
31 December 20X5 prices).
2 The initial working capital required will increase by £1 million pa (in 31 December 20X2
prices), but will be fully recoverable on 31 December 20X5.
3 The overhead costs include a share of GMI head office costs which have been allocated to
this project at a rate of £1.5 million pa.
4 South America would be a new market for GMI and its directors are keen to win this
contract. If GMI were successful then it would be necessary to transfer resources from other
projects – typically service contracts for existing GMI dams in Europe and North America.
The directors estimate that this would result in a loss of contribution in each year of the
construction period.
Inflation rates and cost of capital
GMI's directors propose using the following inflation rates:
Materials, labour and overhead costs 4% pa
Working capital 4% pa
Lost contribution 5% pa
GMI's directors plan to use a money cost of capital of 8% when appraising this investment.
However, one of GMI's directors has commented 'I think that our hurdle rate may be wrong.
Inflation rates may actually be higher than those used in our estimates, which should be adjusted
to take account of this.'
Capital allowances
The specialist equipment attracts 18% (reducing balance) capital allowances in the year of
In the final year, the difference between the plant and equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company either:
or
Contract price
GMI's board is keen that the contract price is not too high and has tendered a price of £95 million.
£10 million would be receivable on 31 December 20X2 when the specialist equipment is
purchased. The second instalment of £85 million (in 31 December 20X5 prices) would be
receivable on completion of the dam.

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Taxation
GMI's directors wish to assume that the corporation tax rate will be 17% for the foreseeable
Maintenance contract
The South American government has also proposed that, were GMI to build the dam, then GMI
should also provide annual maintenance in perpetuity from completion of the dam on
31 December 20X5. GMI's directors estimate that this would cost GMI £3 million pa (in
31 December 20X5 prices) and feel that it would be reasonable to charge a price of £5 million
pa (in 31 December 20X5 prices). Costs and revenues for the maintenance contract are
expected to rise by 3% pa after 31 December 20X5. However, they are concerned about such a
long-term commitment and would like to investigate the price at which GMI could sell this
maintenance contract to another company.
Other information
 Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
 Ignore all foreign currency issues.
Requirements
9.1 Ignoring the maintenance contract, calculate the net present value of the dam project at
31 December 20X2 and advise GMI's directors whether they should proceed with it.
(13 marks)
9.2 Calculate the minimum value of the second instalment of the contract price (receivable on
31 December 20X5) that would be acceptable to the GMI board, assuming that it wishes to
enhance shareholder value. (3 marks)
9.3 With reference to the GMI director's concerns about the rates of inflation being more than
the original estimates, discuss the potential effect of this on the project's cash flows, cost of
capital and net present value. (5 marks)
9.4 Advise the GMI board, showing supporting calculations, of the minimum selling price on
31 December 20X2 that it should set were it to sell the maintenance contract. (4 marks)
9.5 Discuss the types of political risk that GMI may encounter were its proposed investment in
South America to proceed. (5 marks)
Total: 30 marks
10 Wicklow plc
Wicklow plc (Wicklow) is a manufacturer of prestige cast iron cookers, having a long-standing
reputation for selling distinctive high price, high quality cookers to an increasingly global
market. In the face of growing competition from firms offering slightly more modern style
cookers at much lower prices, Wicklow's recent strategy has been to introduce a 'Heritage'
version of some of its major product lines. The aim has been to emphasise the original design
features of the brand and to differentiate itself further from its competitors.
Wicklow is currently considering the introduction of a 'Heritage' version of its existing 'Duo'
product, a standard two-oven cooker. Wicklow has recently spent £375,000 developing the new
version of the product, to be known as the Duo Heritage (DH).
Production of the DH would require Wicklow to invest £2 million in new machinery and
equipment on 31 December 20X8. Based on past experience, the directors are assuming that
this machinery and equipment will have a disposal value on 31 December 20Y2 of £200,000.
Sales of the DH would be expected to commence during the year ending 31 December 20X9.
Based on a unit selling price of £7,000, Wicklow's marketing director has estimated that unit
sales in 20X9 will be either 1,500 (0.65 probability) or 2,000 (0.35 probability). In view of the

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uncertainty of unit demand in the first year of production, the marketing director has also
forecast that if 20X9 sales were to be 1,500 units, then 20Y0 sales would be estimated at either
1,800 units (0.7 probability) or 2,000 units (0.3 probability). However, if 20X9 sales were to be
2,000 units, 20Y0 sales would be estimated at either 2,200 units (0.6 probability) or 2,500 units
(0.4 probability). In 20Y1 and 20Y2 unit sales would be 110% of the expected unit sales in 20Y0.
In each year production will equal sales, which can be assumed to occur on the last day of each
year.
As with other similar 'Heritage' product launches, the company invariably experiences a
consequent loss of sales on the original product line. In this particular case, the expectation is
that for every two DHs sold, the sale of one standard Duo oven will be lost. This effect would be
expected to continue throughout the four years over which the directors have decided to
appraise this potential project. As a result, it can be assumed that sales of both cookers will not
continue beyond 20Y2.
The unit selling price and cost structure of the standard Duo product are as follows:
£
Selling price 6,500
Materials 3,516
Labour (8 hours) 200
Fixed overheads (on a labour hour basis) 480
Launch of the DH is not expected to impact on the company's total fixed overheads.
The material cost per unit of the DH will be £3,800. Production of each DH will require eight
hours of labour. The reduced levels of production on the Duo product line would mean that part
of this labour requirement will be met from labour transferred from that product, but to the
extent that this would provide insufficient hours, additional labour will be recruited at the
company's standard labour rate of £25 per hour.
Each major product line within Wicklow is currently managed by a dedicated team of managers.
However, should the DH be launched, one additional manager would need to be recruited to
the Duo team. Wicklow has identified this new manager. He is currently employed by the
company and had recently accepted voluntary redundancy but would now be asked to stay on
until 31 December 20Y2. He was due to leave Wicklow on 31 December 20X8 and to receive a
lump sum of £35,000 at that time. He will be paid an annual salary of £40,000 together with a
lump sum bonus of £20,000 payable on 31 December 20Y2.
Working capital to support production of the DH would be expected to run at a rate of 15% of
sales value, although this would be off-set to some extent by reduced working capital
commitments in respect of the standard Duo product which also requires working capital equal
to 15% of sales value. The working capital would need to be in place by the beginning of each
year and can be assumed to be released in full on 31 December 20Y2. The working capital flows
will have no tax effects.
Regarding tax, the directors are assuming that if Wicklow buys the new machinery and
equipment it will attract capital allowances of 18% per annum on a reducing balance basis,
commencing in the year of acquisition, with either a balancing charge or allowance arising at the
end of the equipment's useful life. The company can be assumed to be in a position to claim all
tax allowances in full as soon as they become available and to pay corporation tax at a rate of
17% per annum over the life of the DH project. All tax is payable at the end of the year to which it
relates.
At the present time the company is financed entirely by equity and it has been decided that this
will continue even if the DH is launched, with internal funds being used to finance the
investment. The decision on whether or not to introduce the DH is to be based on the expected
net present value of the relevant cash flows, discounted at the company's cost of equity capital
of 8%.

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However, the finance director had argued strongly that if Wicklow did decide to introduce the
DH, then the company should partly finance the project with a four-year loan of £2 million (at an
interest rate of 5% per annum), which would be well within Wicklow's current debt capacity.
Requirements
10.1 Calculate the expected net present value at 31 December 20X8 of the introduction of the
DH product and advise the directors whether or not Wicklow should proceed with its
introduction. (18 marks)
10.2 Calculate the sensitivity of the decision to invest in DH to changes in:
(a) The DH selling price (for the purpose of this calculation, assume working capital does
not change)
(b) The cost of equity (7 marks)
10.3 Calculate the adjusted present value of the introduction of the DH product if Wicklow had
decided to inject debt on the basis proposed by the finance director. (4 marks)
10.4 Making reference to relevant theories, explain the weaknesses of the adjusted present value
methodology used in 10.3 above.
(6 marks)
Total: 35 marks
Note: Ignore inflation.
11 Air Business Ltd

Air Business Limited (ABL) is a UK airline company that offers flights between London and
European cities. All six of its aircraft are four-seaters and the company offers an exclusive travel
service for business customers. ABL has a financial year end of 30 September and has been
trading since 1992. Historically it has not tried to compete with cheaper competitors. However,
the company has now endured two years of stagnant sales.
ABL's board is considering changing its business strategy. It will reduce ticket prices and, to
accommodate the expected increase in demand, buy three larger aircraft to replace two of its
existing aircraft. You work in ABL's finance team and have been asked to help the board with
their decision regarding this proposed investment. You have been given the following
information:
Life of investment
You have been informed that, because of the volatility of the airline market, the board wishes to
set a three-year time limit on this investment appraisal.
Sales and costs
Table 1 below (with notes) is a summary of recent and estimated sales and costs prepared by
ABL's management accounting team:
Table 1
Current strategy Proposed strategy
Sales and costs Annual sales and costs
(year to 30 September 20X3) (three years to 30 September 20X6)
25% Fixed 22% Fixed
Sales margin costs Profit Sales margin costs Profit
£'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
4,150 1,038 (50) 988 7,350 1,617 (90) 1,527

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Notes
1 '% margin' represents the contribution to sales ratio.
2 All figures in Table 1 are in 30 September 20X3 prices.
3 Sales and costs, in 30 September 20X3 prices, can be assumed to remain constant for the
next three years if no change in strategy occurs.
Capital expenditure
On 30 September 20X3 ABL will purchase three larger aircraft for £1 million each. Management
estimates that these would have a trade-in value of £200,000 each (in 30 September 20X6
prices) on 30 September 20X6.
These three new aircraft will replace two of its existing aircraft, which have a current tax written
down value of zero and will be traded in for £380,000 each on 30 September 20X3.
The aircraft will attract 18% (reducing balance) capital allowances in the year of expenditure and
in every subsequent year of ownership by the company, except the final year. In the final year,
the difference between the aircrafts' written down value for tax purposes and their disposal
proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down value; or
Working capital
ABL currently has a working capital investment of £140,000 on 30 September 20X3. The
proposed strategy is expected to increase this to £220,000 on 30 September 20X3 and any
incremental working capital will be fully recoverable on 30 September 20X6.
Inflation
ABL's sales, costs and working capital are all expected to increase in line with the general rate of
inflation, which is estimated at 5% pa.
Taxation
ABL's directors wish to assume that the corporation tax rate will be 17% for the foreseeable
Cost of capital
For investment appraisal purposes ABL uses a money cost of capital of 8% pa.
Other information
Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
In addition to this investment appraisal, ABL's directors are aware that there have been a
number of takeovers and mergers in the airline industry in the past three years. They are
concerned that the company might be the subject of a takeover bid and wish to explore how
they could make use of Shareholder Value Analysis to value the company.
Requirements
11.1 Calculate the net present value of the proposed investment in the three new aircraft on
30 September 20X3 and advise ABL's directors whether they should proceed with the
investment. (16 marks)
11.2 Calculate the sensitivity of your advice in 11.1 to:
(a) Changes in the estimated trade-in value of the new aircraft at 30 September 20X6.
(4 marks)
(b) Changes in the estimated incremental annual profits arising from the new strategy.
(5 marks)

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11.3 Explain the theory underpinning the Shareholder Value Analysis method of valuing a
business and advise ABL's directors as to what extent your calculations in 11.1 could be
used to calculate a valuation of ABL using this method were it to be subject to a takeover
bid. (10 marks)
Total: 35 marks
12 Daniels Ltd
Daniels Ltd (Daniels) is a large civil engineering company and it has a financial year end of
31 May. Much of Daniels' work involves long-term contracts for the railway industry. You work for
Daniels and have been asked for advice by the board on the following problems:
Problem 1
Daniels is considering a major investment involving five possible projects in the West of England
and South Wales which have been put out to tender. Daniels' board of directors has prepared
the following estimated cash flows (and resultant net present values at 31 May 20X7) for the five
projects:
Investment Year to Year to Year to
Project Location on 31/5/X7 31/5/X8 31/5/X9 31/5/Y0 NPV
£'000 £'000 £'000 £'000 £'000
B Bristol (4,150) (1,290) 530 7,270 577
C Cardiff (3,870) (1,310) 3,130 1,550 (1,309)
G Gloucester (6,400) 1,770 2,160 3,160 (632)
S Swansea (5,000) (2,610) 6,450 6,520 2,856
T Tiverton (4,600) 1,290 2,870 3,620 1,664
You can assume that the net present values shown in the table above are accurate.
Due to financial constraints, the company, if successful with its tenders, would be unable to take
on all five projects. The board is prepared to release £8 million for initial investment (on 31 May
20X7) into one or more of the projects, but might increase this figure to £9 million if there are
grounds for doing so. An alternative scenario which has been considered would be to make
available sufficient funds to start all five projects in May 20X7, but this would limit the capital
available in the year to 31 May 20X8 to a maximum of only £500,000.
Problem 2
Daniels runs a fleet of vans to support its operations. Currently it replaces those vans every three
years, but the board is not sure whether this is in the company's best interests. Vans cost, on
average, £12,400 each. Daniels' transport manager has prepared the following schedule of
costs and resale values for the vans:
Maintenance and
running costs Resale value
£ £
In first year of van's life 4,300 After one year 9,800
In second year of van's life 4,800 After two years 7,000
In third year of van's life 5,100 After three years 5,000
Problem 3
About a year ago (March 20X6) Daniels completed construction of a factory for Kithill Ltd (Kithill).
This cost Daniels £720,000 to construct and Kithill is paying £190,000 a year for eight years.
Daniels will, therefore, ultimately make a profit of £800,000, which gives a return on the
investment of over 100%. When Kithill sent its first annual instalment last week, it indicated that
rather than make annual payments it would prefer to settle the outstanding balance by making a
one-off payment of £925,000 in a year's time (March 20X8). One of Daniels' directors is keen on

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this proposal stating 'I know that this is less than we would receive over the full eight years, but
my calculations show that the internal rate of return would be much better.'
General information
(1) Daniels uses a cost of capital of 10% when appraising possible investments.
(2) You should assume that all cash flows take place at the end of the year in question.
(3) All projects are independent.
Requirements
12.1 For Problem 1, assuming that all of the projects are divisible and:
(a) Assuming that Daniels has no capital rationing, advise its directors as to which projects
should be accepted. (2 marks)
(b) Assuming that the directors are prepared to spend a maximum of £8 million on
31 May 20X7, advise them as to which projects should be accepted. (3 marks)
(c) Assuming that the directors are prepared to make available sufficient funds to start all
five projects on 31 May 20X7, but only £500,000 on 31 May 20X8, advise them as to
which projects should be accepted. (5 marks)
12.2 For Problem 1, assuming that none of the projects are divisible and that the directors are
prepared to spend a maximum of £9 million on 31 May 20X7, advise them as to which
projects should be accepted. (4 marks)
12.3 For Problem 2, advise the directors as to the optimal replacement period for Daniels' vans
and comment on the limitations of the approach used. (6 marks)
12.4 For Problem 3, advise the directors as to whether they should accept Kithill's proposal.
(5 marks)
Total: 25 marks
Note: Ignore taxation.
13 Adventurous plc
Adventurous plc (Adventurous) is a UK listed company that manufactures and sells global
positioning system (GPS) devices worldwide. Following favourable market research that cost
£20,000, Adventurous has developed a new GPS-based bicycle computer (BC). It intends to set
up a manufacturing facility in the UK, although the board of Adventurous had contemplated
setting up in an overseas country. The BC project will have a life of four years.
The selling price of the BC will be £295 per unit and sales in the first year to 31 December 20X4
are expected to be 10,000 units per month, increasing by 5% pa thereafter. Relevant direct
labour and materials costs are expected to be £170 per unit and incremental fixed production
costs are expected to be £3 million pa. The selling price and costs are stated in
31 December 20X3 prices and are expected to increase at the rate of 3% pa. Research and
development costs to 31 December 20X3 amounted to £1 million.
Investment in working capital will be £1.5 million on 31 December 20X3 and this will increase in
line with sales volumes and inflation. Working capital will be fully recoverable on
31 December 20X7.
Adventurous will need to rent a factory for the life of the project. Annual rent of £1 million will be
payable in advance on 31 December each year and will not increase over the life of the project.

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Plant and machinery will cost £50 million on 31 December 20X3. The plant and machinery is
expected to have a resale value of £15 million (in 31 December 20X7 prices) at the end of the
project. The plant and machinery will attract 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the plant and machinery's written down value for
tax purposes and its disposal proceeds will be treated by the company either:
or
Adventurous' directors wish to assume that the rate of corporation tax will be 17% pa for the
foreseeable future and that tax flows arise in the same year as the cash flows which gave rise to
them.
The project will be financed from the company's pool of funds and there will be no change in
current gearing levels. An appropriate weighted average cost of capital for the project is 10%
pa.
Adventurous' directors are concerned that there are rumours in the industry of research by a
rival company into a much cheaper alternative to the GPS devices currently available. However,
the rumours that the directors have heard suggest that this research will take another year to
complete and, if it is successful, it will be a further year before any new devices are operational.
Requirements
13.1 Calculate, using money cash flows, the net present value of the BC project on 31 December
20X3 and advise Adventurous' board as to whether it should proceed. (15 marks)
13.2 Calculate and comment upon the sensitivity of the project to a change in each of the
following:
(a) The annual rent of the factory
(b) The weighted average cost of capital (7 marks)
13.3 Assume now that the project had been financed entirely by debt and that this had caused
the gearing of Adventurous to change materially. Describe how you would have appraised
the project in such circumstances. (3 marks)
13.4 If the board of Adventurous decided to set up the manufacturing facility overseas, advise
the board on how political risk could change the value of the project and how it might limit
its effects. (5 marks)
13.5 Identify and discuss the real options available to Adventurous in relation to the BC project.
(5 marks)
Total: 35 marks
14 Hawke Appliances Ltd

14.1 Hawke Appliances Ltd (Hawke) is a UK-based manufacturer of household appliances. It has
a financial year end of 31 December. You work for Hawke and have been asked to advise
the company's board on the viability of a proposed new product.
The company is considering the development of a new vacuum cleaner, the JH143. This will
be more expensive than Hawke's other vacuum cleaners but it contains a number of
innovative design features that Hawke's board believes will be attractive in an increasingly
competitive market. Because of these market conditions, Hawke's board wishes to evaluate
the JH143 over a three-year time horizon.

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Selling price, materials and unskilled labour

You have obtained the following information on the budgeted price and costs per unit for
the JH143 (in 31 December 20X4 prices):
£
Selling price 155
Materials 53
Unskilled labour 28
Fixed costs are not expected to increase as a result of producing the JH143.
Skilled labour
Each JH143 will require one hour of skilled labour that is in short supply. Hawke will need to
transfer some of its skilled labour away from making another older vacuum cleaner (the
JH114), which requires half the skilled labour time per unit of the JH143. The current selling
price of the JH114 is £96 and its materials and unskilled labour costs total £74 per unit (in
31 December 20X4 prices). Hawke's skilled labour is paid £8.80 per hour (in 31 December
20X4 prices).
Inflation
Revenues and costs are expected to inflate at a rate of 4% pa.
Sales volumes
Hawke commissioned market research at a cost of £55,000 for the JH143 project, half of
which remains unpaid and is due for settlement on 31 December 20X4. An extract from the
results of that market research is shown here:
20X5 20X6 20X7
Estimated annual sales of the JH143 (units) 50,000 95,000 45,000
Machinery
Specialised new production machinery will be required in order to make the new vacuum
cleaner. This machinery will cost £4.5 million to buy on 31 December 20X4 and will have an
estimated scrap value of £1 million on 31 December 20X7 (in 31 December 20X7 prices). If
production of the existing JH114 is reduced then some of Hawke's older machinery could
be sold on 31 December 20X4. This machinery had a tax written down value of £80,000 on
1 January 20X4 and Hawke estimates that it could be sold for £220,000.
The machinery will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the machinery's written down value for tax
purposes and its disposal proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down
value; or
 as a balancing charge, if the disposal proceeds are more than the tax written down
value.
Corporation tax
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Working capital
Hawke will invest in working capital at a rate of 10% of the JH143's annual sales revenue, to
be in place at the start of each year. It expects to recover the working capital in full on
31 December 20X7.
Cost of capital
Hawke uses a money cost of capital of 12% pa for investment appraisal purposes.

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Requirements
(a) Using money cash flows, calculate the net present value on 31 December 20X4 of the
proposed development of the JH143 and advise the company's board whether it
should proceed with the investment. (16 marks)
(b) Ignoring the effects on working capital, calculate the sensitivity of your advice in part
(a) to:
 changes in the selling price of the JH143 (3 marks)
 changes in the volume of sales of the JH143 (4 marks)
14.2 Hawke's board is also investigating the possibility of buying another company, Durram
Electricals Ltd (Durram) which is a successful retailer of electrical goods. The board has
obtained the following information about Durram:
Earnings and cash flows for the year ended 31 August 20X4 £700,000
Expected growth of earnings and cash flows 5% pa
Book value of equity at 31 August 20X4 £3,600,000
Average industry P/E ratio 11
Cost of capital 12% pa
Hawke's board has no experience of buying another company and you have been invited to
the next board meeting to answer these questions:
(a) What range of values is reasonable for Durram on 31 August 20X4?
(b) Why do many acquisitions not benefit the bidding firm?
(c) Would it be better to pay for Durram in cash or with Hawke's shares?
Requirement
Prepare calculations and notes that will enable you to answer these questions at the next
board meeting. (12 marks)
Total: 35 marks
15 Alliance plc
You should assume that the current date is 31 December 20X5.
Alliance plc (Alliance) is a manufacturer of electronic devices. At a recent board meeting two
agenda items were discussed as follows:
(1) The possible development of an automatic watering system (Autowater) for indoor potted
plants in private houses and business premises. The sales director commented that there
are similar more expensive products on the market and it is likely that competitors will
develop their technology and bring down their prices in future. Therefore, it would be
prudent to assume a life cycle of four years for the Autowater.
(2) For other projects that have already been appraised using NPV analysis, the 20X6 capital
expenditure budget (excluding Autowater) should not exceed £350 million. The
£350 million will be allocated to projects, excluding Autowater, on the basis of maximising
shareholder wealth.
The chairman of Alliance closed the meeting with the following statement:
"We will continue to see excellent opportunities to invest in profitable projects across
our business and we have no difficulty in raising finance. However we will be
disciplined in our approach to committing to capital expenditure. I would now like the
finance director to evaluate the Autowater project and to determine in which other
projects the £350 million 20X6 capital expenditure budget is going to be invested."

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The following information is available regarding the Autowater project:

 The selling price will be £800 per unit for the year to 31 December 20X6 and will then
increase by 5% pa. Contribution is 40% of the selling price.
 The number of units sold in the year to 31 December 20X6 is expected to be 9,000 per
month. For the year to 31 December 20X7 the number of units sold will increase by 15%.
Because of increased competition in the market it is anticipated that in the two years to
31 December 20X9 the number of units sold will decline by 10% pa.
 Incremental fixed production costs are expected to be £4 million pa and will increase after
31 December 20X6 by the general level of inflation.
 Alliance will rent a factory at an annual rent of £1.5 million, payable in advance on
31 December. The rent is not subject to inflationary increases.
 Investment in working capital will be £2 million on 31 December 20X5 and will increase or
decrease at the start of each year in line with sales volumes and the unit selling price.
Working capital will be fully recoverable on 31 December 20X9.
 On 31 December 20X5 the project will require an investment in machinery and equipment
of £60 million, which is expected to have a realisable value of £5 million (in 31 December
20X9 prices) at the end of the project. The machinery and equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent
year of ownership by the company, except the final year.
In the final year, the difference between the machinery and equipment's written down value
for tax purposes and its disposal proceeds will be treated by the company either:
(1) as a balancing allowance, if the disposal proceeds are less than the tax written down
value; or
(2) as a balancing charge, if the disposal proceeds are more than the tax written down
value.
 Assume that the rate of corporation tax will be 17% pa for the foreseeable future and that
tax flows arise in the same year as the cash flows that gave rise to them.
 An appropriate real cost of capital for the Autowater project is 7% pa and the level of
general inflation is expected to be 3% pa.
The following information relates to the 20X6 capital expenditure budget of £350 million and
excludes the Autowater project.
The indivisible projects available for investment of the £350 million are:
Project Initial expenditure £ million NPV £ million
A 100 180
B 50 90
C 40 100
D 140 150
E 100 140
Requirements
15.1 Using money cash flows, calculate the net present value of the Autowater project on
31 December 20X5 and advise the board whether it should accept the project. (16 marks)
15.2 Ignoring the effects on working capital, calculate the sensitivity of the Autowater project to
changes in sales revenue and indicate whether there is a sufficient margin of safety for the
project to go ahead. (4 marks)

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15.3 Discuss the disadvantages of sensitivity analysis and explain how simulation might be a
better way to assess the risk of the project. (6 marks)
15.4 With regard to the 20X6 capital expenditure budget of £350 million:
(a) Discuss the differences between hard and soft capital rationing and comment on the
form of capital rationing that is being employed by Alliance. (5 marks)
(b) Determine the combination of projects that will maximise shareholder wealth.
(4 marks)
Total: 35 marks

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16 Bradford Bedwyn Medical plc

Bradford Bedwyn Medical plc (BBM) is a UK company that manufactures a range of medical
equipment for use in hospitals and doctors' surgeries. BBM has a year end of 28 February and it
has been trading since 1993.
Extracts from BBM's most recent management accounts are shown below:
Income statement for the year ended 28 February 20X4
£'000
Profit before interest and taxation 6,512
Debenture interest (516)
Profit before taxation 5,996
Taxation (17%) (1,019)
Profit after taxation 4,977
Dividends (1,493)
Retained profit 3,484
Balance sheet at 28 February 20X4

£'000
Ordinary share capital (£1 shares) 34,600
Retained earnings 31,384
65,984
6% Redeemable debentures (redeemable 20X9) 8,600
74,584
BBM's ordinary shares had a market value of £2.45 each (ex-div) and a beta of 0.9 on
28 February 20X4. The return on the market is expected to be 8.6% pa and the risk free rate
2.1% pa.
BBM's debentures had a market value of £110 (cum interest) per £100 nominal on 28 February
20X4 and they are redeemable at par on 28 February 20X9.
BBM's board is now considering diversifying its operations by expanding into a new market. The
average equity beta for companies already operating in this market is 1.9 with an average ratio
of equity to debt (by market values) of 83:17.
This diversification will cost BBM approximately £25 million. However, there is disagreement
amongst BBM's directors as to how the diversification should be funded and whether it should
happen at all. There are three proposals that are being considered:
Proposal 1
BBM proceeds with the diversification. It would raise the additional funding required from equity
and debt sources in such a way as to leave its existing equity: debt ratio (by market values)
unchanged following the diversification. The additional debt raised would be in the form of 8%
redeemable debentures issued at par.
Proposal 2
BBM proceeds with the diversification. It would raise all of the additional funding required in the
form of 8% redeemable debentures issued at par.
Proposal 3
BBM does not proceed with the diversification. The funds, raised as in proposal 2, are used
instead to buy back some of its ordinary shares.

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Requirements
16.1 Ignoring the diversification plans, calculate BBM's WACC (weighted average cost of capital)
on 28 February 20X4, using:
(a) The Gordon growth model (10 marks)
(b) The CAPM (3 marks)
16.2 Explain the limitations of the Gordon growth model. (3 marks)
16.3 Assuming that Proposal 1 is accepted and using the CAPM, calculate the WACC that BBM
should use when appraising its diversification plans and explain your reasoning. (9 marks)
16.4 Assuming that Proposal 2 is accepted, discuss the issues that BBM faces when trying to
determine an appropriate WACC for appraising its diversification plans. Your answer
should make reference to relevant theories. (5 marks)
16.5 Assuming that Proposal 3 is accepted, explain why BBM would wish to buy back its shares
and the implications for its shareholders. (5 marks)
Total: 35 marks
17 Penny Rigby Fashions plc

Penny Rigby Fashions plc (PRF) is a UK-based fashion clothes retailer. It has a financial year end
of 31 May. A friend of yours is a PRF shareholder and has emailed you recently following his
attendance at PRF's annual general meeting (AGM) in August. An extract from his email is shown
here:
At the AGM a sheet of 'Key Figures' was distributed to PRF shareholders. However they weren't
explained very well and I wondered if you could help. Here they are:
Penny Rigby Fashions plc – Key Figures at 31 May 20X1
Type of Total Market Post-tax

Capital Nominal Value Value Cost of Capital
£m
Ordinary shares (50p) 4.0 £2.00/share ex-div 10.50% (ke)
Preference shares (25p) 0.8 £0.80/share ex-div 8.75% (kp)
Irredeemable debentures
(£100) 1.4 £110% ex-int 4.17% (kd)
Weighted Average Cost of Capital (WACC) at 31 May 20X1 9.791%
Retained profits for trading year to 31 May 20X1 £300,000
Dividend growth in the last 3 years 0% pa
PRF's managing director said that when calculating these figures, PRF's directors had taken
account of taxation where appropriate, assuming that the corporation tax rate will be 17% for
the foreseeable future and that tax will be payable in the same year as the cash flows to which it
relates.
PRF's managing director also made these statements at the AGM:
(1) The WACC of 9.791% represented the total return to the company's providers of finance ie,
the total of the after-tax interest and dividends for the trading year to 31 May 20X1.
ICAEW 2019 Finance and capital structure 27

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(2) Unless the company exceeds the WACC 'hurdle rate' when investing in new projects then
shareholder value will be destroyed.
(3) It is possible to calculate, using the 'Key Figures' provided, the following for PRF for the
trading year to 31 May 20X1 – earnings per share, price earnings ratio, gearing ratio and
profit before interest and tax. He said something about 'working backwards' to get these
but I'm not sure what he meant.
Requirements
17.1 Show, with workings, how PRF's WACC figure of 9.791% has been calculated.
Note: Assume that the figure of 9.791% is correct. (4 marks)
17.2 Calculate PRF's total after-tax interest and dividends for the year to 31 May 20X1 and show
how these relate to its WACC figure of 9.791%. (5 marks)
17.3 Explain the managing director's statement regarding the WACC as a 'hurdle rate' in your
friend's email. (4 marks)
17.4 Calculate the following for PRF for the year to/at 31 May 20X1:
(a) Earnings per share
(b) Price earnings ratio
(c) Gearing ratio (based on market values)
(d) Profit before interest and tax (8 marks)
17.5 Explain in general terms how the rate of dividend growth can be calculated and the
significance of PRF's dividend growth figure of 0%. (6 marks)
Total: 27 marks
18 Turners plc
Turners plc (Turners) is a listed company in the food retailing sector and has large stores in all
the major cities in the UK. Turners' board is considering diversifying by opening holiday travel
shops in all of its stores.
At a recent board meeting the directors were discussing how the holiday travel shops project
('the project') should be appraised. The sales director insisted that Turners' current weighted
average cost of capital (WACC) should be used to appraise the project as the majority of its
operations will still be in food retailing. The finance director disagreed because the existing cost
of equity does not take into account the systematic risk of the new project. The finance director
also said that the company's overall WACC, which reflects all of the company's activities, would
change as a result of the project's acceptance. The board were also concerned about the
market's reaction to their diversification plans. A further board meeting was scheduled at which
Turners' advisors would be asked to make a presentation on the project.
You work for Turners' advisors and have been asked to prepare information for the presentation.
You have established the following:
Turners intends to raise the capital required for the project in such a way as to leave its existing
debt:equity ratio (by market values) unchanged following the diversification.
Extracts from Turners' most recent management accounts are shown below:
Balance sheet at 31 May 20X4
£m
Ordinary share capital (10p shares) 233
5,263
6% Redeemable debentures at nominal value (redeemable 20X8) 1,900
Long term bank loans (interest rate 4%) 635
7,798

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On 31 May 20X4 Turners' ordinary shares had a market value of 276p (ex-div) and an equity beta
of 0.60. For the year ended 31 May 20X4 the dividend yield was 4.2% and the earnings per
share were 25p. The return on the market is expected to be 8% pa and the risk-free rate 2% pa.
Turners' debentures had a market value of £108 (ex-interest) per £100 nominal value on 31 May
20X4 and they are redeemable at par on 31 May 20X8.
Companies operating solely in the holiday travel industry have an average equity beta of 1.40
and an average debt: equity ratio (by market values) of 3:5. It has been estimated that if the
project goes ahead the overall equity beta of Turners will be made up of 90% food retailing and
10% holiday travel shops.
Requirements
18.1 Ignoring the project, calculate the current WACC of Turners using:
(a) The CAPM (8 marks)
(b) The Gordon growth model (6 marks)
18.2 Using the CAPM, calculate the cost of equity that should be included in a WACC suitable for
appraising the project and explain your reasoning. (6 marks)
18.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
Turners assuming that the project goes ahead and comment upon the implications of a
permanent change in the overall WACC. (6 marks)
18.4 Discuss whether Turners should diversify its operations and how the stock market might
react to the proposed project. (5 marks)
18.5 Identify the appropriate project appraisal methodology that should be used when a
project's financing results in a major increase in a company's market gearing ratio and,
using the data relating to Turners, calculate the project discount rate that should be used in
these circumstances. (4 marks)
Total: 35 marks
19 Middleham plc
Middleham plc (Middleham) is a company involved in the production of printing inks used in a
wide range of applications in the food packaging industry. The directors of Middleham are
currently considering a £2 million investment in new production facilities. At the present time,
the company's finance director is seeking to establish an appropriate cost of capital figure for
use in the appraisal of the proposed investment. Extracts from Middleham's most recent
financial statements for the year ended 31 March 20X3 are shown below:
£'000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800
£'000
Taxation (510)
Preference share dividends (70)
Ordinary share dividends (1,088)

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The market prices for the company's shares and debentures on 31 March 20X3 were:
(1) Ordinary shares: £1.42 each (cum-div)
(2) 5% irredeemable preference shares: £0.20 each (ex-div)
(3) 7% debentures: £105.00 (per £100 nominal)
The ordinary dividend for the year ended 31 March 20X3 is due to be paid shortly. This is the
first dividend paid since the year ended 31 March 20W9, when the dividend payout ratio was
40% and the earnings per share were £0.35. Middleham's directors expect future dividends to
grow at the annual growth rate implied by the dividends paid in 20W9 and 20X3. The number of
ordinary shares in issue has not changed since March 20W9.
The annual debenture interest has recently been paid. The 7% debentures are redeemable at
par in 10 years' time.
Shares in the industrial sector in which Middleham operates typically have an equity beta of 1.3
with a debt to equity ratio of 1:1. The risk free rate is 6% pa and the return from the market
portfolio is 14% pa.
The company's finance director has proposed that, if the investment is undertaken, then an issue
of redeemable debentures is used to finance it. However, Middleham's Chief Executive has
expressed concerns about the possible use of redeemable debentures. His view is that
increasing the number of debentures issued by the company will increase the company's
gearing dramatically and the increased financial risk associated with this could easily lead to a
fall in the company's share price and, therefore, its market value.
The directors wish to assume a rate of corporation tax of 17% for the foreseeable future.
Requirements
19.1 Calculate (using the dividend growth model) a weighted average cost of capital that could
be used to appraise Middleham's proposed investment. (13 marks)
19.2 Explain the underlying assumptions and any other relevant factors that may mean it is
inappropriate to use the cost of capital figure calculated in requirement 19.1 in the
appraisal of Middleham's proposed investment. (5 marks)
19.3 (a) Estimate Middleham's cost of equity using the capital asset pricing model.
(b) Explain two key assumptions that would underpin the use of this cost of equity in the
calculation of the weighted average cost of capital. (7 marks)
19.4 Making reference to relevant theories, comment on the views expressed by Middleham's
chief executive. (5 marks)
19.5 Explain, with reference to the efficient market hypothesis, when news of the proposed
investment in the new production facilities would be reflected in Middleham's share price
on the London Stock Exchange. (5 marks)
Total: 35 marks
20 Better Deal plc

Better Deal plc (Better Deal) is a UK supermarket chain which has a financial year end of
28 February. An extract from its balance sheet at 28 February 20Y0 is shown below:
£m
Ordinary shares (50p each) 82.5
Retained earnings 391.5
474.0
8% debentures (at nominal value; redeemable at par in 20Y4) 340.0
814.0

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Additional information about Better Deal:

Current market value of one ordinary share (ex div) £2.65
Current market value of one 8% debenture (ex int) £98
Dividends paid on 28 February 20Y0 £29.5m
Dividends paid on 28 February 20X6 £25.2m
Equity beta 1.1
Market return 11.4% pa
Risk free rate 5.2% pa
Notes
1 There have been no changes in the number of issued shares over the period 20X6–20Y0.
Better Deal's annual dividend payments have risen steadily since 20X6.
2 Better Deal's management is considering diversifying its product range and opening petrol
outlets at a number of its stores. The finance for this capital investment would be raised in
such a way as not to alter the current gearing ratio of Better Deal (measured by market
values). The debt element of the finance raised will come from a new issue at par of 9%
irredeemable debentures.
3 Better Deal's finance team has undertaken research into the company's competitors in the
UK petroleum market and has calculated that the equity beta for this market is 1.5 and
companies in that market have, on average, long term funds in the ratio of 64:31 for
equity:debt by market value.
4 You should assume that the corporation tax rate is 17% pa and is payable in the same year
as profits are earned.
Requirements
20.1 Calculate Better Deal's current weighted average cost of capital based on:
(a) The dividend growth model
(b) The CAPM model (10 marks)
20.2 Calculate the cost of capital that Better Deal should use when appraising the proposed
investment in petrol outlets and explain the reasoning for your approach. (11 marks)
20.3 Compare and contrast multiple factor models with the CAPM model as a means of dealing
with risk. (8 marks)
20.4 Making reference to relevant theories, advise Better Deal's management as to what extent
the company's dividend policy will affect the market value of its shares. (6 marks)
Total: 35 marks
21 Puerto plc
You should assume that it is now 1 December 20X3.
Puerto plc (Puerto) is listed on the UK stock market and operates in the vehicle leasing industry.
During a period of expansion from 20W3 to 20W7 the company funded growth by way of
convertible loans obtained from an investment bank, SM Capital (SMC). As a result of the global
economic downturn Puerto has experienced a number of trading difficulties, and the company
ceased to pay dividends to its ordinary shareholders in 20W8. Since 20W9 Puerto has embarked
on a significant restructuring of its business. Although in the current year to 30 November 20X3
the company has sustained losses, industry conditions have stabilised giving both the board of
Puerto and SMC confidence in the company's future. This confidence is also shared by the UK
stock market as Puerto's share price has been increasing over the last six months to 10p per
ordinary share on 30 November 20X3.

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Extracts from Puerto's most recent management accounts are shown below:
Income statement for the year ended 30 November 20X3
£'000
Operating profit 2,280
Interest (2,460)
Profit/(loss) before tax (180)
Taxation 0
Profit/(loss) after tax (180)
The board of Puerto is now considering a further restructuring that includes the purchase on
1 December 20X3 of another vehicle leasing business that in the last financial year achieved a
pre-tax operating profit of £3 million. The purchase price for this business is £24 million. The
board is confident it will be able to raise the additional borrowings required for this purchase on
1 December 20X3, particularly as SMC, as part of the restructuring, has agreed to exercise its
option to convert its convertible loans into equity on that date in order to participate in Puerto's
future growth potential. The board and SMC believe that Puerto's share price will increase
immediately on 1 December 20X3 by 35% as a result of the restructuring.
Additional information:
 The SMC convertible loans amount to £68 million and the rate of interest on these loans is
3% pa. The market value of these loans, on 30 November 20X3, is equal to their nominal value
of £68 million.
 SMC has the option to convert its loans into thirty ordinary shares for every £4 of loan.
 Puerto also has non-convertible secured bank loans amounting to £6 million that carry an
interest rate of 7% pa.
 On 30 November 20X3 Puerto had 492 million ordinary shares in issue.
 £24 million of new secured borrowings at an interest rate of 6% pa will be raised from Risky
Bank plc (Risky) to finance the purchase of the vehicle leasing business. A covenant
attached to this loan requires that the gearing (debt/equity by market values) immediately
after the restructuring is not more than the industry average of 25%.
 Corporation tax is 17% pa on current year profits.
 Puerto has an equity beta of 2.13 which reflects Puerto's gearing on 30 November 20X3.
 The risk free rate is 2.8% pa.
 An appropriate market risk premium is 5% pa.
Requirements
21.1 Prepare Puerto's forecast income statement for the year ended 30 November 20X4
assuming that the restructuring goes ahead and that both the existing and newly-acquired
leasing businesses earn similar operating profits to those in the year to 30 November 20X3.
(3 marks)
21.2 Calculate Puerto's gearing ratio (debt/equity) by market values on 30 November 20X3 and
on 1 December 20X3 immediately after the restructuring. (5 marks)
21.3 Using your answer to 21.1 and 21.2, comment on the financial health of Puerto both before
and after the restructuring and whether the covenant imposed by Risky would be met if
Puerto's share price remains at 10p on 1 December 20X3. (5 marks)
21.4 Calculate (using the capital asset pricing model) the weighted average cost of capital of
Puerto on 30 November 20X3 and on 1 December 20X3 immediately after the
restructuring. (10 marks)
21.5 Discuss, with reference to relevant theories, whether the change in Puerto's capital structure
following the restructuring on 1 December 20X3 will bring about a permanent change in its
weighted average cost of capital. (6 marks)

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21.6 Advise the board of Puerto on the likely reaction of the various stakeholders in the company
to the restructuring. (6 marks)
Total: 35 marks
22 Abydos plc
Abydos plc is considering a large strategic investment in a significantly different line of business
to its existing operations. The scale of the new venture is such that a significant injection of
£12.5 million of new capital will be required.
The current gearing of Abydos is 80% equity and 20% debt by market value.
The new project will require outlays immediately as follows:
£'000
Plant and equipment (purchased on first day of financial year) 10,000
Working capital 1,500
Equity issue costs (not tax allowable) 700
Debt issue costs (not tax allowable) 300
12,500
Other details are as follows:

 Estimates of relevant cash flows and other financial information associated with the possible
new investment. These are shown below.
Year 1 Year 2 Year 3 Year 4
£'000 £'000 £'000 £'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
 The directors have examined similar quoted companies operating in the same sector as the
new investment and have determined that a suitable equity beta is 1.4, using average
industry gearing of 60% equity, 40% debt by market values.
 The risk free rate is 5% and the market return 12%.
 £5 million of debt (an 8% fixed rate debenture) will be raised to fund part of the investment.
The remainder will be equity.
 Capital allowances are at 18% per year on a reducing balance basis.
 Tax is payable at 17% in the year that the taxable cash flow arises.
 The after tax realisable value of the investment (including any balancing allowance/charge
on the equipment) as a continuing operation is estimated to be £4 million (including
working capital) at the end of Year 4.
 Working capital may be assumed to be constant during the four years.
The board of directors of Abydos plc is discussing how the company should appraise the new
investment. There is a difference of opinion between two directors.
The sales director believes that net present value at the current weighted average cost of capital
should be used as positive NPV investments should be quickly reflected in increases in the
company's share price.
The finance director 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).
Requirements
22.1 Calculate the expected APV of the proposed investment. (10 marks)
22.2 Discuss briefly the validity of the views of the two directors. Use your calculations in 22.1 to
illustrate and support the discussion. (6 marks)
Total: 16 marks

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23 Biddaford Lundy plc

Biddaford Lundy plc (BL) is a large UK engineering company. Its ordinary shares are quoted on
the London Stock Exchange.
BL's board is concerned that the company's gearing level is too high and that this is having a
detrimental impact on its market capitalisation. As a result the board is considering a
restructuring of BL's long term funds, details of which are shown here as at 29 February 20X2:
Total par value Market value
£m
Ordinary share capital (50p) 67.5 £2.65/share ex-div
7% Preference share capital (£1) 60.0 £1.44/share ex-div
4% Redeemable debentures (£100) 45.0 £90% ex-int
The debentures are redeemable in 20X7. BL's earnings for the year to 29 February 20X2 were
£32.4 million and are expected to remain at this level for the foreseeable future. Retained
earnings at 29 February 20X2 were £73.2 million.
The board is considering a 1 for 9 rights issue of ordinary shares and this additional funding would
be used to redeem 60% of BL's redeemable debentures at par. However, some of BL's directors
are concerned that this issue of extra ordinary shares will cause the company's ordinary share price
and its earnings per share (EPS) to fall by an excessive amount, to the detriment of BL's
shareholders. Accordingly, they are arguing that the rights issue should be designed so that the
EPS is not diluted by more than 5%.
The directors wish to assume that the corporation tax rate will be 17% for the foreseeable future
and that tax will be payable in the same year as the cash flows to which it relates.
Requirements
23.1 Calculate BL's gearing ratio using both book and market values and discuss, with reference
to relevant theories, why BL's board might have concerns over the level of gearing and its
impact on BL's market capitalisation. (9 marks)
23.2 Assuming that a 1 for 9 rights issue goes ahead, calculate the theoretical ex-rights price of a
BL ordinary share and the value of a right. (4 marks)
23.3 Discuss the directors' view that the rights issue will cause the share price and the EPS to fall
by an excessive amount, to the detriment of BL's ordinary shareholders. Your discussion
should be supported by relevant calculations. (10 marks)
23.4 Calculate and comment on the rights issue price that would cause a 5% dilution in the
current EPS figure. (6 marks)
23.5 Discuss the factors to be considered when making a rights issue. (6 marks)
Total: 35 marks
24 Newspaper articles
A friend of yours has asked you for clarification of five issues relating to newspaper articles that
he has read recently:
Issue (1) He owns 7,000 shares in Bettalot plc (Bettalot), a betting and gaming company. He
has read the following and is not sure what the implications are:
'Yesterday Bettalot announced a one for two rights issue at 95 pence per share to
raise £285 million in order to reduce its level of financial gearing. The rights issue
price represents a 24% discount on the current market value of Bettalot's ordinary
shares. The company's current p/e ratio is 9.6 and all of the money raised will be
used to redeem debenture stock with a coupon rate of 8%.'

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Issue (2) He has read that some UK investors have recently been buying large amounts of
debenture stock in companies that are showing signs of financial distress, as this
gives those investors the opportunity to take control of the companies away from
the equity shareholders.
Issue (3) This article claimed that Cambrian Construction plc (Cambrian) is trying to arrange a
debt for equity swap to appease its debenture holders who are demanding
overdue interest payments to be made on debt whose redemption date is
imminent. The share price is likely to fall if such a swap can be agreed.
Issue (4) He owns £4,000 (nominal value) of 6% debenture stock in Howells Gordon plc (HG),
a UK conglomerate, which is redeemable at par in three years' time. He has read
that this debenture stock has a current after-tax cost of 5%.
Issue (5) He has always believed that stock markets were semi-strong form efficient. He has
read that behavioural finance suggests that this may not be the case.
The corporation tax rate is 17%.
Requirements
24.1 With regard to Issue (1), calculate the impact of the rights issue on:
(a) Bettalot's earnings per share
(b) The value of your friend's shareholding and associated earnings (9 marks)
24.2 With regard to Issue (1), explain briefly:
(a) Why Bettalot may wish to reduce its level of financial gearing
(b) Without undertaking further calculations, the impact a reduction in financial gearing
might have on its cost of equity and the value of its shares
Note: Your answers should make reference to relevant theories. (5 marks)
24.3 (a) With regard to Issue (2), explain how equity holders could lose control of their
company. (3 marks)
(b) With regard to Issue (2), explain and identify the types of covenant lenders may put
into loan agreements to limit the chances of financial distress. (6 marks)
24.4 With regard to Issue (3), explain how a debt for equity swap works, why debt holders might
be persuaded to accept such a scheme and why the Cambrian share price is likely to fall.
(4 marks)
24.5 (a) With regard to Issue (4), calculate the current cum interest market price of the HG
debenture stock and discuss what factors will have set the stock's current after-tax cost at
5%. (4 marks)
24.6 With regard to Issue (5), briefly explain why behavioural finance may mean that the efficient
markets hypothesis may not apply in reality. (4 marks)
Total: 35 marks
25 BBB Sports plc

BBB Sports plc (BBB) operates gyms and health clubs in the UK and it is considering diversifying
by setting up a division called 'Climbhigh' which would operate indoor climbing walls in several
cities in other countries. Some of these countries have unstable governments and/or are
countries where health and safety laws are not as strict as those in the UK. The chairman of BBB
is anxious that any climbing walls that they operate overseas should be of the highest standard
and meet the national guidelines in the UK, which are available from the Association of British
Climbing Walls (ABC).

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The finance director of BBB, who is an ICAEW Chartered Accountant, has available the following
information regarding the Climbhigh project:
• The finance for Climbhigh can be raised in the UK in such a way as to leave the existing
debt:equity ratio (by market values) of BBB unchanged after the diversification.
• An appropriate equity beta for a company that operates climbing walls is 1.90 at a
debt:equity ratio (by market values) of 4:6.
• An email has been received from a contractor in one of the other countries. The contractor
intends to tender for the contract to build one of the climbing walls. Part of the email stated:
"The ABC guidelines are very strict and we can build a cheaper, but safe, wall by just
ignoring them. We do things differently here and can save you a lot of money by cutting
corners!"
• If the Climbhigh project goes ahead, the overall equity beta of BBB will be made up of 80%
existing operations and 20% Climbhigh.
The following information relates to BBB without the Climbhigh project.
Extracts from the most recent management accounts:
Balance sheet at 30 November 20X5
£m
5,153
5% Redeemable debentures at nominal value 2,200
7,353
On 30 November 20X5 BBB's ordinary shares each had a market value of 360p (cum-div) and an
equity beta of 1.10. For the year ended 30 November 20X5, the dividend declared was 10p per
ordinary share and the earnings yield (earnings per share divided by ex-div share price) was 7%.
BBB's debentures had a market value at 30 November 20X5 of £99 (cum-interest) per £100
nominal value and are redeemable at par on 30 November 20X9.
The market return is expected to be 7% pa and the risk free rate 2% pa.
Requirements
25.1 Ignoring the Climbhigh project, calculate the WACC of BBB at 30 November 20X5 using:
(a) The CAPM (8 marks)
(b) The Gordon growth model (6 marks)
25.2 Using the CAPM, calculate a WACC that is suitable for appraising the Climbhigh project
and explain the rationale for using this as the discount rate for the project. (6 marks)
25.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
BBB assuming that the Climbhigh project goes ahead and comment upon the implications
for the value of BBB of any change from the WACC that you have calculated in 25.1(a)
above. (6 marks)
25.4 Advise BBB on how political risk could potentially affect the value of the Climbhigh project
and how it might limit its effects where such risk exists. (6 marks)
25.5 Explain the ethical issues for the finance director in relation to the email received from the
contractor who wishes to tender for building one of the climbing walls, and briefly outline
the action that he should take. (3 marks)
Total: 35 marks

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Business valuations, plans, dividends and growth
26 Cern Ltd
26.1 Cern Ltd (Cern) is an unquoted company that manufactures a range of products used in the
construction industry. Extracts from the most recent management accounts of Cern are set
out below:
Income statement for the year ended 30 September 20X2
£
Profit before interest and tax 1,080,000
Interest (180,000)
Profit before tax 900,000
Tax (17%) (153,000)
Profit after tax 747,000
Dividends declared and paid:

Preference dividend 43,200
Ordinary dividend 180,000
Balance sheet at 30 September 20X2
Non-current assets £ £
Intangibles 900,000
Freehold land and property 1,800,000
Plant and equipment 3,600,000
Investments 900,000
7,200,000
Current assets
Inventory 540,000
Receivables 1,080,000
Cash 180,000
1,800,000
Current liabilities (1,080,000)
720,000
7,920,000
Equity and non-current liabilities
Ordinary share capital (£1 shares) 3,600,000
6% Preference shares (£1 shares) 720,000
Retained earnings 1,800,000
6,120,000
10% Debentures 1,800,000
7,920,000
The following information is also available:
(1) In the two previous financial years the profit before interest and tax was:
• year ended 30 September 20X1: £440,000.
• year ended 30 September 20X0: £1,800,000.
(2) The current market value of the preference shares has been estimated at £0.90 per
preference share.
(3) The current market value of the debentures has been estimated at £110 per £100 of
debentures.
(4) The current rental value of the freehold land and property is £270,000 pa and this
represents a 6% return.
ICAEW 2019 Business valuations, plans, dividends and growth 37

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(5) The current market value of the investments is £1,350,000.

(6) The most recent P/E ratios of two comparable quoted companies operating in the
same sector as Cern are 9.6 and 7.0, and their most recent dividend yields are 4% and
3.4% respectively.
(7) Cern's directors assume that for the foreseeable future the corporation tax rate will be
17%.
The directors have recently received an approach from Fenton Holdings plc (Fenton), a
conglomerate company, whose directors have expressed an interest in making an offer to
buy the whole of Cern. Fenton's directors have confirmed that if an acquisition goes ahead,
they will purchase the debentures at their market value and Fenton's bank has agreed to
buy the preference shares at their market value. Cern's directors have sought your advice as
an external consultant.
Requirements
(a) Using the available information, calculate the minimum price per ordinary share that
the shareholders of Cern should be willing to accept from Fenton using each of the
following methods of valuation:
 Net assets
 Dividend yield
 P/E ratio (13 marks)
(b) Comment on the values you have calculated and any issues you think should be
brought to the attention of Cern's directors. (4 marks)
(c) Identify the motives that might lie behind Fenton's possible acquisition of Cern.
(4 marks)
26.2 Cern has an annual cost of capital of 10%. One of its most successful products is Hadtone, a
mortar colouring agent. Hadtone is made using a single processing machine which mixes
the raw ingredients and dispenses the completed product into five-litre cartons.
A five-litre carton of Hadtone sells for £12.00 and estimated maximum annual demand at
this price is 300,000 cartons. At this level of demand, Cern can justify the operation of only
one processing machine, which Cern currently replaces every three years, although the
processing machine has a productive life of four years.
In the first year of its life the processing machine has a productive capacity in line with the
maximum annual demand for the product, but each year thereafter this productive capacity
falls at a rate of 15,000 units pa. Annual maintenance costs in the first year of operating the
processing machine are estimated at £12,000. Thereafter, the directors expect the annual
maintenance costs to increase by £2,000 pa regardless of the actual number of five-litre
cartons produced. Cern incurs variable costs, excluding depreciation and maintenance
costs, of £8.00 in producing each five-litre carton. Cern provides for depreciation on all its
non-current assets using the straight-line method.
If Cern were to dispose of the processing machine after one year, the directors estimate
sale proceeds of £320,000, but these would fall by £120,000 pa in each of the following two
years. Once the machine has reached the end of its four-year productive life its residual
value will be £10,000.
Following a recent increase in the cost of a processing machine to £480,000, Cern's
directors are reconsidering their current replacement policy with a view to maximising the
present value of the company's cash-flows. It can be assumed that all revenues and costs
are received or paid in cash at the end of the year to which they relate, with the exception of
the initial price of the processing machine which is paid in full at the time of purchase.

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Requirement
Assuming that the processing machine is used to maximum capacity, and showing all your
supporting calculations, advise Cern's directors how often they should replace the
processing machine. (10 marks)
Total: 31 marks
Note: Ignore inflation and taxation when answering 26.2.
27 Wexford plc
Wexford plc (Wexford) is a listed manufacturer of dairy products. In recent years the company
has experienced only modest levels of growth, but following the recent retirement of the chief
executive, his replacement is keen to expand Wexford's operations.
It is currently December 20X8 and the board of directors has recently agreed to support a
proposal by the new chief executive that the company purchase new manufacturing equipment
to enable it to expand its range of yoghurt-based products. The new equipment will cost
£25 million and the company is seeking to raise new finance to fund the expenditure in full.
However, the board of directors is undecided as to how the new finance is to be raised. The
directors are considering either a 1 for 5 rights issue at a price of 250p per share or a floating
rate loan of £25 million at an initial interest rate of 8% per annum. The company's bank has
agreed to provide the £25 million loan. The loan would be for a term of five years, with interest
paid annually in arrears and with the capital being repaid in full at maturity. The loan would be
secured against the company's freehold land and buildings.
You are employed by Wexford as a company accountant and have been able to obtain the
following additional information:
 As a result of the investment in the new machinery, the directors aim to increase the
company's revenue by 15% per annum for the foreseeable future.
 It is expected that direct costs, other than depreciation, will, on average, increase by 18% during
the year ending 30 November 20X9 due to the 'learning curve' effects associated with the new
machinery.
 Indirect costs are expected to increase by £10 million in the year to 30 November 20X9.
 The ratios of receivables to sales and payables to direct costs (excluding depreciation) will
remain the same as in the year to 30 November 20X8.
 Depreciation on assets existing at 30 November 20X8 is forecast to be £18 million in the
year ending 30 November 20X9.
 Depreciation on the new machinery will be 20% per annum on a straight line basis
commencing in the year of purchase.
 Capital allowances can be assumed to be equal to the depreciation charged in a
particular year.
 The company's inventory levels are expected to increase by £10 million as a result of the
increased levels of business.
 Tax is payable at a rate of 17% per annum in the year in which the liability arises.
 Dividends are payable the year following their declaration and the board of directors has
confirmed to the bank its intention to maintain the company's current dividend payout ratio
for the foreseeable future.

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A summary of Wexford's most recent draft financial statements is shown below:

Income statement for the year ended 30 November 20X8
£'000
Revenue 270,000
Direct costs (Note) 171,000
Indirect costs 40,000
Operating profit 59,000
Interest 5,000
Taxation 9,180
Note: Includes depreciation of £19 million.

The company has declared a dividend that will cost £22,680,000.
Balance sheet at 30 November 20X8
£'000 £'000
Non-current assets (carrying amount) 152,590
Current assets
Inventory 35,000
Trade receivables 49,000
Cash at bank 10,500
94,500
247,090
Capital and reserves
£1 Ordinary shares 50,000
131,410
Non-current liabilities
10% Debentures (repayable 20Y5) 50,000
Current liabilities
Trade payables 43,000
Dividends payable 22,680
65,680
247,090
Requirements
27.1 For each of the financing alternatives being considered, prepare a forecast income
statement for the year ending 30 November 20X9 and a forecast Balance sheet at
30 November 20X9. (16 marks)
Note: Transaction costs on the issuing of new capital and returns on surplus cash invested
in the short term can both be ignored.
27.2 Write a report (including appropriate calculations) to Wexford's board of directors that fully
evaluates the two potential methods of financing the company's expansion plans.
(14 marks)
Total: 30 marks

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28 Loxwood
Loxwood is a firm of ICAEW Chartered Accountants. You work in its Business Valuations Unit
(BVU) which advises clients wishing either (a) to sell their own business or (b) to purchase a new
business. You are currently advising three of Loxwood's clients:
Client One
Walton plc (Walton) is considering making takeover bids for two of its competitors, Hampton plc
(Hampton) and Richmond Ltd (Richmond). Loxwood has been asked to advise Walton as to what
value it should place on these target companies. You have obtained the following financial data:
Walton Hampton Richmond
Profit before interest and tax
(year ended 28 February 20X4) £36.2m £5.5m £4.8m
Depreciation charge (year ended 28 February
20X4) £6.5m £2.9m £0.9m
Average annual growth in profit after tax
(years ended 28 February 20X0-20X4) 5% 7.5% 9%
Average dividend pay-out ratio
(years ended 28 February 20X0-20X4) 30% 35% 45%
P/E ratio (at 28 February 20X4) 16.5 15.2 Not available
Cost of equity (estimated) 5.0% 9% 10.5%
Statement of financial position

Extracts at 28 February 20X4
Walton Hampton Richmond
£m £m £m
Non-current assets (Note 1) 177.0 32.7 22.4
Current assets (Note 1) 146.5 22.8 33.3
Current liabilities (96.5) (11.3) (13.7)
Non-current liabilities (Note 2) (70.0) (22.5) (19.3)
157.0 21.7 22.7
Ordinary share capital (£1 shares) 62.0 17.6 9.8
Retained earnings 95.0 4.1 12.9
157.0 21.7 22.7
Notes
1 These assets have been professionally valued on 28 February 20X4 as follows:
Hampton Richmond
£m £m
Non-current assets 45.2 24.1
Current assets 25.1 35.2
2 The non-current liabilities are all debentures, redeemable within the next six years, with
coupon rates as follows: Walton 7%, Hampton, 7%; Richmond, 8%. The debentures are
currently trading at: Walton £125, Hampton £110, Richmond £80.
Client Two
Jackie Wight has run a very successful fashion business, Regent Spark Ltd, for many years and is
now considering selling it and taking early retirement. She has read a recent article in the
financial press and is concerned that she won't get a fair price for her company. As a result she
has contacted Loxwood for guidance. The following is an extract from the article:
'Angel Ventures (AV) recently bid for biometrics company Praed Bio (PB), offering PB's
shareholders £5.20 a share. Maida Money (MM), a hedge fund that owns PB shares, disliked

lOMoARcPSD|5019904
the deal and sought a court's opinion on fair value. MM wanted £10.25 a share. AV
countered with £5.10. In court, the judge, using shareholder value analysis (SVA), settled on
£5.80 but said there were problems in estimating future cash flows and in calculating the
value of the cash flows after the competitive advantage period (the residual value).'
Client Three
Doug Williams owns 60 acres of agricultural land in south west England and is considering
accepting an offer from So Lah Energy Ltd (SLE) to install solar panels on his land. SLE would pay
Doug £1,000 per acre pa (in 28 February 20X4 prices) at the end of each of the next 10 years for
the use of his land, after which time it would revert back to agricultural use. To take account of the
general rate of inflation, SLE will increase this payment by 3% pa (compound). One of Doug's
neighbours, Bill Etheridge, is very unhappy at the prospect of this solar farm and is prepared to
buy Doug's land from him for £500,000 in order to stop it being built. The land has a market value
of £120,000 in agricultural use on 28 February 20X4 and this is expected to rise in line with the
general rate of inflation, ie, 3% pa. Doug could invest Bill's money in a bank account bearing
interest at 4% pa, but he is unsure whether he should accept Bill's offer.
Requirements
28.1 For Client One, prepare a report for Walton's board advising it of a range of suitable prices
for both Hampton and Richmond using asset, dividend, earnings and EBITDA multiple
based valuations. Your report should include your workings supported by a clear
commentary as to the strengths and weaknesses of each of the valuation methods used.
(25 marks)
28.2 For Client Two, explain how SVA works and why future cash flows and the residual value are
such problems. (7 marks)
28.3 For Client Three, ignoring tax, advise Doug Williams as to whether he should accept Bill's
offer. You should support your answer with workings and any assumptions that you make
should be clearly stated. (5 marks)
28.4 Loxwood is planning a new marketing campaign for its BVU. Outline the key ethical issues
that Loxwood should consider when planning this campaign. (3 marks)
Total: 40 marks
29 Arleyhill Redland plc

Arleyhill Redland plc (AR) is a UK listed manufacturer of domestic kitchen equipment. AR's
directors are planning to expand and update the company's product range through a mixture of
organic growth and the acquisition of smaller competitors. These plans would require an
additional £12 million of funding (to be raised in September 20X3) and you, as a project analyst
at AR, have been asked to prepare working papers to aid the directors' decision as to which
source of finance to use. AR's financial year ends on 31 August and extracts from its most recent
management accounts are shown below:
Income statement for the year to 31 August 20X3
£'000
Sales 54,400
Variable costs (32,640)
Fixed costs (8,200)
Profit before interest 13,560
Debenture interest (930)
Taxation (@ 17%) (2,147)
Dividends (1,728)

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Balance sheet at 31 August 20X3

£'000
Ordinary share capital (£1) 28,800
Revenue reserves 30,850
6% debentures 15,500
75,150
Total assets less current liabilities 75,150
Market research commissioned by AR's directors has estimated that the £12 million of additional
funding would increase annual turnover from September 20X3 by one fifth and that this
expansion of the company's operations would also lead to an additional £0.5 million of annual
fixed costs. The directors also expect AR's contribution to sales ratio to remain unchanged. Two
methods of raising the additional funding have been suggested:
(1) a rights issue at £2.50 per share; or
(2) an issue of 7% debentures at par.
The most recent board meeting was held on 2 September 20X3 and an extract from the minutes
of that meeting is shown here:
'Martin Cotham (Finance Director) suggested that AR should raise the £12 million via a
rights issue. The current share price is £3.10. If the issue was priced at £2.50 per share, he
thought this was sufficient a discount to be attractive to shareholders and should guarantee
a successful outcome. He said it's also good as it reduces AR's gearing and so will send the
shareholders a positive message. He felt if, after the rights issue, AR could get its share
price up above its current level, even if it's only a £0.20 per share increase, then the rights
issue looks like the best method.'
'Amy Wills (Managing Director) said that we should issue more debentures as (1) the rights
issue will dilute the value of AR's shares and (2) AR is not making enough use of the tax
shield. She also said that a rights issue might upset the shareholders, as, if they can't afford
it and don't take up the rights, they would lose money. The debentures would also put less
pressure on AR to maintain annual dividend levels and, thereby, maintain investors'
confidence in us. A slightly higher coupon rate of 7% would make the debentures more
attractive than those currently in issue. She also said we should consider other types of debt
such as convertibles and loan stock with warrants.'
Requirements
29.1 Aside from the factors already identified by Martin Cotham and Amy Wills, outline the other
factors that should be considered by a company contemplating a rights issue as a means of
raising finance. (4 marks)
29.2 Using the market research estimates above, and assuming that AR's dividend per share
remains unchanged, prepare AR's forecast income statement for the year to 31 August
20X4 if it uses:
 a rights issue at £2.50 per share; or
 an issue of 7% debentures at par to raise the £12 million of additional funding
required. (9 marks)
29.3 Calculate AR's earnings per share for the year to 31 August 20X3 and, for both financing
methods, its estimated earnings per share for the year to 31 August 20X4. (5 marks)
29.4 Calculate AR's gearing ratio (in book and market value terms) on 31 August 20X3 and
similarly, for both financing methods, its gearing ratio on 31 August 20X4. You should
assume that on 31 August 20X4 AR's ordinary share price is £3.30 per share and that its
debentures are quoted at par on 31 August 20X3 and 31 August 20X4. (8 marks)

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29.5 Using the calculations undertaken in 29.2, 29.3 and 29.4, advise AR's directors of the key
issues to consider when deciding whether to raise the required funds via a rights issue or a
debenture issue. (5 marks)
29.6 Explain the differences between convertible loan stock and loan stock with warrants.
(4 marks)
Total: 35 marks
30 Sennen plc
You should assume that the current date is 31 May 20X4.
Sennen plc (Sennen) is a UK listed company in the chemical industry. Morgan plc (Morgan) is a
UK listed company that has a policy of expanding by way of acquisition. As a result of financing
its acquisitions with borrowings, Morgan's gearing is high compared to its competitors.
Morgan has identified Sennen as a potential takeover target and intends to make an offer for all
of the ordinary shares of the company. The finance director of Morgan wishes to value Sennen's
ordinary shares including any synergistic benefits that may arise following the acquisition. He is
also considering the advantages and disadvantages of the different methods that can be used to
pay for the ordinary shares. The intended offer for Sennen is not public knowledge.
The Finance Director of Morgan has asked North West Corporate Finance (NWCF) to give him
advice regarding the intended offer for the ordinary shares of Sennen. You work for NWCF and
a partner in the firm has asked you to prepare a report for a meeting that he is due to attend with
the board of Morgan. You have established the following data relating to Sennen:
Sales revenue for the year ended 31 May 20X4 £20 million
Competitive advantage period 3 years
Estimated sales revenue growth for the next three years 5% pa
Estimated sales revenue growth thereafter in perpetuity 2% pa
Operating profit margin 15%
Additional working capital investment at the start of each year 1% of that year's sales revenue
Additional non-current asset investment at the end of each year 2% of that year's sales revenue
After tax synergies at the end of each year 2.5% of that year's sales
revenue
Number of ordinary shares in issue 17,000,000
Current share price 160p
Appropriate weighted average cost of capital 7% pa
Price earnings (p/e) multiple used to value recent takeovers in
the chemical industry 17
You may assume that replacement non-current asset expenditure equals depreciation in each
year.
On 31 May 20X4 Sennen had short-term investments with a market value of £2 million currently
yielding 3% pa and irredeemable debt with a market value of £10 million. The current gross yield
on Sennen's debt is 5% pa.
Assume that corporation tax will be 17% of operating profits for the foreseeable future and that
there are no other tax issues that need to be considered.
The management team of Sennen, which includes a member of the ICAEW, has been preparing
a business plan to present to potential financial backers of a management buyout (MBO) that
they intend to launch for the ordinary shares of the company. The intended MBO is not public
knowledge.

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Requirements
30.1 Prepare a report for the partner in NWCF which includes:
(a) The estimated value of the ordinary shares of Sennen calculated using Shareholder
Value Analysis (SVA) and an explanation of the strengths and weaknesses of this
valuation method. (13 marks)
(b) The sensitivity of the total value of Sennen (debt plus the value of equity calculated in
(a) above) to a change in the after tax synergies. (3 marks)
(c) The value of the ordinary shares of Sennen using the p/e method and an explanation of
the strengths and weaknesses of this valuation method. (5 marks)
(d) A discussion of whether Morgan should offer the shareholders of Sennen a premium
over its current share price given the valuations calculated in parts (a) and (c). (3 marks)
(e) Advice on the suitability of each of the following methods that Morgan could use to
pay for the ordinary shares of Sennen:
 Cash
 A share for share exchange
 A loan stock for share exchange
 Part cash and part share for share exchange (8 marks)
30.2 Identify and briefly discuss the ethical issues faced by the MBO team should Morgan make
an offer for the ordinary shares of Sennen. (3 marks)
Total: 35 marks
31 Printwise UK plc
You are employed by Printwise UK plc (Printwise), a very large printing firm with retail outlets
across the UK. Its board is considering making an offer to buy 100% of the shares of Leyton
Stratford Limited (LSL), a competitor of Printwise in the south east of England. LSL's financial year
end is 28 February and its most recent financial statements are summarised below:
LSL Income statement for the year ended 28 February 20X0
£m
Revenue 17.3
Profit before interest and tax 5.9
Interest (0.3)
Profit before taxation 5.6
Corporation tax at 17% (1.0)
Profit after taxation 4.6
Dividends declared 1.1
LSL Balance sheet at 28 February 20X0

£m £m £m
Non-current assets:
Freehold land and buildings (original cost £4.1m) 3.5
Machinery (original cost £8.8m) 5.3
8.8
Current assets:
Inventories 3.0
Receivables 0.5
Cash and bank 2.8
6.3
Current liabilities:
Trade payables 3.5
Dividends 1.1

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£m £m £m
Taxation 1.0
(5.6)
0.7
9.5
Non-current liabilities:
10% debentures (redeemable 20Y0) (3.0)
6.5
Equity:
Ordinary shares of £1 each 2.1
6.5
Additional information
LSL's management had some of the company's assets independently revalued in January 20X0.
Those values are shown below:
£m
Freehold land and buildings 8.3
Machinery 4.1
Inventories 3.1
The average price/earnings ratio for listed businesses in the printing industry is 9, the average
EBITDA multiple is 4 and the average dividend yield is 6% pa.
LSL's debentures are currently trading at £120.
The cost of equity of businesses in the printing industry, taking account of the industry average
level of capital gearing, is 14% pa.
LSL's finance department has estimated that the company's pre-tax net cash inflows (after
interest) for the next four trading years ending 28 February, before taking account of capital
allowances, will be:
£m
Year to 20X1 4.6
Year to 20X2 4.3
Year to 20X3 5.2
Year to 20X4 5.7
LSL's depreciation charge for the year ended 28 February 20X0 was £1.5 million. Its machinery
pool for taxation purposes had a written-down value of £3.6 million at 28 February 20X0. The
pool attracts 18% (reducing balance) tax allowances in every year of ownership by the company,
except the final year. In the final year, the difference between the machinery's written down
value for tax purposes and its disposal proceeds will be treated by the company either as a:
You should assume that LSL will not be purchasing or disposing of any machinery in the years
20X1-20X4 and that it would dispose of the existing pool of machinery on 28 February 20X4 at
its tax written-down value.
Printwise's board estimates that in four years' time, ie, 28 February 20X4, it could, if necessary,
dispose of LSL for an amount equal to four times its after-tax cash flow (ignoring the effects of
capital allowances and the disposal value of the machinery) for the year to 28 February 20X4.
Assume that the corporation tax rate is 17% pa.

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Requirements
Using the information provided, prepare a report for Printwise's board which:
31.1 Calculates the value of one share in LSL based on each of these methods:
(a) Net asset basis (historic cost)
(b) Net asset basis (revalued)
(c) Price/earnings ratio
(d) EV/EBITDA multiple
(e) Dividend yield
(f) Present value of future cash flows (18 marks)
31.2 Explains the advantages and disadvantages of using each of the six valuation methods
in 31.1. (10 marks)
31.3 Identifies and explains the different methods by which the LSL shareholders could be
remunerated for their shares. (6 marks)
Total: 34 marks
32 Tower Brazil plc

You are an ICAEW Chartered Accountant and work in the finance team at Tower Brazil plc
(Tower). The company manufactures wallpaper and paint for major UK homeware retailers and
has been trading since 2001. It has a financial year end of 31 August. Extracts from its most
recent management accounts are shown below.
Income statement for the year ended 31 August 20X4
£'000
Debenture interest (2,338)
Tax at 17% (1,193)
Dividends – preference shares (480)
Dividends – ordinary shares (4,509)
Retained profits 836

£'000
£1 ordinary share capital 16,500
42,920
6% £1 preference shares 8,000
5% debentures at nominal value (redeemable 20X6) 46,750
97,670
The market values of Tower's long-term finance on 31 August 20X4 are shown below:
£1 ordinary share capital £4.20/share
6% £1 preference shares £0.80/share
5% debentures £110%
Extracts from the minutes of Tower's board meeting, 1 September 20X4

AB (Production Director) once again raised the issue of Tower's 'gearing problem' and said that
gearing was now over 50%. DB (Marketing Director) and WR (Sales Director) concurred. All
three felt that gearing should be reduced as a matter of urgency, otherwise, according to AB, it's
very risky and the company's share price (and cost of capital) will be adversely affected which
will make new projects difficult to justify.

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It was agreed to investigate the implications of using a rights issue to address the gearing
problem. The rights issue would enable ordinary shareholders to significantly increase their
investment and so reward them for their loyalty. It was proposed that a one for two rights issue
would be made, but concerns were raised that this would reduce the company's earnings per
share figure by more than 10%.
WR raised the point that dividends have increased 3% pa on average over the past five years. He
suggested that rather than raising more capital the company could change its dividend policy.
As a result it would retain more of its profits for re-investment. He thought this would not be
popular with shareholders, but that, if they did react badly to the change then Tower could
always pay a one-off special dividend to make up for any shortfall.
As a result of these discussions the board decided to explore the implications of making a 1 for
2 rights issue which would raise sufficient funds to purchase and cancel 60% of Tower's
debentures by market value.
In advance of the next board meeting, you have been asked by your manager, Luke Cleeve, to
prepare calculations and advice for Tower's directors. Luke pointed out to you that you should
'be careful with this information as it's potentially price sensitive and not in the public domain.'
Requirements
32.1 Calculate Tower's theoretical ex-rights share price if a 1 for 2 rights issue were made on
1 September 20X4. (3 marks)
32.2 (a) Calculate Tower's earnings per share figure for the year ended 31 August 20X4 and for
the year ended 31 August 20X5 after the proposed rights issue (assuming no change
in profit before interest).
(b) Calculate and comment on the terms of the rights issue required if the earnings per
share figure is not to worsen by more than 10% for the year ended 31 August 20X5.
(11 marks)
32.3 Calculate Tower's gearing (debt/debt + equity) at 31 August 20X4 using both book and
market values and advise its board as to whether it has a 'gearing problem' and how its
gearing level could affect its share price. Where relevant, make reference to theories
regarding the impact of capital structure on share price. (9 marks)
32.4 Advise Tower's board as to whether the suggested change in dividend policy would have a
negative impact on the company's share price. Where relevant, make reference to theories
regarding the impact of dividend policy on share price. (9 marks)
32.5 Explain the ethical implications for an ICAEW Chartered Accountant of having access to
'price-sensitive information'. (3 marks)
Total: 35 marks
33 Brennan plc
Brennan plc is a family run business, which obtained a stock market listing around three years
ago. The board is comprised of 75% of members of the founding family. Brennan plc has a
current stock market capitalisation of £250 million and the board owns 45% of the issued shares.
The net book value of assets held by Brennan plc is £300 million.
Brennan currently enjoys competitive advantage through being a low cost producer and the
board feels that this competitive advantage is likely to continue for the next six years. The
following information relating to Brennan and the period of competitive advantage is available.

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Current sales revenue £200 million

Estimated sales growth 6%
Operating profit margin after depreciation 15%
Additional working capital investment 7% of sales increase
Additional non-current asset investment 12% of sales increase
Following the end of the period of competitive advantage, cash flows are expected to remain
constant for the foreseeable future.
Brennan plc currently has no long-term debt and holds short-term investments worth
£2.5 million. The corporation tax rate is expected to be 17% for the foreseeable future.
Brennan plc has an equity beta of 0.75, the risk free rate of interest is 3% and the return on the
market portfolio is 11%.
Brennan plc has a policy of paying out 10% of its post-tax earnings as dividends.
Requirements
33.1 Calculate the value of Brennan plc using SVA methodology and comment on the results.
(13 marks)
33.2 Discuss the reasons why Brennan plc has a market capitalisation lower than its net book
value of assets. (7 marks)
Total: 20 marks

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Risk management
34 Fratton plc
34.1 Fratton plc (Fratton) trades extensively in Europe. The firm is due to receive €2,960,000 in
three months' time. The following information is available:
(1) The spot exchange rate is currently €1.1845 – 1.1856/£.
(2) The three-month forward rate of exchange is currently at a 0.79 – 0.59 cent premium.
(3) The prices of three-month sterling traded option contracts (premiums in cents per £
are payable up front, with a standard contract size of £62,500) are as follows:
Exercise price Calls Puts
€1.18 2.40 3.60
(4) Annual interest rates at the present time are as follows:
Deposit Borrowing
UK 1.15% 2.40%
Eurozone 0.75% 1.60%
Requirements
(a) Calculate the net sterling receipt that Fratton can expect in three months' time if it
hedges its foreign exchange exposure using:
 the forward market
 the money market
 the options market, assuming the spot exchange rate in three months is:
– €1.1185 – 1.1200/£
– €1.1985 – 1.2000/£ (14 marks)
(b) Discuss the advantages and disadvantages of using futures contracts as opposed to
forward contracts when hedging foreign currency exposure. (7 marks)
34.2 In addition, in three months' time Fratton will be drawing down a three-month £2.5 million
loan facility which is granted each year by its bank to see the firm through its peak
borrowing period. The following information is available:
(1) The quotation for a '3–6' forward rate agreement is currently 2.60 – 1.35.
(2) The spot rate of interest today is 2.40% pa and the relevant three-month sterling
interest rate futures contract (standard contract size £500,000) is currently trading at
97.20.
Requirements
(a) Explain how Fratton could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months' time, the
spot rate of interest is 3% pa. (4 marks)
(b) Explain how Fratton could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months' time, the spot rate of interest is
3% pa and the price of the interest rate futures contract has fallen to 97. (5 marks)
Total: 30 marks

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35 Sunwin plc
35.1 The finance director of Sunwin plc (Sunwin) is a trustee of the firm's employee pension fund.
The vast majority of the fund's assets are currently invested in a portfolio of FTSE 100
shares. It is 1 December 20X2 and the trustees are concerned that FTSE 100 share prices
will fall over the next month and they wish to hedge against this possibility by using FTSE
index options. The current market value of the pension fund's portfolio of shares is
£5.6 million. The FTSE 100 index stands at 5,000 on 1 December 20X2 and the directors
wish to protect the current value of the portfolio. The trustees have obtained the following
information as at 1 December 20X2:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)
4,900 4,950 5,000 5,050 5,100
Call Put Call Put Call Put Call Put Call Put
December 139 34 104 48 74 70 49 99 34 134

January 214 94 184 114 154 134 124 159 104 189
February 275 135 245 155 220 180 190 200 165 225
Requirements
Demonstrate how FTSE 100 index options can be used by the trustees to hedge the
pension fund's exposure to falling share prices and show the outcome if, on 31 December
20X2, the portfolio's value:
(a) Rises to £6.608 million and the FTSE index rises to 5,900
(b) Falls to £4.592 million and the FTSE index falls to 4,100 (8 marks)
35.2 It is 1 December 20X2 and Sunwin's board of directors has recently agreed to purchase
machinery from a UK supplier on 28 February 20X3. The firm's cash flow forecasts reveal
that the firm will need to borrow £4 million on 28 February 20X3 for a period of nine
months. The directors are concerned that short-term sterling interest rates may rise
between now and the end of February and are considering the use of either sterling short-
term interest rate futures or traded interest rate options on futures to hedge against the
firm's exposure to interest rate rises.
The spot rate of interest on 1 December is 3% pa and March three-month sterling interest
rate futures with a contract size of £500,000 are trading at 96. Information regarding traded
interest options on futures on 1 December 20X2 is as follows:
Calls Puts
Strike Price March June September March June September
96.25 0.20 0.23 0.25 0.18 0.96 1.66

96.50 0.09 0.10 0.11 0.32 1.19 1.89
96.75 0.05 0.06 0.07 0.53 1.43 2.14
Premiums are in annual % terms.

Requirements
(a) Demonstrate how sterling short-term interest rate futures can be used by Sunwin to
hedge against interest rate rises, and show the effective loan rate achieved and the
hedge efficiency if, on 28 February 20X3, the spot rate of interest is 4.5% pa and the
March interest rate futures price has fallen to 95. (6 marks)
ICAEW 2019 Risck management 51

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(b) Demonstrate how traded interest rate options on futures can be used by Sunwin to
hedge against the interest rate rising above 3.75% pa and show the effective loan rate
achieved if, on 28 February 20X3:
(1) The spot price is 4.4% pa and the futures price is 95.31.
(2) The spot price is 2.1% pa and the futures price is 97.75. (9 marks)
(c) Identify three factors that will affect the time value of an option. (3 marks)
Total: 26 marks
36 Padd Shoes Ltd

You should assume that the current date is 31 March 20X4.
You work in the finance team at Padd Shoes Ltd (Padd), a footwear manufacturer and retailer
based in the UK. You have been given two tasks to deal with:
Task 1
Padd's chief executive has been contacted by the managing director of a large Indian retailer,
DS, who feels that Padd's footwear would sell well in India because, in her words, "Padd's styles
are attractive to our consumers, UK brands are generally highly regarded here in India and our
country has a growing middle class with enhanced spending power".
It has been agreed that, to test the market, Padd will send a large consignment of footwear to
DS for sale in its shops across India. The price for this consignment is 200 million Indian rupees
(INR), which will be payable by DS on 30 June 20X4.
Padd's board is aware that the Indian rupee has weakened against sterling by almost 2% in the
past six months and so it wishes to explore whether to hedge this sale to DS. In addition,
because Padd has not traded outside of the UK before, its board has some more general
concerns about trading abroad.
You have been asked to prepare advice for the board and have obtained the following
information at the close of business on 31 March 20X4:
Spot rate (INR/£) 94.0625 – 95.4930
Sterling interest rate (lending) 3.2% pa
Sterling interest rate (borrowing) 4.0% pa
INR interest rate (lending) 4.2% pa
INR interest rate (borrowing) 4.8% pa
Three-month OTC currency call option on INR – exercise price INR 94.7500/£
Three-month OTC currency put option on INR – exercise price INR 95.5500/£
Three-month forward rate discount (INR/£) 0.0195 – 0.2265
Cost of relevant OTC currency option £8,000
Cost of forward contract £4,500
Task 2
On 1 April 20X3 Padd borrowed £8.5 million over a four-year period at LIBOR + 1% pa to
finance an expansion of its production capacity and the refurbishment of a number of its larger
stores. Padd's board is now investigating whether it should hedge against adverse interest rate
movements over the next 12 months. Its bank has offered either (a) an option at 4% pa plus a
premium of 0.75% of the sum borrowed or (b) a Forward Rate Agreement (FRA) at 4.5% pa.

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Requirements
36.1 Calculate Padd's sterling receipt from the sale to DS if it:
(a) Does not hedge the receipt and the Indian rupee weakens by 1% by 30 June 20X4
(b) Uses an OTC currency option
(c) Uses a forward contract
(d) Uses a money market hedge (10 marks)
36.2 With reference to your calculations in 36.1 above, advise Padd's board whether it is worth
hedging the DS receipt. (8 marks)
36.3 Advise Padd's board as to the risks, other than currency risk, that should be considered if
the company is to continue to trade abroad in future. (5 marks)
36.4 By preparing suitable interest payment calculations, recommend to Padd's board whether it
is worth hedging against interest rate movements over the next 12 months if LIBOR is either
(a) 3% pa or (b) 6% pa. (7 marks)
Total: 30 marks
37 Stelvio Ltd
37.1 You should assume that the current date is 31 May 20X4.
Stelvio Ltd (Stelvio) imports climbing equipment from suppliers in the USA. In the past
Stelvio has not hedged its foreign exchange rate risk and has purchased foreign currency
on the spot market as and when required. The managing director of Stelvio, Fred Hughes,
has recently been reading about hedging techniques that might assist his company; in
particular he has read about the use of forwards, futures and over the counter options. Fred
is not convinced about the merits of hedging as he is of the opinion that the forward rate is
a good indication of the future spot rate. He believes he can estimate the sterling cost of the
company's future foreign currency payments with confidence, without having to use
complex derivative instruments.
Stelvio currently has a bank overdraft that costs 6% pa. It has a payment to make of
$940,000 on 30 September 20X4.
The following information is available at the close of business on 31 May 20X4:
Exchange rates:
Spot rate ($/£) 1.6025 – 1.6027
Four month forward premium ($/£) 0.0021 – 0.0020
September currency futures price (standard contract size £62,500) $1.5995/£
Over the counter currency option
A September call option to buy $ has an exercise price of $1.6100/£. The premium is 4p per
$ and is payable on 31 May 20X4.
Requirements
Produce a report for Fred Hughes which should include:
(a) A calculation of Stelvio's sterling payment if it uses each of the following to hedge its
foreign exchange rate risk:
 A forward contract
 Currency futures contracts
 An over the counter currency option
You should assume that on 30 September 20X4 the spot exchange rate will be
$1.5002 – 1.5008/£ and that the sterling currency futures price will be $1.5005/£.
(11 marks)

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(b) A discussion of the relative advantages and disadvantages of using the methods in part
(a) above to hedge Stelvio's foreign exchange rate risk. (9 marks)
(c) An explanation, making reference to relevant theories regarding foreign exchange
rates, of whether Fred is correct that he does not need to hedge Stelvio's foreign
exchange rate risk. (4 marks)
37.2 In May 20W9 Stelvio financed the purchase of a warehouse with a £5 million 10-year floating
rate loan at LIBOR + 3% pa. Fred Hughes believes that interest rates are going to rise over the
next five years and he would like to protect the company against interest rate risk. He has
been in contact with Zeta Leasing Ltd (Zeta) which has a policy of keeping a certain
proportion of their borrowings at a fixed rate. Zeta would like to swap £5 million of its fixed
rate loans to a floating rate. A bank has offered to arrange the swap and Fred has agreed that
all the benefits from the swap will be shared equally between Stelvio and Zeta. Stelvio can
borrow at a fixed rate of 5% pa. Zeta can borrow at a fixed rate of 3% pa and at a floating rate
of LIBOR + 2% pa. LIBOR is currently 0.60% pa.
Requirements
(a) Demonstrate how the proposed interest rate swap between Stelvio and Zeta would be
implemented. (4 marks)
(b) Calculate the initial difference in annual interest rates for Stelvio if it enters into the
interest rate swap and calculate the minimum amount by which LIBOR will have to rise
for the swap to breakeven for Stelvio. (2 marks)
Total: 30 marks
38 JEK Computing Ltd

You should assume that the current date is 30 September 20X4.
You work in the finance team at JEK Computing Ltd (JEK), which is a UK-based computer
services company. Founded in 2008, it has to date operated exclusively in the UK but its board
recently decided to expand its operations by looking overseas for new contracts.
JEK is ready to submit a tender bid for a contract with the government of Estonia. The local
currency in Estonia is the euro. As this would the first in a series of possible contracts with this
government, and to make the tender bid more competitive, the board is using a lower sales
margin than is usual on its UK contracts. The following summary information has been prepared:
Estonian contract
Total costs plus margin £12.420 million
Tender bid on 30 September 20X4 at the current spot rate of €1.2165/£ €15.109 million
JEK's board understands that the successful bidder will be announced on 31 October 20X4. If
JEK wins the bid then work would start on that date and the board estimates that it would be
completed on 31 December 20X4 when payment would be received from the Estonian
government.
The board is concerned that the €/£ exchange rate has changed quite significantly over the past
three months and that if this trend continues then it could have an impact on the profitability of
the contract. The board would like, therefore, to consider hedging against exchange rate risk
immediately on 30 September 20X4, even though the outcome of the tender bid is not yet
decided.

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The spot €/£ exchange rate over the past three months is summarised below:
Exchange rate (€/£) at 30 June 20X4 1.1150 – 1.1463
at 31 July 20X4 1.1373 – 1.1692
at 31 August 20X4 1.1600 – 1.1926
at 30 September 20X4 1.1832 – 1.2165
You have been asked to advise JEK's board and the following information has been made
available to you at the close of business on 30 September 20X4:
Euro interest rate (lending) 2.6% pa
Euro interest rate (borrowing) 3.4% pa
Three-month over the counter (OTC) put option on euro, exercise price (€/£) 1.2150
Three-month over the counter (OTC) call option on euro, exercise price (€/£) 1.1818
Three-month forward contract premium (€/£) 0.0025-0.0020
Forward contract arrangement fee (per euro converted) £0.002
Relevant OTC option premium (per euro converted) £0.012
Requirements
38.1 Estimate the spot rate on 31 December 20X4 on the assumption that the €/£ exchange rate
continues to change at the same rate as for the period 30 June to 30 September 20X4.
(2 marks)
38.2 On the assumption that JEK's tender bid is successful:
(a) Calculate JEK's sterling receipt on 31 December 20X4 using your answer to 38.1
above.
(b) Calculate JEK's sterling receipt on 31 December 20X4 if it uses:
 a forward contract
 a money market hedge
 an OTC currency option (9 marks)
38.3 With reference to your calculations in 38.2 above, discuss the issues that should be taken
account of by JEK's board when considering whether it should hedge the Estonian contract,
assuming the tender bid is successful. (8 marks)
38.4 Explain the implications for JEK of using each of the hedging instruments in 38.2(b) above if
its tender bid is unsuccessful. (6 marks)
38.5 Explain the principle of interest rate parity (IRP) and, given the information provided above,
calculate the forward rate of exchange on 31 December 20X4 using IRP, commenting on
your result. You should use the average current spot and borrowing/lending rates for the
purposes of this calculation. (5 marks)
Total: 30 marks
39 Lambourn plc
Throughout both parts of this question you should assume that today's date is 30 June 20X2.
39.1 Lambourn plc (Lambourn) is a UK company that trades in a range of pharmaceutical
products. It buys and sells these products in the UK and also in the USA, where it trades with
three companies – Biotron Inc., Hope Inc. and USMed Inc.

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In the past, the relatively low level of trading with US companies has meant that Lambourn
has not hedged its foreign currency exposure. However, due to increases in the level of
trade conducted in the USA, Lambourn's finance director is now considering the use of a
variety of hedging instruments.
Receipts and payments in respect of the following exports and imports (designated in the
currencies shown) are due in six months' time:
Receipts due from exports to:
Biotron Inc. $600,000
Hope Inc. £400,000
USMed Inc. $200,000
Payments due on imports from:
Biotron Inc. $1,100,000
Hope Inc. £900,000
USMed Inc. $1,250,000
Exchange rates at the present time are as follows:
Spot $1.6666 – 1.6720/£
3-month forward premium 0.90c – 0.98c
6-month forward premium 2.49c – 2.65c
Sterling currency options (standard contract size £31,250) are currently priced as follows
(with premiums, payable up front, quoted in cents per £):
Calls Puts
Strike Price September December September December
$1.63 3.67 4.59 0.06 1.69
$1.65 2.35 3.07 1.63 3.43
$1.67 1.82 2.65 2.04 5.55
Sterling currency futures (standard contract size £62,500) are currently priced as follows:
September $1.6555/£
December $1.6496/£
Annual borrowing and deposit interest rates at the present time are as follows:
Sterling 3.00% – 1.70%
Dollar 1.50% – 0.50%
Requirements
Assuming the spot rate in six months' time will be $1.6400 – 1.6454/£, calculate Lambourn's
net foreign currency exposure, and the outcome achieved, using:
(a) A forward market hedge
(b) Exchange-traded currency options (hedging to the nearest whole number of contracts)
so as to guarantee no worse an exchange rate than the current spot rate
(c) Currency futures contracts (hedging to the nearest whole number of contracts) and
assuming the relevant futures contract is trading at $1.6400 in six months' time
(d) A money market hedge (17 marks)
39.2 In six months' time (ie, in December 20X2), Lambourn will need to borrow £1.5 million for a
period of six months at a fixed rate of interest. The company's finance director is keen to
ensure that the interest rate on the loan does not exceed 3.75% pa. The spot rate of interest
is currently 3% pa. The finance director intends to use three-month sterling traded interest
rate options on futures to hedge the company's interest rate exposure.

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The current schedule of prices (premiums are in annual % terms) for these contracts
(standard contract size £500,000) is as follows:
Calls Puts
Strike Price Sept Dec Mar Sept Dec Mar
96.25 0.20 0.23 0.25 0.19 0.96 1.66
96.50 0.09 0.10 0.11 0.32 1.19 1.89
96.75 0.05 0.06 0.07 0.53 1.43 2.14
Requirements
(a) Calculate the outcome of the hedge and the effective annual rate of interest achieved if
prices in December 20X2, when Lambourn negotiates the six-month fixed rate loan
with its bank, are either:
 a spot interest rate of 4.4% pa and a futures price of 95.31; or
 a spot interest rate of 2.1% pa and a futures price of 97.75. (10 marks)
(b) Explain why a hedge using futures contracts may be less than 100% efficient. (3 marks)
Total: 30 marks
40 American Adventures Ltd

You should assume that it is now 30 November 20X3.
40.1 American Adventures Ltd (AA) is a family owned company based in the UK. AA organises
walking, cycling and climbing holidays in the United States of America for both British and
American customers. AA has the following receipts and payments due in four months' time:
Receipts due from American customers on 31 March 20X4 $2.25 million
Payments due to American suppliers on 31 March 20X4 $3.50 million
You work for Zeta Corporate Finance which has been asked to give advice to AA on
hedging its exchange rate risk. You have available the following data on 30 November
20X3:
Exchange rates:
Spot rate ($/£) 1.5154 – 1.5157
4-month forward contract premium ($/£) 0.0012 – 0.0011
March currency futures price (standard contract size £62,500): $1.5148/£
March traded sterling currency options (standard contract size £10,000):
The premiums are quoted in cents per £ and are payable up front.
Strike price Call premium Put premium
$1.56 1.04 6.15
Annual borrowing and depositing interest rates:
Sterling 4.70% – 3.50%
Dollar 3.51% – 2.25%

American Adventures currently has an overdraft.
Requirements
(a) Assuming the spot exchange rate on 31 March 20X4 will be $1.5150 – 1.5156/£ and
that the sterling currency futures price will be $1.5153/£, calculate AA's net sterling
payment if it uses the following to hedge its foreign exchange risk:

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 Currency futures
 A money market hedge
 Currency options (17 marks)
(b) Describe the relative advantages and disadvantages of using the methods in part (a)
above to hedge AA's foreign exchange risk. (8 marks)
40.2 AA intends to take out a £1 million fixed rate loan in four months' time on 31 March 20X4
for a period of three months. The finance director of AA wishes to use a forward rate
agreement (FRA) to hedge any unexpected increases in interest rates before the end of
March 20X4. The following FRA quotations for annual interest rates have been obtained
from AA's bank:
4v6 3.55 – 2.50%
4v7 3.58 – 2.52%
4v8 3.63 – 2.56%
Requirements
Calculate the receipt from, or payment to, AA's bank arising from the relevant FRA and the
net interest that AA will pay on its loan assuming that the actual borrowing rate on 31 March
20X4 is:
(a) 3.00% pa
(b) 4.00% pa (5 marks)
Total: 30 marks
41 Hammond Beamish Software Ltd

41.1 Hammond Beamish Software Ltd (Hammond) is a computer games software design
company and has been trading for four years. It sells the majority of its games to UK
retailers. In the past year the company's products have proved very popular and it has
started exporting them to Europe. It has recently signed an agreement with a French
customer, Magiprix SA (Magiprix). The first sale under this agreement involves Magiprix
purchasing €3.5 million of games from Hammond and paying for them in three months'
time.
Hammond's Sales Director, Chloe Rigby, is keen to develop this relationship with Magiprix
further, but her colleagues on the board are unsure of the consequences of trading in a
foreign currency. Hammond is operating in a very competitive market and its net margins
are low. As a result the board wants to assess the sensitivity of the Magiprix contract to
movements in the euro exchange rate.
You are a member of Hammond's finance team and have been asked to explain the foreign
exchange implications of trading with Magiprix. As a result, you have collected the
following information:
Spot rate (€/£) 1.1026 – 1.1084
Three month forward rate (€/£) 0.005 – 0.004 premium

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Options are available at an exercise price of €/£1.102, with a standard contract size of
£62,500. Premiums in cents per £ are as follows:
Calls 2.05
Puts 3.40
The company treasurer has predicted the forward spot rate in three months' time will be
€/£1.1035.
Requirements
(a) Calculate the impact of a 1% change in the spot value of sterling (both strengthening
and weakening) over the next three months on Hammond's sterling receipt from
Magiprix. (3 marks)
(b) Calculate the amount receivable in sterling by Hammond in three months' time if it
uses:
• a forward contract
• a money market hedge
• an option (assume the Treasurer's prediction is accurate) (8 marks)
(c) Referring to your calculations in parts (a) and (b) above, discuss the issues that should
be taken account of by Hammond's board when considering whether it should hedge
the Magiprix receipt. (8 marks)
41.2 One year ago, Stourton Wheeler Industrials Limited (SWI) borrowed £24 million for five
years at a fixed rate of 9.2% pa. LIBOR is currently 8.4% pa and SWI's board believes that
this rate will continue to fall. As a result it is keen to investigate the possibility of arranging
an interest rate swap. Consultations with various banks suggest that SWI could borrow
money at LIBOR plus 1.0% pa. SWI's directors are aware that Humphries Davis plc (HD)
currently has a similar sized loan, due for repayment in four years and borrowed at LIBOR
plus 1.4% pa. HD directors are concerned about the risks involved with this variable rate
and would like to fix the interest rate on their loan. The best fixed rate that HD can get is
10.8% pa.
Requirements
(a) Advise SWI's board how an interest rate swap could be set up which would benefit
both SWI and HD equally, with the variable leg of the swap set at LIBOR. You should
prepare supporting workings that show the total annual interest paid by both
companies within your proposed swap arrangements. (8 marks)
(b) Identify three risks associated with interest rate swap agreements. (3 marks)
Total: 30 marks
42 Bridge Engineering plc

David Mann (David) is the finance director of Bridge Engineering plc (BE). David has
approached your firm to give a presentation to the board of BE on the characteristics and use of
options in the following two situations:
(1) BE has been expanding in recent years by acquisition. David would like to know how his
company might use traded options to protect itself against a fall in the value of the small
shareholdings that it holds in potential acquisitions. One such potential acquisition is Stickle
plc (Stickle) in which BE has a holding on 31 December 20X5.

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The following information is available:

On 31 December 20X5 the share price of Stickle is 287 pence (ex div) and traded options
on its shares are available as follows (all figures in pence):
Calls Puts
Exercise price January March January March
280 8.5 16 1.5 10.5
290 2.5 11 5.5 16
(2) BE currently uses forward rate agreements (FRAs) and interest rate futures to hedge its
interest rate risk. David is now considering the use of traded interest rate options. BE needs
to take out a loan of £20 million on 31 July 20X6 for a period of seven months and David
has agreed with BE's bank that the loan will have an interest rate of LIBOR + 4% pa.
LIBOR on 31 December 20X5 is 0.62% pa and David wishes to hedge against any increase
in this rate between 31 December 20X5 and 31 July 20X6.
The following information is available:
At 31 December 20X5 the following traded interest rate options on three month interest
rate futures with a contract size of £500,000 are available (option premiums are in annual %
terms):
Calls Puts
Exercise price March June September March June September
99.13 0.05 0.09 0.13 0.26 0.31 0.35
99.38 0.02 0.03 0.05 0.48 0.50 0.52
99.63 0.01 0.02 0.03 0.71 0.73 0.74
Assume that the options in (1) and (2) above expire at the end of the relevant month and that
premiums are payable on 31 December 20X5. The interest implications of paying the premium
on 31 December 20X5 can be ignored.
You have been asked to prepare briefing notes for the presentation on options to be given to
the board of BE.
Requirements
Prepare the briefing notes for the presentation that include:
42.1 A calculation of the intrinsic value and time value of each of the options on Stickle's shares
at 31 December 20X5. (4 marks)
42.2 A brief explanation of the three factors that affect the time value of the options on Stickle's
shares. (3 marks)
42.3 A brief explanation of the two factors that affect the intrinsic value of the options on Stickle's
shares. (2 marks)
42.4 A demonstration, using options, of how BE can protect itself against a fall in the Stickle
share price in the period up to 31 March 20X6 when it will decide whether to make an offer
for the whole of Stickle. Assume Stickle's share price will be 250p on 31 March 20X6.
(4 marks)
42.5 A demonstration of how traded interest rate options on interest rate futures can be used by
BE to hedge against LIBOR rising above 0.62% pa, showing the effective interest rate on the
loan, if on 31 July 20X6:
(a) LIBOR is 0.80% pa and the futures price is 99.15
(b) LIBOR is 0.40% pa and the futures price is 99.66 (10 marks)
42.6 An explanation of the comparative advantages and disadvantages of using traded interest
rate options, rather than FRAs and interest rate futures, to hedge BE's interest rate risk.
(7 marks)
Total: 30 marks

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March 2016 exam questions
43 Aranheuston Pharma plc

Aranheuston Pharma plc (AP) is a large listed UK pharmaceuticals company and its financial year
end is 31 March. Its directors have decided to invest in new products on a regular basis in order
to keep pace with the global trading environment. In order to help grow the company more
quickly, AP's directors are also investigating the possible takeover of a competitor.
Considerable development time is required for the production of new pharmaceutical products
and so net cash inflows from sales often lag well behind the development costs required.
Forecast life-cycle data for a new product (AP525) that is under consideration are provided
below:
Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£'000 £'000 £'000 £'000
Depreciation (Note 1) (350) (350) (350) –
Rent (Note 2) – (80) (80) (80)
Fixed costs (Notes 3 & 5) – (290) (290) (290)
Interest (Note 4) – (60) (60) (60)
Sales (Note 5) – 0 2,600 700
Variable costs (Note 5) – 0 (1,180) (220)
Profit/(loss) (350) (780) 640 50
Total working capital required (Note 5) 0 260 70 0
Notes
1 New equipment required for the production of AP525 will cost £1,150,000 on 31 March
20X6 and will be sold on 31 March 20X9 for an agreed price of £100,000 (in 31 March 20X9
prices).
AP depreciates its equipment on a straight-line basis. A full year's depreciation is charged
in the year of purchase and none in the year of sale.
If this new equipment is purchased, existing equipment, which originally cost £120,000
many years ago and has a tax written down value of zero, will be sold on 31 March 20X6 for
£70,000.
The new equipment will attract 18% (reducing balance) capital allowances in the year of
year. In the final year, the difference between the equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down
value; or
2 The new equipment will take up extra space, which will have to be rented for three years.
The rent would be at a fixed annual amount of £80,000, payable in advance, with the first
payment due on 31 March 20X6.
3 £130,000 of these fixed costs per annum are existing head office costs that will be allocated
to the project.
4 The purchase of the new equipment would be funded from an issue of debt and this
represents the interest cost on that debt.
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5 Unless otherwise stated, all of the above figures are in 31 March 20X6 prices. The following
inflation rates are expected for the years ended 31 March 20X7–20X9:
 Sales: 2% pa
 Variable and fixed costs and working capital: 3% pa
Other information
Corporation tax will be payable at the rate of 17% pa for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
An appropriate money cost of capital for the project is 8% pa.
Requirements
43.1 Using money cash flows, calculate the net present value of the AP525 product at 31 March
20X6 and advise AP's directors whether the company should proceed with it. (18 marks)
43.2 Calculate the sensitivity of your advice in 43.1 to changes in the variable costs of the AP525
product and comment on your result. (5 marks)
43.3 For the purposes of the possible takeover of a competitor, outline the Shareholder Value
Analysis (SVA) approach to company valuation for AP's directors, identifying its advantages
and disadvantages. (6 marks)
43.4 Agency theory highlights the potential conflicts that may occur between a company's
shareholders and its directors.
(a) Explain how these conflicts might arise in AP in relation to the potential takeover of a
competitor.
(b) Assuming that the AP525 product goes ahead, explain how these conflicts might arise
in AP in relation to:
 debt levels
 short-term versus long-term performance appraisal (6 marks)
Total: 35 marks
44 Oliphant Williams plc

Oliphant Williams plc (OW) is a large UK design company that has traded since 1994. Its capital
structure at 29 February 20X6 is shown below:
Total market
Par Value Market Value value
£m (ex-div/ex-int) £m
Ordinary share capital 96 £1.70/share 326.4
Preference share capital 28 £1.80/share 50.4
3.5% debentures (redeemable at par in 20X9) 160 £105% 168.0
Notes
1 OW's retained earnings at 29 February 20X6 were £43.8 million.
2 OW's earnings for the year to 29 February 20X6 were £21.12 million. Earnings are not
expected to change significantly in the next two years.
3 OW's ordinary dividend for the year to 29 February 20X6 was £0.09 per share.

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You are an ICAEW Chartered Accountant and the managing director of OW. The following
comments were made at OW's most recent board meeting:
Finance director
"The company's level of debt is too high and its balance sheet needs restructuring. Why don't
we raise more equity and pay off some of the debt? This would reduce gearing and have a
positive impact on the price of ordinary shares. A reasonably priced rights issue is probably the
best way forward and should not dilute OW's earnings per share excessively."
Marketing director
"Our dividend is similar, in terms of the payout ratio, to previous years, but I think that this policy
of paying high dividends is an unnecessary drain on our resources. I think that our shareholders
would react positively if we reduce the dividend in future."
Production director
"Whilst we don't expect our earnings to change much in the next two years, surely it would be
better for our share price if we predict some growth when we communicate with our
shareholders?"
In response to the finance director's concerns, OW's board is considering the redemption of
one half of its debentures. The debentures would be redeemed at an agreed price of £110.40%.
The redemption would be funded by a 2 for 5 rights issue.
Requirements
44.1 Calculate OW's gearing ratio (debt / debt + equity) at 29 February 20X6, using both book
and market values. (3 marks)
44.2 Discuss, with reference to relevant theories and your calculations in 44.1 above, the finance
director's view that a reduction in OW's gearing would have a positive impact on the
company's share price. (6 marks)
44.3 Assuming that the debenture redemption and rights issue goes ahead on 1 March 20X6 as
outlined above, calculate the theoretical ex-rights price of one OW ordinary share. Show
the financial impact of the proposed rights issue on an OW shareholder who owns 10,000
ordinary shares and who:
(a) Takes up all of the rights
(b) Sells all of the rights
(c) Does nothing (9 marks)
44.4 Calculate, and comment upon, the actual price of an ordinary OW share after the rights
issue is made, assuming that OW's current P/E (price/earnings) ratio remains unchanged.
(7 marks)
44.5 Making reference to relevant theories, discuss whether the marketing director is correct that
a reduction in OW's ordinary dividend would affect the price of its ordinary shares.
(7 marks)
44.6 Comment on the ethical implications of the production director's suggestion for you as an
ICAEW Chartered Accountant. (3 marks)
Total: 35 marks

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45 Tully Carlisle Ltd

You should assume that the current date is 29 February 20X6.
45.1 Tully Carlisle Ltd (TC) is a UK construction firm. Most of its suppliers are UK-based. However,
since 20X4 it has been purchasing steel girders from a Russian company, GSL.
At a recent board meeting one of TC's directors commented:
"With our GSL purchases, we've never hedged against adverse exchange rate movements.
I think that we should as we're now buying a lot of steel from GSL. The orders are made
three months ahead of delivery and payment. A lot could happen to the exchange rate in
those three months."
TC's next order from GSL, at a price of R145.6 million (R = roubles, the Russian currency) will
be paid for in three months' time on 31 May 20X6. You are a member of TC's finance team
and have been asked to advise the board of the implications of hedging this purchase. You
have collected the following information:
Spot exchange rate at 31 December 20X4 (R/£) 79.45 – 91.34
Spot exchange rate at 31 December 20X5 (R/£) 76.51 – 87.95
Spot exchange rate at 29 February 20X6 (R/£) 78.81 – 90.62
Three-month forward contract discount (R/£) 0.55 – 0.63
Forward contract arrangement fee (per one million roubles converted) £40
Three-month over the counter (OTC) put option on roubles, exercise price
(R/£) 91.83
Three-month OTC call option on roubles, exercise price (R/£) 79.85
Relevant OTC option premium (per one million roubles converted) £90
Rouble interest rate (borrowing) 6.6% pa
Rouble interest rate (lending) 5.6% pa
Requirements
(a) Calculate the sterling cost of TC's payment to GSL on 31 May 20X6 if it uses the
following to hedge its exchange rate risk:
 A money market hedge
 An OTC currency option (8 marks)
(b) With reference to your calculations in (a) above and the spot exchange rates provided,
advise TC's board whether to hedge the payment to GSL. (9 marks)
(c) Explain, with relevant workings, why the three-month forward rate is expressed at a
discount to the spot rate on 29 February 20X6. (5 marks)
45.2 TC borrowed £18.5 million last year at a fixed rate of 5.2% pa and this loan is repayable in
March 20X9. Anticipating a fall in interest rates, TC's board has asked its finance team to
investigate the possibility of arranging an interest rate swap. TC's bank has offered the
company a variable rate loan at LIBOR plus 1.2% pa.
Saunders Southgate Media (SSM), a company with a similar sized loan to TC (at a variable
rate of LIBOR plus 1.6% pa), is keen to swap its loan for one at a fixed rate. SSM has been
offered a fixed rate of 6.4% pa by its bank. LIBOR is currently 3.5% pa.
Requirement
Prepare workings for TC's board that show how an interest rate swap that is equally
beneficial to both companies could be set up. The variable leg of the swap should be set at
LIBOR. Your workings should include a calculation of the total annual interest payable by
each company once the swap has been made. (8 marks)
Total: 30 marks

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June 2016 exam questions
46 Zeus plc
You should assume that the current date is 30 June 20X6.
Zeus plc (Zeus) is a large clothing retailer. Over the past five years it has built up an internet
based division, Venus, which specialises in selling to 16–24 year old female customers.
At a recent board meeting the Chief Executive Officer (CEO) of Zeus stated that:
"Venus has been successful, but we have not been able to get the value out of it that we initially
expected and the management time involved in running Venus is damaging the financial
performance of the group as a whole. Because internet-based companies have very high values
compared to non-internet companies with similar earnings, I feel that there could be more value
in Venus if it operated outside of our group. I think that we should divest ourselves of Venus and
appoint a financial advisor to assist us in the process. I wonder whether an Initial Public Offering
(IPO), where the shares are brought to the stock market for the first time, is a possibility."
The board agreed with the CEO and voted in favour of the divestment of Venus. Starr
Accountants (SA), a firm of ICAEW Chartered Accountants, has been appointed to give advice to
Zeus regarding the value of Venus and the potential IPO. In their valuation SA would like to use
net present value analysis and also a multiple of earnings. In addition to general corporate
finance work, SA also has a team that specialises in giving investment advice to clients who buy
shares in IPOs.
Extracts from Venus's most recent management accounts are shown below:
Balance sheet value of net assets at 30 June 20X6: £39 million.
Income statement for the year ended 30 June 20X6
£m
Sales 140.0
Cost of sales (56.0)
Gross profit 84.0
Selling and administration costs (72.0)
Operating profit 12.0
Taxation 17% (2.0)
Profit after tax 10.0
Note: Selling and administration costs include depreciation of £2 million.

Additional information relating to Venus:
(1) An analyst has estimated that, for the four years to 30 June 20Y0, the volume of sales will
grow by 18% pa and selling prices will increase by 2% pa. Because of volume discounts, the
gross profit percentage will increase to 66%.
(2) Selling and administration costs, excluding depreciation, are estimated to increase by
5% pa for the four years to 30 June 20Y0.
(3) Venus will require an additional investment in working capital on 1 July 20X6 of £26 million.
This will increase at the start of each subsequent year in line with sales volume growth and
selling price increases. Working capital will be fully recoverable on 30 June 20Y0.
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(4) On 30 June 20X6 Venus will need to invest in a new warehouse management system that
will cost £10 million and will not have any scrap value on 30 June 20Y0. The warehouse
management system will attract 18% (reducing balance) capital allowances in the year of
year.
At 30 June 20Y0, the difference between the warehouse management system's written
down value for tax purposes and its disposal proceeds will be treated by the company
either as a:
or
(5) SA intends to include in the net present value analysis a continuing value at the end of four
years that will represent the value of the net cash flows after tax beyond the fourth year. This
will be calculated by treating the after-tax operating cash flows for the year ended 30 June
20Y0 as a growing perpetuity with a growth rate of 1% pa.
(6) An appropriate money discount rate to reflect the risk of Venus is 10% pa.
(7) SA would like to assume that the rate of corporation tax will be 17% for the foreseeable
future and that tax flows arise in the same year as the cash flows that gave rise to them.
(8) The average price earnings (P/E) ratio of companies similar to Venus is 55.
(9) Unless otherwise stated assume that all cash flows arise at the end of the year to which they
relate.
Requirements
46.1 Using money cash flows, calculate the value of Venus on 30 June 20X6 using net present
value analysis. (15 marks)
46.2 Calculate the value of Venus on 30 June 20X6 using a multiple of current earnings.
(2 marks)
46.3 Summarise the advantages and disadvantages of the two valuation methods used in parts
46.1 and 46.2 and identify any concerns you have in respect of using them to value Venus.
(5 marks)
46.4 In relation to the potential IPO, explain the difference between an offer for sale and an offer
for subscription (also known as a direct offer). (2 marks)
46.5 Outline the advantages and disadvantages of underwriting and advise the board of Zeus as
to whether the potential IPO should be underwritten. (4 marks)
46.6 Explain two methods, other than an IPO, by which Zeus could divest itself of Venus.
(4 marks)
46.7 Identify any ethical issues that SA may have in relation to the potential Venus IPO and state
how they might be resolved. (3 marks)
Total: 35 marks
47 Ross Travel plc
Ross Travel plc (Ross) provides public transport services in the UK. Ross is planning to set up a
new division called 'Happytours' and to expand into a different sector of the transportation
industry by operating holiday and sightseeing tours. The Chief Executive Officer (CEO) of Ross
believes that the expansion will cost £500 million and that the finance can be raised in such a
way as to leave the existing debt:equity ratio, by market values, of the company unchanged after
the expansion.

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The CEO of Ross would like the finance director of the company to advise him of how the
company's current weighted average cost of capital (WACC) can be adjusted to take into
account the risk of expanding into the new sector. The debt proportion of the new finance will
be raised in the form of redeemable debentures. However, the CEO would also like to know the
advantages and disadvantages of Ross issuing convertible debentures.
The finance director has established the following:
 The debt proportion of the £500 million finance to be raised on 1 June 20X6 will be in the
form of new 4% coupon debentures, which will be redeemed on 31 May 20Y1 at par. The
redemption yield of the new debentures will be equal to the redemption yield of Ross's
existing debentures.
 An appropriate equity beta for a company that operates in the holiday and sightseeing tour
sector is 1.3 at a debt:equity ratio, by market values, of 1:1.
 The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
 The corporation tax rate will be 17% for the foreseeable future.
The following information relates to Ross without the Happytours project
Extracts from Ross's most recent management accounts are as follows:
£m
3,104
6% Redeemable debentures at nominal value 608
3,712
On 31 May 20X6 Ross's ordinary shares each had a market value of 576p (cum-div) and an
equity beta of 0.65. For the year ended 31 May 20X6, the dividend declared was 11p per
ordinary share and the earnings yield (earnings per share divided by the ex-div share price) was
6%.
Ross's 6% coupon debentures had a market value on 31 May 20X6 of £111 (cum-interest) per
£100 nominal value and are redeemable at par on 31 May 20Y0.
Requirements
47.1 Ignoring the Happytours project, calculate the WACC of Ross at 31 May 20X6 using:
(a) The Gordon growth model (12 marks)
47.2 Explain the limitations of the Gordon growth model. (3 marks)
47.3 Using the CAPM, calculate a WACC that is suitable for appraising the Happytours project
and explain your rationale. (6 marks)
47.4 Assuming that £75 million is raised from the new 4% coupon debentures issued on 1 June
20X6, calculate the issue price per £100 nominal value and the total nominal value that will
have to be issued. Comment on the issue terms for these new debentures. (7 marks)
47.5 Explain what is meant by a convertible debenture and outline the advantages and
disadvantages for Ross in raising finance using this type of debt. (5 marks)
Total: 35 marks

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48 Heaton Risk Management

You should assume that the current date is 31 May 20X6.
48.1 Heaton Risk Management (HRM) is an authorised financial advisor and provides investment
and risk management advice. You work for HRM and currently you are advising two clients,
Orchid Cars Ltd (Orchid) and Sheldon Investments (Sheldon).
Orchid is a UK company that manufactures sports cars. Orchid's main market is the UK but it
also exports cars to the USA.
Currently Orchid uses forward contracts to hedge its foreign exchange rate risk. However,
Orchid's managing director has recently been considering using foreign currency futures
and over-the-counter foreign currency options. You have been asked to make a comparison
of the results of hedging using the three different techniques.
Orchid is due to receive $2,500,000 on 30 September 20X6.
The following data is available to you at the close of business on 31 May 20X6:
Exchange rates:
Spot exchange rate ($/£) 1.5398 – 1.5402
Four-month forward premium ($/£) 0.0015 – 0.0010
September currency futures price (standard contract size £62,500): $1.5379/£
Four-month over-the-counter currency options:
Call options to buy £ have an exercise price of $1.5300/£. The premium is £0.03 per $ to be
converted and is payable on 31 May 20X6.
Put options to sell £ have an exercise price of $1.5200/£. The premium is £0.01 per $ to be
converted and is payable on 31 May 20X6.
Orchid has surplus cash funds on which it receives interest at 3.60% pa.
Requirements
(a) Assuming that the spot exchange rate on 30 September 20X6 will be $/£1.5315 –
1.5325 and that the sterling currency futures price will be $1.5320/£, calculate Orchid's
net sterling receipt if it uses the following to hedge its foreign exchange rate risk:
 Currency futures contracts
 An over-the-counter currency option (11 marks)
(b) Discuss the relative advantages and disadvantages of each hedging technique and
advise Orchid on which would be most beneficial for hedging its foreign exchange rate
risk. (9 marks)
48.2 Sheldon holds a portfolio of FTSE 100 shares and the current market value on 31 May 20X6
is £9,657,000. The managers at Sheldon are worried that over the next three months the
FTSE 100 will fall in value due to economic uncertainty in Europe and Asia. The managers at
Sheldon do not want to sell the company's portfolio and wish to protect its current value
against a potential fall in the FTSE 100.
The FTSE 100 index is 6,525 on 31 May 20X6 and you have the following information
available to you regarding traded index option premiums:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)
6,450 6,525 6,600
Calls Puts Calls Puts Calls Puts
July 155 51 87 85 70 135
August 215 120 171 159 120 213

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Option contracts expire at the end of the month.

Requirements
Demonstrate how FTSE 100 index options can be used by Sheldon to hedge its portfolio of
shares against a fall in the FTSE 100 and show the outcome if, on 31 August 20X6, the
portfolio's value:
(a) Rises to £10,471,000 and the FTSE 100 index rises to 7,075
(b) Falls to £8,695,000 and the FTSE 100 index falls to 5,875 (7 marks)
48.3 Sheldon's managers would like an explanation regarding the time value of the FTSE 100
index options.
Requirement
Explain the three factors that will affect the time value of the FTSE 100 index options in
48.2 above. (3 marks)
Total: 30 marks

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September 2016 exam questions
49 Northern Energy Ltd

You should assume that the current date is 30 September 20X6.
Northern Energy Ltd (Northern) is a UK electricity generator. On 31 March 20X7 it has
contracted to borrow £9.5 million for a year at an interest rate of LIBOR + 2% pa. The loan will be
used to finance the construction of a new rail terminal at one of its power stations. Northern's
board is now worried that interest rates may well increase over the next six months and would
like to investigate how it might hedge against any adverse movements. Northern's bank has
offered the company either a Forward Rate Agreement (FRA) at 7.25% pa or an option at 6.5%
pa plus a premium of 1% of the sum borrowed. The board would also like to consider the
possibility of an interest rate swap.
Northern's three power stations are coal-fired and the company has for many years imported
coal from China and India, with payment made to suppliers at the time of the order. Northern's
board is concerned that in recent months the Indian and Chinese exchange rates have become
more volatile. As a result Northern's board is considering buying coal from the USA.
Earlier this month Northern's purchasing team started discussions with ACT Inc (ACT), an
American coal mining company. ACT has informed Northern that, because of the logistical
issues involved, the first consignment of coal would arrive in three months' time on
31 December 20X6. Northern has agreed to pay for the coal one month later on 31 January
20X7. Northern's board is keen to establish whether it is worth hedging its dollar exchange
rate risk.
ACT has quoted Northern a price of $4.8 million for this first consignment. You work in
Northern's finance team and have been asked to prepare workings to help Northern's board to
decide on a hedging strategy. You have collected the following data at the close of business on
30 September 20X6:
Spot rate ($/£) 1.5150 – 1.5260
Relevant currency futures contract price (standard contract size $1.5095/£

£62,500)
OTC currency option Four-month put option on dollars ($/£) 1.5110

Four-month call option on dollars ($/£) 1.5020
Premium (per $ converted) £0.011
Forward contract Four month forward premium ($/£) 0.0112 – 0.0094

Arrangement fee (per $ converted) £0.004
Interest rates US dollar interest rate (lending) 3.6% pa

US dollar interest rate (borrowing) 4.5% pa

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Requirements
49.1 Assuming that on 31 March 20X7 LIBOR will be:
(a) 5% pa
(b) 7% pa
prepare suitable interest payment calculations for each eventuality and recommend to
Northern's board whether it should hedge against interest rate movements using a FRA, an
option or an interest rate swap. (9 marks)
49.2 Calculate Northern's sterling cost of the ACT consignment if it uses the following to hedge
its exchange rate risk:
(a) Currency futures contracts
(b) An OTC currency option
(c) A forward contract
(d) A money market hedge
You should assume that on 31 January 20X7 the spot exchange rate will be
$1.4895 – 1.4956/£ and that the sterling currency futures price will be $1.4945/£.
(13 marks)
49.3 With reference to your calculations in 49.2 above, explain to Northern's board the
implications of hedging or not hedging the payment to ACT. (8 marks)
Total: 30 marks
50 Roper Newey plc

Roper Newey plc (Roper) is a UK engineering company that operates in the oil industry
providing support services on oil rigs and at oil terminals. It started trading nearly 20 years ago
and it has a financial year end of 31 August.
For a number of years Roper has used a weighted average cost of capital (WACC) figure of 7%
pa as its hurdle rate when appraising large-scale investments. At Roper's most recent board
meeting it was decided to investigate the possibility of the company diversifying into the UK
fracking industry. Fracking involves extracting oil and gas from beneath the ground via the high
pressure injection of water and sand. It is a very controversial industry in the UK, not least
because of concerns about its impact on the natural environment.
Roper's board is considering supplying services to the fracking industry. The finance for this
investment would be raised in such a way so as not to alter Roper's current gearing ratio
(measured by market values). The debt element of the finance will come from a new issue of 6%
irredeemable debentures at par.
Roper's directors are aware that many American companies have been very successful
financially when investing in fracking, but are concerned that such a diversification by Roper in
the UK would be excessively risky. As a result Becky Challoner, Roper's finance director, has
agreed to present relevant figures and advice at the next board meeting. Becky has asked you,
as a member of Roper's finance team, to work with her on this.
Details of Roper's capital structure at 31 August 20X6 are shown below:
Total nominal value Market value
£m
Ordinary share capital (£1 shares) 15.5 £5.20/share (ex-div)
Preference share capital (£1 shares) 9.0 £1.08/share (ex-div)
4% redeemable debentures (Note 1) 6.5 £107% (cum-int)
5% irredeemable debentures 10.0 £101% (cum-int)
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Roper's most recent dividend payments and the interest payments due in the near future are
shown below:
Ordinary dividends (Note 2) £3,797,500 Paid in August 20X6
Preference dividends (Note 2) £540,000 Paid in August 20X6
4% redeemable debentures interest £260,000 To be paid in September 20X6
5% irredeemable debentures interest £500,000 To be paid in September 20X6
Notes
1 These are redeemable at par on 31 August 20X9.
2 Ordinary and preference dividends are paid once a year. Ordinary dividend payments have
increased at a steady annual rate since August 20X2 at which time the ordinary dividend
per share was £0.201. There have been no issues of ordinary shares since August 20X2.
Additional information at 31 August 20X6
Roper equity beta 1.2
Risk free rate (pa) 1.9%
Market return (pa) 9.5%
Fracking industry – market data at 31 August 20X6
Average equity beta 1.9
Ratio of long–term funds (equity:debt) by market values 90:25
Assume that corporation tax will be payable at the rate of 17% for the foreseeable future and tax
will be payable in the same year as the cash flows to which it relates.
Requirements
50.1 Ignoring the investment in fracking services, calculate Roper's WACC at 31 August 20X6
using:
(a) The dividend growth model and
50.2 Ignoring the investment in fracking services, advise Roper's board, giving reasons, whether
it should continue using 7% as its hurdle rate when appraising large-scale investments.
(3 marks)
50.3 Explain the underlying logic for using the CAPM when calculating a company's WACC.
(5 marks)
50.4 Calculate the WACC that Roper should use when appraising its proposed investment in
fracking and explain the reasoning behind your approach. (10 marks)
50.5 With reference to the information provided, explain the circumstances in which it would be
appropriate to use the adjusted present value approach to investment appraisal. (4 marks)
Total: 35 marks
51 Darlo Games Ltd

Darlo Games Ltd (Darlo) is a UK company which was formed in 20W5 by Michelle Cartmel and
Rob Orton. Darlo produces games for use on computers and mobile devices such as phones. Its
financial year end is 31 August. Michelle and Rob own 70% of Darlo's issued share capital and are
part of its executive management team. The remainder of Darlo's share capital is owned by
Michelle and Rob's friends and family. Darlo has been particularly successful in the past three years
as two of its games introduced in late 20X3 have generated very high levels of sales. A game has a
typical lifespan of three to five years.

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NSL plc (NSL) is a listed software development company based in the UK and is actively seeking
to invest in other companies. You are an ICAEW Chartered Accountant and work in Darlo's
finance team. You have received an email from your manager, Jackie Tann, an extract from
which is shown below:
From: Jackie Tann

Date: 1 September 20X6
A member of the board has told me, in confidence, that NSL is considering buying shares in
Darlo. I'm not sure at this stage if they want to buy all of them or just a minority holding. We
need some guidance on what a reasonable share price might be. I've extracted the key figures
from our most recent management accounts in the document attached to this email. I've also
provided you with some working assumptions.
Could you please prepare a range of prices for the Darlo board to consider? Also I'm keen to
know if we could value Darlo using Shareholder Value Analysis (SVA).
Email attachment:
Income statement for the year ended 31 August 20X6
£'000
Revenue 9,390
Profit before interest and tax 2,849

Interest (30)
Corporation tax at 17% (479)
Profit after taxation 2,340
Dividends paid (740)

£'000
Freehold land and buildings (original cost £2.8 million) 2,400
Equipment (original cost £4.5 million) 3,200
5,600
Working capital 148
5,748
4% debentures (redeemable in 20Y3) at nominal value (750)
4,998
Ordinary shares of £1 each 500

4,998
Working assumptions
(1) Darlo's fixed assets were revalued at 31 August 20X6 as follows:
£'000
Freehold land and buildings 3,150
Equipment 3,370
These revalued amounts have not been recognised in the balance sheet at 31 August 20X6.
(2) The average price/earnings ratio for listed businesses in Darlo's industrial sector is 10 and
the average dividend yield is 8%.
(3) A discount rate of 12% pa appropriately reflects the risk of Darlo's cash flows.

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(4) Darlo's pre-tax net cash inflows (after interest) for the next three years are estimated to
be:
£'000
Year to 31 August 20X7 2,900
Projecting forward from 31 August 20X9 and taking a prudent view, our estimated net cash
inflows (after interest, capital asset replacement and all necessary tax adjustments) will be
£2 million pa.
(5) On 31 August 20X6 Darlo's equipment had a tax written down value of £920,000. Assume
that we will scrap it (ie, dispose of it for zero income) on 31 August 20X9. The equipment
attracts 18% (reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year. In the final year, the
difference between the equipment's written down value for tax purposes and its disposal
proceeds will be treated by the company either as a:
or
(6) Corporation tax will be payable at the rate of 17% for the foreseeable future and that tax will
be payable in the same year as the cash flows to which it relates.
Requirements
51.1 Prepare a report for Darlo's board which:
(a) Calculates the value of one share in Darlo based on each of these methods:
 Net asset basis (historic cost)
 Net asset basis (revalued)
 Price/earnings ratio
 Dividend yield
 Present value of future cash flows (14 marks)
(b) Explains, with reference to your calculations and the information provided, the
advantages and disadvantages of using each of the five valuation methods in
(a) above. (10 marks)
51.2 Explain how the SVA approach works and whether the information provided by Jackie Tann
is sufficient to value Darlo using SVA (calculations are not required). (8 marks)
51.3 Explain the ethical issues that you should consider as an ICAEW Chartered Accountant
arising from Jackie Tann's email. (3 marks)
Total: 35 marks

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December 2016 exam questions
52 Ribble plc
Ribble plc (Ribble), a UK company, manufactures hoverboards and other products. Hoverboards
are a form of self-balancing scooter powered by rechargeable batteries. In the last two years
total UK sales of hoverboards have increased rapidly but major concerns have arisen over their
safety and, even though they are still in high demand, some retailers have stopped selling them.
At a recent directors' meeting of Ribble the chief executive officer (CEO), who is an ICAEW
Chartered Accountant, presented a research and development report (that had cost £100,000)
on a new and safer hoverboard; the Ribbleboard. The CEO stated that he believed the new
Ribbleboard could be successfully marketed for a period of four years and would replace the
company's existing hoverboard, the Ribflyer. The directors decided that a project appraisal
should be undertaken to ascertain whether the Ribbleboard should be marketed. Some
directors felt that as there is a continuing demand for the Ribflyer, even though there are
concerns about its safety, it should still be manufactured and sold rather than taking the risk of
marketing the Ribbleboard. There was also concern that a rival company was known to be
developing a new safer hoverboard and it is likely to launch it onto the market on 31 December
20X7.
The following information is available regarding the Ribbleboard project:
• The selling price will be £299 per unit in the year to 31 December 20X7 and will remain
fixed in each subsequent year of the product's life. The contribution for the year to
31 December 20X7 is expected to be 45% of the selling price. The variable cost of
producing the Ribbleboard is expected to increase by 5% pa in the three years to
31 December 20Y0.
• The number of units sold in the year to 31 December 20X7 is expected to be 8,000 per
month. For the year to 31 December 20X8 the number of units sold is expected to increase
by 20%. For the remaining two years to 31 December 20Y0, the number of units sold is
expected to decline by 15% pa.
• The new specialist equipment required to manufacture the Ribbleboard requires more
space than Ribble currently has available. Therefore, Ribble will use factory space that it
currently owns and rents out for storage to another company for a fixed rent of £1 million pa
payable in advance on 31 December. The space will be re-let for £1 million pa at the end of
the project on 31 December 20Y0.
• If the project goes ahead, two managers who had already accepted voluntary redundancy
would be asked to remain employed until 31 December 20Y0 and manage the project at a
salary of £60,000 pa each. These managers were due to leave on 31 December 20X6 and
receive lump sum payments of £50,000 each at that time. They will now receive lump sum
payments of £60,000 each on 31 December 20Y0 when their services will no longer be
required. The managers were also due to receive consultancy fees of £25,000 pa each for
the two years ended 31 December 20X7 and 20X8. These consultancy fees would not be
paid to them if they remained employed to manage the project. All of the above salaries,
lump sums and fees are stated in money terms.
• It is estimated that for every 10 Ribbleboards sold there will be a loss of sales of one unit of
the Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a contribution
of 25%, in each of the four years to 31 December 20Y0.
ICAEW 2019 December 2016 exam questions 75

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• The project will incur fixed overhead costs of £500,000 in the year to 31 December 20X7 of
which 40% is centrally allocated overheads. The fixed overhead costs will increase after
31 December 20X7 by 3% pa.
• Investment in working capital will be £1 million on 1 January 20X7 and will increase or
decrease at the start of each year in line with sales volumes. Working capital will be fully
recoverable on 31 December 20Y0.
• On 31 December 20X6 the project will require an investment in machinery and equipment
of £24 million, which is expected to have a realisable value of £4 million (in 31 December
20Y0 prices) at the end of the project. The machinery and equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent
year of ownership by the company, except the final year.
In the final year, the difference between the machinery and equipment's written down value
for tax purposes and its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down
value; or
– balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that give rise to them.
• An appropriate money cost of capital for the Ribbleboard project is 10% pa.
Requirements
52.1 Using money cash flows calculate the net present value of the Ribbleboard project at
31 December 20X6 and advise Ribble's directors whether it should be accepted.
(20 marks)
52.2 Advise Ribble's directors as to the sensitivity of the NPV of the Ribbleboard project to:
(a) Changes in sales revenue (ignoring the effects on working capital) (4 marks)
(b) Changes in the realisable value of the machinery and equipment (3 marks)
52.3 Identify and discuss two real options available to Ribble in relation to the Ribbleboard
project. (5 marks)
52.4 Discuss the ethical issues that the CEO should consider regarding the suggestion by some
directors that only the Ribflyer hoverboard should continue to be manufactured. (3 marks)
Total: 35 marks
53 Bristol Corporate Finance

You work for Bristol Corporate Finance (BCF). Two of the clients for whom you are responsible
are Middleton plc (Middleton) and the management team of Oldham Ltd (Oldham).
53.1 Middleton
Middleton is a listed company and is seeking to raise £70 million to invest in new projects
during 20X7. Currently Middleton is financed only by equity. However, at a recent board
meeting the finance director stated that, since other companies in Middleton's industry
sector have average gearing ratios (measured as debt/equity by market value) of 30% (with
a maximum of 40%) and an average interest cover of six times (with a minimum of five
times), perhaps the company should access the debt markets. The finance director
presented the board with two alternative sources of finance to raise the £70 million.

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Equity issue: The £70 million would be raised by a 1 for 2 rights issue, priced at a discount
on the current market value of Middleton's shares.
Debt issue: The £70 million would be raised by an issue of 7% coupon debentures,
redeemable at par on 31 December 20Y6. The yield to redemption of the debentures
would be equal to the yield to redemption of the debentures of Wood plc (Wood), another
listed company in Middleton's market sector. Wood has a similar risk profile to Middleton
and has recently issued its debentures. Wood's debentures have a coupon of 7%, will be
redeemed in four years at par and their current cum-interest market price is £110 per £100
nominal value.
There were concerns expressed by a number of board members regarding the debt issue
since it has been the long-standing policy of the company not to borrow. Their concerns
were how Middleton's shareholders and the stock market would react and that the
company's cost of capital would increase as a result of borrowing, leading to a fall in the
company's value.
An extract from Middleton's most recent management accounts is shown below:
Income statement for the year ended 31 December 20X6
£m
Taxation at 17% (4.25)
• Middleton has an equity beta of 1.1
• The risk free rate is expected to be 3% pa
• The market return is expected to be 8% pa
• Middleton's current share price is £5 per share ex-div
• Middleton has 40 million ordinary shares in issue
Requirements
(a) Calculate, using the CAPM, Middleton's cost of capital on 31 December 20X6.
(1 mark)
(b) Assuming a 1 for 2 rights issue is made on 1 January 20X7:
• Calculate the discount the rights price represents on Middleton's current share
price.
• Calculate the theoretical ex-rights price per share.
• Discuss whether the actual share price is likely to be equal to the theoretical ex-
rights price. (5 marks)
(c) Alternatively, assuming debt is issued on 1 January 20X7:
• Calculate the issue price and total nominal value of the debentures that will have
to be issued to give a yield to redemption equal to that of Wood's debentures.
• Discuss the validity of the use of the yield to redemption of Wood's debentures in
the above calculation. (7 marks)
(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using
the gearing and interest cover information provided by the finance director) and advise
Middleton's board on which source of finance should be used. (12 marks)

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53.2 The management team of Oldham

You have been asked to make a presentation to the management team of Oldham, an
unlisted company, who are considering a management buyout (MBO) of the company. Your
presentation will cover certain aspects of the MBO process and the contents of the financial
information section of the business plan that will need to be prepared for potential
financiers.
Requirements
Prepare notes for your presentation which include:
(a) An outline of the sources and forms of finance that the management team is likely to
need. (3 marks)
(b) The possible exit routes for the financiers that contribute to the funding of the MBO.
(2 marks)
(c) The content of the financial information section of the business plan. (5 marks)
Total : 35 marks
54 Orion plc
You should assume that the current date is 30 November 20X6.
Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to the
USA and receives payment in dollars. Orion imports raw materials from a number of countries
located in Europe and makes payments to suppliers in euros.
At a recent board meeting of Orion concern was expressed about several aspects of the
company's foreign exchange rate risk (forex) hedging strategy. Below is an extract from the
minutes of the meeting:
Managing director: "We have always hedged our forex and we should continue to do so.
But I am worried that because we import our raw materials and export our finished
products, we are subject to economic risk."
Production director: "We use derivative instruments to hedge forex and I think they are too
complicated. How do the banks calculate forward rates for example? Also can someone
explain to me what economic risk is?"
It was decided that at the next board meeting the finance director should make a presentation
to the board on the subject of forex. The finance director has asked you to prepare some
information for his presentation including an example of how receipts are hedged using
different hedging techniques.
You have the following information available to you at the close of business on 30 November
20X6:
Orion currently has substantial sterling funds on deposit.
Receipts due from USA customers on 31 March 20X7 are $5,000,000.
Exchange rates:
Spot rate ($/£) 1.4336 – 1.4340
Four month forward discount ($/£) 0.0086 – 0.0090
March currency futures price (standard contract size £62,500) $1.4410/£
Over-the-counter (OTC) currency option
A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is
£0.03 per $ and is payable on 30 November 20X6.

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Annual borrowing and depositing interest rates (%)

Dollar 5.20 – 4.80
Sterling 3.30 – 3.00
Requirements
Provide the following information for the finance director of Orion:
54.1 A calculation of Orion's sterling receipt using:
(a) A forward contract
(b) Currency futures
(c) An OTC currency option
assuming that the spot price on 31 March 20X7 is $/£ 1.4484 – 1.4490 and the March
futures price is $1.4487/£. (11 marks)
54.2 An explanation of the advantages and disadvantages of the three hedging techniques used
in 54.1 above and, using your results from 54.1 above, advice on which hedging technique
Orion should use. (8 marks)
54.3 A demonstration, with reference to theories and relevant workings, of why the forward rate
is at a discount to the spot rate at 30 November 20X6. (5 marks)
54.4 An explanation of what economic risk is, a discussion of how it affects Orion and an outline
of how economic risk can be mitigated. (6 marks)
Total: 30 marks

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55 Sentry Underwood plc

You should assume that the current date is 28 February 20X7.
Sentry Underwood plc (Sentry) is a large, listed UK drinks manufacturer. Sentry's recent
profitability has deteriorated because of increased competition and a volatile consumer market.
As a result, Sentry's board is considering a major change in the company's trading strategy
which will cost £20 million to implement. The board has decided that this investment will be
funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry's finance
director and she is an ICAEW Chartered Accountant. Sentry's other directors have asked her to
provide information to help them decide on the source of funding for the new investment.
Extracts from Sentry's most recent management accounts are shown below:
Income statement for the year to 28 February 20X7
£'000
Sales 78,500
Variable costs (56,520)
Fixed costs (13,850)
Debenture interest (1,421)
Taxation at 17% (1,141)
Dividends proposed (3,000)
Balance sheet at 28 February 20X7

£'000
Retained profits 11,286
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
44,086
The market values of Sentry's ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
(1) A rights issue at £2.50 per ordinary share; or
(2) An issue of 8% debentures at par, redeemable in 20Y3.
You have been asked by the directors to assume the following for the year to 28 February 20X8:
 Sales will increase by 20%
 The contribution to sales ratio will remain unchanged
 Fixed costs will increase by £2 million pa
 The current level of dividends per share will be maintained
 Corporation tax will remain at 17%

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At last week's board meeting the following comments were made by two of Sentry's other
directors:
Matthew Girvan: "We could decrease the amount of new capital that we have to raise by
reducing the annual dividend. Our payout ratio has been excessive for a
number of years now. Why not halve it?"
Roger Smyth: "We need to be very careful with this issue of shares or debentures. There's a
danger that our earnings per share (EPS) figure will be diluted, which could
cause a fall in our share price. To avoid any problem with our share price, I
suggest it would be better to tell our shareholders that we expect sales to
increase by 30%–35% next year, rather than the 20% we are forecasting."
Requirements
55.1 For both the rights issue and the debenture issue, prepare forecast income statements for
Sentry for the year to 28 February 20X8. (6 marks)
55.2 For both the rights issue and the debenture issue, calculate Sentry's forecast:
 EPS figure for the year to 28 February 20X8; and
 gearing ratio (book value of long-term borrowings/long-term funds) as at 28 February
20X8. (6 marks)
55.3 For the rights issue only, calculate the increase in annual sales required for the year to
28 February 20X8 in order that Sentry's EPS figure remains the same as in the current year.
(6 marks)
55.4 Making reference to your calculations in 55.1, 55.2 and 55.3 above, discuss the implications
for Sentry's shareholders of the company using a rights issue or a debenture issue to fund
its proposed £20 million investment. (8 marks)
55.5 Discuss Matthew Girvan's proposal that dividends should be cut, making reference to
relevant theories. (6 marks)
55.6 Discuss the ethical issues for Jenna Helier that would be caused by Roger Smyth's
suggestion. (3 marks)
Total: 35 marks
56 White Rock plc

White Rock plc (White), a UK listed company, manufactures a range of cosmetics at three
factories: lipsticks (London), mascara (Newcastle) and foundation products (Manchester).
White's financial year end is 31 March.
At its most recent board meeting the following matters were discussed:
(1) Closure of the London factory
(2) Investment priorities at the Manchester factory
(3) The impact of (1) and (2) above on White's share price
56.1 Closure of the London factory
The cosmetics industry is very competitive and products can quickly become unfashionable.
Falling demand for White's lipsticks and the high costs of operating in London have meant
that the company's directors have decided to close the London factory. Instead, White will
manufacture a smaller range of lipsticks at its Newcastle factory which currently only makes
mascara, but does have spare capacity. Manufacture of this smaller range of lipsticks would
commence in Newcastle as soon as the London factory is closed. White's directors are
unsure whether to close the London factory on 31 March 20X7 or on 31 March 20X9, when
its lease expires.

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You work in White's finance team and have been asked to provide information to aid the
directors' decision on the date of the factory closure. Information to support your task is
shown below:
Sales and contribution
London Newcastle
factory factory
Estimated lipstick sales (all at 31 March 20X7 prices)
Year to 31 March 20X8 £7.2m £1.3m
Year to 31 March 20X9 £5.5m £1.5m
Contribution to sales ratio 60% 65%

Leases
The London factory lease costs £1.8 million pa and expires on 31 March 20X9. The annual
lease cost is fixed and is payable on 1 April. If the factory is closed on 31 March 20X7 then
White would pay a tax allowable cancellation charge of £3 million on that date to cancel the
lease. The Newcastle factory lease costs a fixed £0.8 million pa which is payable on 1 April.
Other fixed costs
London Newcastle
factory factory
Factory-wide fixed costs pa (at 31 March 20X7 prices) £1.4m £1.2m
Allocated head office costs pa (at 31 March 20X7 prices) £1.6m £1.3m
Working capital
The London factory has a working capital balance on 31 March 20X7 of £0.8 million. White's
policy is that at the start of each financial year, there should be working capital in place that
is equivalent to 10% of the estimated sales for that year.
Tax allowable London factory closure payments
Closure payments if closure is on 31 March 20X7 £1.6m
Closure payments if closure is on 31 March 20X9 (at 31 March 20X9 prices) £2.3m
London factory machinery
Machinery tax written down value at 1 April 20X6 £3.1m
Resale value of machinery at 31 March 20X7 £1.7m
Resale value of machinery at 31 March 20X9 (at 31 March 20X9 prices) £0.6m
The factory machinery attracts 18% (reducing balance) capital allowances in the year of
year. In the final year, the difference between the machinery's written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down
value; or
• balancing charge, if the disposal proceeds are more than the tax written down value.
Inflation rates (applicable to all sales and costs unless otherwise indicated)
Year to 31 March 20X8 2%
Year to 31 March 20X9 3%
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.

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White uses a money cost of capital of 11% for investment appraisal purposes.
Requirements
(a) Calculate the relevant money cash flows associated with closing the London factory on:
(1) 31 March 20X7
(2) 31 March 20X9
and use these to calculate the net present value at 31 March 20X7 of each of these
possible closure dates.
In both of these calculations you should ignore any opportunity cash flows associated
with the alternative closure date. (21 marks)
(b) Advise White's directors as to the preferred closure date of the London factory.
(1 mark)
56.2 Investment priorities at the Manchester factory
The Manchester factory has a capital expenditure budget of £15 million for the financial
year to 31 March 20X8. White's board needs to choose which of the available projects
would maximise shareholder wealth. Details of the four projects available are shown below:
Project 1 2 3 4
£'000 £'000 £'000 £'000
Investment required 6,000 4,500 4,700 3,850
Net Present Value 621 563 869 622
Requirement
Prepare calculations showing the combination of projects that will maximise White's
shareholders' wealth if the four projects are assumed to be either (1) divisible or (2)
indivisible. (6 marks)
56.3 White's managing director has stated that once the London closure date and the
Manchester investment plans are announced to the stock market, White's share price will
adjust to reflect this information accurately. However, the finance director has pointed out
that there are behavioural factors that may mean that this is not the case.
Requirement
Explain the key principles underlying the Efficient Market Hypothesis and how behavioural
factors question the validity of that hypothesis. (7 marks)
Total: 35 marks
57 ST Leonard Foods
ST Leonard Foods (STL) is a UK frozen food company. It buys raw vegetables and fish from its
suppliers and, following processing and freezing, sells them to its customers.
You work in STL's finance team and have been asked to prepare calculations that will help STL's
management decide on the best strategy with regard to these two issues:
Issue 1 – foreign exchange rate hedging
Earlier this year STL's management signed a contract worth €1,750,000 with one of its Spanish
suppliers and the goods arrived at STL last week. In addition, it has agreed to sell €600,000
worth of frozen goods to a new customer, a French hypermarket, and these goods will be
despatched to France in 10 days' time.

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Both of these contracts are due to be settled in three months' time on 30 June 20X7. STL's
management is keen to explore whether it is worth hedging against movements in the value of
the euro between now and then. Four possible strategies are under consideration by the board:
 Do not hedge
 Use an over-the-counter (OTC) currency option
 Use a money market hedge
 Use a forward contract
The following data has been collected at the close of business on 31 March 20X7:
Spot rate (€/£) 1.2652 – 1.2744
Three-month OTC call option on € – exercise price 1.2540/£
Three-month OTC put option on € – exercise price 1.2650/£
Three month forward contract premium (€/£) 0.0058 – 0.0042
Cost of relevant OTC option £0.70 per €100 converted
Arrangement fee for forward contract £5,500
Issue 2 – interest rate hedging
STL has recently signed a contract with its bank to borrow £4.2 million on 1 July 20X7 to help
fund the construction of a new factory. The loan is for three years at an interest rate of LIBOR +
1% pa. STL's management is concerned that interest rates will rise before 1 July and wishes to
explore whether it should hedge its borrowing cost. Its bank has offered STL a Forward Rate
Agreement (FRA) at 5.8% pa, or an option at 5.2% pa plus a premium of 0.5% of the sum
borrowed.
Requirements
57.1 For Issue 1, show the net sterling payment for the four possible strategies under
consideration, assuming that on 30 June 20X7 the spot exchange rate will be:
(a) €1.1875 – 1.1960/£
(b) €1.2745 – 1.2860/£ (11 marks)
57.2 For Issue 1, with reference to your calculations in 57.1 above, advise STL's board whether it
should hedge against movements in the value of the euro. (8 marks)
57.3 For Issue 2, assuming that on 1 July 20X7 LIBOR will be:
(a) 4% pa
(b) 6% pa
calculate the annual interest rate payment if STL chooses an FRA, an option or no hedging
instrument and advise STL's management as to its best strategy. (7 marks)
57.4 Explain briefly how FRAs differ from interest rate futures. (4 marks)
Total: 30 marks

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58 Brighton plc
Brighton plc (Brighton) manufactures and sells various types of lock. After undertaking market
research that cost £50,000, Brighton is considering manufacturing and selling a new type of lock
for bikes. For the purposes of the initial project appraisal it can be assumed that the locks would
be manufactured in the UK. However, the board of Brighton are considering manufacturing
them overseas where labour costs and associated safety standards for employees are much
lower than in the UK. The bike lock market is highly competitive with companies entering and
leaving the market on a regular basis.
The decision on whether to introduce the new lock will be based on net present value analysis.
At a recent board meeting one of Brighton's directors quoted from a recent financial newspaper
article that he had read:
"Shareholder wealth maximisation is the generally accepted corporate objective. Net
present value analysis is the most logical way to achieve this when used in conjunction with
Shareholder Value Analysis."
The director felt that Brighton should be concerned with more than just the shareholders since
there are other stakeholders who also contribute to the business. However, some of the other
directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that
the company should not be concerned about these other stakeholders.
The following data relates to the new bike lock
• The bike lock's product life-cycle is estimated to be four years and the sales volume is
expected to be 5,500 units per month in the year to 30 June 20X8. The sales volume is
expected to increase by 5% in the year to 30 June 20X9 and then decrease at the rate of
10% pa (compound) in the two years to 30 June 20Y1.
• The selling price will be £100 per lock in the year to 30 June 20X8 and will increase at
2% pa for the three years to 30 June 20Y1. The contribution per unit is expected to be 45%
of the selling price.
• Fixed production overhead costs are estimated to be £0.2 million in the year to 30 June
20X8. 50% of these fixed production overheads are centrally allocated. The fixed
production overheads are expected to increase by 3% pa in the three years to 30 June
20Y1.
• Selling and administration costs are estimated to be £0.5 million in the year to 30 June
20X8 and are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Warehousing and office space that Brighton currently owns and lets to third parties for an
annual fixed rent of £0.4 million pa, payable in advance on 30 June, will be used for the
bike lock project. The rent will not increase with inflation. At the end of the project the
warehousing and office space will be re-let to third parties.
• An investment in working capital of £1 million will be required on 1 July 20X7. This will
increase at the start of each subsequent year in line with sales volume growth and selling
price increases. Working capital will be fully recoverable on 30 June 20Y1.
• An investment in plant and machinery costing £8 million will be required on 30 June 20X7
and this will not have any scrap value on 30 June 20Y1. The plant and machinery will attract
18% (reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year.

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At 30 June 20Y1, the difference between the plant and machinery's written down value for
tax purposes and its disposal proceeds will be treated by the company either as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down value;
or
(2) balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that gave rise to them.
• A suitable real cost of capital to appraise the project is 7% pa and the general level of
inflation is expected to be 2.5% pa.
Requirements
58.1 Using money cash flows, calculate the net present value of the bike lock project on 30 June
20X7 and advise Brighton as to whether it should proceed with the project. (15 marks)
58.2 Ignoring the effects on working capital, calculate and comment upon the sensitivity of the
project to changes in sales revenue. (4 marks)
58.3 Outline what is meant by Shareholder Value Analysis and identify how it might be
specifically applied to the bike lock project. (6 marks)
58.4 Identify and explain two real options associated with the proposed bike lock project.
(4 marks)
58.5 Giving two examples, illustrate how conflicts may arise between the shareholders and the
other stakeholders in Brighton. (3 marks)
58.6 Outline the main elements of an ethical employment policy that Brighton could adopt if it
were to manufacture the bike locks overseas. (3 marks)
Total: 35 marks
Note: Ignore any issues relating to foreign exchange throughout this question.
59 Easton plc
Easton plc (Easton) is a listed company and a specialist retailer of pet-related products and
operates stores throughout the UK. The company is considering diversifying by opening
veterinary practices ('the project'), which will operate from dedicated space in all of its stores.
At a board meeting of Easton it was agreed to appraise the project using net present value
analysis. However, considerable debate took place regarding the discount factor to use and
whether the company should be diversifying at all. At the meeting the finance director said:
"I will have to calculate a weighted average cost of capital (WACC) that reflects the
systematic risk of the project. I also intend to raise the capital required for the project in
such a way as to leave our existing debt:equity ratio (by market values) unchanged
following the diversification".
Various comments made by the other attendees at the meeting were as follows:
"Why can't we just use our current WACC?"
"I have read that the shareholders of listed companies should diversify away unsystematic
risk. But I am confused as to what systematic and unsystematic risks are."
"I think that we should stick to what we know and not attempt to diversify. I am worried
about the stock market's reaction to this diversification."
"What happens if we can't maintain our existing capital structure? How do we then appraise
the project?"

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Extracts from Easton's most recent management accounts are shown below:
£m
1,103
4% Redeemable debentures at nominal value (redeemable 20Y5) 200
1,303
On 31 May 20X7 Easton's ordinary shares had a market value of 252p each (cum-div). The
company declared a dividend of 10p per ordinary share during the year to 31 May 20X7 and it is
expected to be paid shortly. The equity beta of Easton is 0.45. The return on the market is
expected to be 9% pa and the risk free rate 2% pa.
On 31 May 20X7 Easton's 4% redeemable debentures had a market value of £109 (cum-interest)
per £100 nominal value. The debentures are due to be redeemed at par on 31 May 20Y5.
A listed company operating solely in the veterinary practices market had an equity beta of 0.80
and a debt:equity ratio by market values of 3:7 on 31 May 20X7. It has been estimated by the
finance director that if the project goes ahead the overall equity beta of Easton will be made up
of 75% pet-related products and 25% veterinary practices.
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
59.1 Ignoring the project, calculate the current WACC of Easton on 31 May 20X7 using the
CAPM. (8 marks)
59.2 Using the CAPM, calculate a cost of equity that reflects the systematic risk of the project and
explain your reasoning. (6 marks)
59.3 Assuming that the project goes ahead, estimate, using the CAPM, the overall WACC of
Easton and comment upon the implications of any permanent change in the overall WACC.
(6 marks)
59.4 Explain what is meant by systematic and unsystematic risk and give two examples of each
for Easton. (6 marks)
59.5 Discuss whether Easton should diversify its operations and how its shareholders and the
stock market might react to the proposed project. (4 marks)
59.6 Identify and describe the appropriate project appraisal methodology that should be used if,
as a result of financing the project, the current capital structure of Easton is not maintained.
Using the data relating to Easton, calculate the project discount rate that should be used in
these circumstances. (5 marks)
Total: 35 marks
60 Lake Ltd
Lake Ltd (Lake) is a UK company that has recently started exporting leather goods to the USA.
Lake is fully aware of its exposure to foreign exchange rate risk ('forex risk') and the need to
hedge it. However, Lake is concerned that there may be other overseas trading risks that it
should be protecting itself against.
You work for Lake and have been asked to advise the board on how to hedge the forex risk
associated with its US trading activities. You have the following information available to you at
the close of business on 30 June 20X7:

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Lake is due to receive payments from its US customers in three months' time totalling
$1,300,000. Lake currently has an overdraft.
Exchange rates
Spot rate ($/£) 1.3086 – 1.3092
Three-month forward contract discount ($/£) 0.0014 – 0.0018
September currency futures price (standard contract size £62,500): $1.3105/£
Annual borrowing and depositing interest rates
Sterling 3.20% – 3.10%
Dollar 3.70% – 3.60%
Three-month over-the-counter currency options
Call options to buy £ have an exercise price of $/£1.3200 and premium of £0.02 per $
converted.
Put options to sell £ have an exercise price of $/£1.3100 and a premium of £0.01 per $
converted.
Requirements
60.1 Assuming that the spot exchange rate on 30 September 20X7 will be $/£1.3210 – 1.3250
and that the sterling currency futures price will be $1.3230/£, calculate Lake's sterling
receipt if it uses the following to hedge its forex risk:
• A forward contract
• A money market hedge
• Currency futures contracts
• An over-the-counter currency option (14 marks)
60.2 Describe the relative advantages and disadvantages of each of the hedging techniques in
60.1 above and advise Lake on which would be most beneficial for hedging its forex risk.
(10 marks)
60.3 Identify and explain two overseas trading risks (other than forex risk) that Lake is exposed to
and discuss how they might be mitigated. (6 marks)
Total: 30 marks

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61 Merikan Media plc

Merikan Media plc (Merikan) is a large listed media group based in the UK. It currently owns a
controlling interest in 35 companies worldwide. Merikan's board is considering altering its UK
investment portfolio via:
(1) the purchase of all of the shares in a commercial radio company; and
(2) the disposal of all of its shares in a newspaper company.
You work in Merikan's finance team and have been asked to prepare valuations and supporting
notes for the board. Details of the two proposed transactions are shown below.
61.1 Purchase of all of the shares in a commercial radio company
Coastal Radio Ltd (Coastal) was formed nearly 15 years ago, and has been a very successful
radio station. Its listener numbers have increased steadily, as have advertising revenue and
annual profits. Extracts from Coastal's most recent management accounts (together with
supporting notes) are shown here:
Income statement Balance sheet
for the year ended 31 August 20X7 at 31 August 20X7
£'000 £'000
Sales 28,400 Non-current assets 36,310
Operating costs (15,600) Current assets 4,316
Depreciation (3,500) 40,626
Amortisation (1,200)
Profit before interest 8,100 £1 ordinary shares 3,500
Debenture interest (400) Retained earnings 27,206
Profit before tax 7,700 5% debentures 8,000
Taxation (at 17%) (1,309) Current liabilities 1,920
Profit after taxation 6,391 40,626
Dividends paid (1,750)
Notes
1 Coastal's non-current assets originally cost £52.8 million. They were valued at
£37.8 million on 31 August 20X7 and its current assets were valued at £4.2 million on
the same date. Neither of these valuations is reflected in the balance sheet at
31 August 20X7.
2 Coastal's debentures were trading at £110% on 31 August 20X7.
3 Average figures for listed UK commercial radio companies:
P/E ratio 8.5
Dividend yield 5%
Enterprise value multiple 6.5
Requirements
(a) Calculate the value of one Coastal share based on each of the following methods:
 Price earnings ratio
 Dividend yield
 Enterprise value
 Net assets basis (historic cost)
 Net assets basis (revalued) (12 marks)

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(b) Justify and advise the board of the price range within which it should make an offer for
Coastal's shares. Refer to your calculations in part (a) above. (8 marks)
61.2 Disposal of all of its shares in a newspaper company
Merikan has owned all of the share capital of Albion Newspaper Group Ltd (Albion) since
2005. Recently Albion's directors have informed Merikan's board that they are willing to
make a management buy-out (MBO) of Albion. Accordingly, Merikan's board wishes to
value Albion using the shareholder value analysis method (SVA). Merikan's board estimates
that Albion has a three-year competitive advantage over its competitors (to 31 August
20Y0) and the following data regarding Albion's value drivers and additional financial
information has been collected:
Sales for the current year (to 31 August 20X7) £70.0 million
Annual depreciation
(equal to annual replacement non-current asset expenditure) £1.5 million
Par value of 6% debentures in issue (current market value £95%) £10.0 million
Short-term investments held £0.7 million
Corporation tax rate 17%
Current WACC 8%
Beyond
Year to 31 August (budgeted) 20X8 20X9 20Y0 20Y0
Sales growth 5% 3% 2% 0%
Operating profit margin 8% 9% 9% 9%
Incremental non-current asset investment
(as a % of sales increase) 6% 5% 2% 0%
Incremental working capital investment
(as a % of sales increase) 5% 5% 4% 0%
Requirements
(a) Calculate the value of Albion's equity using SVA. (12 marks)
(b) Outline the methods by which Albion's directors might raise the funds necessary for
the proposed MBO of the company. (3 marks)
Total: 35 marks
62 Ramsey Douglas Motors plc

You should assume that the current date is 31 August 20X7.
Ramsey Douglas Motors plc (Ramsey) is a UK-listed, UK-based motor car manufacturer which
was formed nearly 40 years ago. Ramsey's financial year end is 31 August.
Details of Ramsey's long term-finance at 31 August 20X7 and its total dividend and interest
payments for the year to 31 August 20X7 are shown in the following table:

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Table
Market value Nominal value Dividends Interest paid
at at paid in year to in year to
31/8/X7 31/8/X7 31/8/X7 31/8/X7
£'000 £'000 £'000 £'000
£1 ordinary shares (note 1) 65,600 32,000 5,440
£0.50 preference shares 10,800 2,000 640
£100 irredeemable
debentures 6,000 5,000 275
£100 redeemable
debentures 4,200 4,000 240
(Note 2)
Notes
1 Ordinary share dividends have been growing at 3% pa for the past four years.
2 The redeemable debentures are redeemable at par on 31 August 20Y0.
3 All dividends and interest for the year to 31 August 20X7 have been paid in full.
You are Ramsey's finance director and an ICAEW Chartered Accountant. At its 22 August 20X7
meeting, the board considered two proposed new investments. You were asked to prepare
workings and recommendations in advance of the next meeting regarding those two
investments, details of which are shown below:
Investment 1
Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making use of
robotic techniques. Half of this investment would be funded from Ramsey's retained earnings and
the balance via a bank loan at an agreed rate of 7.5% pa. A report was presented by the
production director at the 22 August board meeting. It concluded that this new system would
generate efficiencies that would increase manufacturing profit by 6–8% pa. At the same meeting,
one of Ramsey's other directors, Michael Bateman, said that "because the company should be
striving for a higher share price, any press releases regarding the new system should state that
profits are expected to increase by at least 15% pa."
Investment 2
Ramsey's board is considering a major change in strategy by investing in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and
navigating without human input. The finance for this investment would be raised in such a way
so as not to alter Ramsey's current gearing ratio (measured as debt:equity by market values).
The debt element of the finance will come from a new issue of 9% irredeemable debentures at
par.
Ramsey's directors want to establish a cost of capital that could be used to appraise the
investment in driverless cars. They are aware that such a diversification would be very risky and is
likely to increase Ramsey's equity beta which is currently 1.25.
The following data, collected at 31 August 20X7, should be used when preparing your workings
for the next board meeting:
Driverless cars industry sector
Equity beta 2.10
Ratio of long-term funds (debt:equity) by market values 16:72
Expected risk free rate 2.25% pa
Expected return on the market 9.15% pa

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The board also discussed the possible negative impact of this risky investment on Ramsey's
share price. One director, Laura Young, commented "It's okay. Markets are efficient. Even if it
does fall, the share price will soon adjust to its normal level."
Other information
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
Requirements
62.1 Using the information in the table, calculate Ramsey's WACC at 31 August 20X7. (10 marks)
62.2 Calculate, and briefly comment upon, the impact on the market value of Ramsey's
redeemable debentures of a rise in their gross redemption yield to 5% pa. (3 marks)
62.3 Advise, with reasons, whether Ramsey should use the WACC figure calculated in part 62.1
above when appraising Investment 1. (5 marks)
62.4 Explain the ethical implications for you, as an ICAEW Chartered Accountant, arising from
Michael Bateman's suggestion regarding the press releases for Investment 1. (3 marks)
62.5 Calculate an appropriate WACC that Ramsey could use when appraising Investment 2 and
explain the reasoning behind your approach. (10 marks)
62.6 Evaluate briefly Laura Young's comments regarding Investment 2's effect on Ramsey's share
price. (4 marks)
Total: 35 marks
63 Jenson Grosvenor plc

You should assume that the current date is 31 August 20X7.
Jenson Grosvenor plc (Jenson) is a UK-based manufacturer of industrial pumps. The majority of
the raw materials and component parts used in the manufacture of Jenson's pumps are
imported from EU countries and are invoiced in euros.
You work in Jenson's finance team and have been asked to provide guidance on two issues to
be discussed at the next board meeting.
Issue 1 – AZS Oil contract
Jenson's directors recently signed a contract with a Canadian oil company, AZS Oil (AZS). This
contract is for the supply of a large consignment of specialised oil pumps for use by AZS at its
oilfields in northern Canada. The contract is valued at 5.2 million Canadian dollars (C$). The
pumps will be dispatched on 31 October 20X7 and Jenson will receive the C$5.2 million from
AZS on 30 November 20X7.
You have been given the following information at the close of business on 31 August 20X7:
Spot rate (C$/£) 1.6305 – 1.6385
Three-month forward contract discount (C$/£) 0.0045 – 0.0085
Arrangement fee for forward contract £0.35 per C$100 converted
Canadian dollar interest rate (lending) 4.4% pa
Canadian dollar interest rate (borrowing) 5.2% pa
Three-month OTC call option on C$ – exercise price 1.6090/£
Three-month OTC put option on C$ – exercise price 1.6245/£
Cost of relevant OTC option £0.75 per C$100 converted

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In relation to the AZS contract, you are aware that at the next board meeting Jenson's directors
will discuss (a) the implications of an increase in the value of sterling and (b) the foreign
exchange hedging techniques that Jenson might employ.
Issue 2 – Shareholding in Callella plc
Jenson owns 50,000 shares in Callella plc (Callella). The company has never used any hedging
techniques to protect it from a fall in the value of this investment and the board now wishes to
remedy that. As a first step, the directors will consider how traded options work at the next
board meeting.
The market price of one Callella share at 31 August 20X7 is 365p. Traded options on Callella
shares at the same date are available as follows (all figures are in pence):
Calls Puts
Exercise price September October September October
355 11.0 21.0 2.0 13.5
370 3.5 14.0 9.0 20.5
Requirements
63.1 For Issue 1, calculate Jenson's sterling receipt from the AZS contract if it:
(a) Uses an OTC currency option
(b) Uses a forward contract
(c) Uses a money market hedge
(d) Does not hedge the Canadian dollar receipt and sterling strengthens by 5% by
30 November 20X7 (9 marks)
63.2 With reference to your calculations in part 63.1, advise Jenson's board whether or not it
should hedge its Canadian dollar receipt from the AZS contract. (7 marks)
63.3 Explain why Jenson's imports and exports might expose the company to economic risk.
(3 marks)
63.4 Explain the advantages and disadvantages of using currency futures rather than a forward
contract to manage foreign exchange risk. (4 marks)
63.5 For Issue 2, calculate the intrinsic value and the time value of each of the options on
Callella's shares at 31 August 20X7. (4 marks)
63.6 For Issue 2, explain briefly the three factors that affect the time value of the options on
Callella's shares. (3 marks)
Total: 30 marks

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December 2017 exam questions
64 Innovative Alarms
Assume that the current date is 31 December 20X7.
Innovative Alarms (Innovative) is a division of a major quoted company and manufactures and
sells a single alarm system to private houses and commercial premises. The financial
management department of Innovative is considering two separate issues:
Issue One: Whether to launch onto the market a new type of alarm system, the Defender, which
when triggered will not only ring a bell but also play a realistic recording of dogs barking.
Issue Two: How often the division's fleet of delivery vans should be replaced.
You are asked to provide advice on both of these issues and report to the head of the financial
management department.
64.1 Issue One: The Defender Project
The Defender is to be evaluated over a planning horizon of three years from 31 December
20X7. It has been agreed that on 31 December 20Y0 the rights to manufacture the
Defender will be sold to a team made up of the current management of Innovative (‘the
team') as by that date the Defender is expected to be Innovative's only product. The
finance director of Innovative, who is an ICAEW Chartered Accountant, will be a member of
the team and is responsible for calculating the value of the rights to manufacture the
Defender.
The following information is available regarding the Defender project:
 The selling price will be £399 per unit in the year to 31 December 20X8 and the
contribution per unit is expected to be 40% of the selling price. The selling price and
variable costs per unit are expected to increase by 3% pa in the two years to
31 December 20Y0.
 The number of units sold in the year to 31 December 20X8 is estimated to be 30,000
and is expected to increase by 6% pa in the two years to 31 December 20Y0.
 On 31 December 20X7 the project will require an investment in working capital of
£2 million, which will increase at the start of each subsequent year in line with sales
volume growth and sales price increases. Working capital will be fully recoverable on
31 December 20Y0.
 Incremental fixed costs for the year ended 31 December 20X8 are expected to be
£0.5 million and are expected to increase by 5% pa in the two years to 31 December
20Y0.
 The Defender will require two hours of skilled labour per unit. Skilled labour is
expected to be in short supply over the next three years. Innovative will need to
transfer skilled labour from its existing product, which requires half the skilled labour
time per unit of the Defender. The existing product has a selling price of £175 and an
expected material and skilled labour cost of £150 in the year to 31 December 20X8.
The selling price and variable costs are expected to increase by 3% pa in the two years
to 31 December 20Y0, the end of the existing product's life cycle. Innovative's skilled
labour is paid at the rate of £15 per hour (in 31 December 20X8 prices). Any working
capital adjustments associated with the existing product can be ignored.

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New equipment will be required to manufacture the Defender, which will cost
£8 million on 31 December 20X7 and will have an estimated scrap value of £2 million
on 31 December 20Y0 (in 31 December 20Y0 prices). The new equipment will attract
18% (reducing balance) capital allowances in the year of expenditure, except in the
final year.
At 31 December 20Y0, the difference between the equipment's written down value for
tax purposes and its disposal proceeds will be treated by the company as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down
value; or
(2) balancing charge, if the disposal proceeds are more than the tax written down
value.
 Assume that the rate of corporation tax will be 17% for the foreseeable future and that
tax flows arise in the same year as the cash flows that gave rise to them.
 The finance director calculated the value of the rights to manufacture the Defender as
three times the net contribution after tax for the year to 31 December 20Y0.
 A suitable money cost of capital to appraise the project is 10% pa.
Requirements
(a) Using money cash flows, calculate the net present value of the Defender project on
31 December 20X7 and advise whether Innovative should proceed with the project.
(16 marks)
(b) Outline the disadvantages of sensitivity analysis for the head of the financial
management department and how simulation might be a better way to assess the risk
of the Defender project. (4 marks)
(c) Describe two real options that are available at the end of the project on 31 December
20Y0 as an alternative to selling the rights to manufacture the Defender. (4 marks)
(d) Identify and discuss the ethical issues in relation to the sale of the rights to manufacture
the Defender. (3 marks)
64.2 Issue Two: Replacing the fleet of delivery vans
Innovative would like to decide upon a policy for replacing its fleet of delivery vans, since
no formal policy exists at the present time. A new delivery van costs £30,000. The following
information is available:
Interval between Trade-in Maintenance cost
replacement (years) value (paid at the end of the year)
£ £
1 22,500 500
2 17,000 2,500
3 12,000 3,500
A suitable cost of capital for evaluating the replacement policy is 15% pa.
Requirement
Calculate the optimal replacement policy for the delivery vans and advise the head of the
financial management department of the limitations of the approach used.
Note: Ignore inflation and taxation when determining the optimal replacement policy.
(8 marks)
Total: 35 marks

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65 Peel Kitchens plc

Assume that the current date is 1 December 20X7.
Peel Kitchens plc (Peel) is a quoted wholesaler of kitchen cabinets and worktops and has a
financial year end of 30 November.
The board of Peel is considering diversifying into the supply of domestic appliances and would
need to raise finance of £200 million during 20X8 should the diversification go ahead. The
finance director of Peel, Debbie Harris (Debbie), needs to calculate the weighted average cost
of capital (WACC) that will be used to appraise the potential diversification. She is also
considering whether the finance required should be raised by debt in the form of 6%
debentures issued at par or by equity in the form of an issue of 100 million ordinary shares.
Debbie is particularly concerned about how the financial markets and the company's
shareholders might react to the impact the additional £200 million finance may have on the
company's capital structure.
The board of Peel is also contemplating its dividend policy beyond 20X7. Extracts from Peel's
management accounts are produced below:
Year ended 30 November
20X3 20X4 20X5 20X6 20X7
£m £m £m £m £m
Profits before interest and tax 81.03 78.86 87.54 85.37 94.04
Interest (33.32) (33.32) (33.32) (33.32) (33.32)
47.71 45.54 54.22 52.05 60.72
Taxation (8.11) (7.74) (9.22) (8.85) (10.32)
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividends 19.80 18.90 22.50 21.60 25.20
Special dividend – – – – 9.00
Total dividends 19.80 18.90 22.50 21.60 34.20
Capital at 30 November 20X7 £m

Ordinary shares (50p nominal value) 90.00
346.50
7% Debentures at nominal value
(redeemable at par on 30 November 20Y2) 476.00
822.50
The number of shares in issue has not changed during the period from 1 December 20X2 to
30 November 20X7.
 The cum-div share price on 1 December 20X7 is £2.92 per ordinary share. The special
dividend was paid in June 20X7.
 The 7% debentures have a cum-interest market value of £111 per £100 nominal value.
 Peel has an equity beta of 1.3.
 A company that supplies domestic appliances has an equity beta of 1.1 and a debt:equity
ratio of 40:60 by market values.
 The risk free rate is expected to be 3% pa.
 The market risk premium is expected to be 6% pa.
 Assume that the rate of corporation tax will be 17% for the foreseeable future.

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 An analyst has calculated the gearing ratios (measured as debt/equity by market values)
and interest cover for companies that operate in Peel's market sector as follows:
Maximum Minimum Average
Gearing ratio 135% 80% 100%

Interest cover 3 2 2.4
Debbie has asked you to provide her with certain information so that she can prepare a
report for the board of Peel.
Requirements
65.1 Calculate Peel's WACC on 1 December 20X7 using:
(a) The dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information provided)
65.2 Explain and evaluate whether either of the WACC figures calculated in 65.1 above would
be appropriate for appraising Peel's diversification into supplying domestic appliances.
(5 marks)
65.3 Determine whether the £200 million finance required should be raised from either debt or
equity sources. You should discuss the likely reaction of both shareholders and the financial
markets, and make reference to the gearing and interest cover data provided and give
advice to Debbie on which source of finance should be used. (12 marks)
65.4 Assuming that Peel raises the £200 million finance required wholly from debt, identify the
most appropriate project appraisal methodology that could be used to appraise the
diversification. Also determine the project discount rate that should be used in these
circumstances. (3 marks)
65.5 Discuss whether Peel's dividend policy over the last five years is appropriate for a listed
company. (5 marks)
Total: 35 marks
66 Jewel House Investments Ltd

Assume that the current date is 30 November 20X7.
Jewel House Investments Ltd (Jewel) is an investment company based in the UK. You work for
Jewel and at a recent meeting with the company's finance director it was agreed that you would
work on three specific tasks:
Task One: Hedging foreign exchange rate risk for receipts from foreign investors.
Task Two: Hedging a portfolio of investments.
Task Three: Arranging an interest rate swap for a loan that the company has recently taken out.
66.1 Task One: Jewel is due to receive an investment of $8 million from a client in the USA on
31 March 20X8. It was agreed with the client that Jewel would hedge the foreign exchange
rate risk associated with the $ receipt and invest the sterling equivalent of the $8 million on
behalf of the client.
You have the following information available to you on 30 November 20X7:
Exchange rates:
Spot rate ($/£) 1.2490 – 1.2492
Four-month forward contract discount ($/£) 0.0031 – 0.0034

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Over-the-counter (OTC) currency option

A put option to sell $ is available with an exercise price of $1.2400. The premium is £0.02
per $ and is payable on 30 November 20X7.
Jewel has funds on deposit which earns interest of 3% pa.
Requirements
(a) Calculate the amount of sterling to be invested on behalf of the US client using:
 a forward contract
 an OTC currency option
assuming that the spot price on 31 March 20X8 is $/£ 1.2697 – 1.2700. (6 marks)
(b) Using your results from 66.1 (a) above, explain the advantages and disadvantages of
the two hedging techniques used and advise which hedging technique would be the
more beneficial for Jewel's client. (4 marks)
(c) Outline whether currency futures would have been more advantageous than using a
forward contract to hedge the foreign exchange rate risk associated with the $8 million
receipt. (2 marks)
66.2 Task Two: One of Jewel's investments is a portfolio of UK FTSE 100 shares, which is worth
£100 million on 30 November 20X7. The finance director of Jewel is concerned about a
potential fall in value of the portfolio over the next four months.
You have the following information available to you on 30 November 20X7:
 The FTSE 100 index is 7,261
 The price for a March 20X8 FTSE 100 index future is 7,195
 The face value of a FTSE 100 index futures contract is £10 per index point
Requirements
(a) Calculate the outcome of hedging Jewel's £100 million portfolio using March 20X8
FTSE 100 index futures. Assume that on 31 March 20X8 both the FTSE 100 index and
the FTSE 100 index futures price are 7,010 and that the portfolio value changes exactly
in line with the change in the FTSE 100 index. (6 marks)
(b) Explain why the hedge in 66.2 (a) above will not be 100% efficient. (2 marks)
66.3 Task Three: Jewel recently bought new premises and borrowed £50 million for a period of
10 years. The loan is at a floating rate of LIBOR + 4% pa. LIBOR is currently 0.36% pa. The
finance director of Jewel believes that interest rates are going to rise and he would like to
protect the company against interest rate risk.
The finance director of Jewel identified Nevis plc (Nevis), which is a company that would like
to swap £50 million of its 5% pa fixed rate loans to a floating rate. Jewel and Nevis agreed
to enter into an interest rate swap with any benefits from the swap being shared equally
between the two companies. Jewel can borrow at a fixed rate of 6.5% pa and Nevis can
borrow at a floating rate of LIBOR + 3.5% pa.
Requirements
(a) Demonstrate how the interest rate swap between Jewel and Nevis would be
implemented, with the floating rate leg of the swap set at LIBOR. (4 marks)

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(b) Calculate:
 the initial difference in annual interest rates for Jewel if it enters into the interest
rate swap with Nevis.
 the amount to which LIBOR would have to rise for the cost of Jewel's floating rate
borrowing to equal the fixed rate achieved through the interest rate swap.
(2 marks)
(c) Identify four advantages for Jewel of entering into an interest rate swap with Nevis.
(4 marks)
Total: 30 marks

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67 Wells Bakers plc

Assume that the current date is 31 March 20X8.
Wells Bakers plc (Wells) is a UK bakery firm that has been trading since 1983. It manufactures
and sells its own branded products to UK supermarkets and its financial year end is 31 March.
Wells' board is considering a change in the company's strategy with the opening of a number of
retail bakery outlets across the UK. This would be a major investment for the company. The
£17 million required for this investment would be raised in such a way as not to alter the
company's existing gearing ratio (equity:debt by market values). Wells' bank, London &
Edinburgh plc (L&E), is aware of the company's plans and has stated that it is prepared to
provide the debt element of the £17 million at an interest rate of 8.5% pa, with repayment due in
10 years' time.
Wells has always used a discount rate of 7% when assessing potential investments. The following
comments made by directors regarding the planned £17 million investment were recorded in
the minutes of the board meeting held on 27 February 20X8:
Phil Turner: "Let's carry on using 7% as the discount rate. We're being prudent here, as
7% represents the most costly source of finance that we have, ie, preference
shares. At least that's a fixed cost, unlike the ordinary shares."
Alana Clarke: "I don't think we can ignore the ordinary shares. Can't we average out the
costs of the various types of capital and use that?"
Alison Hughes: "We should use 8.5% as our discount rate as that's what L&E would charge us
for funding the retail expansion."
The board wants to determine the appropriate discount rate to use when assessing the
investment in retail bakery outlets. You work in Wells' finance team and are an ICAEW Chartered
Accountant. You have been asked to provide workings for the board to consider when it meets
next month. You have collected the following data as at 31 March 20X8:
Balance sheet extract Nominal value Market value
(£'000)
£1 ordinary shares (Note 1) 6,600 £3.46/share cum-div
7% £1 preference shares 1,000 £1.35/share ex-div
6% Irredeemable debentures 1,200 £106% ex-int
4% Redeemable debentures (Note 2) 1,800 £100% cum-int
Notes
(1) Wells will pay its ordinary dividend (£1.716 million) for the year to 31 March 20X8 in early
April 20X8. Its annual dividend has been growing steadily every year since April 20X5, at
which time the dividend totalled £1.570 million.
(2) The 4% debentures are redeemable at par in 20Y1.
CAPM data
Wells' equity beta 1.25
Expected risk-free return 2.4% pa
Expected return on the market portfolio 10.8% pa
Average equity beta for bakery retailers 1.80
Ratio of long-term funds (equity:debt by market values) for bakery retailers 77:23

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Two days ago, Alison Hughes sent you an email about Wells' proposed investment. An extract
from her email is shown below:
Email extract
.....................The board has managed to
keep our expansion plans very quiet so
far. Do be very careful who you share
this information with as the proposals
are likely to have an impact on the Wells
share price.....................
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
67.1 Ignoring the investment in retail bakery outlets, calculate Wells' weighted average cost of
capital (WACC) at 31 March 20X8 using:
(a) The dividend growth model and (14 marks)
67.2 Discuss the points raised by the three directors at the 27 February 20X8 board meeting.
(6 marks)
67.3 Calculate an appropriate WACC that Wells could use when appraising the £17 million
investment in retail bakery outlets and explain the reasoning behind your approach.
(10 marks)
67.4 Identify and explain the ethical implications of Alison Hughes' email for you, as an ICAEW
Chartered Accountant. (3 marks)
Total 35 marks
68 Hunt Trading plc

Assume that the current date is 31 March 20X8.
Hunt Trading plc (Hunt) is a UK supplier of timber products. It imports timber in large quantities
and manufactures a range of products for sale to builders' merchants and garden centres in the
UK. You work in Hunt's finance team and have been asked to provide advice on two issues.
68.1 Issue one: interest rate risk
The company has been very successful recently with demand for its products growing
steadily. At its March meeting, Hunt's board identified a need for £4.5 million of short term
finance to fund additional machinery and increasing levels of working capital. A £4.5 million
bank loan would be required for a six-month period from 1 June 20X8 until 30 November
20X8. The board is concerned that the current cost of borrowing, 6.4% pa, will increase
before 1 June and would like to investigate how it might hedge this risk using either traded
sterling interest rate futures or over-the-counter (OTC) interest rate options.
You have collected the following information on 31 March 20X8:
Traded sterling interest rate futures OTC interest rate options
June 3-month futures price = 93.2 Strike rate = 7.3% pa plus
a premium of 0.2% of the sum borrowed
Standard contact size = £500,000

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Requirements
(a) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses traded
sterling interest rate futures to hedge its interest rate risk and if by 1 June 20X8:
 interest rates increase to 7.5% pa and the futures price moves to 92.2
 interest rates increase to 8.0% pa and the futures price moves to 91.8
 interest rates decrease to 5.5% pa and the futures price moves to 94.1 (8 marks)
(b) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses OTC
interest rate options to hedge its interest rate risk and if by 1 June 20X8:
 interest rates increase to 7.5% pa
 interest rates increase to 8.0% pa
 interest rates decrease to 5.5% pa (3 marks)
(c) Based on your calculations in (a) and (b) above, advise Hunt's board as to the preferred
method of hedging its interest rate risk. (2 marks)
68.2 Issue two: foreign exchange rate risk
The majority of Hunt's timber suppliers are based in Scotland and Wales. However, Hunt's
board is concerned that those suppliers' delivery lead times are lengthening as they
struggle to keep pace with increasing demand. The board has a contract with a Finnish
supplier for a very large consignment of timber costing €1.7 million. This is due to arrive at
Hunt's factory on 31 May 20X8, with payment due on 30 June 20X8. There is concern
amongst board members that sterling might weaken against the euro before the end of
June and they would like to explore the implications of hedging the foreign exchange risk
of the Finnish purchase.
You have been asked to advise Hunt's board and have collected the following information
at the close of business on 31 March 20X8:
Spot rate (€/£) 1.1764 – 1.1808
Three-month forward contract discount (€/£) 0.0059 – 0.0081
Arrangement fee for forward contract £4,600
Requirements
(a) Calculate Hunt's sterling payment if it:
 does not hedge the euro payment and sterling weakens by 5% by 30 June 20X8
 uses a forward contract
 uses a money market hedge (7 marks)
(b) With reference to your calculations in (a) above, advise Hunt's board whether it should
hedge its euro payment. (7 marks)
(c) Identify the differences between traded currency options and OTC currency options.
(3 marks)
Total: 30 marks

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69 Bishop Homes Ltd

Bishop Homes Ltd (Bishop) is a UK property company that started trading in 20W8. It has a
financial year-end of 31 March. Bishop builds low-cost houses for sale and for rent. It currently
owns and collects rent from 12,500 rental properties.
Bishop has the opportunity to invest in a new development of 500 identical low-energy houses
on one of its vacant sites called Garthwick. Once the land has been cleared then Bishop will
employ Piper Hardwick plc (Piper), a UK house-building firm, to construct the houses over a two
year period. You work in Bishop's finance department and have been asked to provide
information on the viability of the Garthwick development for Bishop's board. You have been
provided with the following details:
Land clearance
This will cost £1.4 million, payable on 31 March 20X8.
Construction cost
The total contract price for the 500 houses is £57 million, which will be payable to Piper in three
equal annual instalments starting on 31 March 20X8. Only the construction costs relating to the
houses for sale are an allowable expense for tax purposes. Those construction costs are
allowable for tax in the year of sale (see building schedule below).
Building schedule
Of the 500 houses built, 150 will be sold and 350 will be rented. Houses built for sale are sold in
the year of construction whereas houses built for rent are not rented out until the year after
construction.
Year to 31 March
20X9 20Y0 20Y1
Houses constructed in year 250 250 0
Houses sold in year 75 75 0
Houses rented in year 0 175 350
Houses for rent
The rent per property will be £5,940 pa. Bishop estimates that bad debts amount to 1.5% of
rental income.
Houses for sale
The selling price of a house will be £340,000.
New staff
Bishop will need to employ two new full-time employees to manage the additional rented
houses in the year to 31 March 20Y0 and then two more employees will be employed in the year
to 31 March 20Y1. The average salary per employee will be £23,000 pa.
Other costs
In addition to the new employees, it is estimated that the new houses for rent will lead to an
increase in general costs equal to 3% of their rental income before bad debts.
New machinery
Bishop will need to purchase specialist equipment to check the low-energy specifications of the
new houses. This will be purchased on 31 March 20X9 at a cost of £1.2 million. Because this
equipment has a high rate of obsolescence, Bishop estimates that it will be sold on 31 March
20Y1 for £100,000.

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The equipment attracts 18% (reducing balance) capital allowances in the year of expenditure
and in every subsequent year of ownership by the company, except the final year. In the final
year, the difference between the equipment's written down value for tax purposes and its
disposal proceeds will be treated by the company either as a:
Assumptions to be used in calculations
 Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
 All income will be liable to corporation tax.
 Unless indicated otherwise, all costs will be allowable for corporation tax.
 Inflation can be ignored throughout.
 A suitable cost of capital is 6%.
 All cash flows occur at the end of the relevant financial year.
Investment appraisal
Bishop appraises its capital investments using the net present value approach. For new
developments Bishop discounts its future income and costs over a 20-year period.
6% annuity factors
Year 3 = 2.673
Year 17 = 10.477
Year 20 = 11.470
Requirements
69.1 Calculate the net present value of the Garthwick development at 31 March 20X8 and advise
Bishop's board whether the company should proceed with it. (18 marks)
69.2 Calculate the sensitivity of the decision in 69.1 above to changes in the selling price per
house sold and hence the minimum selling price per house sold that Bishop should accept
for the Garthwick development to proceed. (4 marks)
69.3 Determine the impact on your advice in 69.1 above if Piper offers to accept a revised
contract price of £54 million payable in full on 31 March 20X8. (5 marks)
69.4 Compare the strengths and weaknesses of sensitivity analysis with those of simulation.
(4 marks)
69.5 Explain what is meant by the term ‘real options' and identify two real options that could
apply to the Garthwick development. (4 marks)
Total: 35 marks

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70 Helvellyn Corporate Finance

You work for Helvellyn Corporate Finance (HCF) and you are currently working on two tasks:
Task 1: Evans Stores Ltd (Evans) is an independent food retailer. Evans is considering an initial
public offering (IPO) of its ordinary shares on 30 June 20X8 and you have been asked to advise
on a value for these shares.
Task 2: Huzzey plc (Huzzey) is a quoted conglomerate that is considering divesting itself of one
of its divisions. You have been asked to value the division.
70.1 Task 1: Valuation of Evans's ordinary shares
Extracts from Evans's most recent management accounts are as follows:
Income statement Balance sheet
for the year ended as at 31 May 20X8
31 May 20X8
£'000 £'000
Sales 280,000 Non-current assets 53,000
Operating costs (270,000) Current assets 31,000
Depreciation (6,000) 84,000
Amortisation (500)
Profit before interest 3,500 Share capital (£1 ordinary shares) 3,000
Interest (950) Retained earnings 12,000
Profit before tax 2,550 15,000
Taxation (at 17%) (434) Long term loans 41,000
Profit after tax 2,116 Current liabilities 28,000
84,000
(1) Evans's current assets include cash balances and short-term investments, which total
£7 million.
(2) The market value of Evans's non-current assets at 31 May 20X8 was estimated to be
£59 million.
(3) Average multiples for a sample of listed companies in the same market sector as Evans
at 31 May 20X8 are:
 Enterprise value 6.5
 Price earnings (P/E) ratio 12.1
Requirements
(a) Calculate the value of one Evans ordinary share at 31 May 20X8 based on each of the
following methods:
 Enterprise value
 P/E ratio
 Net assets basis (historic)
 Net assets basis (re-valued) (8 marks)
(b) Recommend and justify to the board of Evans an issue price per share on 30 June 20X8
for the company's ordinary shares. Refer to the range of values calculated in part (a)
above. (4 marks)

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(c) Discuss whether Shareholder Value Analysis (SVA) might be a useful additional
method, to those in part (a) above, of valuing Evans's ordinary shares. (3 marks)
70.2 Task 2: Divestment of the Huzzey division
Assume that the current date is 30 June 20X8
At a recent board meeting of Huzzey it was decided that the company should divest itself of
its paint-manufacturing subsidiary, Supercover Ltd (Supercover). The board discussed the
following three proposed ways of carrying out the divestment:
 Proposal 1 – To reduce Supercover's operations over a period of three years and then
close it down.
 Proposal 2 – To sell Supercover to another company.
 Proposal 3 – To sell Supercover to a team made up of its current management.
It was decided at the board meeting that one of the criteria for choosing the best method of
divestment would be the present value of the cash flows associated with each proposal.
A suitable discount rate to assess the present value of the cash flows of all three proposals is
10%.
You should assume that corporation tax will be payable at the rate of 17% for the
foreseeable future and tax will be payable in the same year as the cash flows to which it
relates.
Financial information for each proposal is as follows:
Proposal 1:
 Sales revenue for the year to 30 June 20X8 was £25 million. For the three years to
30 June 20Y1 sales volumes are expected to decrease by 10% pa compound. Selling
prices will not change and contribution is expected to be 60% of the selling price.
 The amount invested in working capital on 30 June 20X8 was £2 million. This amount
will reduce at the end of each year in line with the reduction in sales volumes. On
30 June 20Y1 all remaining working capital will be recovered in full.
 On 30 June 20X8 Supercover's plant and equipment has a tax written down value of
£3 million.
 On 30 June 20Y1 Supercover's plant and equipment will be sold for an estimated
£9 million (at 30 June 20Y1 prices).
 The plant and equipment attracts 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company,
except the final year. In the final year, the difference between the plant and
equipment's written down value for tax purposes and its disposal proceeds will be
treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down
value; or
– balancing charge, if the disposal proceeds are more than the tax written down
value.
 Redundancy payments on 30 June 20Y1 will amount to £0.50 million (at 30 June 20Y1
prices). This amount is fully allowable for tax.
Proposal 2:
All the shares in Supercover will be sold for £38 million before taxation on 30 June 20X8.
Assume that this amount is fully taxable.

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Proposal 3:
The management team will buy the shares of Supercover for £41 million. The £41 million
will be received in three instalments as follows:
 On 30 June 20X8 £15 million
 On 30 June 20X9 £13 million
 On 30 June 20Y0 £13 million
Assume that all these instalments are fully taxable in the year that they are received.
Requirements
(a) Calculate the present value at 30 June 20X8 of each of the three proposed ways in
which Huzzey could divest itself of Supercover. (10 marks)
(b) Identify one advantage and one disadvantage for each of the three divestment
proposals. (6 marks)
(c) Advise the board of Huzzey as to which of the three divestment proposals should be
chosen. (4 marks)
Total: 35 marks
71 Blackstar plc
Assume that the current date is 30 June 20X8.
Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a listed
client, Blackstar plc (Blackstar), on the following two issues:
Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of its
existing operations.
Issue 2: Blackstar is concerned about its existing dividend policy.
71.1 Issue 1: Raising additional funds of £150 million
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar's
market sector have average gearing ratios (measured as debt/equity by market values) of
25%, with a maximum of 35%, and an average interest cover of eight times, with a minimum
of six. The finance director of Blackstar is considering raising the £150 million by either a
rights issue or by the company now borrowing and issuing debentures.
The details of the alternative sources of finance are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount
on the current market value of Blackstar's ordinary shares.
Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 20Y5. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar's
market sector. One such company is Blue plc (Blue). Details for Blue's debentures are as
follows:
 Coupon 5%
 The current market price on 30 June 20X8 is £109 cum interest
 Redemption at par on 30 June 20Y3
Further information regarding Blackstar:
 The forecast pre-tax operating profit for the year ending 30 June 20X8 is £50 million
 The corporation tax rate is 17%
 The current share price at 30 June 20X8 is £7.50 ex-div
 The number of ordinary shares in issue is 60 million

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Requirements
(a) Assuming a 2 for 3 rights issue is made on 1 July 20X8:
 Calculate the discount the rights price represents on Blackstar's current share price.
 Calculate the theoretical ex-rights price per share.
 Discuss whether the actual share price is likely to be equal to the theoretical ex-
rights price. (5 marks)
(b) Alternatively, assuming debt is issued on 1 July 20X8:
 Calculate the issue price per debenture and total nominal value of the debentures
that will have to be issued to give a yield to redemption equal to that of Blue's
debentures.
 Discuss the validity of using the yield to redemption of Blue's debentures in the
above calculation. (7 marks)
(c) Advise Blackstar's finance director of the advantages and disadvantages of raising the
£150 million by debt or equity or a combination of the two.
You should also discuss the likely reaction of Blackstar's shareholders and the stock
market (you should refer to the gearing and interest cover information provided).
(12 marks)
71.2 Issue 2: Blackstar's dividend policy
Blackstar is reviewing its dividend policy, which has been to maintain a constant payout
ratio of 30% of profits after tax. The following views were expressed by two directors at the
most recent board meeting:
Director A: "We should have a constant dividend growth policy with some growth
irrespective of whether profits after tax rise or fall. If we have surplus cash after reinvestment
we can leave it in the bank."
Director B: "I agree with Director A, but instead of leaving surplus cash in the bank we can
pay a special dividend or repurchase some shares."
Requirements
(a) Describe what is meant by:
 a special dividend
 a share repurchase (4 marks)
(b) Discuss whether Blackstar's current dividend policy is appropriate for a listed company
and critically evaluate the alternatives suggested by Directors A and B. (4 marks)
71.3 Mitchells is also advising Goldwing plc, which is considering making a takeover bid for
Blackstar.
Requirement
Identify the ethical issues for Mitchells regarding giving advice to both Goldwing plc and
Blackstar. Also advise Mitchells on what safeguards might be put in place. (3 marks)
Total: 35 marks

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72 Tarbena plc
Assume that the current date is 30 June 20X8.
Tarbena plc (Tarbena) is a UK company that has a subsidiary company in Germany and also has
customers and suppliers in the USA.
At a recent board meeting of Tarbena there was a discussion about the company's exposure to
foreign exchange rate risk (forex). In particular the following points were discussed:
 How the company's dollar receipts and payments are hedged
 The role that interest rate parity and purchasing power parity play in relation to forex
 The likely effect on the company's share price if it shows exchange rate losses when
translating the German subsidiary's financial statements into sterling
It was decided at the meeting that the finance director would make a presentation to the board
and he has asked you to prepare some notes for his presentation, including numerical examples
where appropriate.
You have the following information available to you at the close of business on 30 June 20X8:
Receipts and payments
Receipts due from customers on 30 September 20X8 are $6,000,000.
Payments due to suppliers on 30 September 20X8 are $10,000,000.
Exchange rates
Spot rate ($/£) 1.3078 – 1.3080
Three month forward discount ($/£) 0.0088 – 0.0092
September currency futures price
Standard contract size £62,500 $1.3096/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3190. The premium is
£0.03 per $ and is payable on 30 June 20X8.
September call options to buy $ are available with an exercise price of $1.3170. The premium is
£0.04 per $ and is payable on 30 June 20X8.
Annual borrowing and depositing interest rates (%)
Dollar 6.00 – 5.80
Sterling 3.28 – 2.98
Tarbena currently has an overdraft.
Requirements
Prepare notes for the finance director of Tarbena, which should include:
72.1 A calculation of Tarbena's net sterling payment if it uses the following to hedge its forex:
(a) A forward contract
(b) Currency futures
(c) An OTC currency option
assuming that the spot rate on 30 September 20X8 will be $/£1.3167 – 1.3175 and the
September futures price will be $/£1.3171. (12 marks)

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72.2 A discussion of the advantages and disadvantages of the three hedging techniques used in
72.1 above and, using your results from 72.1 above, advice on which hedging technique is
the most advantageous for Tarbena. (7 marks)
72.3 An explanation of interest rate parity together with calculations which show why the forward
rate is at a discount to the spot rate on 30 June 20X8. (5 marks)
72.4 An explanation, without calculations, of purchasing power parity. (3 marks)
72.5 The likely effect on Tarbena's share price if there are exchange rate losses when translating
the German subsidiary's financial statements into sterling. (3 marks)
Total: 30 marks

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73 Thomas Rumsey Group plc
Note: Assume that the current date is 31 August 2018.
The Thomas Rumsey Group plc (Rumsey) is a UK company which was founded in 2001 and has a
financial year end of 31 August. Rumsey manufactures computer hardware and also supplies
information technology (IT) support services. Since its formation the group has expanded via
organic growth and the acquisition of other companies.
Snowdog Printers Ltd (Snowdog) is a UK company that manufactures computer printers. Rumsey
has owned 100% of Snowdog's ordinary shares since 2009.
Snowdog's sales and profits have fallen in each of the last two years. Rumsey's board met in July
2018 and decided to wind down Snowdog's operations and that Snowdog will cease trading in
three years' time, on 31 August 2021.
Following the July 2018 meeting, Snowdog's directors informed the Rumsey board that they
would like to investigate a management buy-out (MBO) of 100% of Snowdog's share capital. You
are an ICAEW Chartered Accountant and you work in Rumsey's finance team. You have been
asked to provide guidance on the MBO for Rumsey's board.
The Snowdog MBO was discussed at the Rumsey board meeting on 15 August 2018. Three key
issues discussed at that meeting are summarised below:
 It was agreed that the buy-out price for Snowdog would be its economic value to Rumsey,
assuming that it remained in the group until 31 August 2021. The economic value would be
the expected net present value of Snowdog's projected cash flows over the next three
years, discounted at Rumsey's WACC. The forecast data for this calculation is shown below.
 One of Rumsey's directors asked "Couldn't we add a premium to the MBO price? The cash
flows are only estimates after all. I'm sure that we could inflate the cash inflows or alter the
WACC figure in our favour. Snowdog's directors would be unaware of this and they seem
very keen to buy the company."
 Another director asked whether Shareholder Value Analysis (SVA) could be used as an
alternative to the expected NPV to calculate the value of Snowdog.
Forecast data
(1) Sales in the year to 31 August 2020 will be dependent on the level of sales in the year to
31 August 2019 as shown in the table below:
y/e August 2019 y/e 31 August 2020

Sales (£m) Probability Sales (£m) Probability
5.0 0.6
7.0 0.7
4.0 0.4
4.0 0.4
4.5 0.3
3.0 0.6
Sales in the year to 31 August 2021 will be £2.5 million. The expected value of annual sales
is to be used in the NPV calculation.
(2) Variable costs will be 30% of sales.
(3) Fixed costs (including depreciation of £600,000 pa) will be £1.7 million pa.
(4) Closure costs on 31 August 2021 will be £600,000.

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(5) All of the figures in (1)–(4) above are in 31 August 2018 prices. The inflation rate for sales
and costs is 2% pa.
(6) The tax written down value at 31 August 2018 of Snowdog's plant and machinery is
£3.3 million. It is estimated that this will have a scrap value of £1.5 million (in 31 August
2021 prices) on 31 August 2021. The plant and machinery attracts 18% (reducing balance)
capital allowances in the year of expenditure and in every subsequent year of ownership by
the company, except the final year. In the final year, the difference between the equipment's
written down value for tax purposes and its disposal proceeds will be treated by the
company either as:
 a balancing allowance, if the disposal proceeds are less than the tax written down
value, or
 a balancing charge, if the disposal proceeds are more than the tax written down value.
(7) Snowdog's working capital on 31 August 2018 totalled £1.8 million. It is planned to reduce
this by £0.2 million on 31 August 2019 and £0.3 million on 31 August 2020. The outstanding
balance will be released on 31 August 2021. All working capital figures are given in money
terms.
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
Rumsey's money WACC is 11% pa.
Requirements
73.1 Calculate the expected NPV of Snowdog's money cash flows at 31 August 2018. (18 marks)
73.2 Calculate the effect on this expected NPV if the scrap value of Snowdog's plant and
machinery on 31 August 2021 is £1 million. (4 marks)
73.3 Comment on the ethical implications for you as an ICAEW Chartered Accountant of the
Rumsey director's suggestion regarding the MBO premium. (3 marks)
73.4 Explain what is meant by the term 'real options' and identify for Rumsey's board two real
options that could apply to Snowdog as alternatives to the MBO. (5 marks)
73.5 Outline the Shareholder Value Analysis (SVA) approach to company valuation, identifying its
advantages and disadvantages. (5 marks)
Total: 35 marks
74 Heath Care plc

Note: Assume that the current date is 1 September 2018.
Heath Care plc (Heath) is a listed UK company that sells baby products. The company was
founded in 1995 and it has a financial year end of 31 August.
All of Heath's customers are based in the UK. They order goods online and these are then
delivered by a national courier company from Heath's central warehouse. Despite not having any
physical shops, Heath was initially very successful. However, in the past two years the market for
baby products has become much more competitive and the company's market share has fallen
as a result. This has led to a 15% decline in the price of its ordinary shares.

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You work in Heath's finance team and have been asked to provide guidance for the company's
board following its most recent meeting. At that meeting the following suggestions were made
by two of Heath's directors:
Janine Barrowland – "We could establish a number of Heath shops across the UK. This
would give more visibility to our brand. I estimate it would cost us £10 million for 10 shops.
I can see from the management accounts that we've not got sufficient cash to make that sort
of investment, but I see no reason why we shouldn't borrow the £10 million. Interest rates
are still very low and we could probably borrow it from our bank at a maximum cost of 4%
pa. Our WACC wouldn't alter by much, which would make any investment decision very
straightforward."
Chris Sinnott – "Why not invest in a completely different type of business? We know that
people in the UK are living longer and I know of an established care home business that is
for sale and it may well be a good investment for us.
There's a steady net cash inflow and we'd own a number of valuable properties. Yes, it's
risky, but diversification like this would be good for our investors as we'd be making positive
use of the portfolio effect."
An extract from Heath's balance sheet at 31 August 2018 is shown below:
£'000
Retained earnings (Note 1) 2,520
9% Preference share capital (£1 shares) 750
4% Redeemable debentures (Note 2) 680
5% Irredeemable debentures 1,240
11,490
Notes
1 Earnings for the year to 31 August 2018 were £1,050,000 and an ordinary dividend of
£630,000 for the year to 31 August 2018 has been proposed.
2 These debentures are redeemable at par on 1 September 2021.
The market prices of Heath's long-term finance on 1 September 2018 are:
Ordinary shares £3.45/share (cum div)
Preference shares £1.62/share (cum div)
Redeemable debentures £103% (cum interest)
Irredeemable debentures £94% (ex interest)
Additional information
Heath's equity beta 1.4
Expected risk free rate 3.35% pa
Expected return on the market 8.25% pa
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You should assume that corporation tax will be payable at the rate of 17% for the
foreseeable future and tax will be payable in the same year as the cash flows to which it
relates.
Note: In the earnings retention model g = rb.
Requirements
74.1 Calculate Heath's WACC on 1 September 2018 using:
(a) Gordon's growth model (earnings retention model) (17 marks)
(b) CAPM (3 marks)
74.2 Compare and contrast Gordon's growth model with the CAPM as alternative means of
calculating the cost of equity. (5 marks)

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74.3 Advise Heath's directors whether they should use the existing WACC figure calculated in
part 74.1 above when appraising the investment suggested by Janine Barrowland. Your
advice should include specific reference to the use of the APV technique and the
circumstances under which it is applicable. (6 marks)
74.4 From the point of view of a shareholder, explain the portfolio effect and discuss the validity
of Chris Sinnott's proposal that Heath should purchase a care home business. (4 marks)
Total: 35 marks
75 Eddyson Cordless Ltd

Note: Assume that the current date is 1 September 2018.
Eddyson Cordless Ltd (Eddyson) is a UK-based company that designs and manufactures battery-
powered home and garden appliances. It was formed in 2010 and an analysis of its sales and
purchases, by value, over the past 12 months shows the following:
UK Eurozone
Sales 96% 4%
Purchases of raw materials 74% 26%
Recently, a very large US electrical wholesale company, Timba Inc (Timba), placed an order with
Eddyson worth $2.3 million. The goods will be exported to the US next week and Timba will pay
for them on 30 November 2018.
Eddyson's board is considering whether it is worth hedging the foreign exchange rate risk
associated with the sale to Timba. Four possible strategies have been proposed:
 Do not hedge
 Use a forward contract
 Use a money market hedge
 Use sterling traded currency options
You work in Eddyson's finance team and have been asked to provide calculations and guidance
for the board. You have collected the following information at the close of business on
1 September 2018:
Spot exchange rate ($/£) 1.3655 – 1.3775
Three-month forward contract premium ($/£) 0.0060 – 0.0044
Arrangement fee for forward contract £0.30 per $100 converted
US dollar interest rate (borrowing) 4.0% pa
US dollar interest rate (lending) 3.2% pa
Sterling traded currency options (standard contract size £31,250) are priced as follows on
1 September 2018 (premiums are quoted in cents per £):
September 2018 November 2018
contracts contracts
Exercise price ($/£) Calls Puts Calls Puts
1.351.08 2.36 1.99 3.70

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Requirements
75.1 Calculate Eddyson's net sterling receipt for each of the four proposed strategies under
consideration, assuming that on 30 November 2018 the spot exchange rate will be:
(a) $/£ 1.3240 – 1.3350
(b) $/£ 1.3935 – 1.4050
Note: Interest on option premiums should be ignored. (16 marks)
75.2 With reference to your calculations in 75.1 above, advise Eddyson's board whether it should
hedge against movements in the value of the US dollar. (6 marks)
75.3 Explain, with relevant workings, why the three-month forward rate is expressed at a
premium to the spot rate on 1 September 2018. (5 marks)
75.4 Briefly discuss whether any future sales to Timba might expose Eddyson to economic risk.
(3 marks)
Total: 30 marks

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Answer Bank

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118 Financial Management: Answer Bank ICAEW 2019

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Objectives and investment appraisal
1 Stoane Gayte Sounds plc (March 2013)

Marking guide
Marks
1.1 Machinery 1
Tax saving 2
Tax on income 1
Working capital investment 2
Discounting and NPV 1
Recommendation 1
No market research costs 1
No fixed costs 1
Selling price 1
Raw materials 1
Loss of contribution 3
Labour costs ignored 1
17
1.2 NPV 1
IRR 1
Advice on usefulness 4
6
1.3 Relevant discussion
6
29
1.1
March 20X3 March 20X4 March 20X5 March 20X6
£'000 £'000 £'000 £'000
Machinery (4,900.000) 980.000
Tax saving (W1) 149.940 122.951 100.820 292.690
Income (W2) 2,008.500 3,500.970 1,803.000
Tax on income (W2) (341.445) (595.165) (306.510)
Working capital investment (W3) (750.000) (22.500) (23.175) 795.675
Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855
11% factor 1.000 0.901 0.812 0.731
PV (5,500.060) 1,592.523 2,422.561 2,605.909
NPV 1,120.933
As the NPV is positive SGS should proceed with the investment as this will enhance
shareholder wealth.
No market research costs.
No fixed costs.

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WORKINGS
(1)
March 20X3 March 20X4 March 20X5 March 20X6
£'000 £'000 £'000 £'000
Cost/WDV 4,900.000 4,018.000 3,294.760 2,701.703
WDA (18%) (882.000) (723.240) (593.057) (1,721.703)
WDV/disposal 4,018.000 3,294.760 2,701.703 980.000
Tax saved (17%  WDA) 149.940 122.951 100.820 292.690
(2)
March
20X3
Contribution/unit £
Selling price 190
Less: Raw materials (43)
Variable overheads (45)
Loss of Boom-Boom contribution ([£99 – £28 – £35]  2) (72)
Contribution/unit 30
Labour costs ignored

Contribution adjusted for inflation
March March March
20X4 20X5 20X6
Contribution/unit (real terms) £30.00 £30.00 £30.00
  
Sales volume (units) 65,000 110,000 55,000
= = =
Total contribution £1,950,000 £3,300,000 £1,650,000
 
Inflation adjustment 1.03 (1.03)2 (1.03)3
= = =
Total contribution (money terms) £2,008,500 £3,500,970 £1,803,000
Corporation tax on contribution (@ 17%) £341,445 £595,165 £306,510
(3) Working capital investment

March March March March
20X3 20X4 20X5 20X6
Working capital £750,000 1.03
£772,500 1.03
£795,675
Increment (£750,000) (£22,500) (£23,175) £795,675
1.2 IRR calculation

Rework total cash flows at (say) 15%:
Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855
15% factor 1.000 0.870 0.756 0.658
PV (5,500.060) 1,537.730 2,255.488 2,345.675
NPV 638.833
IRR = 15% + [4%  (638,833/(1,120.933 – 638.833))] = 20.3%
The IRR is approximately 20.3%, which exceeds SGS's cost of capital (11%) and so the
investment will enhance shareholder wealth. If, however, the IRR had been less than the
cost of capital then shareholder wealth would decline.

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IRR and NPV normally give the same result as to whether investment should take place or
not. As a percentage return, IRR may be easier to understand for managers and employees.
However, IRR does not calculate the change in absolute shareholder wealth. As a
consequence, it may provide the wrong result when alternative projects are being ranked.
Also non-conventional cash flows can create more than one IRR.
1.3 The traditional school of thought regarding dividends states:
Shareholders would prefer dividends today rather than dividends or capital gains in the
future.
This is because cash now is more certain than cash in the future.
However, this implies that future payments would be discounted at a higher rate to take
account of the uncertainty, but does risk really increase over time?
Risk is however related to the activities and operations of the business, and so the discount
rates applied to dividends should reflect this.
Modigliani and Miller (MM)
MM argued that share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities and any loss in dividend
income will be offset by gains in share price.
Shareholders can create home-made dividends and do not have to rely on the company's
dividend policy; if cash is needed, they can sell some shares instead.
Taxes, share transaction costs and share issue costs will have an effect.
Other issues
Informational content – dividends mean that management is confident of the future. The
signalling view.
Clientele effect – investors have a preferred habitat. That is, they seek a company with a
particular dividend policy that suits them. If shares are unpopular because of inconsistent
policy, then the share price will suffer.
Agency – separation of ownership from management of a firm can lead to sub-optimal
decisions being made. Agency costs are borne by shareholders. Managers may often make
investments that do not increase shareholder wealth, and dividends worsen as a result.
Dividend commitments can reduce agency costs. A high dividend payout and low
retentions leads to greater scrutiny of the firm's investment decisions by outsiders (due to
the need for external funds).
Tax – some shareholders may prefer income to capital gains.
Overall
Evidence seems to support MM – valuation not closely related to levels of dividends.
Clientele effect seems to operate.
Dividends do not affect the value of shares, provided the shareholders know the dividend
policy of the company. It is important to establish a consistent policy and stick to it.
Lack of consistency means that shareholders will leave, and as a result the share price is
likely to fall.

lOMoARcPSD|5019904
Examiner's comments:
This question was generally done very well and had the highest average mark on the paper.
This was a three-part question that tested the candidates' understanding of the investment
decisions and valuations element of the syllabus. In addition it tested candidates' understanding
of IRR and dividend theory.
In the scenario a company was considering whether or not to proceed with the development of
a new range of audio speakers for cars. Part 1.1 for 17 marks was a fairly traditional NPV
calculation and required candidates to deal with lost contribution, inflation, working capital and
capital allowances. Part 1.2 for six marks asked candidates to calculate the IRR of the proposed
investment and explain the usefulness of this figure to the company's directors. In part 1.3, also
for six marks, candidates had to discuss whether the company should use company funds to pay
a dividend instead of investing in the audio speakers project.
In requirement 1.1, the majority of candidates scored high marks. The most common errors
were made with regard to the lost contribution and the non-relevance of skilled labour costs.
Also a fair number of candidates were unable to deal correctly with (a) the working capital
requirements and/or (b) the correct discount rate.
Most answers to part 1.2 were disappointing. Too few candidates were able to calculate the
project's IRR correctly, even allowing for errors made in the NPV calculation in part 1.1. Also it
was clear that far too few candidates understood the meaning of the IRR figure and its
usefulness to management.
Part 1.3 was answered far better and most candidates demonstrated a good understanding of
the theory underpinning dividend policy and thus scored high marks.
2 Profitis plc (December 2001)

Marking guide
Marks
2.1 Calculations:
Time 0 1
Time 1 1
Time 2 1.5
Time 3 2.5
Time 4 1
PV 2
Equivalent annual cost 3
Conclusion 1
13
2.2 1½ marks per point max 4
17

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2.1 Derivation of the equivalent annual cost: Net present value

3 years 4 years
Time PV @ 15% PV @ 15%
£ £ £ £
0 Cost (80,000) (80,000)
Capital allowance (w) 2,448 2,448
(77,552) (77,552) (77,552) (77,552)
1 Capital allowance 2,007 2,007
Maintenance (10,000) (10,000)
(7,993) (6,954) (7,993) (6,954)
Maintenance (10,000) (10,000)
Tax on maintenance 1,700 1,700
(6,654) (5,030) (6,654) (5,030)
Maintenance – (20,000)
Tax on maintenance 1,700 1,700
Proceeds 10,000 –
17,499 11,514 (16,950) (11,153)
4 Capital allowance – 6,149
Tax on maintenance – 3,400
9,549 5,462
Present value (78,022) (95,227)
Annuity factor 2.283 2.855
Equivalent annual cost £34,175 £33,354
Therefore a four-year life is marginally more economic.

WORKING
Time @ 17%
£ £
0 Cost 80,000
Writing-down allowance (18%) (14,400) 2,448
65,600
1 Writing-down allowance (18%) (11,808) 2,007
53,792
44,109
3 Proceeds (10,000)
34,109 5,799
or
2 Written-down value 44,109

36,169
4 Proceeds Nil
36,169 6,149
2.2 Discussion of other issues

Relevant issues include the following.
(a) The analysis in 2.1 ignores price changes of all descriptions. A change in the price of a
new machine, for example, could easily alter the conclusion. The same would be true
for all of the input factors.

lOMoARcPSD|5019904
(b) The approach taken assumes that replacement will take place with an identical
machine. The machine may be technologically superseded. The company may
conclude that it no longer has a need for such a machine. In practice it seems unlikely
that many such assets are replaced with identical models on a continuing basis.
(c) The timing of the cash outflows on new machines could be an issue in practice, ie,
making payments every fourth year may cause less of a cash flow problem than every
third year.
3 Horton plc (June 2009)

Marking guide
Marks
3.1 (a) Calculation of capital allowances 3
Calculation of NPV 1
4
(b) Scenario 1 1
Scenario 2 4
Scenario 3 5
Scenario 4 2
12
(c) Characteristics of finance leases 3
Characteristics of operating leases 3
Reasons why leasing might be a preferred source of finance:
1 mark per valid point max 2 8
3.2 (a) Calculations for:
1 year cycle 1
2 year cycle 1
3 year cycle 1
Annual equivalent cost, 0.5 marks per cycle 1.5
Conclusion 0.5
5
(b) 1.5 marks per valid issue discussed max 6
35
3.1 (a) Project 3

Capital Allowances
Cost 3,000,000
20X9 WDA 540,000 @ 17% = 91,800
2,460,000
20Y0 WDA 442,800 @ 17% = 75,276
2,017,200
20Y1 WDA 363,096 @ 17% = 61,726
1,654,104
20Y2 WDA 297,739 @ 17% = 50,616
1,356,365
Proceeds 1,000,000
Bal. All. 356,365 @ 17% = 60,582

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Year 0 1 2 3 4
(2,908,200) (1,424,724) 3,811,726 3,800,616 3,810,582
1 0.909 0.826 0.751 0.683
PV (2,908,200) (1,295,074) 3,148,486 2,854,263 2,602,628
NPV £4,402,103
(b) Scenario 1:
With no capital rationing, all projects yielding a positive NPV should be accepted.
Therefore, accept 100% of Projects 1, 3 and 4.
Scenario 2:
With capital rationing of £4.5 million at T0 and divisible projects, the NPV per £
invested needs to be calculated for each project:
Project 1: 2,676,600/2,400,000 = £1.12 (Rank 2)
Project 2: (461,700)/2,250,000 = Negative
Project 3: 4,402,103/3,000,000 = £1.47 (Rank 1)
Project 4: 2,016,250/2,630,000 = £0.77 (Rank 3)
Project 5: (45,250)/3,750,000 = Negative
So with £4.5 million to invest, accept 100% of Project 3 (£3m) and 62.5% of Project 1
(£1.5m).
Scenario 3:
Under this scenario, Project 2 will never be accepted as it yields a negative NPV and
consumes funds in the year of capital rationing. However, Project 4 will always be
accepted as it yields a positive NPV and generates funds in the year of capital
rationing.
Of the remaining projects:
Project 1: 2,676,600/750,000 = £3.57 (Rank 1)
Project 3: 4,402,103/1,500,000 = £2.93 (Rank 2)
Project 5: Negative NPV
However, although Project 5 has a negative NPV of £45,250 it does release £1,050,000
at T1. The question that needs to be asked, therefore, is whether the negative NPV is
outweighed by the return on these released funds if Project 5 is undertaken.
Without Project 5, capital available = £300,000 + £750,000 (from Project 4) which
means Horton can accept 100% of Projects 1 and 4, and 20% of Project 3 to yield an
overall NPV of £5,573,271 (£2,676,600 + £2,016,250 + (0.2  £4,402,103)).
If Project 5 is undertaken, capital available = £300,000 + £750,000 (from Project 4) +
£1,050,000 (from Project 5) which means Horton can accept 100% of Projects 1, 4, 5
and 90% of Project 3 (£1.35m) to yield an overall NPV of £8,609,493. So this latter
solution maximises shareholder wealth.
Scenario 4:
With indivisible projects, the potential portfolios of investments possible with capital of
£5.25 million are as follows: Project 1 or Project 3 or Project 4 or Projects 1 and 4.
The NPVs generated by these four possibilities are:
Project 1: 2,676,600
Project 3: 4,402,103
Project 4: 2,016,250
Projects 1 and 4: 4,692,850

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Therefore, the projects that should be undertaken are Projects 1 and 4.

Note: 99.9% of candidates attempting this question proceeded on the basis set out
above, which takes account of the revised NPV for Project 3 calculated in part 3.1(a) –
£4,402,103 – but which retains the original Project 3 cash outlays as (£3m) in T0 and
(£1.5m) in T1, thereby reflecting the practical reality that Horton would have to spend
these sums before receiving the benefit of the capital allowances calculated in part
3.1(a).
However, it should be noted that full credit was given to any candidate who used the
revised Project 3 cash outlays of £2,908,200in T0 and £1,424,724 in T1.
Taking this approach would have the following impact on the calculations:
In Scenario 1, no impact.
In Scenario 2, Project 3 would now yield an NPV per £ invested of £1.51 (still Rank 1)
and 66.3% of Project 1 could now be undertaken (up from 62.5%).
In Scenario 3, Project 3 would now yield an NPV per £ invested of £3.09 (still Rank 2);
without Project 5, 21.1% of Project 3 could now be undertaken (up from 20%); and this
would now yield an overall NPV of £5,621,694; with Project 5, 94.8% of Project 3 could
now be undertaken and this would now yield an overall NPV of £8,820,794.
(c) The differences between finance leases and operating leases can be summarised as
follows:
A finance lease transfers substantially all the risks and rewards of ownership of an asset
to the lessee (ie, the lessor does not retain these risks and rewards). One lease will exist
for the whole or major part of the useful life of the asset – with ownership possibly
passing to the lessee at the end of the term, possibly at a 'bargain price' or a
peppercorn rent is paid during a secondary lease period. The lessor does not usually
deal directly in the type of asset leased. The lease cannot usually be cancelled and if it
is the lessee usually has to pay a penalty that equates to liability for all outstanding
payments due under the lease agreement. The substance of the transaction is the
purchase of the asset by the lessee, financed by a loan from the lessor.
With an operating lease the lease period will be less than the useful life of the asset
and the lessor will depend on the subsequent leasing or eventual sale to cover his
outlay and generate a profit. The lessor may very well carry on a trade in the particular
type of asset leased. The lessor is normally responsible for repairs and maintenance.
The lease can sometimes be cancelled at short notice. The substance of the transaction
is the short-term rental of the asset by the lessee.
The reasons why leasing might be a preferred source of finance are as follows:
(1) Tax: The tax effects of owning an asset compared to using one under a lease are
different and can lead to a preference for leasing as a source of finance.
(2) Capital rationing: Firms, in particular small firms, who may encounter difficulties
raising conventional loan finance, are effectively able to use the asset acquired as
security to overcome such potential funding problems.
(3) Cash flow: Leasing means avoiding the large cash outlay at the outset. Lease
payments will be predictable which aids business planning.
(4) Cost of capital: The implicit cost of borrowing in the lease can be lower than that
in a conventional bank loan.
(5) Flexibility: Examples such as ease of arrangement; lower payments in early stages;
combining other elements into overall package – service, insurance, secondary
lease terms.

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3.2 (a) Calculation of NPVs of each potential replacement cycle:

1-year cycle:
(11,000) + {7,000  0.909} + {(6,600)  0.909} = £(10,636)
2-year cycle:
(11,000) + {4,200  0.826} + {(6,600)  0.909} + {(7,600)  0.826} = £(19,808)
3-year cycle:
(11,000) + {1,800  0.751} + {(6,600)  0.909} + {(7,600)  0.826} + {(9,200)  0.751}
= £(28,834)
The annual equivalent costs are:
1-year cycle: (10,636)/0.909 = £(11,701)
2-year cycle: (19,808)/1.736 = £(11,410)
3-year cycle: (28,834)/2.487 = £(11,594)
Therefore the advice to the managing director should be to replace the new company
cars after two years.
(b) Weaknesses of the method:
 The analysis in part 3.1(a) ignores price changes of all descriptions. A change in
the price of a new car, for example, could easily alter the conclusion. The same
would be true for all of the input factors.
 The approach taken assumes that replacement will take place with an identical car.
The car may be replaced with an improved model. Horton may conclude that it no
longer has a need for such a car. In practice it seems unlikely that cars are
replaced with identical models on a continuing basis.
 The timing of the cash outflows on new cars could be an issue in practice, ie,
making payments every fourth year may cause less of a cash flow problem than
every third year.
 The effects of taxation have been ignored in this analysis.
Candidates generally coped well with the calculation of capital allowances in the opening
section of part 3.1 and it was a rare script that failed to pick up full marks (where this did happen,
it was most commonly due only to arithmetical slips of the pen). With the four capital rationing
scenarios most candidates were able to identify the correct projects to pursue in scenario 1.
However, in scenario 2 there were weaker candidates who simply failed to use the ranking
methodology based on NPV per £ invested. Weaker candidates also found scenario 3 rather
challenging, overlooking the need to consider Project 5 in spite of its negative NPV in view of
the cash released in the second period. Most candidates coped well with scenario 4. Most
candidates picked up high marks on the technical knowledge part of the lease discussion, but
scored less strongly on the whole in discussing the relative merits of leasing over outright
purchase. Another notable feature was that some candidates tended to answer the question
with their 'financial reporting' hat on rather than their 'financial management' hat – the
examination is a test of candidates' knowledge of the financial management learning materials.
Most candidates found little to trouble them in the standard replacement analysis question in
part 3.2.

lOMoARcPSD|5019904
4 Broadham Hotels Ltd (December 2001)

Marking guide
Marks
4.1 Annual cost 4

Money terms 2
PV of expected cost 1
Annual fee 2
Workings 4
13
4.2 1 mark per point max 4

22
4.1 Determination of the minimum annual payment

Expected value of the loss of the rooms
Since at the two lowest levels of demand occupancy would not be affected by the Septo
proposal, the expected value of lost bookings will be as follows.
[(420 – 400)  0.3] + [(440 – 400)  0.2] + [(460 – 400)  0.1] = 20 rooms per night
Annual cost (at 1 July 20X2 prices) = 20  50 (1 – 10%)  360 = £324,000
In 'money' terms
Year ending Factor
30 June Net of tax (see below) PV
£ £ £
20X3 £324,000  1.03 = 333,720 276,988 0.883 244,580
20X4 £324,000  1.032 = 343,732 285,298 0.779 222,247
20X5 £324,000  1.033 = 354,044 293,857 0.688 202,174
20X6 £324,000  1.034 = 364,665 302,672 0.607 183,722
20X7 £324,000  1.035 = 375,605 311,752 0.536 167,099
Present value of expected cost 1,019,822
Let F = Annual Septo fee

F + 2.957F – (3.493F  0.17) = 1,019,822
F = £303,231
(The annual fee is receivable on 1 July 20X2 and on 1 July of each of the four subsequent
years. Tax is payable on 30 June 20X3 and on 30 June of each of the four subsequent
years.)

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WORKING
Discount factors 1+m = (1 + r)  (1 + i)
M = (1.10  1.03) – 1
= 0.133
1
Factor for 1 year = = 0.883
1.133
1
Factor for 2 years = = 0.779
1.1332
1
1.1333
1
Factor for 4 years = = 0.607 2.957 = 4 year annuity factor
1.1334
1
1.1335
3.493 = 5 year annuity factor
4.2 Information that should have been brought into the annual payment determined in 4.1
Possible information that could have been brought into the determination of the annual
payment includes the following.
 The possible effect on room sales of the loss of the top floors (view and security etc).
 The possible loss of sales as a result of customers not attempting to book a room
because of the likelihood that the hotel will be full.
 The possible room sales to Septo if the proposal does not go ahead; Septo's staff will
have to stay somewhere locally.
 The likely loss of ancillary sales eg, restaurant sales.
4.3 Discussion of the advisability of the proposal from Septo's perspective
Septo is seeking to have 'in house' an activity that most businesses would 'outsource'. It
involves Septo in an activity that seems well outside its core activity and, presumably, its
area of expertise.
This could be expensive and risky as it turns a variable type of cost (paying by room/night as
needed) into a fixed cost. How often will Septo need all 100 rooms?
Five years is a long time to commit to use a facility like this.
It also has an adverse cash flow profile, since the annual fee is payable in advance.
On the other hand, Septo has the opportunity to control quality and style. It could prove to
be much cheaper than taking rooms by the night, provided that Septo were able to make
good use of the facility.
Generally the performance on this question, particularly on requirement 4.1, was disappointing.
This is difficult to understand because the scenario is straightforward and well defined in the
question.
In part 4.1 candidates were asked to use NPV to identify the fixed annual fee that a business
needs to pay a hotel to make the hotel owners indifferent between letting out a significant part
of the hotel as a block and letting the rooms available in the normal way.
This was generally not well answered, with relatively few correct answers. Many candidates failed
to recognise that the effective cost to BH of leasing 100 rooms to Septo, all other things being
equal, was the expected loss of room lettings. Since BH would still have 400 rooms available, it
was only its inability to meet demand above that number that would represent a cost of a deal

lOMoARcPSD|5019904
with Septo. These candidates tended to calculate the cost of the arrangement to BH by taking
the expected value of the entire projected demand.
Many candidates who correctly recognised the incremental nature of the cost, failed to
recognise that at the two lowest levels of projected demand the Septo arrangement would not
affect matters. Having identified the ENPV of the lost rooms, some candidates experienced
difficulties in converting this to a fixed annual fee. Some simply divided by five, some treated the
fee as being receivable at year ends and some ignored tax on the fee.
Part 4.2 asked candidates to state and explain any information, not taken into account in 4.1 that
should have been included. Generally this requirement was well answered. There were plenty of
good, obvious points to be made and most candidates made sufficient of them to score well.
Part 4.3 asked candidates to discuss whether, from the point of view of the potential lessee, the
proposed arrangement seems a good idea. Generally this was not well answered. Septo is
contemplating taking 'in house' a normally 'outsourced' activity, yet few candidates picked up
this area of discussion. A number of candidates made points that were simply not justified, such
as saying that a possible deal with BH would be cheaper for Septo than booking rooms as it
needed them. Without knowing the fee that BH would accept and much else besides, it is simply
not logical to make such an assertion.
5 ProBuild plc (June 2013)

Marking guide
Marks
5.1 Best case scenario:
Plant and equipment 2
Capital allowance 2
Operating cash flow 2
Tax 1
Working capital 2
Discount factor and NPV 2
Worst case scenario:
Capital allowance 2
Operating cash flow 1
Tax 2
NPV 1
17
5.2 Discussion of uncertainty and risk 6
5.3 Discussion of real options 6

29

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5.1 Best case scenario

20X3 20X4 20X5 20X6 20X7
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 1,173,000 1,196,460 1,220,389 1,244,797
Tax (17%) (199,410) (203,398) (207,466) (211,615)
Working Capital (W3) (163,200) (3,264) (3,329) (3,396) 173,189
(1,617,300) 1,007,964 1,020,596 1,034,835 1,404,662
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,617,300) 941,136 881,387 818,658 1,018,380
NPV £2,042,260
Worst case scenario

20X3 20X4 20X5 20X6 20X7
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 499,800 509,796 519,992 530,392
Tax (17%) (84,966) (86,665) (88,399) (90,167)
Working Capital (W3) (97,920) (1,958) (1,998) (2,038) 103,914
(1,552,020) 450,514 451,996 454,863 742,430
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,552,020) 420,645 390,344 359,842 538,262
NPV £157,073
WORKINGS
(1) Capital Allowances (£)
20X3 Cost 1,500,000
WDA 18% 270,000  17% = 45,900
1,230,000
20X4 WDA 18% 221,400  17% = 37,638
1,008,600
20X5 WDA 18% 181,548  17% = 30,863
827,052
20X6 WDA 18% 148,869  17% = 25,308
678,183
20X7 Disposal 100,000
578,183  17% = 98,291
(2) Operating Cash Flows

Best Case Scenario: 2,000,000 – (500,000 + 350,000) = 1,150,000
20X4: 1,173,000 (1,150,000  1.02)
20X5: 1,196,460 (1,150,000  1.022)
20X6: 1,220,389 (1,150,000  1.023)
20X7: 1,244,797 (1,150,000  1.024)
Worst Case Scenario: 1,200,000 – (360,000 + 350,000) = 490,000

20X4: 499,800 (490,000  1.02)
2
20X5: 509,796 (490,000  1.02 )
3
20X6: 519,992 (490,000  1.02 )
4
20X7: 530,392 (490,000  1.02 )

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(3) Working Capital

Best Case Scenario:
20X3: (2,000,000  1.02  0.08) = (163,200)
20X4: (2,000,000  1.022  0.08) – 163,200 = (3,264)
20X5: (2,000,000  1.023  0.08) – 166,464 = (3,329)
20X6: (2,000,000  1.024  0.08) – 169,793 = (3,396)
20X7: 173,189
Worst Case Scenario:

20X3: (1,200,000  1.02  0.08) = 97,920
20X4: (1,200,000  1.022  0.08) – 97,920 = (1,958)
20X5: (1,200,000  1.023  0.08) – 99,878 = (1,998)
20X6: (1,200,000  1.024  0.08) – 101,876 = (2,038)
20X7: 103,914
(4) Discount Factor
20X4: 1/(1 + 0.05) (1.02) = 0.9337
2
20X5: 1/(1 + 0.05) (1 + 0.06) (1.02 ) = 0.8636
3
20X6: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07) (1.02 ) = 0.7911
2 4
20X7: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07) (1.02 ) = 0.7250
5.2 Decisions are usually said to be subject to uncertainty if the possible outcomes of a decision
are known but the probabilities attaching to each possible outcome are unknown.
Decisions are usually said to be subject to risk if, although there are several possible
outcomes of a decision, these outcomes as well as the respective probabilities attaching to
each of these possible outcomes are known.
The calculations undertaken in part 5.1 have been made under conditions of uncertainty as
the directors do not have details of the probabilities attaching to the two scenarios. So they
need to establish such probabilities and then calculate expected values for each variable
(the arithmetic mean of possible outcomes weighted by the probability of each outcome).
5.3 The concept of 'real options' relates to the strategic implications attaching to undertaking a
particular project – the value of such 'real options' would not ordinarily be included in a
traditional NPV calculation.
Two obvious 'real options' applicable to Brixham's acquisition of Cabin are as follows:
(1) Follow-on option: For example, the opportunity to add further acquisitions in due
course to gain the benefits of increased economies of scale/market share.
(2) Growth option: For example, the opportunity to broaden the range of services on offer
in due course.
The first question on the paper was a standard investment appraisal question, supplemented by
tests of technical knowledge and its practical application. For the most part, candidates scored
strongly on the first part of the question, the majority clearly being well-drilled in the quantitative
techniques involved in this part of the question. Equally apparent was that the majority of
candidates were ill-equipped in terms of simple technical knowledge to pick up full or even high
marks in the second and third parts of the question, with many scripts scoring zero or at most
very low marks on both parts.
In the first part of the question, probably the most common error was inaccurate calculation of
the inflation-adjusted discount factors. However, there were many instances of full marks.

lOMoARcPSD|5019904
The second part of the question was a straightforward test of knowledge of elements from the
learning materials, but many candidates were completely unacquainted with them and
consequently there was much waffling and little accuracy and substance to many of the
candidates' responses. In the final part of the question, many candidates were completely
unaware of what a 'real option' was in an investment decision-making context, with many
candidates incorrectly interpreting 'real' as meaning after taking account of the effects of
inflation, thereby betraying their lack of study of the learning materials. The last part of the
question was of a different character to the second part in that it was not merely looking for
technical knowledge, but also the application of that knowledge to the scenario in the question
and weaker candidates too often simply presented theory rather than practical application.
6 Frome Lee Electronics Ltd (September 2008)

Marking guide
Marks
6.1 Net present value 15
6.2 Inflation 4 max 3
6.3 Diana Marshall note 5 max 4
6.4 Real investment options 6 max 4
26
6.1
T0 T1 T2 T3
£'000 £'000 £'000 £'000
Plant (400.000) 60.000
Tax saved (W1) 12.240 10.037 8.230 27.293
Working capital (W2) (32.000) (5.000) (3.000) 40.000
Sales (W2) 320.000 370.000 400.000
Materials (52.000) (64.000) (70.000)
Labour (26.000) (32.000) (35.000)
Other variable costs (12.000) (14.000) (16.000)
Fixed overheads (11.000) (11.800) (12.700)
Tax on profit (W3) (37.230) (42.194) (45.271)
Total Cash Flows (419.760) 186.807 211.236 348.322
Discount factor (W4) 1.000 0.925 0.855 0.783
PV (419.760) 172.796 180.607 272.736
NPV 206.379
Comments:
The NPV is positive and so Frome should proceed with the investment as shareholder value is
enhanced.
WORKINGS
(1)
Cost 400.000 328.000 268.960 220.547
WDA @ 18% (72.000) (59.040) (48.413) (160.547)
WDV 328.000 268.960 220.547 60.000
Tax saved @ 17% 12.240 10.037 8.230 27.293

lOMoARcPSD|5019904
(2)
Working capital increment 32,000 5,000 3,000 (40,000)
Working capital total 32,000 37,000 40,000
Sales (WC total  10) 320,000 370,000 400,000
(3)
Sales (W2) 320,000 370,000 400,000
Total costs (101,000) (121,800) (133,700)
Taxable profits 219,000 248,200 266,300
Tax payable @ 17% (37,230) (42.194) (45.271)
(4)
Discount factor (1/1.05/1.03) 0.925
(1/1.05/1.03/1.05/1.03) 0.855
(1/1.05/1.03/1.05/1.03/1.05/1.04) 0.783
6.2 Inflation has to be taken properly into account so that the correct NPV is calculated. Inflation
will have a negative effect on the real value of money and an investor will need to be
compensated for that loss of value. As a result it is important to match real cash flows with
real interest/discount rate. This method can be problematic and so it is preferable, if
possible, to match money (nominal) cash flows, ie, actual cash flows, with an inflated
discount rate. This discount rate is calculated as follows: (1 + m) = (1 + r)  (1 + i), where
m = money rate, r = real rate and i = inflation rate.
6.3 The cost of capital is the cost of funds that a company raises and uses, and the return that
investors expect to be paid (commensurate with the risk exposure) for putting funds into the
company and therefore is the minimum return that a company must make on its own
investments, to earn the cash flows out of which investors can be paid their return.
If a company calculates its cost of capital at too high a figure then it is likely to reject
investment opportunities that it should be taking on (ie, would provide a positive NPV).
In contrast if it sets the cost of capital at too low a level then it is likely to take on investment
opportunities that it shouldn't be taking on (ie, those with negative NPVs).
Both of these outcomes would be detrimental to shareholder value.
6.4 Follow-on
Launching the Pink 'Un would give Frome an opportunity to launch further models at a later
date. By investing in this first model, Frome effectively has the right to 'follow-on'. It is a call
option.
Abandonment
Frome has budgeted to sell the capital equipment for £60,000 in September 20Y1. It may
be that the three year project does not go as well as hoped and the company might then
wish to abandon it and sell the assets earlier than anticipated. This would be a put option.
These two real options could be taken account of by Frome's management and would
affect their decision regarding the project, which is otherwise only appraised by calculating
its NPV.

lOMoARcPSD|5019904
This question scored the highest average mark for the paper and was done very well.
Part 6.1 was relatively straightforward and most candidates scored high marks. The main errors
were candidates inflating the cash flows (unnecessarily) or getting the discount factor to t2 and t3
incorrect.
Part 6.2 was done reasonably well, but too few candidates were able to adequately explain the
reasons for their approach to inflation.
Most candidates failed to explain the meaning of the cost of capital in part 6.3. Otherwise it was
done well.
Part 6.4 was generally done well and those candidates who scored well here explained the real
options in the context of the question.
7 Nuts and Bolts Ltd (March 2011)

Marking guide
Marks
7.1 Calculation of expected sales 2.5

Initial investment 1
Tax savings 3
Contribution 1
Fixed costs 1.5
Tax on extra profit 1.5
Working capital 2
Discount factor 1
Optimistic contribution 1
Optimistic tax on extra profit 1.5
Average NPV 1
Conclusion 1
18
7.2 Calculation of money cost of capital 1
Calculation of difference in contribution 2
Calculation of difference in working capital 3
6
24
7.1
Pessimistic Optimistic
Annual Annual
sales (units) p EV sales sales (units) p EV sales
6,000 25% 1,500 10,000 25.0 % 2,500
10,000 50% 5,000 12,800 37.5% 4,800
12,800 25% 3,200 12,800 37.5% 4,800
9,700 12,100
Expected sales 9,700 units Expected sales 12,100 units

lOMoARcPSD|5019904
EITHER
Pessimistic
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c (W1) 14,688 12,044 9,876 44,992
Contribution (W2) 320,100 320,100 320,100
Fixed costs (W3) (140,000) (140,000) (140,000)
Tax on extra profit (W4) (30,617) (30,617) (30,617)
Working capital (50,000) 50,000
Total cash flows (515,312) 161,527 159,359 244,475
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 146,828 131,631 183,601
NPV (53,252)
Optimistic
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (W5) 399,300 399,300 399,300
Fixed costs (140,000) (140,000) (140,000)
Total cash flows (515,312) 227,263 225,095 310,4211
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 206,582 185,928 232,968
NPV 110,166
 53,252 +110,166
Average NPV = £28,457
2
OR
Overall expected sales = (9,700+12,100)/2=10,900 units
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (@£33) 359,700 359,700 359,700
Fixed costs (140,000) (140,000) (140,000)
Total cash flows (515,312) 194,395 192,227 277,343
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 176,705 158,780 208,285
NPV 28,458
Positive NPV and shareholder wealth increased; therefore, proceed.

lOMoARcPSD|5019904
WORKINGS
(1)
t0 t1 t+ t3
£ £ £ £
Cost/WDV 480,000 393,600 322,752 264,657
WDA @ 18% (86,400) (70,848) (58,095) (264,657)
WDV 393,600 322,752 264,657 0
Tax @ 17% 14,688 12,044 9,876 44,992
(2) Annual contribution £33/unit  9,700 units = £320,100

(3) Annual fixed costs £300,000 – £160,000 = £140,000
(4) Annual tax on extra profit (£320,100 – £140,000)  17% = £30,617
(5) Annual contribution £33/unit  12,100 units = £399,300
7.2 If inflation is taken into account then money (inflated) cash flows will be matched against
NBL's money cost of capital, which is 15.5% (1.10  1.05).
(1) Contribution – there will be no effect on the NPV of the investment as both the cash
inflows (annual contribution) and the cost of capital will have been inflated by 5% per
annum, which will produce the same present value (allowing for small rounding
differences) in each relevant year.
t1 t2 t3 Total
'Real' cash flow (W2) £320,100 £320,100 £320,100
'Real' discount factor (10%) (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value £291,000 £264,545 £240,496 £796,041
t1 t2 t3 Total
'Money' cash flow (inflated) £336,105 £352,910 £370,556
'Money' discount factor (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value £291,000 £264,545 £240,496 £796,041
NPV difference 0
(2) Working capital – the NPV will be affected by the impact of inflation on the working
capital investment as there will be incremental increases to the working capital in the
three years of the project and there will be an inflated working capital figure at the end
of the project.
t0 t1 t2 t3 Total
'Real' cash flow [see (a)] (50,000) 0 0 50,000 0
'Real' discount
factor (10%) 1.000 (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value (50,000) 0 0 37,566 (12,434)
t0 t1 t2 t3 Total
'Money' cash flow (50,000) (2,500) (2,625) 55,125 0
'Money' discount
factor (15.5%) 1.000 (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value (50,000) (2,164) (1,968) 35,777 (18,355)
NPV difference (5,921)
So the total impact of 5% annual inflation on contribution and working capital will be an
NPV figure that is £5,921 lower.

lOMoARcPSD|5019904
This question had the highest average mark on the paper and most candidates scored high
marks.
This question tested the investment decisions element of the syllabus. The scenario was that of a
manufacturer wishing to introduce a new product to the market and therefore needing to make
a major capital investment.
In part 7.1 for 18 marks candidates were presented with a lot of information, as in a typical NPV
setting, and were required to calculate the NPV of the proposal. The question was unusual in
that candidates had to calculate the level of customer demand by using expected values. In
addition, this demand was constrained by the fact that the new equipment had a maximum level
of output. Despite this intricacy, candidates could secure a good mark here if they followed the
key elements of an NPV calculation. Part 7.2 for six marks required candidates to explain the
implications for their NPV calculation in part 7.1 if the contribution and working capital figures
were adjusted to take account of a 5% annual inflation rate.
In part 7.1 most errors related to the expected values calculation with only a small minority of
candidates getting it right. Many candidates ignored the production constraint completely.
Despite these errors the majority of candidates scored high marks.
In part 7.2 the contribution figure was generally inflated accurately, but too many candidates
only adjusted the final working capital figure, without taking account of the incremental annual
changes. Also, too many candidates failed to make use of a money (inflated) discount rate,
which suggests a real lack of understanding of the impact of inflation on cash flows.

lOMoARcPSD|5019904
8 Newmarket plc (Sample paper)

Marking guide
Marks
8.1 Discount factor 1
Equipment cost 1
Incremental unit costs 2
Incremental salary 1
Market research fee 1
Tax 2
Writing down allowance 2
Sale proceeds 1
Price calculation – revenue 1
Price calculation – tax on revenue 1
Price calculation – equation 1
Price calculation – selling price 1
15
8.4 Existence of real options 1
Follow on options 2
Abandonment options 2
Timing option 2
Growth option 2
max 8
35
8.1 The schedule of relevant cash-flows and present values (in £) would be as follows:
Year Item CF 10% df PV
0 Equipment purchase (750,000) 1.000 (750,000)
1–5 Incremental unit costs (W1) (170,000) 3.791 (644,470)
1–5 Tax re: unit costs 28,900 3.791 109,560
1–5 Incremental salary (35,000) 3.791 (132,685)
1–5 Tax re: incremental salary 5,950 3.791 22,556
1 Market research fee (10,000) 0.909 (9,090)
1 Tax re: market research fee 1,700 0.909 1,545
0 WDA (W2) 22,950 1.000 22,950
1 WDA 18,819 0.909 17,106
2 WDA 15,432 0.826 12,747
3 WDA 12,654 0.751 9,503
4 WDA 10,376 0.683 7,087
5 WDA 38,769 0.621 24,076
5 Sale proceeds 50,000 0.621 31,050
(1,278,065)

lOMoARcPSD|5019904
Alternative presentation (also in £)

0 1 2 3 4 5
Cost (750,000) 50,000
Fee (10,000)
Inc. Costs (170,000) (170,000) (170,000) (170,000) (170,000)
Salary (35,000) (35,000) (35,000) (35,000) (35,000)
Tax 36,550 34,850 34,850 34,850 34,850
WDA 22,950 18,819 15,432 12,654 10,376 38,769
Net (727,050) (159,631) (154,718) (157,496) (159,774) (81,381)
10% 1 0.909 0.826 0.751 0.683 0.621
PV (727,050) (145,105) (127,797) (118,279) (109,126) (50,538)
Total PV = (1,277,895) difference due to rounding discount factors.
If we set price equal to P:

1–5 Revenue 2,000P 3.791 7,582P
1–5 Tax re: revenue (340)P 3.791 (1,289)P
6,293P
Therefore: 6,293P – 1,278,065 = 300,000
6,293P = 1,578,065
P = £250.77
To the nearest £, Newmarket would need to charge a minimum unit price of £251.
WORKINGS
(1) Incremental unit costs
Incremental unit cost: £
Labour (4 hours @ £12 per hour) 48.00 incremental
Components 32.00 incremental
Loan interest 0.00 dealt with via df
Depreciation 0.00 not a cash-flow
Energy costs 5.00 incremental
Share of Newmarket's fixed costs 0.00 not incremental
85.00
£85.00  2,000 = £170,000
(2) Writing Down Allowances
Tax effect @
Year end 17% Year
£ £
30 June 20X2 Purchase 750,000
WDA @ 18% (135,000) 22,950 0
615,000
30 June 20X3 WDA @ 18% (110,700) 18,819 1
504,300
30 June 20X4 WDA @ 18% (90,774) 15,432 2
413,526
30 June 20X5 WDA @ 18% (74,435) 12,654 3
339,091
30 June 20X6 WDA @ 18% (61,036) 10,376 4
278,055
30 June 20X7 Sale proceeds 50,000
Balancing allowance 228,055 38,769 5

lOMoARcPSD|5019904
8.2 1 Sensitivity analysis:

 A way of incorporating alternative forecasts into project evaluation
 Involves taking each uncertain forecast and calculating the change in the variable
necessary for the NPV of the project to fall to zero
 Formula: Sensitivity = NPV of project/PV of cash-flows subject to uncertainty  100
2 Simulation (scenario analysis):
 Allows the effect of more than one variable changing simultaneously to be
assessed
 Monte Carlo simulation, for example, makes use of random numbers and
probability statistics to evaluate projects armed with a more detailed insight into
the nature of risks and returns
(Reference to expected values would also be rewarded with up to three marks.)
8.3 Systematic risk:
Also known as market risk.
It is that element of risk which cannot be eliminated by diversification.
It affects all markets within the economy systematically.
Examples in this (or any such scenario) would be changes in macroeconomic variables, for
example, changes in interest rates, inflation rates, capital allowances or other tax rate
changes.
Non-systematic (unsystematic) risk:
Also known as unique or specific risk.
It is that element of risk that can be eliminated by diversification.
It is related to factors that affect the return on individual investments in unique ways.
Examples in this scenario would be a decrease in demand for the product below
projections, unexpected actions of competitors or an increase in component costs.
8.4 NPV only considers the cash flows associated with the NL500 project. It is possible that the
project is worth more than the target NPV of £300,000 because of the existence of real
options associated with the project.
Follow on options
Launching the NL500 gives an opportunity to launch a second (and third and so on) version
of the lawnmower that could be very profitable (or not). The right to invest in later versions
is a call option.
Abandonment option
If the NL500 is a failure then management can terminate the project early and sell the
equipment, giving them a put option.
Timing option
It may be possible to delay the introduction of the NL500, particularly if the demand
estimates are uncertain, effectively a call option. The longer the possible delay the more
valuable the option. Newmarket would need to protect its position, eg, from a competitor
establishing a strong market position, by using patents.
Growth option
If the NL500 is more successful than envisaged, Newmarket have the (call) option to expand
production facilities ie, the opposite of the abandonment option.

lOMoARcPSD|5019904
Rather surprisingly, this was the lowest scoring question on the paper, which is not something
we normally associate with the investment appraisal question, albeit on a paper with a relatively
high pass rate of 88%. The final stage of part 8.1 of the question proved beyond many
candidates, who up until that point had generally coped well with the standard demands of the
question. Parts 8.2 and 8.3 proved relatively straightforward for well-prepared candidates, but
the failure of many weak candidates to complement their learning of technique with the
acquisition of basic knowledge led to many of them often sacrificing all 12 of the marks available
on these parts of the question.
Overall, the performance in part 8.1 of the question was strong, although where errors were
made the most common ones related to the inclusion and timing of the fee payment, the
inclusion of irrelevant costs and an inability to use the net present value calculation to accurately
address the final stage of the question.
For the most part, well-prepared candidates scored full marks in part 8.2, but there were still a
surprising number of scripts that missed the opportunity to score strongly, often veering off course
into other areas of the syllabus, notably derivatives, which were not relevant to the precise
requirements of the question.
Although part 8.3 covers an element of the syllabus that is tested relatively infrequently, the
majority of candidates coped well with it, although there were still a significant number of
weaker scripts that displayed a complete misunderstanding of the terms and that were,
consequently, unable to apply them meaningfully to the scenario in the question.
9 Grimpen McColl International Ltd (September 2012)

Marking guide
Marks
9.1 Equipment cost and residual value 0.5
Tax saving 2
Income 0.5
Materials and labour 1
Overheads 2
Lost contribution 1
Tax on extra profit 2
Working capital 2
Discount factor 1
Conclusion 1
13
9.2 Calculation of decrease 2
Minimum value of second instalment 1
3
9.4 Annual surplus from year 4 1

Tax 1
Perpetuity factor 1
Discount to PV 1
4
30

lOMoARcPSD|5019904
9.1
20X2 20X3 20X4 20X5
£'000 £'000 £'000 £'000
Machinery (30,000) 5,000
Tax saving (W1) 918 753 617 1,962
Income 10,000 85,000
Materials and labour (W2) (7,280) (8,653) (10,124)
Overheads (W3) (2,600) (3,245) (3,937)
Lost contribution (W4) (4,200) (4,410) (4,631)
Tax on extra profit (W5) (1,700) 2,394 2,772 (11,272)
Working capital (W6) (5,000) (1,240) (1,331) 7,571
Total Cash Flows (25,782) (12,173) (14,250) 69,569
8% factor 1.000 0.926 0.857 0.794
PV (25,782) (11,272) (12,212) 55,238
NPV 5,972
As the NPV is positive GMI should proceed with the investment as this will enhance
shareholder wealth.
WORKINGS
(1)
£'000 £'000 £'000 £'000
Cost of machinery 30,000 24,600 20,172 16,541
WDA @ 18% (5,400) (4,428) (3,631) (11,541)
WDV/sale 24,600 20,172 16,541 5,000
Tax saving @ 17% 918 753 617 1,962
(2)
£'000 £'000 £'000 £'000
Materials and labour (7,000) (8,000) (9,000)
Inflation @ 4% pa  1.04  1.042  1.043
(7,280) (8,653) (10,124)
(3)
Overheads (excluding Head office costs) (2,500) (3,000) (3,500)
Inflation @ 4% pa  1.04  1.042  1.043
(2,600) (3,245) (3,937)
(4)
£'000 £'000 £'000
Lost contribution (4,000) (4,000) (4,000)
Inflation @ 5% pa  1.05  1.052  1.053
(4,200) (4,410) (4,631)
(5)
Income 10,000 85,000
Materials and labour (7,280) (8,653) (10,124)
Overheads (2,600) (3,245) (3,937)
Lost contribution (4,200) (4,410) (4,631)
Profit/(loss) 10,000 (14,080) (16,308) 66,308
Tax @ 17% on profit/(loss) (1,700) 2,394 2,772 (11,272)

lOMoARcPSD|5019904
(6)
£'000 £'000 £'000 £'000
Total investment (money terms) 5,000
£6,000  1.04 (year 1) 6,240
2
£7,000  1.04 (year 2) 7,571 0
(Increase)/decrease in WC (5,000) (1,240) (1,331) 7,571
9.2 For NPV to fall to zero then the second instalment will need to fall by:
£
£5,972,000/0.794/0.83 = (9,061,940)
Estimated second instalment = 85,000,000
Minimum value of the second instalment 75,938,060
9.3 GMI's money cost of capital already takes into account GMI's estimated inflation rate. So if
the cash flows are inflated at the same rate then the correct NPV will be calculated.
If the South American inflation rates are higher than predicted then inflate further the
money cost of capital and the estimated cash flows. NPV will not be affected.
However, for the WDA, equipment resale and the second instalment, the NPV will fall as the
money discount rate rises. These are in money terms already.
9.4
£'000
Annual income from 20X6 (Year 4) 5,000
Annual costs from 20X6 (3,000)
Annual surplus from 20X6 2,000
Less tax @ 17% (340)
1,660
Perpetuity factor (1.08/1.03) 4.85%
PV of future cash flows at Year 3 [end 20X5] (£1,660/4.85%) 34,227
Discount to PV (from Year 3 [end 20X5])  0.794
PV of future cash flows (minimum selling price of the maintenance contract) 27,176
9.5 Political risk is the risk that political action will affect the position and value of a company.
Candidates' discussion should be based on the following possible risks:
 Quotas/tariffs/barriers imposed by the overseas government
 Nationalisation of assets by the overseas government
 Stability of the overseas government
 Political and business ethics
 Economic stability/inflation
 Remittance restrictions
 Special taxes
 Regulations on overseas investors
This question was a good discriminator between those students who have learned the
calculations and underlying theory by rote and those who really understand the topic.
In general, in part 9.1, a fairly standard NPV calculation, most candidates scored high marks. The
most common errors were made with regard to working capital investment and the corporation
tax flows.
Part 9.2 was done reasonably, but a surprising number of candidates forgot to take taxation into
account in their calculations.

lOMoARcPSD|5019904
The discursive nature of part 9.3 caught out many candidates – they failed to adequately explain
the impact of using an erroneous inflation rate and therefore to demonstrate that they fully
understood this part of the syllabus. A common error made by candidates was to forget that
revenue from the project was fixed.
Part 9.4 was done poorly and too few candidates were able to adequately deal with the
discounting techniques required.
10 Wicklow plc (December 2008)

Marking guide
Marks
10.1 Capital allowances 3
Revenue 3
Material costs 2
Lost contribution 3
Labour 2
Working capital 4
Tax 1
NPV calculation 1
Maximum 18
10.2 Calculation of selling price sensitivity 4

Calculation of cost of equity sensitivity 3
7
10.3 PV of tax shield 2
APV calculation 2
4
10.4 2 marks per valid point
Maximum 6
35
10.1
20X8 20X9 20Y0 20Y1 20Y2
Investment (2,000,000) 200,000
Capital allowances (W1) 61,200 50,184 41,151 33,744 119,721
DH revenue (W2) 11,725,000 14,147,000 15,561,000 15,561,000
DH material costs (W3) (6,365,000) (7,679,800) (8,447,400) (8,447,400)
Duo lost contribution
(W4) (2,500,592) (3,016,824) (3,318,208) (3,318,208)
Additional labour (W5) (167,500) (202,100) (222,300) (222,300)
New manager 35,000 (40,000) (40,000) (40,000) (60,000)
Working capital (W6) (941,700) (194,625) (113,625) 1,249,950
Taxation (17%) (5,950) (450,824) (545,407) (600,626) (597,226)
NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537
df (8%) 1 0.926 0.857 0.794 0.735
DCF (2,851,450) 1,904,451 2,219,969 2,355,171 3,296,870
NPV £6,925,011
The recommendation to the directors should, therefore, be to proceed with the 'Heritage'
version of the Duo cooker.

lOMoARcPSD|5019904
WORKINGS
(1) Capital Allowances
£ £
20X8
Cost 2,000,000
WDA (18%) 360,000  17% = 61,200
20X9 1,640,000
WDA (18%) 295,200
20Y0 1,344,800  17% = 50,184
WDA (18%) 242,064
20Y1 1,102,736  17% = 41,151
WDA (18%) 198,492
20Y2 904,244  17% = 33,744
Proceeds 200,000
Bal. Allowance  17% = 119,721
704,244
(2) DH Revenue
20X9: 1,500 (0.65) + 2,000 (0.35) = 1,675  £7,000 = £11,725,000
20Y0: 1,800 (0.65  0.7) + 2,000 (0.65  0.3) + 2,200 (0.35  0.6) + 2,500 (0.35  0.4) =
2,021  £7,000 = £14,147,000
20Y1 and 20Y2: 110%  2,021 = 2,223  £7,000 = £15,561,000 p.a.
(3) DH Material Costs
Unit sales  £3,800
20X9: 1,675 units = £6,365,000
20Y0: 2,021 units = £7,679,800
20Y1 and 20Y2: 2,223 units = £8,447,400 p.a.
(4) Duo Lost Contribution
The effective lost contribution on each Duo = £6,500 – £3,516 = £2,984 as the labour
cost and fixed overheads will still be incurred.
20X9: 838  £2,984 = £2,500,592
20Y0: 1,011  £2,984 = £3,016,824
20Y1 and 20Y2: 1,112  £2,984 = £3,318,208 p.a.
(5) Additional Labour Costs
The standard Duo product will simply provide half of the labour required to
manufacture the 'Heritage' version of the product.
20X9: 1,675 units  8 = 13,400/2 = 6,700  £25 = £167,500
20Y0: 2,021 units  8 = 16,168/2 = 8,084  £25 = £202,100
20Y1 and 20Y2: 2,223 units  8 = 17,784/2 = 8,892  £25 = £222,300 p.a.
(6) Working Capital
Next year's
sales value 15%
DH:
20X8 11,725,000 (1,758,750)
20X9 14,147,000 (2,122,050)
20Y0 15,561,000 (2,334,150)
20Y1 15,561,000 (2,334,150)
20Y2 0 0

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Next year's
sales value 15%
Duo:
20X8 (5,447,000) 817,050
20X9 (6,571,500) 985,725
20Y0 (7,228,000) 1,084,200
20Y1 (7,228,000) 1,084,200
20Y2 0 0
Net effect:
20X8 (941,700)
20X9 (194,625)
20Y0 (113,625)
20Y1 0
20Y2 1,249,950
10.2 (a) To calculate the sensitivity of changes in sales price, it is assumed sales quantity is fixed
and then the relevant cash flows from part 10.1 are considered.
20X9 20Y0 20Y1 20Y2
DH revenue 11,725,000 14,147,000 15,561,000 15,561,000
Tax on revenue (1,993,250) (2,404,990) (2,645,370) (2,645,370)
Cash flow 9,731,750 11,742,010 12,915,630 12,915,630
df (8%) 0.926 0.857 0.794 0.735
Present value 9,011,601 10,062,903 10,255,010 9,492,988
Total present value = £38,822,502

Sensitivity = 6,925,011/38,822,502= 17.8%
This means selling price can fall by 17.8% to £5,754 before the decision to invest would
change.
(b) To calculate the sensitivity to the cost of equity, an IRR is required, using the net cash
flows from part 10.1.
NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537
df (15%) 1 0.870 0.756 0.658 0.572
DCF (2,851,450) 1,789,279 1,958,339 1,951,766 2,565,727
NPV = £5,413,661
IRR for this project = 8 + (6,925,011/(6,925,011 – 5,413,661))(15 – 8) = 40.1%
The cost of equity would need to increase to 40.1% (an increase of almost 400% from
its current level) before the investment decision would change.
10.3 The NPV calculated in 10.1 at £6,925,011 is for an ungeared firm.
The PV of the tax shield (interest = £2m  0.05 = £0.1m) is calculated as follows:
Time £ per annum df @ 5% PV (£)
1–4 0.1m  0.17 = 0.017m 3.546 60,282
Therefore the adjusted present value = £6,925,011 + £60,282 = £6,985,293.
10.4 The APV technique is based upon the assumptions of Modigliani and Miller with tax.
That means that issues which may affect the attractiveness of debt finance are not reflected
in the technique:
 Direct and indirect costs of bankruptcy
 Agency costs and covenants
 Tax exhaustion
 Perfect market assumptions eg, risk-free debt

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To the extent that any of these assumptions do not hold true, the APV methodology will not
take account of all the potential implications of increased debt within a firm's capital
structure.
There is also a question mark over the appropriate rate at which to discount the tax shield.
Most candidates found part 10.1 of the question to their liking. The initial calculation of expected
values proved largely unproblematic, but common errors among weaker candidates were
incorrect calculation of the lost contribution from the existing product and an inability to calculate
accurately the net working capital impact of the project. In this latter regard, a surprising number
of candidates correctly calculated the impact of the new product, but then failed to deduct the off-
setting impact of the existing product. It was also apparent that a significant number of candidates
appear to believe that it is an effective time-saving tactic not to bother with the calculation of
discount factors and/or the actual discounting of cash flows and simply to say that if the resultant
NPV was positive their recommendation would be to accept the project (or vice versa). Given that
marks were explicitly available for both the discount factors and the discounting process itself, this
was a potentially costly omission.
Section 10.3, along with section 10.4, proved to be effective discriminators between stronger
and weaker candidates. Many weaker candidates were unable to make any meaningful attempt,
some simply believing that what was required was to discount the net cash flows calculated in
section 10.1 at a discount factor of 5%. Common errors among candidates who were able to
adopt the correct approach were to use an incorrect annuity factor in the calculation or to use
the post-tax cost of debt, but for well prepared candidates this proved to be easy marks.
Section 10.4 polarised performance, although unlike in section 10.3 it was the majority rather
than the minority of candidates who struggled. The question required candidates to think
laterally across the syllabus to establish the link to underlying theory. However, many candidates
resorted simply to listing all they knew about the limitations of issues such as WACC and CAPM.
Performance overall was relatively strong on this question with the majority of candidates
scoring well in the first section, although the adjusted present value sections of the question
served to polarise performance.

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11 Air Business Ltd (September 2013)

Marking guide
Marks
11.1 Old aircraft 1
Tax cost 2
New aircraft 1
Tax saved 2
Extra profit 4
Tax 1.5
Working capital 2
Total cash flows 0.5
PV 1
Negative NPV and advise not to proceed 1
16
11.2(a) Extra income needed in Y3 2
Estimated trade-in value in Y3 1
Trade-in value required to break even 1
4
(b) Pre-tax extra profit 1
Tax 1
Discount factor and NPV 1
Sensitivity 1
Advice based on calculation 1
5
11.3 Theory – including 2 marks for drivers 5

Practical 5
10
35
11.1
Y0 Y1 Y2 Y3
£ £ £ £
Old aircraft 760,000
Tax cost (W1) (129,200)
New aircraft (3,000,000) 600,000
Tax saved (W2) 91,800 75,276 61,726 179,198
Extra profit (W3) 566,475 594,799 624,539
Tax (W4) (96,301) (101,116) (106,172)
Working Capital (W5) (80,000) (4,000) (4,200) 88,200
Total cash flows (2,357,400) 541,450 551,209 1,385,765
8% factor 1.000 0.926 0.857 0.794
PV (2,357,400) 501,383 472,386 1,100,297
NPV (283,334)
Negative NPV and so do not proceed, as shareholders' wealth would fall.

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WORKINGS
(1) Y0
£
WDV b/f 0
Balancing charge 760,000
Sale proceeds 760,000
Tax due (balancing charge  17%) 129,200
(2) Y0 Y1 Y2 Y3
£'000 £'000 £'000 £'000
Cost/WDV 3,000.000 2,460.000 2,017.200 1,654.104
WDA @18% (540.000) (442.800) (363.096) (1,054.104)
WDV/sale 2,460.000 2,017.200 1,654.104 600.000
Tax saving (WDA  17%) 91.800 75.276 61.726 179.198
(3) Y0 Y1 Y2 Y3
£ £ £ £
Current profit 987,500
Estimated profit 1,527,000
Increase 539,500
 1.05 566,475
 1.05 = 594,799
 1.05 624,539
(4) Y0 Y1 Y2 Y3
£ £ £ £
Extra profit (W3) 566,475 594,799 624,539
Tax @ 17% (96,301) (101,116) (106,172)
(5) Y0 Y1 Y2 Y3
£ £ £ £
Extra working capital £80,000  1.05
£84,000  1.05
88,200
Increment (£80,000) (4,000) (4,200) 88,200
11.2 (a)
£283,334/83%/0.794 £429,932 Extra income needed in Y3
£600,000 Estimated trade-in value in Y3
£1,029,932 Trade-in value required to break even (NPV = 0)
(b)
Y1 Y2 Y3
£ £ £
Pre-tax extra profit 566,475 594,799 624,539
less: Tax at 17% (96,301) (101,116) (106,172)
Post-tax extra profit 470,174 493,683 518,367
8% factor 0.926 0.857 0.794
PV 435,381 423,086 411,583
Total NPV 1270,050
Sensitivity: £283,334/£1,270,050 = 22.3%
Thus post-tax profits would need to increase by 22.3% for the project to be taken on,
ie, where NPV = 0.

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11.3 Theory
Shareholder value analysis (SVA) concentrates on a company's ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a
business is equal to the sum of the present values of all of its activities. SVA posits that a
business has seven value drivers:
Relevance to ABL figures
(1) Life of projected cash flows Three year projection – so relevant in part but not to
infinity
(2) Sales growth rate Not used – no growth rate other than inflation
(3) Operating profit margin Yes, relevant – margin and fixed costs used
(4) Corporate tax rate Yes, relevant
(5) Investment in non-current Not used as in usual SVA approach (% of change in sales)
assets
(6) Investment in working capital Not used as in usual SVA approach
(7) Cost of capital Yes, a discount rate of 8% was used
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). A terminal/residual value is
also calculated to cover the period from the end of competitive advantage to infinity. This
can create major problems with estimating a PV of future cash flows. However, SVA links a
business' value to its strategy (via the value drivers).
Practical
Some of the information in 11.1 is relevant to a SVA calculation (see relevance column in bold
above), but 11.1 is looking at a specific investment (three new aircraft) – no terminal/residual
value has been calculated, ie, the PV of future cash flows once the period of competitive
advantage lapses.
Examiner's comments
This question had the lowest average mark on the paper.
decisions and valuation element of the syllabus.
In the scenario an airline company was considering whether or not to proceed with the purchase
of three new aircraft. In addition its management was concerned that the company might be the
subject of a takeover bid and wanted guidance. Part 11.1 for 16 marks was a fairly traditional
NPV calculation and required candidates to deal with capital allowances (including the trade-in
of old aircraft), incremental cash flows with regard to contribution and fixed costs, inflation and
working capital. Part 11.2 for nine marks tested candidates' ability with sensitivity analysis, ie,
how sensitive was the investment to changes in (a) the trade-in value of the aircraft and (b) the
incremental profits arising. Part 11.3 for 10 marks examined candidates' understanding of
shareholder value analysis (SVA) and to what extent the NPV calculations in part 11.1 could be
employed if the company was the subject of a takeover bid.
Part 11.1 was generally answered well, but too few candidates were able to correctly calculate
the incremental change in contribution and fixed costs. Not many candidates scored full marks
with regard to the balancing charge arising on the sale of the old aircraft. A majority of
candidates failed to calculate the working capital figures correctly.

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In part 11.2(a), when testing the sensitivity of the NPV with regard to the trade-in value of the old
aircraft, few candidates took into account the impact of taxation/capital allowances.
In part 11.2(b), candidates generally did better when calculating the sensitivity of the
incremental profits, but their interpretation of the results was often rather weak.
Part 11.3 was not done well, even the theoretical aspects of SVA, which should have been
straightforward. Too many candidates explained the value drivers and how the company's value
could be increased as these changed. There were few attempts to explain the relevance of SVA
to candidates' calculations in part 11.1.
12 Daniels Ltd (March 2007)

Marking guide
Marks
12.1 (a) Reasoning: 1 Figures: 1 2
(b) Method and figures: 2 Ranking: 1 3
(c) Method: 1 Calculations: 2 Conclusions and reasoning: 2 5
10
12.2 Reasoning: 2 Conclusion: 1 NPV: 1 4
12.3 Calculations: 4 Limitations: 2 6
12.4 PV calculations: 3 Conclusion and reasoning: 2 5
25
12.1 (a) No capital rationing, so choose all projects with a positive NPV, ie:
NPV
£'000
Bristol 577
Swansea 2,856
Tiverton 1,664
Total 5,097
(b) Capital rationing of £8 million on 31/5/X7 (t0). Rank according to NPV/£ invested:
Bristol Cardiff Gloucester Swansea Tiverton
£'000 £'000 £'000 £'000 £'000
NPV (£'000) 577 (1,309) (632) 2,856 1,664
Investment t0 4,150 3,870 6,400 5,000 4,600
NPV/£ 0.139 n/a n/a 0.571 0.362
Rank 3 1 2
Therefore choose all of Swansea (£5m investment) and 65.2% (£3,000/£4,600) of

Tiverton:
NPV
£'000
Swansea (100%) 2,856
Tiverton (65.2%) 1,085
Total 3,941

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(c) No capital rationing at t0 but only £500,000 available at t1:

Bristol Positive NPV and negative funds in t1 So consider further
Cardiff Negative NPV and negative funds in t1 So ignore
Gloucester Negative NPV and positive funds in t1 So consider further
Swansea Positive NPV and negative funds in t1 So consider further
Tiverton Positive NPV and positive funds in t1 So accept unconditionally
If Gloucester is ignored, because it has a negative NPV, then there is £1,790,000

(£500,000 + 1,290,000 [Tiverton]) available at t1.
Thus choose Swansea (higher ranking than Bristol) and do 68.6% (£1,790/£2,610) of it.
Thus the total NPV would be:
£'000
Tiverton 1,664
Swansea (68.6%  £2,856,000) 1,959
3,623
Alternatively, if Gloucester is considered and its positive t1 cash flow utilised then there is
£3,560,000 capital available (£1,790,000 + £1,770,000) at t1.
Based on the same ranking, for t1 choose 100% Swansea and use the balance (£950,000) to
fund Bristol, ie, (higher ranking than Bristol) and do 73.6% (£950/£1,290) of it. Thus the total
NPV would be:
£'000
Tiverton 1,664
Swansea (100%) 2,856
Bristol (73.6%  £577,000) 425
Gloucester (632)
4,313
Thus it is preferable if the Gloucester project is taken on as this produces the higher total
NPV.
12.2 Capital rationing of £9 million in t0, but projects not divisible:
Only choose the projects with positive NPVs, ie, Bristol, Swansea or Tiverton. The highest
NPV is generated from Swansea (and is higher than Bristol and Tiverton added together).
Thus the NPV would be £2,856,000.
12.3
PV PV Eq. Ann
factor PV factor Cost
£ £ £ £
Replace vans after
one year
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300)
Resale value 9,800
5,500 0.909 5,000
(7,400) 0.909 (8,140)
Replace vans after
two years
t0 Cost of van 1.000 (12,400)
(12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
Resale value 7,000
2,200 0.826 1,818
(14,491) 1.735 (8,352)

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PV PV Eq. Ann
factor PV factor Cost
£ £ £ £
Replace vans after
three years
t0 Cost of van (12,400) 1.000 (12,400)
Resale value 5,000
(100) 0.751 (75)
(20,349) 2.486 (8,185)
Thus the cheapest option for Daniels is to replace the vans every year as this produces the
lowest Equivalent Annual Cost (EAC). However it should be noted that this is by no means a
clear decision, as a three-year cycle produces only a slightly higher EAC.
Limitations
 Changing technology, leading to obsolescence, changes in design
 Inflation – affecting estimates and the replacement cycles
 How far ahead can estimates be made and with what certainty?
Note: A further limitation is the ignoring of taxation, which the candidates were told to do.
12.4 The PV of the two investments should be considered:
Original situation Proposed change
Cash 10% Cash 10%
Flow factor PV Flow factor PV
Year 1–7 190,000 4.868 925,000 Year 1 925,000 0.909 840,825
The NPV is higher if Daniels maintains the current cash flow profile and so is better off not
accepting Kithill's proposal. The IRR might be higher by accepting, but the NPV is the key
measure and should be followed.
This question was based on (a) investment appraisal with capital rationing and (b) replacement
analysis. Both of these elements, whilst comprehensive and technical, were straightforward and
most candidates did well. In addition there was a small final part to the question which required
candidates to compare, in effect, net present value and internal rate of return.
As expected most candidates scored full marks for part 12.1(a).
Part 12.1(b) was also done well, and most candidates demonstrated how to rank the projects on
the basis of NPV/£ invested.
Part 12.1(c) was answered satisfactorily and a good number of scripts demonstrated how to deal
with capital rationing in the second year of the projects.
Part 12.2 was answered well, and most students were able to make the right decision.
Part 12.3 was also answered well and a good number of students scored full marks for it.
In the final part of the question, part 12.4, a majority of candidates gave the correct advice,
although few were able to produce the exact relevant cash flow.

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13 Adventurous plc (December 2013)

Marking guide
Marks
13.1 Contribution 3
Fixed costs 1
Rent 1
Tax 1
Plant and equipment 1
Tax saved on CAs 2
Working capital 2
Discount factor 1
NPV 1
Negative NPV and reject 1
Not include sunk costs in NPV 1
15
13.2(a)PV of factory annual rent after tax 1
Sensitivity 1
Extent rent must fall 1
(b)IRR 2
Sensitivity 1
Sensible comments on the sensitivities 1
7
13.3 Problem if gearing changes 1
APV model is suitable 1
Base case value 1
Adjustments to base case 1
Maximum 3
13.4 Effect on value 1

Possible political measures taken by government 3
Strategies to limit effects 3
Maximum 5
13.5 Follow on options 1.5

Abandonment options 1.5
Timing options 1.5
Growth options 1.5
Maximum 5
35

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13.1
Year
0 1 2 3 4
£'000 £'000 £'000 £'000 £'000
Contribution (W1) 15,450 16,709 18,071 19,544
Fixed costs (3,090) (3,183) (3,278) (3,377)
Rent (1,000) (1,000) (1,000) (1,000) 0
Operating cash flow (1,000) 11,360 12,526 13,793 16,167
Tax 170 (1,931) (2,129) (2,345) (2,748)
Plant and Equipment (50,000) 15,000

Tax saved on CAs (W2) 1,530 1,255 1,029 844 1,293
Working Capital (W3) (1,500) (122) (133) (142) 1,897
Net cash flow (50,800) 10,562 11,293 12,150 31,609
Discount factor (10%) 1 0.909 0.826 0.751 0.683
Present Value (50,800) 9,601 9,328 9,125 21,589
Net Present Value (1,157)
Decision: negative NPV therefore reject the project.

Note: Not including sunk costs in the NPV.
WORKINGS
(1) Contribution = £295 – £170 = £125
Year £'000
1 120,000  £125 (1.03) 15,450
2
2 120,000  (1.05)  £125  (1.03) 16,709
2 3
3 120,000  (1.05)  £125  (1.03) 18,071
3 4
4 120,000  (1.05)  £125  (1.03) 19,544
(2) Capital allowances
Year Cost/WDV CAs @18% Tax @17%
£'000 £'000 £'000
1 50,000 9,000 1,530
2 41,000 7,380 1,255
3 33,620 6,052 1,029
4 27,568 4,962 844
5 22,606
Sale (15,000) 7,606 1,293
(3) Working capital
Year 1 1,500  1.05  1.03 = 1,622
Year 2 1,622  1.05  1.03 = 1,755
Year 3 1,755  1.05  1.03 = 1,897
13.2 (a) The present value of the factory annual rent after tax is (£'000):
1,000 (1 – 0.17)  3.487 = 2,894.21. Round to 2,894.
Note: 3.487 = 1 + The annuity factor for three years at 10%.
The sensitivity is found by: NPV/PV of annual rent = –1,157/2,894 = –0.4 or –40%
The rent must fall by 40%.

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(b) The internal rate of return of the project must be calculated. The net present value of
the project at 5% = £6,008,000:
฀ Year
฀ 0 1 2 3 4
£'000 £'000 £'000 £'000 £'000
Contribution 15,450 16,709 18,071 19,544
Fixed costs (3,090) (3,183) (3,278) (3,377)
Rent (1,000) (1,000) (1,000) (1,000)
Operating CF (1,000) 11,360 12,526 13,793 16,167
Tax 170 (1,931) (2,129) (2,345) (2,748)

Plant (50,000) 15,000
Tax on CAs 1,530 1,255 1,029 844 1,293
Working cap (1,500) (122) (133) (142) 1,897
Net cash flow (50,800) 10,561 11,292 12,150 31,609
DCF 5% 1 0.952 0.907 0.864 0.823
PV (50,800) 10,054 10,242 10,497 26,014

NPV 6,008
 1,157  
The internal rate of return is: 10 – 10 –     5  = 9.2%
 1,157 + 6,008  
The WACC would have to fall by (9.2 – 10)/10 = 0.08 or 8%

(Marks available for sensible comments on the sensitivities.)
13.3 A major assumption of the WACC/NPV model is that the gearing of a company will not
change as a result of taking on projects and that the projects are financed from a pool of
funds made up of debt and equity.
If the gearing of Adventurous changes materially as a result of taking on the project it is no
longer appropriate to use the WACC/NPV model.
M & M argued that in a world with tax changing the capital structure may cause the cost of
capital to alter.
The appropriate project appraisal model to use is Adjusted Present Value (APV).
APV is calculated discounting the ungeared cash flows using the cost of equity of
Adventurous as if it were ungeared; this is the base case value of the project.
The base case value is then adjusted for the present value of the tax shield on loan interest
and any costs associated with raising finance for the project.
13.4 The risk is that political action will reduce the value of the project.
The measures that a foreign government might use include: Quotas; Tariffs; Non-tariff
barriers; Restrictions; Nationalisation; Minimum shareholding; Blocked funds.
Strategies that can be used to limit the effects of political risk include: Negotiations with the
host government; Insurance; Production strategies; Management structure.
13.5 NPV only considers the cash flows associated with the bicycle computer project. It is
possible that the project may be worthwhile as a result of the real options associated with it.
These are as follows:
Follow on options – Adventurous has the opportunity at the end of four years to continue
production of the bicycle computer. This might be profitable or not. This is a call option.
Abandonment options – If the bicycle computer is not popular and is a failure Adventurous
has the right to terminate the project early and sell the equipment. This is a put option.

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Timing options – It may be possible for Adventurous to delay the production of the bicycle
computer and wait until the rumours about the rival company are either dispelled or are
based on fact. This is a call option.
Growth options – The rumours of the new GPS system also create growth options.
Adventurous could invest and hope that the new GPS system does not materialise. Wait and
see if the GPS system comes to market but competitors might take a lead and not wait.
If the new bicycle computer is successful and demand is greater than estimated
Adventurous may expand production. This is a call option.
This was a five-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The question was based on a scenario where the company was intending to launch a new
product and set up a manufacturing facility in the UK. The question covered NPV analysis,
inflation, relevant and irrelevant cash flows, working capital requirements and capital allowance
calculations. Part 13.1 for 15 marks required candidates to calculate, using money cash flows,
the net present value of the project and advise the board of the company as to whether it should
proceed. Part 13.2 for seven marks required candidates to calculate and comment upon the
sensitivity of the project to two of the inputs to the NPV analysis. Part 13.3 for three marks
required candidates to describe a different project appraisal methodology to WACC/NPV. Part
13.4 for five marks required candidates to consider the political risk of setting up the
manufacturing facility overseas and how the company might limit its effects. Part 13.5 for five
marks required candidates to identify and comment upon the 'real options' available to the
company.
Part 13.1 was well answered, however candidates did not always pay full attention to the timing
of cash flows and when they should be increased for price inflation and growth in turnover.
In part 13.2, weaker candidates had some difficulty since the project produced a negative NPV.
Candidates should be prepared to apply their knowledge to projects that have either a negative
or positive NPV.
Part 13.3 was well answered with most candidates identifying APV as the alternative
methodology to use.
In part 13.4, most candidates were able to identify political risk, however few were able to state
how to limit its effects.
In part 13.5, most candidates were able to identify the real options available to the company;
however a disappointing number of candidates did not refer to the scenario of the question.

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14 Hawke Appliances Ltd (September 2014)

Marking guide
Marks
14.1 (a) New machine 1

Tax relief 2 16
Old machine 0.5 16
Tax due 1 16
Sales, materials, unskilled labour, lost contribution 5.5 16
Tax on extra profits 1 16
Working capital 2 16
Discount factor 0.5 16
NPV 0.5 16
Advise to proceed as NPV is positive 1 16
State market research fee is not a relevant cash flow as it is sunk 1 16
16
(b) Sensitivity of sales price 3
Sensitivity of sales volume 4 7
7
14.2 Asset value 1
P/E with current earnings 1
P/E with one year of growth 1
Future cash flows/earnings 2
Dividend valuation 1
Reasons why acquisitions do not benefit bidding firm 4
Compare cash and shares 4
Max 12
35
14.1 (a)
Y0 Y1 Y2 Y3
£'000 £'000 £'000 £'000
New machine (4,500.000) 1,000.000
Tax relief (W1) 137.700 112.914 92.589 251.797
Old machine 220.000
Tax due (W2) (23.800)
Sales (W3) 8,060.000 15,926.560 7,845.926
Materials (W4) (2,756.000) (5,445.856) (2,682.801)
Unskilled labour (W5) (1,456.000) (2,877.056) (1,417.329)
Lost contribution (W6) (2,288.000) (4,521.088) (2,227.231)
Tax on extra profits (W7) (265.200) (524.035) (258.156)
Working capital (W8) (806.000) (786.656) 808.063 784.593
Total cash flows (4,972.1) 621.058 3,459.177 3,296.799
12% discount factor 1.000 0.893 0.797 0.712
PV (4,972.1) 554.605 2,756.964 2,347.321
NPV 686.790
The NPV is positive and so the investment should go ahead as it will enhance
shareholder wealth.
The market research fee is not a relevant cash flow as it is sunk/committed (candidates
needed to state this to get the mark and not just ignore).

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(1)
£'000 £'000 £'000 £'000
Cost/WDV 4,500.000 3,690.000 3,025.800 2,481.156
WDA @ 18%/Bal. allowance (810.000) (664.200) (544.644) (1,481.156)
WDV/sale 3,690.000 3,025.800 2,481.156 1,000.000
Tax on WDA @ 17% 137.700 112.914 92.589 251.797

(2)
WDV b/f 80.000
Balancing charge 140.000
Sale proceeds 220.000
Tax due on bal. charge @ 17% (23.800)
(3)
Sales units 50,000 95,000 45,000
Selling price/unit £155  1.04 £155  1.042 £155  1.043
Sales 8,060.000 15,926.560 7,845.926
(4)
Sales units 50,000 95,000 45,000
Material cost/unit £53  1.04 £53  1.042 £53  1.043
Materials 2,756.000 5,445.856 2,682.801
(5)
Sales units 50,000 95,000 45,000
Unskilled cost/unit £28  1.04 £28  1.042 £28  1.043
Unskilled costs 1,456.000 2,877.056 1,417.329
(6)
Sales units 50,000 95,000 45,000
Lost contribution/unit ([£96 – £74]  2) £44  1.04 £44  1.042 £44  1.043
Variable costs 2,288.000 4,521.088 2,227.231
(7)
Extra profit (sales less materials, 1,560.000 3,082.560 1,518.565
unskilled labour, lost contribution)
Tax at 17% 265.200 524.035 258.156
(8)
Sales 8,060.000 15,926.560 7,845.926
Sales increment 8,060.000 7,866.560 (8,080.634)
Working capital at 10% (806.000) (786.656) 808.063 784.593
(b)
Sales 8,060.000 15,926.560 7,845.926
Discount rate at 12%  0.893  0.797  0.712
PV of sales 7,197.580 12,693.468 5,586.299
Total PV of sales 25,477.347
less: Tax at 17% (4,331.149)
21,146.198
Sensitivity of sales price 686.79

21,146.198
= 3.25%

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Sensitivity of sales volume

Contribution (£30  50  1.04) £1,560.000
Contribution (£30  95  1.04  1.04) £3,082.560
Contribution (£30  45  1.04  1.04  1.04) £1,518.565
Discount rate at 12%  0.893  0.797  0.712
PV of contribution 1,393.080 2,456.800 1,081.218
Total PV of contribution 4,931.098
less: Tax at 17% (838.287)
4,092.811
Sensitivity of sales volume 686.79
4,092.811
= 16.8%
14.2 (a) Possible values for Durram

Asset value (book value) = £3.6m
P/E – with current earnings – 11  £0.7m = £7.7m
P/E – with one year of growth – 11  (£0.7m  1.05) = £8.1m
Future cash flows/earnings (12% discount rate) for PV of future cash flows
(£0.7m  1.05)/(12% – 5%) = £10.5m
Dividend valuation (no growth) – £0.7m/12% = £5.8m
(b) Reasons why acquisitions do not benefit the bidding firm
The price paid is too high and synergies go to the target shareholders.
Lack of fit within the existing group of companies, so cost savings and synergies are not
as great as forecast.
Transaction costs – underwriting, legal fees etc – are expensive and reduce any gains
made.
Talented staff in the target company may leave.
The takeover/merger may be because of management hubris rather than an increase
in shareholder value.
The subsidiary is too small and does not warrant the management time required.
Conglomerate discount may exist, ie, the individual parts of the business are worth
more than the group as a whole.
(c) Is it better to pay with cash or shares?
Paying in cash
This is more attractive to the target shareholders as the value is certain, but there may
be personal tax implications.
This may cause liquidity problems for the bidding firm and so it may be necessary to
increase its gearing.
Lower transaction costs will arise with a cash purchase.
Paying with shares
There will be a dilution of ownership and any gains made will now be shared with the
target shareholders.
This question had the highest average mark on the paper. Candidate performance was very
good.

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This was a four-part question that tested the candidates' understanding of the investment
decisions and valuation element of the syllabus.
In the scenario a UK manufacturer of household appliances was planning (1) the development of
a new product and (2) the possible purchase of an electrical goods retailer. Part 14.1(a) for 16
marks required candidates to advise the company's board, based on an NPV calculation,
whether the proposed product manufacture should proceed. Candidates were required to deal
with relevant cash flows, tax allowances and costs, inflation and working capital. In part 14.1(b))
for seven marks they had to calculate the sensitivity of their calculations to changes in the
proposed selling price and estimated sales volumes. Part 14.2 was worth 12 marks and required
candidates to calculate a range of values for the target retailer and then provide guidance for
the board on the inherent dangers of buying another company and the best method with which
to pay for it, ie, cash or shares.
In part 14.1(a) most candidates scored well. The main weakness evident was the opportunity
cost calculation, which was either completely ignored (by the weakest candidates) or halved
instead of doubling the lost volume. Also many candidates included calculations regarding
skilled labour, which was not a relevant cost. A number of candidates failed to calculate the
balancing charge arising on the sale of the old machinery.
Part 14.1(b) was generally done well, but a disappointing number of candidates used
contribution rather than sales revenue in their first set of sensitivity calculations.
In part 14.2 candidates coped well, as expected, with the book value and P/E methods of
valuation, but many were unsure of themselves (as in previous papers) when valuing the
company based on discounted cash flows. A high proportion of candidates struggled with the
reasons for the failure of acquisitions, but in general the cohort was stronger when explaining
the implications of buying in cash or shares.
15 Alliance plc (December 2015)

Marking guide
Marks
15.1 Calculation of net present value:

Contribution per unit 1
Annual sales units 1
Total contribution per year, Year 1 to Year 4 2
Fixed costs 1
Annual rent 1
Machinery and equipment 1
Tax 1
Tax saved on capital allowances 2
Working capital flows 3
Use of correct discount rate 1
NPV and conclusion 2
16
15.2 Correct contribution figure, after tax 2
Calculation of NPV 1
Correct sensitivity 0.5
Conclusion 1.5
max 4

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Marks
15.3 Disadvantages of sensitivity analysis – 1 mark per point 3
Advantages of simulation as a technique – 1 mark per point 3
6
15.4 (a) Explanation of hard capital rationing 1
Explanation of soft capital rationing 2
Form that is being adopted by Alliance 1
Use of evidence from the scenario 1
5
(b) Allocation to combination that yields the highest NPV 1
Determination of best combination 2
Conclusion 1
4
35
15.1
0 1 2 3 4
£m £m £m £m £m
Contribution 34.56 41.73 39.44 37.27
Fixed costs (4.00) (4.12) (4.24) (4.37)

Annual Rent (1.50) (1.50) (1.50) (1.50)
Operating cash flows (1.50) 29.06 36.11 33.70 32.90
Tax 17% 0.26 (4.94) (6.14) (5.73) (5.59)
Machinery and equipment (60.00) 5.00

Tax saved on CA's 1.84 1.51 1.23 1.01 3.76
Working capital (2.00) (0.42) 0.13 0.13 2.16
Net cash flows (61.40) 25.21 31.33 29.11 38.23
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value (61.40) 22.92 25.88 21.86 26.11
NPV 35.37
The project has a positive NPV, and therefore Alliance should accept it.
The contribution per unit = £800  0.40 = £320.
The annual sales in units in year one = 9,000  12 = 108,000 units.
The total contribution per year =
Year 1: 108,000  £320 = £34.56m
Year 2: £34.56m  1.15  1.05 = £41.73m
Year 3: £41.73m  0.90  1.05 = £39.44m
Year 4: £39.44m  0.90  1.05 = £37.27m
Working capital:
Year 1: 2.00  1.15  1.05 = £2.42m. Increment 2.00 – 2.42 = £(0.42)m
Year 2: 2.42  0.90  1.05 = £2.29m. Increment 2.42 – 2.29 = £0.13m
Year 3: 2.29  0.90  1.05 = £2.16m. Increment 2.29 – 2.16 = £0.13m
Year 4: Release of working capital £2.16m.

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Capital allowances and the tax saved:

Cost/WDV CA Tax
0 60.00 10.80 1.84
1 49.20 8.86 1.51
2 40.34 7.26 1.23
3 33.08 5.95 1.01
4 27.13
Sale –5.00 22.13 3.76
Nominal cost of capital: (1.07  1.03) – 1 = 0.1021. 10.21% or 10%
15.2
Contribution X (1 – 0.17) 28.68 34.64 32.74 30.93
PV factors at 10% 0.909 0.826 0.751 0.683
Present Value 26.07 28.61 24.59 21.13
Total present value £100.40
Sensitivity: £35.37m/£100.40m = 35.2%
A 35.2% fall in sales would result in a zero NPV.
Alliance should consider its estimates of future sales, and decide whether it is likely that
there will be a 35.2% drop. This is especially pertinent when there are similar products on
the market, and Alliance's market share may be eroded to a greater extent than predicted.
15.3 The disadvantages of sensitivity analysis are as follows:
 It assumes that changes to variables can be made independently.
 It ignores probability. It identifies how far a variable needs to change to result in a zero
NPV, but it does not look at the probability of such a change.
 It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to addressing the weaknesses of sensitivity analysis.
The main advantage is that it allows the effect of more than one variable changing at the
same time to be assessed. This gives more information about the possible outcomes and
their relative probabilities.
It is also useful for problems that cannot be solved analytically.
However it should be noted that simulation also is not an optimising technique, and does
not point directly to a correct decision.
15.4 (a) There are two types of capital rationing:
Hard rationing is where the external capital markets limit the supply of funds.
Soft rationing is where the firm imposes its own internal constraints on the amount of
funds to be raised and invested in projects.
This investment limit may be used as a surrogate for other constraints, such as
insufficient managerial capacity to handle all positive NPV projects.
Soft rationing may also arise where it is impractical for the firm to go the market and
raise a small amount of finance.
Alliance's chairman has stated that: "We will continue to see excellent opportunities to
invest in profitable projects across our business and we have no difficulty in raising
finance. However we will be disciplined in our approach to committing to capital
expenditure". The board of Alliance has chosen to limit the capital expenditure budget
(excluding Autowater) to £350 million. It is therefore apparent that Alliance is
employing soft capital rationing.

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(b) The £350 million will be allocated to the combination of projects that yields the highest
NPV by trial and error, since they are indivisible.
The possible combinations are:
Projects Initial expenditure NPV
£m £m
A, B, C, D 330 520
A, B, C, E 290 510
B, C, D, E 330 480
A, D, E 340 470
The combination of projects that maximises shareholder wealth is A, B C, D.
This was a four-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario was that a UK company was considering
launching a new product on the market, and also planning additional investment into other
projects.
Part 15.1 was well answered by many candidates; common errors that weaker candidates made
were failing to calculate annual demand from monthly data, inflating cash flows which had already
been inflated because of price increases, deducting contribution from sales, treating WDAs as
outflows rather than inflows, failing to put rent in advance and using real discount rate for money
flows. All easy things, where errors should have been avoided. The hardest part was WC flows (as
expected). Part 15.2 was not well answered by the majority of candidates, with weaker candidates
using sales instead of contribution. Responses to part 15.3 were mixed and often lacked detail or
included irrelevant material (eg, advantages of sensitivity). Part 15.4(a) was well answered by many
students; however weaker candidates thought that hard versus soft capital rationing meant the
difference between indivisible and divisible projects. Part 15.4(b) had very mixed and unclear
answers, with many candidates using NPV/£ invested, which applies to divisible rather than
indivisible projects. The question clearly stated that the projects were indivisible.

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16 Bradford Bedwyn Medical plc (March 2014)

Marking guide
Marks
16.1 (a) Dividend/share 1

Current accounting rate of return 1.5
Proportion of profits retained 1
Growth rate 0.5
ke 1
kd 2
IRR 2
WACC 2
Maximum 10
(b) Market risk premium 1

Cost of equity via CAPM 1
WACC 1
3
16.2 Limitations of Gordon growth model 3
16.3 Ungeared beta 1

Geared beta 1
Cost of equity via CAPM 1
Cost of new debt 1
WACC 2
Explanation 3
9
16.4 Discussion of issues (max 2 for 5
traditional
and M&M)
16.5 Share buy back 5
35
16.1 (a) Cost of equity

Dividend/share for year to 28/2/X4 £1,493/34,600 = £0.0432
Dividend growth rate = g = r  b r = current accounting rate of return

b = proportion of profits retained
Current accounting rate of return = Earnings/Opening Equity Capital Employed
(£4,977/[£65,984 – £3,484]) = r = 8%
Proportion of profits retained Retained profits/Earnings

£3,484/£4,977 b = 70%

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Thus the growth rate (g) = 8%  70% = 5.6%
d1 £0.0432  1.056
ke = +g + 0.056 = 7.5%
MV £2.45
kd = Year Cash Flow 5% PV 10% PV

0 (104.00) 1.000 (104.00) 1.000 (104.00)
1-5 6 4.329 25.97 3.791 22.75
5 100 0.784 78.40 0.621 62.10
0.37 (19.15)
Thus IRR is approx. 5% (fractionally higher). So kd = 5% (1 – 0.17) = 4.15%
WACC
Market value
Equity 34,600  £2.45 84,770 7.5%  84,770/93,714 6.78%

6% debentures £8,600  104/100 8,944 4.15%  8,944/93,714 0.40%
93,714 WACC = 7.18%
(b)
Market risk premium = (8.6% – 2.1%) 6.50%
BBM's beta is equity beta so no adjustment required 0.9
BBM's risk premium = (6.5%  0.9) 5.85%

plus: Risk free rate 2.10%
Cost of equity via CAPM 7.95%
WACC
Market value
Equity 84,770 7.95%  84,770/93,714 7.19%
6% debentures 8,944 4.15%  8,944/93,714 0.40%
93,714 WACC = 7.59%
16.2 The Gordon growth model is a simple model of dividend behaviour. In particular:
The growth rate (g) must be less than the cost of equity (ke). Otherwise the share price will
be infinitely high. To maintain such a high growth rate to perpetuity is impossible.
Companies are likely to experience periods of varying growth rates for which sophisticated
models have been developed.
In addition the model:
 relies on accounting profits
 assumes that b and r are constant
 can be distorted by inflation
 assumes all new finance is from equity or gearing is held constant
16.3
Beta of the new market = 1.90
Ungeared beta of the new market = 1.9  (83/(83 + [17  83%]) 1.62
BBM's geared beta for the new market = 1.62  ([84.770 + (8.944  83%)]/84.770) 1.76
BBM's cost of equity:

BBM's risk premium = (6.5%  1.76) 11.44%
plus: Risk free rate 2.10%
Cost of equity via CAPM 13.54%
Cost of new debt (8%  83%) 6.64%

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WACC
Market value
Equity £84,770 13.54%  84,770/93,714 12.25%
6% debentures £8,944 6.64%  8,944/93,714 0.63%
£93,714 WACC = 12.88%
BBM's current WACC figure (part 16.1 above) is 7.18% – 7.59%, depending on the method
of calculation. It would be unwise to use this figure (approx. 7%) when appraising the
diversification.
This is because the company will be working in a new market and its systematic risk (a key
tenet of the CAPM) will change. This new market has a beta of 1.9, whereas BBM currently
uses a beta of 0.9.
Were BBM to underestimate its WACC figure it would overestimate the NPV of the planned
diversification. The cost of new debt is higher.
฀
16.4 Gearing and systematic business risk have both changed. To get WACC one needs the MV
of equity which includes the NPV of the project. To get NPV one needs WACC. So it's a
circular argument. One could use APV to overcome this.
BBM cannot use the cost of the new debt after tax as the required return of the
shareholders would be ignored. Neither can it use its risk adjusted cost of equity (as this
ignores debt finance raised).
It cannot use the risk adjusted WACC figure from part 16.3 because BBM's gearing level will
have changed (it's an all-debt issue) – the WACC to be used then depends on the reaction
to the increased gearing (U-shaped under traditional and M&M 1963 with market
imperfections). If however there was a subsequent issue of equity planned which would
re-establish the current gearing level, then the risk adjusted WACC from 16.3 could be used.
฀
16.5 Normally a share buy-back returns money to shareholders and enables a company to use
surplus cash when there are no investment opportunities with a positive NPV available. It
does not appear to be the case here as the company is issuing debt.
If BBM made a large dividend payment then this would be contrary to company dividend
policy. It might have an adverse effect on the company's share price – uncertainty created if
larger dividend is not maintained in future.
A buy-back would reduce the number of shares in the market and this will mean that BBM's
earnings per share and market value per share may increase depending on the reaction to
the change in gearing – see below.
A buy-back could change control eg, remove the influence of an unwelcome shareholder
by buying their shares.
A share buy-back would increase BBM's gearing, which might, if BBM is below its optimal
level of gearing, lead to an increase in BBM's share price via a reduced WACC.
A buy-back gives a capital gain subject to CGT rather than a dividend subject to income tax.
This question had the second highest average mark on the paper. Candidate performance was
very variable.
It was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus.
In the scenario a medical equipment manufacturer was planning to raise additional funding to
support a diversification into a new market. Part 16.1 for 13 marks required candidates to
calculate the company's current weighted average cost of capital (WACC) figure using (a) the

lOMoARcPSD|5019904
Gordon growth model and (b) CAPM. Part 16.2 for three marks asked them to explain the
limitations of the Gordon growth model. In part 16.3 (nine marks), they were required to re-
calculate and explain the WACC figure that should be used when appraising the company's
diversification plans. The assumption in this scenario was that the funding raised would be in the
same debt: equity ratio as currently exists. Part 16.4 for five marks asked candidates to discuss
how the company would determine its WACC figure if the funding raised would all be in the
form of debentures. In part 16.5 (five marks) candidates had to explain the implications of using
the funds raised for a share buy-back rather than a diversification.
In part 16.1(a) many candidates did well, as expected, but a disappointing number of them were
unable to calculate the dividend growth rate (g = b  r) and a lot of candidates used
(erroneously) the cum-interest value of the debentures when calculating the cost of debt,
despite there being numerous examples of these calculations in the study materials.
In part 16.1(b), when calculating WACC using CAPM, many candidates correctly established the
cost of equity, but then failed to calculate a WACC subsequently.
Few candidates knew the limitations of the Gordon model for part 16.2. This was straightforward
and a better understanding was expected.
In part 16.3, many candidates were able to correctly de-gear and re-gear the beta figure as
required, but too many used book values when re-gearing (incorrect). Also a vast majority of
candidates only did calculations in this part despite the explicit requirement to explain their
reasoning.
For part 16.4, this has been asked regularly in the past, ie, the issues in determining a WACC,
but it was, overall, done poorly.
In part 16.5 too few candidates recognised that the share buy-back financed by a debt issue
would increase gearing. Many candidates argued that gearing would decrease and,
disappointingly, many confused the buy-back with a rights issue.
17 Penny Rigby Fashions plc (September 2011)

Marking guide
Marks
17.1 Market value of ordinary shares 1

Market value of preference shares 1
Market value of irredeemable debentures 1
Calculation of WACC 1
4
17.2 Ordinary dividends 1.5
Preference dividends 1.5
Debenture interest 1.5
Proof of WACC 0.5
5
17.3 Explanation of hurdle rate 3
Explanation that failure to meet hurdle rate means value 2
declines
max 4
17.4 Earnings per share 1
Price earnings ratio 1
Gearing ratio 1
Calculation of earnings
Profit before interest and tax 0.5

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Marks
Interest 1.5
Corporation tax 1
Preference dividends 1
Ordinary dividend 1
8
17.5 Growth rate should represent future growth 1.5
But commonly use past measures: dividends per share 1.5
Or Gordon growth model 1.5
0% growth means no capital growth 1.5
6
27
17.1
Type of Capital Market Capitalisation
£
Ordinary shares (50p) (£4m/£0.50)  £2 16,000,000
Preference shares (25p) (£0.8m/£0.25)  £0.80 2,560,000
Irredeemable debentures £1.4m  110/100 1,540,000
20,100,000
Ordinary shares 10.50%  £16,000/£20,100 8.358%

Preference shares 8.75%  £2,560/£20,100 1.114%
Irredeemable debentures 4.17%  £1,540/£20,100 0.319%
Weighted Average Cost of Capital 9.791%
17.2
£
Ordinary dividends = £16m  10.5% (or 0.105 = d/2; d = 0.21  8m) 1,680,000
Preference dividends = £2.56m  8.75% (or 0.0875 = d/0.80; d = 0.07  3.2m) 224,000
Debenture interest = £1.54m  4.17% (or 0.0417 = I(1-t)/110; I(1-t) = 4.587  0.014m) 64,218
1,968,218
£1,968,218 / £20,100,000 = 9.792% (difference due to rounding)
17.3 The hurdle rate (WACC) is:
(a) the cost of funds that a company raises and uses, and the return that investors expect
to be paid for putting funds into the company; and therefore is
(b) the minimum return that a company must make on its own investments, to earn the
cash flows out of which investors can be paid their return.
If the company does not achieve this hurdle rate on its investments then it will be investing
in projects that produce a negative net present value and the value of the company (and the
wealth of the shareholders) will decline.
17.4
Earnings (see Workings below) £1,980,000
Ordinary shares in issue 8 million
Earnings per share (£1,980,000/8,000,000) £0.2475
Price earnings ratio £2.00/£0.2475 8.08
Gearing ratio = Fixed Return Capital £2.56m + £1.54m 20.4%

Total Long term Capital £20.1m

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Profit before interest and tax – see Workings below

WORKINGS (working upwards)
£
Profit before interest and tax 2,732,793
Less interest (£1.54m  4.17% / 0.83) (77,371)
Profit before tax 2,655,422
Less corporation Tax (£2,204,000  17/83) (451,422)
Profit after tax 2,204,000
Less preference dividends (£2.56m  8.75%) (224,000)
Earnings 1,980,000
Less ordinary dividends (£16m  10.5%) (1,680,000)
Retained Profits (given) 300,000
17.5 Key points regarding dividend growth:

 It should be future growth – forecasts, strategy, retentions etc – but often use past ie,
past dividends per share or the Gordon growth model.
 0% growth means constant share price with no capital growth. The return is just
dividend yield.
This question had the lowest average mark on this paper and caused problems for a large
number of students.
Most candidates scored full marks in part 17.1, but a surprising minority could not calculate the
number of shares and debentures.
Part 17.2 was poorly done although a minority of candidates did secure full marks. The majority
however were unable to work to an unknown figure which isn't the cost of capital (as this was
given in the question). This was surprising as candidates would have learnt the formulae
required or, in the case of the Dividend Valuation Model, it was given in the formulae sheet. Also
many OT's in the learning materials require candidates to work backwards towards an answer,
as was required here.
In part 17.3 many candidates knew about the desirability and impact of positive NPV's, but could
not explain what a WACC actually is, ie, a required rate of return.
Part 17.4 was in general answered very poorly indeed. Too many candidates treated retained
earnings and earnings as the same figure. A significant minority added ordinary and preference
share prices for the P/E calculation. The majority could not work backwards, up through the
income statement, despite this appearing in the learning materials.
In part 17.5 virtually no-one considered future forecasts. When past dividend growth rates and
the Gordon model were used few candidates noted the assumption that past growth = future
growth. The significance of the company's 0% dividend growth rate was poorly answered. The
question was couched in terms of returns but few candidates spotted that there would be no
capital return on the current share price.

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18 Turners plc (June 2014)

Marking guide
Marks
18.1 (a) Ke 1
Kd 3
Loans 1
WACC 3
8
(b) Retentions rate 2
Shareholders' return 1.5
Growth 0.5
Ke 1
WACC 1
6
18.2 Degearing equity beta 1.5
Regear asset beta 1.5
Ke 1
State discount rate should reflect systematic risk 1
State discount rate should reflect financial risk 1
6
18.3 Weighted average beta of enlarged group 1
Ke 1
WACC of enlarged group 1
Implications 3
Capital structure theory; max 2
6
18.4 Diversification plans 5
EMH max 3
5
18.5 Project appraisal methodology and discount rate 4
35
18.1 (a) The current WACC using CAPM is calculated as follows: Ke = 2 + 0.60 (8 – 2) = 5.6%
Calculation of Kd
The cost of the debentures the cost can be calculated using linear interpolation
5% 1%
T0 (108) 1 (108) 1 (108)
T1–4 6 3.546 21.276 3.902 23.412
T4 100 0.823 82.3 0.961 96.1
(4.424) 11.512
IRR = 1%+ (11.512/11.512 + 4.424)(5 – 1) = 3.89%  (1 – 0.17) = 3.23% after tax

Loans have an after-tax cost of 4(1 – 0.17) = 3.32%

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Market values:
Equity 233m/0.10  276p = £6,431m
Debentures 1,900m  108/100 = £2,052m
Loans £635m
Total market values £9,118m
WACC = (5.6%  6,431 + 3.23%  2,052 + 3.32%  635)/ 9,118 = 4.91%

(b) The current WACC using the Gordon growth model is calculated as follows:
Calculating growth using the formula r  b.
Retentions rate:
Dividends = share price  dividend yield = 276p  4.2% = 11.6p
Dividend payout ratio = dividend/ EPS = 11.6/25 = 46.4% ∴ Retentions = 1 – 0.464 =
0.536 or 53.6%
Shareholders return is calculated as follows:
Profit after tax (PAT) = EPS  number of shares in issue = 25p  233/0.10 = £582.5m
Return = PAT/opg shareholders funds = 582.5/(5,263 – (2,330  £0.134*)) = 11.77%
*EPS – Dividend: 25p – 11.6p = 13.4p
Growth = r  b = 0.1177  0.536 = 0.063 or 6.3%
Ke = (Do(1 + g)/Po) + g = (11.6(1 + 0.063)/276) + 0.063 = 10.77%
Kd and market values as in (a)
WACC = (10.77%  6,431 + 3.23%  2,052 + 3.32%  635)/9,118 = 8.55%
18.2 The cost of equity should be adjusted to reflect the systematic risk of the new project. The
beta factor for the holiday travel industry should be adjusted for gearing. Degearing the
equity beta, ßa = 1.40/(1 + (3(1 – 0.17)/5) = 0.93
Gear up the asset beta to reflect Turners' gearing:
ße = 0.93  (1 + (2,687(1 – 0.17)/6,431) = 1.25
The Ke should be = 2 + 1.25 (8 – 2) = 9.5%
With regard to the WACC to be used for the project students should state that the discount
rate should reflect the systematic risk of the project and the financial risk of the company.
18.3 If the diversification goes ahead the cost of equity will reflect the systematic risk of both
divisions.
The weighted average beta of the enlarged group = 1.26  0.10 + 0.6  0.90 = 0.666
Ke = 2 + 0.666(8 – 2) = 6.00%
The WACC of the enlarged group will be:
(6%  6,431 + 3.23%  2,052 + 3.32%  635)/9,118 = 5.19%
The implications of a permanent change in the company's WACC from 4.91% to 5.19% are
less clear. An increase in the WACC is usually associated with reductions in value, on the
other hand assuming that the new project has a positive net present value this could result
in an increase in the market capitalisation.
18.4 The diversification plans may not be welcomed by the market. Portfolio theory tells us that
rational shareholders would hold a well-diversified portfolio and that they might not
welcome the company diversifying. Conglomerate companies often trade at a discount.

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18.5 Students should mention that if the gearing changes dramatically then it is not suitable to
use WACC/NPV to appraise the project. Instead APV should be used.
The discount rate will be that of an all equity company using the ßa of 0.93 to reflect the
systematic risk. The discount rate will be = 2 + 0.93(8 – 2) = 7.58%.
This will be used to calculate the base case NPV. This will then be adjusted for the benefits
and costs of the actual way that the project has been financed.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying its activities. The diversification was to be financed in such a way that the gearing of
the company remained unchanged. Part 18.1 of the question required candidates to calculate
the current WACC of the company using CAPM and also the Gordon growth model. Part 18.2 of
the question required candidates to calculate, using CAPM, the cost of equity to be included in
the WACC that should have been used to appraise the new project. Part 18.3 of the question
required candidates to calculate the overall WACC of the company after the diversification. Part
18.4 of the question required candidates to discuss whether the company should diversify its
operations. Part 18.5 of the question required candidates to discuss how the project should have
been appraised assuming that there was a major change in financial gearing of the company.
Also candidates were required to calculate a discount rate that should have been used in these
circumstances.
Part 18.1 (a) was designed to give a basic eight marks to build on and was set at a textbook level
with no tricks or complications. However, weaker candidates lost many of these marks by:
completely ignoring the cost of a bank loan (two marks) or not deducting tax (one mark);
incorrect calculation of the cost of the redeemable debentures, incorrect interpolation
calculations, incorrect coupon and timing (three marks), correct interpolation but no tax
adjustment (one mark); incorrect equity beta or correct beta but error in computation (one mark).
Part 18.1 (b) was a discriminator as expected, however many candidates demonstrated poor
knowledge of what a dividend yield is, many students multiplying earnings by the dividend yield.
In part 18.2, again many basic errors were made: eg, degearing using market values but
regearing using book values, even though the formulae sheet states market values on the key to
the formulae and despite the examiner's comments regarding March 2014, omitting tax
completely from the computations and poor mathematical ability using beta equations. Also no
explanation of what candidates were doing threw away two marks in this part.
Part 18.3 was well answered by many candidates. However in the discursive part of their answers
some candidates mainly discussed capital structure theory.
Part 18.4 had very mixed responses but flexible marking allowed candidates to pick up two to
three marks.
In part 18.5, most candidates mentioned APV but many did not calculate the discount rate
needed.

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19 Middleham plc (Sample paper)

Marking guide
Marks
19.1 Earnings in 20W8 1
Dividend in 20W8 1
Dividend growth rate 1
Dividend per share in 20X2 1
Current ex-dividend share value 1
Cost of equity 1
Cost of preference shares 1
Cost of debentures – two present values calculated 2
Cost of debentures – IRR calculation 1
WACC calculation 3
13
19.3 Ungear industry beta 2

Regear using Middleham's data 2
CAPM calculation 1
1 mark per assumption 3
max 7
19.5 Forms of efficiency (1.5 marks for each) 4.5

Stock exchange regarded as semi-strong form efficient 1
Market reacts to press announcement if semi-strong form 1.5
Market does not react to press announcement if strong form 1.5
max 5
35
19.1 Cost of equity capital:

Earnings in 20W9 = £0.35  6,400,000 = £2,240,000
Dividends in 20W9 = £2,240,000  40% = £896,000
4
Dividend growth rate: 896,000  (1 + g) = £1,088,000
4
(1 + g) = 1,088,000/896,000 = 1.2143
4
1+g = 1.2143 = 1.0497
g = 5%
Dividend per share in 20X3 (d0) = £1,088,000/6,400,000 = 17p
Current ex-dividend share value = £1.42 – £0.17 = 125p
Using the dividend growth model: ke = d0 (1 + g)/p0 + g
= 17(1.05)/125 + 5%
= 19.3%
Cost of preference share capital: = 2.5p/20p
= 12.5%
Cost of debentures:
Cash 10% Cash 1%
Year Flow df PV Flow df PV
0 (105) 1.000 (105.00) (105) 1.000 (105.00)
1–10 7 6.145 43.02 7 9.471 66.30
10 100 0.386 38.60 100 0.905 90.50
NPV (23.38) NPV 51.80

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IRR = 1% + 51.8/75.18  9 = 7.20%
Post-tax = 7.20  (1 – 0.17) = 5.98%

Weighted Average Cost of Capital:
Total market
Cost value (£'000) WACC
Equity 19.3% 8,000 15.2
Preference shares 12.5% 560 0.7
Debentures 5.98% 1,575 0.9
10,135 16.8
Thus the Weighted Average Cost of Capital = 16.8%

19.2 If this weighted average cost of capital of 16.8% is used in the appraisal of the proposed
investment then the following assumptions must be recognised and if these assumptions
do not hold then the WACC figure has serious limitations if used as a discount factor:
 Historical proportions of debt and equity are to remain unchanged.
 Business risk is to remain unchanged.
 The finance raised is not project specific.
 The project is small in size relative to the size of the company.
Other factors are as follows:
 Is the dividend growth rate sustainable given the lack of track record?
 There could be other sources of finance that have not been considered.
 Future tax rate changes will affect the cost of debt and so the WACC.
 Will the redeemable debentures be replaced by similar funds in 10 years?
19.3 (a) Ungear the equity beta of the industry
1.3= ßa(1 + (1(1 – 0.17)/1))
ßa=0.7104
regear using Middleham's gearing from part 19.1 (prefs are treated as debt)
ße=0.7104(1 + (2,135(1 – 0.17)/8,000))
ße=0.868
Cost of equity capital = Rf + ß(Rm – Rf) = 6 + 0.868 (14 – 6) = 12.94%
(b) Key assumptions comprise:
(1) The objective of the company is to maximise the wealth of shareholders.
(2) All shareholders hold the market portfolio (they are fully diversified).
(3) Shareholders are the only participants in the firm.
19.4 The increased risk created by issuing more debentures is a financial or gearing risk. The
traditional view of gearing is that at low levels of gearing a company's WACC will decrease
(because debt is cheaper than equity) – this will cause the value of the company to rise.
However, as gearing becomes a greater proportion of total long term funds, the cost of
debt will start to increase and WACC will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company's WACC, and therefore value, is
not affected by the level of gearing other than through the effects of tax relief and that this
leads to a fall in WACC and a corresponding increase in the value of the company.
However, at very high levels of gearing bankruptcy costs, tax exhaustion and agency costs
can all cause the cost of debt to increase and, as with the traditional theory, the WACC will
start to rise and the value of the company fall.

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19.5 The are three levels of market efficiency:

 Weak form – Share prices reflect information about past price movements and future
price movements cannot be predicted from past movements (Chartism/technical
analysis).
 Semi-strong form – Share prices incorporate all publicly available information rapidly
and accurately. The market cannot be beaten by analysing publicly available
information.
 Strong-form – Share prices reflect all information whether published or not. Insider
dealing has no value.
The London Stock Exchange is generally regarded as at least semi-strong efficient.
If the stock market is semi-strong efficient then Middleham's share price should rise (+NPV
project) or fall (–NPV) when the project is announced to the market eg, in the newspaper,
press release.
If the stock market is Strong-form efficient then Middleham's share price should remain
unaltered as the +NPV or –NPV will already be reflected in the share price ie, as soon as the
decision is made (unlikely).
A generally very well answered question which was the second highest scoring question on the
paper.
A very common error on this relatively straightforward cost of capital question was a failure to
follow the instructions in the question – many candidates chose to use the Gordon growth model
rather than the dividend growth model – an easy way to lose marks. Other common errors were
an inability to accurately calculate the dividend growth rate from the data provided, errors in
calculating market values in the final WACC calculation and in calculating the cost of debt a
number of candidates betrayed basic misunderstanding by firstly applying one discount rate
that produced a negative NPV and then choosing a larger rather than smaller discount rate for
their second choice.
Parts 19.2 to 19.5 were generally well answered.
20 Better Deal plc (March 2010)

Marking guide
Marks
20.1 (a) Dividend growth rate 1
Cost of equity 1
IRR 3
Market value of equity 1
Market value of debt 1
WACC 1
(b) Cost of equity 1

WACC 1
10

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Marks
20.2 New market ungeared beta 2
Better Deal's geared beta 2
Cost of equity 1
Cost of debt 1
WACC 1
Reasoning for approach – 1 mark per point max 4
11
20.3 1–2 marks per relevant point max 8
20.4 Key theories regarding dividend policy 3

Additional comments max 3
Relating theory to the scenario max 3
max 6
35
20.1 (a)
Dividend per share 20Y0 (29.5m/165m) = 17.9 pence
Dividend growth rate = 4

29.5 / 25.2 – 1 = 4% p.a.
d1 (£0.179  1.04)
Cost of equity = +g + 4% = 11%
MV £2.65
Cost of debt
Year Cash Flow 5% factor PV 10% factor PV
0 (98.00) 1.000 (98.00) 1.000 (98.00)
1–4 8.00 3.546 28.37 3.170 25.36
4 100.00 0.823 82.30 0.683 68.30
NPV 12.67 NPV (4.34)
IRR = 5% + (12.67/(12.67 + 4.34))  (10% – 5%) = 8.72%

Post-tax = 8.72  (1 – 0.17) = 7.24%
WACC
£m
Total market value of equity = (£82.5m/£0.50)  £2.65 = 437.250
Total market value of debt = £340m  98/100 = 333.200
Total market value 770.450
WACC = (11%  437.250/770.450) + (7.24%  333.200/770.450) = 9.37%

(b)
Cost of equity = (1.1  (11.4% – 5.2%)) + 5.2% = 12.02%
Cost of debt (as above) 7.24%
WACC = (12.02%  437.250/770.450) + (7.24%  333.200/770.450) = 9.95%
20.2
New market geared beta = 1.5
1.5  64 1.5  64
New market ungeared beta = = = 1.07
(64 + (31 83%)) 89.73
1.07  (£437.25m + (£333.2m  83%))

Better Deal's geared beta = = 1.75
£437.25m

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So, cost of equity = (1.75  (11.4% – 5.2%)) + 5.2% = 16.05%

Cost of debt = 9%  83% = 7.47%
WACC = (16.05%  £437.25m/£770.45m) + (7.47%  £333.2m/£770.45m) = 12.33%
It would be unwise to use the existing WACC (9.37%) as Better Deal's plan involves
diversification and therefore a change in the level of systematic risk. Thus a new WACC
must be calculated. Systematic risk is accounted for by taking into account the beta of the
petroleum market and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then 're-geared' by taking into account the level
of gearing of the new funds being raised. Using this, the WACC can be calculated.
20.3 CAPM theory is based on the fact that there is one factor that affects the expected return on
a security (or portfolio) and that is systematic risk. This measure of risk is given by the equity
beta of a security (or portfolio).
Multiple factor models are based on the idea that other factors will also determine the
return as there are other aspects of risk attached to securities, not just the market portfolio.
Arbitrage pricing theory states that there are many factors, but it does not state what these
factors are.
Some models have been developed which actually state factors, such as the French and
Fama model, which stated that the size of the company (size) and the difference between
book and market values of the shares (value) would also influence the level of returns.
Since their original model, the momentum has been added as a fourth factor which shows
the difference in returns between shares that are increasing in value and those that are
decreasing in value.
Multiple factor models have been designed to get around the problem caused by the
simplicity of the CAPM, but they are complex to understand and the factors are difficult to
identify and quantify.
20.4 Key theories regarding dividend policy:
(1) Traditional view
(2) Modigliani and Miller theory
(3) Residual theory
The key points of these should be expanded to attract a good mark.
Additional areas for comment:
(1) Dividend signalling
(2) Clientele effect
(3) Pecking order
Candidates will also have been given credit for covering these topics.
Credit would also be given for (1) relating, where possible, dividend theory to the Better
Deal scenario and (2) producing a cohesive answer.
Most candidates scored well on this question and it had the highest average mark in the paper.
It was based on a supermarket operation and covered the topics of cost of capital and dividend
policy. Part 20.1 was worth 10 marks and required candidates to calculate the company's WACC
based on (a) the dividend growth model and then (b) the CAPM model.

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Part 20.2 was worth 11 marks and tested the candidates' understanding of geared and
ungeared betas and required them to calculate the relevant cost of capital for the company to
use if it diversified its operations into a new product range. Part 20.4 made up six marks and
candidates had to explain the relationship between a company's dividend policy and the value
of its shares.
Part 20.1(a) was pretty straightforward and candidates generally did well. However, a number of
them were unable to calculate the rate of dividend growth correctly and a disappointing number
of candidates calculated the cost of redeemable debentures as if they were irredeemable.
As expected, most candidates scored full marks for the calculation in part 20.1(b).
Part 20.2 was more difficult, but many candidates scored well here. However, key errors made
were (1) book values rather than market values were used when re-gearing beta and (2) too few
candidates calculated the new WACC figure as required.
Part 20.4 was done well and candidates who produced a well-rounded answer will have scored
high marks.
21 Puerto plc (December 2013)

Marking guide
Marks
21.1 Operating profit 1

Interest 1
Taxation 1
3
21.2 Market capitalisation 0.5
Market value of debt 0.5
Gearing 30 November 0.5
No. of shares issued to SMC 0.5
Total no. of shares in issue 0.5
Market capitalisation of new share price 1
Market value of debt 1
Gearing 1 December 0.5
5
21.3 Relevant discussion 9
max 5
21.4 Cost of equity 1
Cost of debt 1
WACC at 30 November 1
Degear the equity beta 2
Regear the asset beta 2
Cost of equity 1
Cost of debt 1
WACC after 1 December 1
10
max 6
max 6
35

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21.1 Income statement for the year to 30 November 20X4

£'000
Operating profit (2,280 + 3,000) 5,280
Interest (24,000  6% + 6,000  7%) (1,860)
Taxation @ 17% (581)
21.2 Gearing (debt/equity) by market values at 30 November 20X3:

Market capitalisation: 492 million  10p = £49.2 million
Market value of debt: £68 million + £6 million = £74 million
Gearing 74/49.2 = 150%
Gearing (debt/equity) by market values after the restructuring on 1 December 20X3:
Number of shares in issue:
Issued to SMC (£68/4)  30 = 510 million.
Total number of shares in issue = 492 + 510 = 1,002 million.
Market capitalisation at the new share price (10p  1.35 = 13.5p): 1,002  13.5p =
£135.27 million.
Market value of debt: Secured bank loans £6 million + Risky Bank £24 million = £30 million.
Gearing 30/135.27 = 22.18%
21.3 Profitability: Puerto has been loss making and the purchase of the additional vehicle leasing
business will make the business profitable.
Financial risk: The interest cover of Puerto before the restructuring is less than one. This
increases to 5,280/1,860 = 2.8 after the restructuring which appears to be reasonable and
should give the markets and stakeholders some comfort.
The 150% gearing of Puerto at 30 November is far in excess of the industry average of 25%
which means that the company is in serious risk of bankruptcy. This improves to 22% after
the restructuring which is below the industry average and should give the markets and
stakeholders confidence. However this is only the case if the share price does increase to
13.5p. Puerto may be in danger of breaching SMC's covenant if the share price does not
reach 13.5p. If the share price remains at 10p the gearing will be:
Market capitalisation: 1,002  10p = £100.2 million
Debt £30 million
Gearing 30/100.2 = 30%
A gearing ratio of 30% breaches the Risky Bank plc covenant and, depending on the action
taken by Risky Bank plc, could cause problems for Puerto. Any other sensible comment will
be awarded marks.
21.4 The WACC of Puerto at 30 November 20X3:
Ke = 2.8 + 2.13  5 = 13.45%
Kd = 7% (non-convertible loans) and
3% (convertible loans)
Note: Since Puerto is not paying tax at this date no adjustment for tax is necessary.
WACC using the weightings previously calculated:
(13.45%  49.2 + 7%  6 + 3%  68)/(49.2 + 74) = 7.37%
The WACC of Puerto at 1 December 20X3 immediately after the restructuring:
Ke. Since the financial risk of Puerto has changed the equity beta will have to be adjusted to
the new gearing level:
Degear the equity beta (Note: No tax adjustment is necessary since Puerto is not paying tax
prior to the restructuring): ßa = 2.13/(1 + (74/49.2)) = 0.8506

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Regear the asset beta to calculate Puerto's new equity beta (Note: Puerto is now paying tax
and tax adjustments are therefore necessary): ße = 0.8506 (1 + (30(1 – 0.17)/135.27)) =
1.007
Ke = 2.8 + (1.007  5) = 7.835%
Kd (1-tax) (Note: Puerto is now paying tax): 7%(1 – 0.17) = 5.81% and 6%(1 – 0.17) = 4.98%
WACC = (7.835%  135.27 + 5.81%  6 + 4.98%  24)/(135.27 + 24 + 6) = 7.35%
21.5 Prior to the restructuring Puerto had a very high level of gearing at 150% compared to the
industry average of 25%. Consequently the cost of equity reflected this extreme level of
financial risk.
The traditional view of gearing is that at lower levels of gearing a company's WACC will
decrease – this will cause the value of the company to rise. However, as gearing becomes a
greater proportion of total long term funds, the cost of debt will start to increase and WACC
will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company's WACC and therefore value is
not affected by the level of gearing other than through the effects of tax relief and that this
leads to a fall in WACC and a corresponding increase in the value of the company.
However, at Puerto's very high level of gearing bankruptcy costs, tax exhaustion and agency
costs can all cause the cost of debt to increase and, as with the traditional theory, the WACC
will start to rise and the value of the company fall.
Now Puerto has a more normal level of gearing at 22% the WACC should now remain
around 7.35%. Any other sensible comment will be awarded marks.
21.6 Prior to the restructuring Puerto is very highly geared at 150% and is also not profitable. The
various stakeholders' reaction to the restructuring is likely to be:
 Shareholders: Shareholders have limited liability and may be tempted to take risks.
However in this case the shareholders have not received dividends since 2008 and the
share price has only recently risen. This may be because the industry has stabilised but
also may be in anticipation of a restructuring. Shareholders are likely to welcome the
restructuring since there is a very real possibility of increasing their wealth through
dividend income and capital gains. However the shareholders may be concerned
about the change in control due to the new shares issued to SMC.
 SMC: SMC was in a very vulnerable position before the restructuring since interest
cover was below one and there was a very real possibility of the company being unable
to meet interest payments. Since the loan was unsecured SMC would be uncertain as
to how much it might receive if Puerto was wound up. Converting their loan to equity
means that with the company now profitable there is a very real chance of them
realising their investment.
 Risky Bank plc: Risky Bank plc are secured and since the interest cover is now more
substantial at 2.8 and gearing is below the industry average, assuming a share price of
13.5p, the company is on a sound financial footing. The same comments apply to the
original secured bank loans.
 Employees: Employees should welcome the restructuring since the company now has
a much more certain future and they will feel more confident about keeping their jobs.
 Suppliers: Suppliers will also welcome the restructuring since Puerto will now be more
likely to continue and they will not lose the business that it creates for them.
 Customers: Customers of Puerto will be pleased that the company is now on a sound
financial footing and that it will be able to provide them with services in the future.
 Government: Puerto will now be paying tax.
Any other sensible point will be given marks.

lOMoARcPSD|5019904
The scenario of this question was that a company had been in difficulty and was considering a
reconstruction, whereby debt would be converted to equity. The company would then purchase
an additional business opportunity, which would be financed by new borrowings.
Part 21.1 for three marks required candidates to restate the income statement in 12 months'
time assuming that the reconstruction went ahead. Part 21.2 for five marks required candidates
to calculate the gearing ratio, by market values, both before and immediately after the
reconstruction. Part 21.3 for five marks required candidates to comment upon the financial
health of the company both before and after the reconstruction. Also candidates had to
consider a covenant imposed by the providers of the finance for the new business. Part 21.4 for
10 marks required candidates to calculate, using the CAPM, the WACC of the company both
before and after the reconstruction. This involved adjusting the equity beta for gearing and
consideration of taxation. Part 21.5 for six marks required candidates to consider, with reference
to relevant theories, how the reconstruction would affect the WACC in the long term. Part 21.6
for six marks required candidates to consider the likely reaction to the reconstruction of various
stakeholders in the company.
Part 21.1 was well answered by the majority of candidates. However it was disappointing to see
that some candidates did not really demonstrate a full understanding of the scenario and also
included the interest in the income statement for the loan which had been converted to equity.
The majority of candidates answered part 21.2 well, however some candidates failed to
understand the scenario and showed gearing increasing rather than decreasing, whereas a
correct interpretation of the facts would show a substantial decrease.
Part 21.3 was reasonably well answered, however those who had misinterpreted the question
scored poorly.
In part 21.4, many candidates did not take account of the fact that the company was not paying
tax until after the reconstruction. When taking into account the effect of the change in gearing
on the equity beta, weaker candidates showed that they need to practise gearing adjustments.
In part 21.5, a lot of candidates gave a generic answer and did not relate to the scenario of the
question.
Part 21.6 was well answered and many students identified a sufficient number of stakeholders.
22 Abydos plc
Marking guide
Marks
22.1 Capital allowances/tax saving 2
Base case NPV 3–4
Financing side effects 2–4
Give credit for technique max 10
22.2 Reward sensible discussion

Bonus mark for mention of real options max 6
16

lOMoARcPSD|5019904
22.1 Expected APV

To calculate the base case NPV, the investment cash flows are discounted at the ungeared
cost of equity, assuming the corporate debt is risk free (and has a beta of zero).
E
ßa = e
E +D(1– t)
0.6
= 1.4  = 0.901
0.6 + 0.4(1– 0.17)
The ungeared cost of equity can now be estimated using the CAPM:
Keu = 5 + 0.901(12 – 5)
= 11.31% (say, approximately 11%)
Capital allowances
These are on the £10 million part of the investment that is non-current assets (not working
capital or issue costs).
Capital allowance Tax saving
Year Value at start of year 18% 17%
£'000 £'000 £'000
1 10,000 1,800 306
2 8,200 1,476 251
3 6,724 1,210 206
4 5,514 993 169
Year 0 1 2 3 4
£'000 £'000 £'000 £'000 £'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 17% (510) (578) (646) (731)
Tax savings from capital allowances 306 251 206 169
Investment cost (11,500)
Issue costs
After tax realisable value 4,000
Net cash flows (11,500) 2,796 3,073 3,360 7,738
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (11,500) 2,519 2,495 2,456 5,099
The expected base case net present value is £1,069,000.

Financing side effects
Issue costs
£1 million, because they are treated as a side-effect they are not included in this NPV
calculation.
Present value of tax shield
Debt issued by project = £5m

Annual tax savings on debt interest = £5m  8%  17% = £68,000
PV of tax savings for four years, discounted at the gross cost of debt 8%, is:
£68,000  3.312 = £225,216
 1  1  
  1– 4  = 3.312 
 0.08  1.08  

lOMoARcPSD|5019904
£'000
Adjusted present value
Base case NPV 1,069
Tax relief on debt interest 225
Issue costs (1,000)
294
The adjusted present value is £294,000.

22.2 Validity of the views of the two directors
Sales director
The sales director believes that the net present value method should be used, on the basis
that the NPV of a project will be reflected in an equivalent increase in the company's share
price. However, even if the market is efficient, this is only likely to be true if:
 the financing used does not create a significant change in gearing (finance ratio 
current gearing so gearing may change).
 the project is small relative to the size of the company.
 the project risk is the same as the company's average operating risk (but different line
of business).
Finance director
The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then
adjusted for financing side effects such as issue costs and the tax shield on debt interest.
The main problem with the APV method is the estimation of the various financing side
effects and the discount rates used to appraise them. The ungearing process assumes risk
free debt (5%) which it is not as it costs 8%.
Problems with both viewpoints
Both methods rely on the restrictive assumptions about capital markets which are made in
the capital asset pricing model and in the theories of capital structure. The figures used in
CAPM (risk-free rate, market rate and betas) can be difficult to determine. Business risks are
assumed to be constant.
Neither method attempts to value the possible real options for abandonment or further
investment which may be associated with the project.
23 Biddaford Lundy plc (March 2012)

Marking guide
Marks
23.1 Total funds calculations 1
Total geared funds 1
Gearing calculation 2
One mark per relevant point max 5
9
23.2 Rights issue calculations 2
Theoretical ex-rights price 1
Value of a right per new share 1
4

lOMoARcPSD|5019904
Marks
23.3 Current EPS 1
Current P/E ratio 1
Interest savings 2
New EPS 1
New P/E ratio 1
Reduction in EPS 1
Relevant discussion max 3
10
23.4 Amended EPS 1
Ordinary shares required 1
Number of shares in rights issue 1
Rights issue price 1
Relevant discussion on rights issue success 2
max 6
23.5 1–2 marks per relevant point made 6
35
23.1 Gearing level Par value Market value

£m £m
Ordinary share capital (50p) 67.50 (135m  £2.65) 357.75
7% Preference share capital (£1) 60.00 (60m  £1.44) 86.40
4% redeemable debentures (20X7) 45.00 (45m  0.9) 40.50
Total funds 245.70 484.65
Total geared funds (£m) 105.000 126.90
Gearing % 1 (Gearing/Total Funds) 42.7% 26.2%

Or
Gearing % 2 (Gearing/Equity) 74.6% 35.5%
Traditional view
Loan finance is cheap because (a) it is low risk to lenders and (b) loan interest is tax
deductible. This means that as gearing increases, WACC decreases.
Shareholders and lenders are relatively unconcerned about increased risk at lower levels of
gearing.
As gearing increases, both groups start to be concerned – higher returns are demanded
and so WACC increases.
Thus, WACC decreases (value of equity increases) as gearing is introduced. It reaches a
minimum and then starts to increase again. This is the optimal level of gearing.
Modigliani and Miller (M&M) view
Shareholders immediately become concerned by the existence of any gearing.
Ignoring taxes, the cost of 'cheap' loan finance is precisely offset by the increasing cost of
equity, so WACC remains constant at all levels of gearing. There is no optimal level –
managers should not concern themselves with gearing questions. M&M '58 position Vg =
Vu.
Taking taxation into account, interest is cheap enough to cause WACC to fall despite
increasing cost of equity. This leads to an all-debt-financing conclusion. M&M '63 position
Vg = Vu + DT (Tax shield).

lOMoARcPSD|5019904
Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, investor worries about the costs of the business going into
enforced liquidation ('bankruptcy') become significant and required returns (both equity
and debt) would increase at high levels of gearing.
Conclusion: A business should gear up to a point where the benefits of tax relief are
balanced by potential costs of bankruptcy and interest rate increases – here WACC will be
at a minimum and value of the business at a maximum.
Presumably the directors feel that the current level of gearing is beyond the optimum ie,
where the WACC is minimised and the company's value is maximised (perhaps because as
an engineering company its operational risk is very high and gearing adds additional
financial risk). Alternatively, they are incorrectly looking at the book value gearing ratio, as
the market value ratio doesn't look particularly bad.
23.2
£m
Value of current ordinary shareholding 135m £2.65 357.750
Rights issue (135m/9) (£45m  60%) 15m £1.80 27.000
Theoretical ex-rights values 150m £2.565 384.750
Theoretical ex-rights share price [TERP] (£384.75m/150m) £2.565

Value of a right (£2.565 – £1.800) per new share £0.765
OR per existing share £0.765/9 = £0.085
23.3
Current earnings per share (EPS) £32.4m/135m £0.240
Current P/E ratio £2.65/£0.24 11.04
£m
Current earnings figure 32.400
Savings on debenture interest (£45m  60%  4%  83%) 0.896
Amended earnings figure 33.296
New EPS £33.296m/150m £0.222
New P/E ratio (using TERP) £2.565/£0.222 11.55
The earnings per share figure will fall by 7.5% (from £0.240 to £0.222).
The proposed rights issue will, as the board suggests, cause a dilution of the EPS figure as
the additional shares issued have a greater negative impact than the interest saved from the
debenture redemption. Whilst in theory (TERP) the market price of BL's ordinary shares will
fall, at least initially, it is very difficult to predict what will happen to the market value of the
shares in practice. As gearing is being reduced the market may react favourably (ie, there
would be a share price increase). However, based on market values the gearing level is
currently not high (26.2% or 35.5%), and so the market may react negatively (ie, there would
be a share price decrease) if it considers that insufficient use is being made of the tax
savings that gearing affords.
23.4 Current earnings per share (EPS) £32.4m/135m £0.240
Amended EPS (with a 5% reduction) £0.24  95% £0.228
New earnings figure £33.296m

Thus required total ordinary shares ex-rights £33.296/£0.228 146.035m
New shares to be issued via rights 146.035m – 135.000m 11.035m
Rights issue price per share £27.000m/11.035m £2.45

lOMoARcPSD|5019904
This rights issue price is only £0.20 less than the current market value, ie, a 7.5% discount
and this is likely to be an insufficient inducement for shareholders. As a result the issue
would fail to raise the £27 million of funds required for the debenture redemption.
23.5 Issue costs are a significant part of a rights issue. They have been estimated at around 4%
on £2 million raised but, as many of the costs are fixed, the percentage falls as the sum
raised increases.
Shareholders may react badly to firms who continually make rights issues as they are forced
either to take up their rights or sell them, since doing nothing decreases their wealth. They
may sell their shares in the company, driving down the market price.
Unless large numbers of existing shareholders sell their rights to new shareholders there
should be little impact in terms of control of the business by existing shareholders.
Unlisted companies often find rights issues difficult to use, because shareholders unable to
raise sufficient funds to take up their rights may not have available the alternative of selling
them if the firm's shares are not listed. This is less likely to be a concern for a listed company
like Biddaford Lundy.
This question was, overall, done poorly and produced the weakest set of answers in the
examination.
In general, part 23.1 was not done well. The book value of equity often excluded retained
earnings. When calculating the market value, a majority of candidates included retained
earnings in the equity figure. Very few of them could calculate the gearing ratio correctly – far
too many included preference shares as equity. In the discursive part of the answer, some
candidates made no reference to the theories on capital structure at all and some referred to the
'Modigliani and Miller traditional theory'. Disappointingly, very few candidates made reference
to the ratios that they had calculated (high/low gearing level etc).
Answers to part 23.2 were better and the most common mistake was to confuse the market
value and the book value of debt when calculating the redemption figure.
Part 23.3 was very poorly answered. The vast majority of candidates ignored the reduction in
interest post-redemption. Also far too many candidates restricted their discussion to a
consideration of the impact of the rights issue on the shareholders' wealth. This was not relevant
to the question which was about gearing.
In part 23.4 there were some good attempts, but often candidates' answers just consisted of
identifying a 5% fall in EPS.

lOMoARcPSD|5019904
24 Newspaper articles (September 2010)

Marking guide
Marks
24.1 (a) Impact of the rights issue on company earnings:

Current situation ½
Ex rights 2
Current total earnings ½
New total earnings 1
Add interest saved on redeemed debenture stock 1
New Earnings per share (EPS) ½
Current Earnings per share ½
Decrease in EPS ½
(b) Impact of the rights issue on shareholder wealth:

Current value of shareholding ½
Value of new shareholding ½
Less cost of taking up the rights ½
Current share of earnings ½
New share of earnings ½
9
24.2 (a) Reasons to reduce financial gearing:
One mark per well explained point 2
(b) The impact of a reduction in financial gearing:

One mark per well explained point with reference to the scenario 3
max 5
24.3 (a) One mark per well explained point max 3
(b) One mark per well explained point max 6

24.4 One mark per well explained point max 4
24.5 Current cum interest market price:
Total present value 1½
Cum interest price 1
Factors to consider (market interest rates, tax rate, risk) 1½ 4
24.6 One mark per well explained point max 4
Total 35
24.1 (a) Number of shares to be issued = 285/0.95 = 300m

Number of existing shares = 300m  2 = 600m
Price of existing shares = £0.95/(1 – 0.24) = £1.25
Shares Market value
m £ £m
Current situation 600 1.25 750
Rights issue 300 0.95 285
Ex-rights 900 1.15 1,035

lOMoARcPSD|5019904
£'000
Current total earnings £750m/9.6 78,125
Plus interest saved on redeemed 285m  8%  83% debenture stock 18,924
New total earnings 97,049
New Earnings per Share (EPS) £97,049,000/900m £0.108
Current Earnings per Share £1.25/9.6 (EPS = price / P/E ratio) £0.130
Decrease in EPS 16.9%
(b) £
Current value of shareholding 7,000  £1.25 8,750 ½
Value of new shareholding 7,000  1.5  £1.15 12,075 ½
Less cost of taking up the rights 3,500  £0.95 (3,325) ½
8,750
Current share of earnings 7,000  £0.13 £910 ½
New share of earnings 10,500  £0.108 £1,134 ½

24.2 (a) Reduced gearing will cut the financial risk.
The impact of gearing is that there will be (a) regular interest payments and (b) the
need at some future date to repay the capital sum that has been borrowed.
The implication of the cut in gearing is that it is regarded as too high at the moment by
Bettalot and beyond its optimal level.
(b) As gearing increases or decreases, then financial risk does the same.
The traditional view and M&M (1963) allowing for market imperfections is that the cost
of equity moves in the same direction as the level of gearing.
Thus by repaying some of its outstanding debt, Bettalot will cut its cost of equity
(reduced financial risk/financial distress) and as a result, all else being equal, its share
price will increase.
The M&M (1963) view suggests two opposing effects on the share price from a
reduction in gearing – a fall from a reduction in the tax shield on debt, and a rise from a
reduction in the cost of equity through lower financial risk.
24.3 (a) With the companies in financial distress, there is a real chance that they will default on
interest payments and/or the repayment of sums due on redemption.
If they do default, then where the debentures are secured on assets these assets could
be sold, which would put the companies' futures in doubt.
Thus debenture holders would have far greater influence/control over company policy
than is the norm.
(b) Covenants used by suppliers of debt finance can be divided into five main categories:
Financial covenants
Certain financial limits must not be breached, for example, gearing ratio, interest cover
and net worth of the business.
Restrictions on issuing new debt
These usually prevent the issue of new debt with a superior claim on assets, unless the
existing debt is upgraded to have the same priority, or unless the firm maintains a
minimum prescribed asset backing.
Restrictions on asset rentals, leasing, and sale and leaseback are also often used.

lOMoARcPSD|5019904
Restrictions on dividends
Dividend growth is usually required to be linked to earnings. Repurchase of equity
(effectively a dividend) is also often restricted.
Restrictions on merger activity
Debt covenants may prohibit mergers unless post-merger asset backing of loans is
maintained at a minimum prescribed level.
Restrictions on investment policy
Covenants employed include restrictions on investments in other companies,
restrictions on the disposal of assets, and requirements for the maintenance of assets.
This is usually considered to be the most difficult aspect for creditors to monitor.
Contravention of these agreements may result in the loan becoming immediately
repayable, thus allowing the debenture holders to restrict the size of any losses.
However, in some cases, the debt can be renegotiated.
24.4 In a debt for equity swap lenders are given shares in the company in exchange for the
cancellation of some (or all) of their debt.
The alternative outcome for lenders (ie, if no swap takes place) could be that they lose their
money altogether, as the company concerned in a swap will be suffering liquidity problems.
If the debt equity swap went ahead there would now be more shares in issue.
The gearing level would fall and any tax advantages of gearing would be lost.
These two combined are likely to cause a fall in the share price.
24.5 To calculate the market value, the pre-tax cost of debt needs to be found and used to
discount the pre-tax cashflows.
Pre-tax cost of debt = 5%/(1 – 0.17) = 6.02%
Year Cash flow 6.02% factor PV
£ £
1–3 6.00 2.672* 16.03
3 100 0.839** 83.90
Total Present Value 99.93

3 3
*AF1-3 = 1/0.0602[1 – 1/(1.0602 )] **DF3 = 1/1.0602
The PV of the future cash flows is £99.93, which would be the ex interest price in Year 0.
Thus the cum interest price would be (£99.93 + £6) £105.93.
Other factors to consider: market interest rates, tax rate, risk (linked to any security, amount
of other debt).
24.6 Behavioural finance is seen as an alternative to the efficient markets hypothesis.
It attempts to explain the market implications of the behavioural tendencies behind investor
decisions.
There are a number of observed behavioural effects, which question the validity of the
efficient markets hypothesis (EMH).
These behavioural effects include overconfidence by investors in their own ability, leading
them to ignore warning signs about company performance and for example not sell their
shares when a company makes an announcement about poor financial performance as
would be expected under EMH.

lOMoARcPSD|5019904
A further significant effect occurs where investors ignore the bigger picture and
concentrate on one small area of performance, such as that of one particular share. This is
known as narrow framing.
Another important effect is that of extrapolative expectations, where investors expect rising
prices to keep rising. This effect is thought to contribute to stock market bubbles.
Overall, despite these behavioural tendencies meaning that investors do not necessarily act
rationally in all circumstances, the UK Stock Market can be seen as relatively efficient with
the odd anomaly, rather than not being efficient at all.
In part 24.1, most candidates were able to calculate the theoretical ex-rights price correctly (and
its impact on shareholder wealth), but far too few adjusted the earnings figure to take account of
the interest savings made from the debenture redemption.
Answers to part 24.2 were reasonable, but too many candidates included a lot of theory without
application to the scenario, ie, they considered the impact of an increase in gearing, and not a
reduction as per the question.
The answers to part 24.3 were in general disappointing, and too few candidates were able to
apply their knowledge in a practical setting.
More candidates did well in part 24.4, and were able to demonstrate an understanding of the
workings of a debt for equity swap. Many candidates did not answer part 24.5; of those that did,
most struggled to work backwards from a given market rate of return to a current market price.
25 BBB Sports plc (December 2015)

Marking guide
Marks
25.1 (a) Calculation of WACC using CAPM:
Cost of equity 1
Cost of debt:
Use of ex interest debenture price 1
PV calculation 1
IRR calculation 1
Post-tax cost of debt 1
Ex-div share price 1
Market value of equity 0.5
Market value of debt 0.5
WACC calculation 1
8
25.1 (b) Calculation of WACC using Gordon growth model:
Earnings per share 1
Proportion retained 1
Total earnings 0.5
Calculation of ARR 1.5
Growth rate 0.5
Cost of equity 1
WACC calculation 0.5
6

lOMoARcPSD|5019904
Marks
25.2 Suitable WACC for appraising Climbhigh:
Commentary on use of appropriate equity beta 2
Degearing and regearing calculations 2
New cost of equity 1
Revised WACC 1
6
25.3 Overall WACC of BBB if Climbhigh goes ahead:
Overall equity beta 1
Overall cost of equity 1
Overall WACC 1
Appropriate commentary upon implications 3
6
25.4 Political risk areas – 1 mark per point 4
Ways of limiting the effects of political risk factors 4
max 6
25.5 Ethical considerations – 1 mark per point 3
35
25.1 (a) The current WACC using CAPM.

Ke = 2 + (1.1  (7 – 2)) = 7.5%
Kd = The ex-interest debenture price is £94 (99 – 5).
Timing – years Cash Flow Factors at PV Factors at PV
£ 5% £ 10% £
0 (94) 1 (94) 1 (94)
1–4 5 3.546 17.73 3.170 15.85
4 100 0.823 82.30 0.683 68.30
6.03 (9.85)
IRR = 5 + (6.03/(6.03 + 9.85))  5 = 6.90%
Kd = 6.90  (1 – 0.17) = 5.73%
The ex div share price is 360p – 10p = 350p.
The market value of equity is: 350p  (365m/0.20) = £6,387.50m
The market value of debt is: £2,200m  (94/100) = £2,068m
The debt/equity ratio is: 0.24:0.76.
The current WACC is: (5.73  0.24) + (7.5  0.76) = 7.1%
(b) The current WACC using the Gordon growth model.
The growth rate is calculated using r  b:
Earnings per share = Share (ex div)  earnings yield = 350p  0.07 = 24.5p.
The proportion of profits retained (b) = (24.5 – 10)/24.5 = 59%
Total earnings = EPS  the number of shares in issue = 24.5p  1,825m = £447m (The
number of shares in issue = £365m/£0.20 = 1,825m)
The accounting rate of return (r) = £447m/ [£5,153 – (1,825m  £0.145)]m = 9.1%
The growth rate is: 0.091  0.59 = 0.054 or 5%
Using the Gordon growth model Ke = ((10  1.05)/350) + 0.05 = 0.08 or 8%
WACC = (8  0.76) + (5.73  0.24) = 7.46%

lOMoARcPSD|5019904
25.2 The gearing of BBB will be unchanged after the diversification and it is therefore
appropriate to apply the existing gearing ratio of debt:equity 0.24:0.76 in the calculation of
the WACC to be used to appraise the Climbhigh project.
However, the cost of equity to be included in the WACC calculation should reflect the
systematic risk of the climbing wall industry. This can be achieved by using an appropriate
equity beta in the CAPM. An equity beta for a company operating in the climbing wall
industry is 1.90, but the company has a different gearing ratio to BBB and gearing
adjustments will have to be made.
Degearing the equity beta: Ba = 1.90  (6/(6 + 4 (1 – 0.17)) = 1.22
Regearing using BBB's gearing ratio Be = 1.22  ((0.76 + 0.24(1 – 0.17))/0.76) = 1.54
Ke = 2 + (1.54 (7 – 2)) = 9.7%
The appropriate WACC to appraise the project is:
(9.7  0.76) + (5.73  0.24) = 8.75%
25.3 The overall equity beta of BBB if it undertakes the Climbhigh project will be:
(1.10  0.80) + (1.54  0.20) = 1.19
The overall Ke will be: 2 + (1.19  (7 – 2 )) = 7.95%
The overall WACC will be: (7.95  0.76) + (5.73  0.24) = 7.42%
The overall WACC (using CAPM) excluding the Climbhigh project was 7.1% and with the
project it is 7.42%.
This is not a material change in the company's WACC and, considering the discount rate
alone, there should not be any material reduction in the company's value.
However, the actual effect will depend on the market's view of the diversification.
25.4 BBB is considering investing in other countries, some of which are developing countries.
BBB could face the political risk of action by a country's government, which might restrict its
operations. If a government tries to prevent the exploitation of its country by BBB, it may
take various measures including:
 Quotas: Limiting the quantities of goods that can be bought from BBB and imported.
 Tariffs: A tariff on goods imported by BBB, thereby making locally produced goods
more competitive.
 Non-tariff barriers: Legal standard of safety or quality could be imposed on BBB.
 Restrictions: Restricting BBB from buying other climbing wall companies.
 Nationalisation: A government could nationalise foreign-owned companies and their
assets.
 Minimum shareholding: A government could insist on a minimum shareholding in
companies by residents.
BBB can limit the effects of political risk by:
 Negotiations with the host government: The aim of such negotiations is to obtain a
concession agreement.
 Insurance: In the UK the Export Credits Guarantee Department provides protection
against various threats.
 Production strategies: It may be necessary to strike a balance between contracting out
to local sources and producing directly.
 Management structure: Possible methods include joint ventures or ceding control to
local investors.

lOMoARcPSD|5019904
25.5 The finance director should disregard the suggestion made by the contractor.
He should act with integrity and not be corrupted by self-interest, or the interests of other
parties.
He should be objective in his dealings with the contractor, and not be influenced by his
assertion that it is acceptable to disregard safety standards and cut corners.
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying into a different industry sector. The diversification would have been in non-domestic
countries, some of which would be in developing countries.
Part 25.1(a) saw many basic errors, which really should not be occurring given how many times
this has been set. The errors included inability to calculate numbers correctly, incorrect use of
the CAPM equation, incorrectly calculating the number of shares in issue, not calculating the ex-
div share price and/or the ex-interest debenture price, for the cost of debt calculating positive
and negative values and interpolating outside the range calculated and no tax adjustment for
the cost of debt. Again there were many basic errors in part 25.1(b), despite very similar
questions in the revision question bank. Many had no idea at all. However there were some
good answers, but even those forgot to correctly calculate the retained profits. Many students
calculated unrealistic growth figures and blindly used them with no reality check.
Part 25.2 was often confused with part 25.3. No reality checks again, with some students clearly
demonstrating that they have a very shallow knowledge of the topic; errors included calculating
unrealistic equity betas, eg, Beta = 20.485, degearing using MV and regearing with BV despite
the formulae sheet clearly stating MV should be used, degearing and regearing with same
debt/equity ratio and ending up with a different figure from the original. Explanations were very
brief. Despite this being set before and there being a detailed example in the Study Manual,
part 25.3 saw very poor attempts by most candidates. Candidates' explanations of the
relationship between the value of the company and the discount rate were very poor.
Answers to part 25.4 were fine when they talked about political risk as required, but weaker
candidates just talked about foreign exchange and hedging, or focussed on climbing wall
regulations. Answers to part 25.5 were fine where they used the language of ethics, but many
just stated that it was unethical because it was unethical. Many candidates incorrectly thought
that this was a money laundering issue.

lOMoARcPSD|5019904
Business valuations, plans, dividends and growth
26 Cern Ltd (December 2012)

Marking guide
Marks
26.1 (a) Freehold land and property adjustment 1
Investments adjustment 1
Preference shares adjustment 1
Debentures adjustment 1
Net assets value per share 1
Calculation of dividend per share 1
Choice of yield 0.5
Valuation per share 1
Non-marketability discount 0.5
Calculation of average EBIT 1
Calculation of profit after tax 1
EPS 1
Choice of P/E ratio 0.5
Valuation per share 1
Non-marketability discount 0.5
13
(b) Basic weaknesses of net asset, dividend yield and P/E valuations 2
Other issues – 1 mark per point 5
Max 4
(c) 1 mark per point Max 4
26.2 Calculation of each possible replacement cycle – 2.5 marks 10
31
26.1 (a)
Net asset valuation: £
Intangibles 900,000
Freehold land and property 4,500,000
Plant and equipment 3,600,000
Investments 1,350,000
Inventory 540,000
Receivables 1,080,000
Cash 180,000
12,150,000
Less
Current liabilities 1,080,000
Preference shares 648,000
Debentures 1,980,000
8,442,000
£8,442,000/3,600,000 = £2.345 per share
Dividend yield valuation:
Dividend in 20X2 = £180,000
Number of shares = 3,600,000

lOMoARcPSD|5019904
Dividend per share = £0.05

Average dividend yield of other two quoted firms: 3.7% (or the minimum 3.4%)
Valuation = £0.05/0.037 = £1.35 (or £0.05/0.034 = £1.47)
Less discount to reflect non-marketability (25% – any % will suffice) = £0.34 or £0.37
Valuation = £1.01 per share (or £1.10 per share)
Price/earnings valuation:
Average PBIT = (1,080 + 440 + 1,800)/3 = £1,106,667
Less interest £180,000 and tax £157,533 (£926,667  17%) = PAIT £769,134 – 43,200 =
£725,934
EPS = £725,933/3,600,000 = £0.2016
Average price-earnings ratio of the other two quoted firms: 8.3 (or the minimum 7)
Valuation = £0.2016  8.3 = £1.67 (or £1.41)
Less discount to reflect non-marketability (25%) = £0.42 (any % deduction will suffice)
Valuation = £1.25 per share (or £1.06)
(b) In addition to a discussion of basic elements surrounding the weaknesses of net asset
valuation (historic cost, omission of internally-generated intangibles) and dividend
yield and price/earnings valuations (comparator statistics, unrepresentative annual
figures), the following areas were worthy of comment in this specific scenario:
 The erratic profits in recent years suggests the earnings value may be somewhat
unreliable.
 Purchasers may prefer a valuation based on the present value of forecast future
cash-flows.
 Given the dividend yield and price/earnings valuations, Cern's directors may
prefer to sell off the firm on a break-up basis rather than as a going concern.
 Is the discount for non-marketability reasonable?
(c) (1) Synergy: the '2 + 2 = 5' effect
(2) Risk reduction via diversification
(3) Removal of a competitor
(4) Vertical integration: safeguard Fenton's position by acquiring a supplier or
distributor
(5) Access a new market (possibly overcoming barriers to entry)
(6) The acquisition of skills/knowledge
(7) Speed compared to organic growth
(8) Asset-stripping
26.2
Maximum annual production/sales (units) 300,000 285,000 270,000 255,000
Annual revenue @ £12 per unit (£) 3.60m 3.42m 3.24m 3.06m
Annual variable costs @ £8 per unit 2.40m 2.28m 2.16m 2.04m
Annual contribution 1.20m 1.14m 1.08m 1.02m
One-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 320,000
Maintenance costs (12,000)
Contribution 1,200,000
Net cash flow (480,000) 1,508,000

lOMoARcPSD|5019904
NPV (480,000) + (1,508,000  0.909) = £890,772/0.909 = £979,947

Two-year replacement cycle:
Scrap value 200,000
Maintenance costs (12,000) (14,000)
Contribution 1,200,000 1,140,000
Net cash flow (480,000) 1,188,000 1,326,000
NPV (480,000) + (1,188,000  0.909) + (1,326,000  0.826) = £1,695,168/1.736 = £976,479
Three-year replacement cycle:
Scrap value 80,000
Maintenance costs (12,000) (14,000) (16,000)
Contribution 1,200,000 1,140,000 1,080,000
Net cash flow (480,000) 1,188,000 1,126,000 1,144,000
NPV (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,144,000  0.751) =
£2,389,112/2.487 = £960,640
Four-year replacement cycle:
Scrap value 10,000
Maintenance costs (12,000) (14,000) (16,000) (18,000)
Contribution 1,200,000 1,140,000 1,080,000 1,020,000
Net cash flow (480,000) 1,188,000 1,126,000 1,064,000 1,012,000
NPV (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,064,000  0.751) +
(1,012,000  0.683) = £3,020,228/3.170 = £952,753
Therefore, the directors should change their existing policy of replacing the processing
machine every three years to replacing it every year, as that gives the greatest annual
equivalent net revenue.
Whilst there were many strong responses to the valuation questions, less well-prepared
candidates were undoubtedly exposed by the question and were particularly weak in dealing
with the technicalities of both the dividend yield and price/earnings valuation techniques. In the
second section, whilst many candidates were able to list classic text-book commentary on the
respective valuation techniques, far fewer were able to augment this basic analysis with
insightful commentary on the relevance of the techniques to the specific scenario set out in the
question. The third and final section of the first part of the paper, on take-over motives, was,
however, generally very well answered across the board.
The second part of the question was, again, very well answered by the stronger candidates but
performance was somewhat polarised as those candidates who had clearly banked on there
being a traditional NPV question found their lack of a firm grasp of the replacement
methodology exposed. Even some candidates who scored well on the calculations themselves
arrived at incorrect conclusions as a result of treating the calculated figures as equivalent annual
costs rather than net revenues.

lOMoARcPSD|5019904
27 Wexford plc (December 2008)

Marking guide
Marks
27.1 Forecast income statement 8
Forecast balance sheet 8
16
27.2 Rights issue: Up to 2 marks per valid point max 7
Floating rate loan: Up to 2 marks per valid point max 6
Report format 1
14
30
27.1 Rights Issue

Forecast income statement for the year ending 30 November 20X9
£'000
Revenue (270  1.15) 310,500
Direct costs ((171 – 19)  1.18) 179,360
Depreciation (18 + (20%  25)) 23,000
Indirect costs (40 + 10) 50,000
Profit from operations 58,140
Interest 5,000
Taxation (17%) 9,034
Dividends declared ((22.68/44.82)  44,106) 22,319
Forecast balance sheet at 30 November 20X9

£'000 £'000
Non-current assets (carrying amount) (152.59 + 25 – 23) 154,590
Current assets:
Inventory (35 + 10) 45,000
Receivables ((49/270)  310.5) 56,350
Cash at bank (balancing figure) 45,316
146,666
301,256
Capital and reserves:
£1 Ordinary shares (50 + 10) 60,000
Share premium (25 – 10) 15,000
Retained earnings (81.41 + 21.787) 103,197
178,197
Trade payables ((43/152)  179.36) 50,740
73,059
301,256

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Floating rate loan

Forecast income statement for the year ending 30 November 20X9
£'000
Revenue 310,500
Direct costs 179,360
Depreciation 23,000
Indirect costs 50,000
Profit from operations 58,140
Interest (5 + (25  8%)) 7,000
Taxation (17%) 8,694
Dividends declared ((22.68/44.82)  42.446) 21,479
Forecast balance sheet at 30 November 20X9
£'000 £'000
Non-current assets (carrying amount) 154,590
Current assets:
Inventory 45,000
Receivables 56,350
Cash at bank (balancing figure) 43,656 145,006
299,596
Capital and reserves:
£1 Ordinary shares 50,000
Retained earnings (81.41 + 20.967) 102,377
152,377
Loan 25,000
75,000
Trade payables 50,740
72,219
299,596
27.2 REPORT
To: The board of directors
From: Company Accountant
Date: x – x – xx
Subject: Methods of financing expansion plans
In terms of gearing, the rights issue will produce lower gearing than the floating rate loan
(ie, a lower level of financial risk), although in neither case does the proposed level of
gearing appear beyond the ability of the company to service (see interest cover below).
In terms of eps, the rights issue will produce a figure of 73.5p per share, whilst the floating
rate loan will boost eps to 84.9p per share.
In terms of interest cover, with the rights issue interest cover is a comfortable 11.6 times
against 8.3 times with the floating rate loan. In neither case, therefore, does interest cover
appear to be a cause for concern.
In terms of cost of capital, the floating rate loan may reduce the company's cost of capital as
a result of the tax shield applying to loan interest (depending on what happens to the cost
of equity as a result of the increased financial risk).

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The issues surrounding the use of the rights issue are as follows:
 Issue costs likely to be more than the arrangement fees associated with the floating
rate loan.
 There may also be underwriting costs if the company decides to protect its position.
Shareholders' reaction may be negative.
 Control – no dilution of control for those shareholders who take up their rights.
 The need to discount the offer price to ensure that the issue is fully subscribed and to
cover the possibility that the market price of shares might fall between the
announcement of the rights issue and its conclusion.
 The use of a rights issue leaves credit lines free to finance further expansion and
enables the freehold land and buildings to be used to secure other lines of finance, if
required.
The issues surrounding the use of the floating rate loan are as follows:
 The advantage of avoiding being tied into higher fixed rates if market interest rates fall.
 The risk of interest rates rising and the uncertainty of cash budgeting that this creates.
 Issue costs (arrangement fees) – likely to be less than those associated with a rights
issue.
 The potential for early repayment if the company finds this to be beneficial.
 Marks were also available for discussion of security and/or covenants, increased
operating gearing and the potential cash flow issues surrounding the loan.
A question which most candidates found to their liking with many scoring very strongly in the
numerical first section. The second section once again served to polarise performance between
stronger and weaker candidates.
For the most part candidates performed well on section 27.1 of the question, although there
were some common errors among weaker candidates, most notably the incorrect treatment of
both the cash and dividend figures. Weaker candidates completely overlooked the fact that cash
was the balancing figure in the whole exercise and simply chose to leave the original cash figure
unchanged. In similar fashion, the dividends were often left at their original level with no
changes incorporated to reflect profits in 20X9.
In section 27.2, stronger candidates combined relevant discussion of the two sources of finance
with the calculation of relevant calculations to underpin that discussion. However, a feature
among weaker candidates was their failure to undertake any calculations in spite of the precise
instruction in the question. Another common feature of weaker answers was a lack of breadth in
their response. For example, there was a tendency for some candidates to correctly identify the
issue of the potential impact on the firm's cost of capital but then to write at great length all they
knew on the underlying theory. Whilst this invariably earned the full marks available for this
aspect of the answer, this represented minimal reward in the context of the overall question and
was often achieved at the cost of many more marks that were available for discussion of other
relevant issues.

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28 Loxwood (March 2014, amended)

Marking guide
Marks
28.1 Total asset value 1
Total revalued assets 2
Dividend valuation 2
Earnings valuation 2
EV/EBITDA multiples 4
Profit before tax 2
Profit after tax 1
Retained profit after dividends 1
Strengths and weaknesses of each valuation method 10
25
28.2 SVA explanation 3
Problems of future cash flow and residual value 4
7
28.3 Discount at an effective 1% pa 1
Present value calculation 2
Compare to £500k offered and advise not to sell land 1
Ignore £120,000 as common to both alternatives 1
5
28.4 Professional accountants' conduct:
Be honest and truthful 1
Avoid making exaggerated claims of what they can do, and
their qualifications and experience 2
Avoid making disparaging claims of others 1
Not use confidential information from other clients in campaign 1
max 3
40
28.1
Hampton Richmond
Total asset value (historic) £21.7m £22.7m
Value per share (£21.7m/17.6m) £1.23 (£22.7m/9.8m) £2.32
Total revalued assets

[21.7 + 45.2 + 25.1 – 32.7 – 22.8] [22.7 + 24.1 + 35.2 – 22.4 – 33.3]
£36.5m £26.3m
Value per share (£36.5m/17.6m) £2.07 (£26.3m/9.8m) £2.68
Dividend valuation
Dividends (W1) d1 1.140  1.075 1.216  1.09 £88.363m
£81.7m
ke – g 9% – 7.5%  10.5% – 9% 
Value per share £81.7m/17.6m £4.64 £88.363m/9.8m £9.02
Earnings valuation (Earnings  P/E)
£3.258m  15.2 £2.702m  15.2 (Hampton)
£49.52m £41.07m
Value per share £49.52m/17.6m £2.81 £41.07m/9.8m £4.19
When it comes to valuation using an EV/EBITDA multiple, we can use the multiples of
Hampton and Walton (as listed companies) to estimate a value for Richmond.

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Hampton
EV = £74.27m, being:
Market capitalisation = £2.81  17.6m shares (above) = £49.52m, plus
Market value of debentures = 1.10  £22.5m = £24.75m
EBITDA of Hampton = £5.5m + £2.9m = £8.4m
EV/EBITDA multiple = £74.27m/£8.4m = 8.84
Walton
Need to calculate a market capitalisation, using earnings  P/E:
£m
PBIT 36.2
Less interest (£70m  7%) (4.9)
Profit before tax 31.3
Tax at 17% (5.3)
Profit after tax / earnings 26.0
Market capitalisation = £26m  16.5 = £429m

Market value of debentures = 1.25  £70m = £87.5m
EV of Walton = £516.5m
EBITDA is £36.2m + £6.5m = £42.7m
EV/EBITDA multiple = £516.5m / £42.7m = 12.1
Applying these multiples to the EBITDA of Richmond:

EBITDA = £4.8m + £0.9m = £5.7m
Appling EV/EBITDA multiple of Hampton: £5.7m  8.84 = £50.388m
Appling EV/EBITDA multiple of Walton: £5.7m  12.1 = £68.97m
Commentary
Asset values – historic so not equal to MV and only considers tangible assets and ignores
income. Revalued figures are better as more up to date, but still have the same
disadvantages.
The P/E ratio is a better guide for Hampton as it will give the company's actual market value
at 28 February 20X4 but based only on a small number of shares changing hands at any
one time – a premium would normally be paid above MV to get control. Also, have there
been significant changes since 28 February which would affect the value?
It is a takeover bid and so, presumably, Walton will be looking forwards and intending to
generate future earnings from Hampton, not liquidate (asset strip) it as in asset values. For
Richmond (a private company) it would be reasonable to use Hampton's P/E ratio (same
market), but it will be necessary to discount (by 25% to 50%) this valuation because
Richmond's shares will be less marketable. For both companies, are the current year's
earnings reasonable ie, not distorted in any way? Synergy is also ignored in the calculations.
When it comes to the EV/EBITDA valuation, the market value of Richmond's debt (£15.44m)
will need to be deducted to obtain an equity valuation, giving a range between
£34.948 million and £53.53 million.
These figures are before any discount that might be made for the non-marketability of
Richmond's shares. If we were to apply say a 25% discount, this would give a range of
values between £26.21 million and £40.15 million.

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It should also be noted that care needs to be taken when using the EBITDA multiple of
either Walton or Hampton when valuing Richmond. These companies may be trading on
higher or lower multiples than the average for the sector due to various market factors.
The dividend growth model (DGM) gives the highest valuations for both companies, but the
cost of equity and dividend growth rate will need to be treated with caution as they are very
close to each other giving high values. This puts the valuation in some doubt. Particularly
one should bear in mind that the market has priced Hampton at a much lower figure (via
P/E) than the value given by the DGM. Similar comments re synergy apply.
WORKING
£m £m
Profit before interest and tax 5.500 4.800
less: Interest (£22.5m  7%) (1.575) (£19.3m  8%) (1.544)
Profit before tax 3.925 3.256
less: Tax at 17% (0.667) (0.554)
Profit after tax/Earnings 3.258 2.702
less: Dividends (35%  £3.258m) (1.140) (45%  £2.702m) (1.216)
Retained 2.118 1.486
28.2 Shareholder value analysis (SVA) concentrates on a company's ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a
business is equal to the sum of the present values of all of its activities.
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). SVA links a business' value
to its strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
Company projections tend to show cash flows growing steadily upwards into an indefinite
future. In the real world, economies falter, competition increases and margins decline.
The majority of a DCF value estimate comes from the 'residual value', the worth of the
company at the end of the projection period. That, naturally, depends heavily on the cash
flows estimate in the final year modelled – a result, logically, of the trend in the early years.
28.3 £60k inflating at 3% pa discounted at 4% pa is the same as £60k discounted at an effective
1% pa so:
[£60,000  9.471] + [£120,000  0.905] (assuming land sold at year 10) = £676,860 (Present
Value) vs £500,000 offered, so do not sell the land.
£120,000 ignored as common to both alternatives
28.4 When marketing themselves and their work, professional accountants should:
 be honest and truthful.
 avoid making exaggerated claims about (a) what they can do (b) their qualifications and
experience.
 avoid making disparaging references to the work of others.
 not use confidential information from other clients in the campaign.

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This question had the lowest average mark on the paper and, in general, was done very badly
indeed.
It was a four-part question that tested the candidates' understanding of the investment decisions
and valuation element of the syllabus.
In the scenario a firm of ICAEW Chartered Accountants is advising three clients in its Business
Valuations Unit (BVU):
Client One is considering a takeover bid for two of its competitors. Candidates were given
financial data about the client and its target companies. Using this data they were asked to
calculate a range of suitable prices for the targets and a commentary on the strengths and
weaknesses of each of the valuation methods used.
Client Two had read a newspaper article which outlined a court case in which a company had
been valued using Shareholder Value Analysis (SVA). Candidates were required to explain how
SVA works and the problems that can arise from its employment.
Client Three was a landowner who, in effect, needed to calculate the present value of 60 acres of
his agricultural land for which he had been offered 10 years of rental income. Candidates were
given annual discount and inflation rates.
Finally, in part 28.4, candidates were asked to outline the ethical issues that the firm should
consider when planning a marketing campaign for its BVU.
In part 28.1 many candidates' calculations of value were very poor or non-existent. For example
they were unable to identify the net assets figure straight from the financial data made available
with many just using assets rather than assets less liabilities. Also they couldn't change that
number (for asset revaluation) with the two adjustments that were given in the data. Many used
the profit before interest figure as earnings (and therefore the basis for the dividend figure).
Interest and tax details were provided for calculating profit after interest and tax.
In part 28.2 there was a poor understanding of the SVA method of valuation, in particular the
issues associated with future cash flows and residual value.
Part 28.3 was probably the worst overall performance in the paper. Very few candidates
demonstrated an understanding of basic discounting. Many discounted the cash flows using the
annual inflation rate rather than cost of capital. In addition many compared terminal values and
present values to get to their decision.
Many candidates answered part 28.4 by dealing with ethics in the context of valuing companies,
rather than in the context of the promotional campaign. In other words they didn't answer the
question.

lOMoARcPSD|5019904
29 Arleyhill Redland plc (September 2013)

Marking guide
Marks
29.1 Factors and explanations (1 mark for factor, 1 for explanation):
Issue costs 2
Shareholder reactions 2
Control 2
Unlisted companies 2
max 4
29.2 Sales 1
Variable costs 1
Fixed costs 1
Debenture interest 2
Taxation 1
Dividends 2
Retained 1
9
29.3 Current EPS 1
Extra shares 1
New shares in issue 1
EPS 2
5
29.4 Current gearing (book value) 1
Current gearing (market value) 1
Gearing ratio (book value) 3
Gearing ratio (market value) 3
8
29.5 Advice on funding 5
29.6 CLS 2
Loan stock with warrants 2
4
35
29.1 Other factors included the following:

 Issue costs – these are high compared for equity with debt.
 Shareholder reactions – they may react badly if the firm regularly makes rights issues.
They may sell their shares as a result, which will adversely affect the share price.
 Control – should not be affected by a rights issue unless a considerable number of
existing shareholders sell their rights.
 Unlisted companies – shareholders may not be able to sell their rights (if unlisted) and
so a rights issue would not be practical.

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29.2
Rights issue Debenture issue
£m £m
Sales 65.280 65.280
Less variable costs (39.168) (39.168)
Less fixed costs (8.700) (8.700)
Profit before interest 17.412 17.412
Debenture interest (0.930) (1.770)
Taxation (at 17%) (2.802) (2.659)
Profit after tax 13.680 12.983
Dividends (2.016) (1.728)
Retained 11.664 11.255
29.3
Current EPS 36.4p (£10.483m/28,800)
Extra shares £12.0m
£2.50
4.8m shares None
New total shares in issue 28.8m 28.8m

4.8m 0.0m
33.6m 28.8m
Earnings per share £13.680 £12.983

33.600m 28.800m
40.7p 45.1p
29.4 Based on debt/total long term funds
Current gearing (book value) 20.6% (£15.500/£75.150)
Current gearing (market value) 14.8% [£15.500/([£3.10  28.800] + £15.500)
£15.500 £15.500 + £12.000
Gearing ratio (book value) £75.150 + £12.000 + £11.664 £75.150 + £12.000 + £11.255
= 15.7% = 27.9%
Gearing ratio (market value) £15.500 £27.500
(33.600  £3.30) + £15.500 (28.800  £3.30) + £27.500
= 12.3% = 22.4%
or
Based on debt/total equity
Current gearing (book value) 26.0% (£15.500/£59.650)
Current gearing (market value) 17.4% [£15.500/([£3.10  28.800])
£15.500 £27.500
Gearing ratio (book value) £59.650 + £12.000 + £11.664 £59.650 + £11.255
= 18.6% = 38.8%
Gearing ratio (market value) £15.500 £27.500
(33.600  £3.30) (28.800  £3.30)
= 14.0% = 28.9%

lOMoARcPSD|5019904
29.5
Current Rights issue Debenture issue
EPS £0.364 £0.407 £0.451
P/E ratio 8.52 8.11 7.32
Gearing (BV) 20.6% or 26.0% 15.7% or 18.6% 27.9% or 38.8%
Gearing (MV) 14.8% or 17.4% 12.3% or 14.0% 22.4% or 28.9%
EPS increases in both cases. It is highest with the debenture issue. However gearing (BV) is
now nearly 30%, which might be too high and could have an adverse effect on share price if
investors worry about level of financial risk. If one takes the MV then the gearing level is
more moderate (22.4% with issue of extra debt).
Important point regarding share price – £3.30 has been used (as per MC's quote). Is this
achievable? The theoretical ex-rights price is £3.01 because of the dilution caused by the
rights issue. Thus an extra 29p would need to be added to the actual share price ex-rights,
ie, the NPV of the expansion would need to be at least 29p per share. If it is a debt issue,
would the market react favourably to the increase in gearing?
29.6 Convertible Loan Stock (CLS)
Fixed return securities which may at the discretion of the holder be converted into ordinary
shares of the same company.
Loan stock with warrants
Loan stocks which give the holder the right to subscribe at a fixed future date for ordinary
shares at a predetermined price. Debt is not converted, but remains as such.
This question was generally done very well and had the highest average mark on the paper.
In the scenario a manufacturing company was planning to raise additional funding for an
expansion of its product range and was considering whether to use equity (via a share issue) or
debt (via debentures). Part 29.1 for four marks required candidates to highlight the factors to
consider when deciding between a rights issue and a debenture issue. Part 29.2 for nine marks
asked them to prepare next year's income statement using both methods of funding. In part
29.3 (five marks), they were required to calculate the resultant earnings per share figures under
both methods. Part 29.4 for eight marks asked candidates to calculate the gearing figures for
both schemes (at book value and market value). In part 29.5 (five marks) candidates had to
advise the company's directors of the merits of both schemes, based on their calculations in 29.2
to 29.4 above. Finally, for four marks, in part 29.6 they had to explain the differences between
convertible loan stock and loan stock with warrants.
There was a variable performance in part 29.1 and the weakest scripts re-hashed/embellished
existing points in the question.
Part 29.2 was very straightforward and most candidates scored full marks. The most common
errors were made with the interest and dividend calculations. A disappointing number of
students failed to increase the sales and/or variable costs figures correctly.
Part 29.3 was, again, very straightforward and the average mark here reflects that. It was good to
see that fewer candidates than previously had (incorrectly) used the retained earnings figure for
the EPS calculation.
Part 29.4 was poorly done in general. A majority of students failed to deal correctly with retained
profits in the book value and market value calculations for gearing.

lOMoARcPSD|5019904
Part 29.5 was reasonably well answered, but too few candidates considered the validity of the
£3.30 share price (it's only the director's opinion) given in the question.
Part 29.6 tested the candidates' knowledge and there was a wide range of marks here. Few
candidates were able to explain how loan stock with warrants operates.
30 Sennen plc (June 2014)

Marking guide
Marks
30.1 (a) Sales revenue 1

Tax 1
After tax synergies 1
Working capital 1
Additional CAPEX 1
Free cash flow 0.5
Present value 1
Terminal value 2
Value per share 2
Advantages and disadvantages 2
13
(b) Sensitivity to change in after tax synergies 3
(c) Operating profit 0.5

Interest 0.5
Investment income 0.5
Tax 0.5
Share price 1
Strengths and weaknesses 2
5
(d) Relevant discussion 3
(e) Advice on suitability of each method 8
30.2 Ethical issues 3

35

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30.1 REPORT
To: Partner in NWCF
From: Accountant
Subject: Possible acquisition of Sennen plc
(a)
Year
0 1 2 3
£m £m £m £m
Sales revenue 21.00 22.05 23.15
Operating profit 3.15 3.31 3.47
Tax (17%) –0.54 –0.56 –0.59
After tax synergies 0.53 0.55 0.58
Working capital –0.21 –0.22 –0.23 –0.24
Additional CAPEX –0.42 –0.44 –0.46
Free cash flow –0.21 2.50 2.63 2.76
Present value factor (7%) 1.00 0.935 0.873 0.816
Present value –0.21 2.34 2.30 2.25
£m
Present value of free cash flow years 0–3 6.68
Terminal value: (2.76(1 + 0.02)/(0.07 – 0.02))  0.816 45.94
Enterprise value 52.62

Less debt –10.00
Add short term investments 2.00
Equity 44.62
Value per share in pence (44.62/17  100p) 262

This methodology has the advantage of valuing the free cash flows of the company and
is not distorted by accounting policies which can affect other methods. However the
valuation is dominated by the terminal value. The methodology is also heavily
dependent upon the inputs to the model such as estimating cash flows and growth.
For example, reducing the estimated sales growth after the competitive advantage
period to, say, 1% would reduce the terminal value to (2.76(1 + 0.01)/(0.07 – 0.01)) 
0.816 = £37.91m, a reduction of 47p per share.
(b) The sensitivity of the enterprise value to a change in the after tax synergies: PV of
synergies/total value:
1 2 3
£m £m £m
After tax synergies 0.53 0.55 0.58
PV @ 7% 0.5 0.48 0.47
£m
Present value years 1–3 1.45
Amount in terminal value (0.58(1 + 0.02)/(0.07 – 0.02))  0.816 9.65
Total present value of synergies 11.10
£11.10m/£54.62 = 20.3%.
Synergies represent 20.3% of the value of debt plus equity.

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(c) The earnings per share has to be calculated:

£m
Operating profit £20m  0.15 3
Less interest £10m  0.05 (0.5)
Add investment income £2m  0.03 0.06
Taxable 2.56
Tax at 17% (0.44)
Earnings per share £2.12m/17m = 12.47p
Note: Credit any attempt to calculate prospective EPS rather than historic.
The share price using the p/e ratio for recent takeovers = 12.47p  17 = 212p
The p/e ratio basis is a market measure and has the advantage of valuing the shares by
comparison to other takeovers. However we do not know how comparable to Sennen
the other companies are. Also the valuation is based on historic EPS and a more
realistic measure might be a prospective EPS.
(d) The range in values is 212p – 262p.
The free cash flow valuation can be considered as a maximum value, however the
valuation is quite sensitive at 20.3% to the synergistic savings which may or may not be
made and the growth rate of sales in perpetuity.
Both measures offer a premium to the current share price of 160p and the Board of
Morgan should feel comfortable offering the shareholders of Sennen a bid premium.
(e) Students should take into account that the company is highly geared and their answers
should reflect this. They should consider both the shareholders of Sennen and Morgan
in their answers. Some areas that they may mention and expand upon for each method
are as follows:
 The ability of Morgan to raise extra funds by borrowing and/or an issue of shares,
maybe a rights issue
 Does Morgan have any cash reserves
 Dilution of control
 The tax position of Sennen's shareholders
 Risk
30.2 There is a serious conflict of interest with the management team who are party to the MBO
also considering making an offer for the company. The management team should be acting
in the interests of the shareholders of Sennen and be recommending to the shareholders
the best price for their shares. It would be highly unethical for any member of the
management team who are party to the MBO to take part in negotiations with Morgan or to
make recommendations to Sennen's shareholders.
This was a six-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company had
identified a takeover target.
The acquirer has had a policy of expanding by acquisition and, as a result, is highly geared
compared to its peers. Also there is a potential bid from the management of the target in the
form of a management buyout (MBO). Part 30.1(a) of the question required candidates to use
Shareholder Value Analysis (SVA) to value the target. The valuation included after tax synergies,
also candidates were required to state the strengths and weaknesses of the valuation method.
Part 30.1(b) of the question required candidates to calculate how sensitive the valuation using
SVA was to a change in the synergies. Part 30.1(c) of the question required candidates to value

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the target using p/e ratios and to state the strengths and weaknesses of the valuation method.
Part 30.1(d) of the question required candidates to discuss the range of values and whether the
acquirer should have offered the target company's shareholders a bid premium. Part 30.1(e) of
the question required candidates to discuss the methods that the acquirer could have used to
pay for the shares of the target. Part 30.2 of the question required candidates to discuss the
ethical position of the members of the MBO team.
In part 30.1(a), the basic discounting was fine with some candidates making the usual timing
errors, however the inclusion and computation of the perpetuity flow and discounting it was
variable. Few candidates made adjustments to the present value of the free cash flows for the
debt and investments. Many candidates wasted time by stating the seven drivers of SVA, which
was not required.
In part 30.1(b), many candidates were able to calculate the present value of the after tax
synergies but did not realise that this should then be stated as a percentage of the value
calculated in part 30.1(a).
Part 30.1(c) was very disappointing since p/e valuations have been tested several times in the
past. Many candidates lost marks by making no attempt to calculate the earnings. Instead a
common calculation was to divide the target share price by the p/e ratio given in the question
for recent takeovers in the sector and then multiplying the resultant figure back up again:
17  eps = 160p, eps = 9.41p, Offer price = 9.41p  17 = 160p!
Part 30.1(d) had reasonable responses. However weaker candidates did not make reference to
their range of values calculated in 30.1(a) and 30.1(c).
Part 30.1(e) was quite well answered but weaker candidates did not refer to the offeror being
already highly geared compared to its peers.
In part 30.2 many candidates ignored the ethical position of the members of the MBO team.
31 Printwise UK plc (March 2010, amended)

Marking guide
Marks
31.1 Net assets valuation (historic) per share 1

Net assets valuation (revalued) per share 2
Price earnings valuation per share 2
Marked-down price (PE valuation) 1
EV/EBITDA multiple 2
Dividend yield valuation per share 2
Marked-down price (Dividend yield valuation) 1
Discounted cash flow valuation per share:

Pre-tax cash flows 1
Taxation 1
Capital allowances 2
Disposal of pool (proceeds) 1
Discount factor 1
Present value 0.5
Total present values 0.5
Potential sale 2
Final total present values 1
max 18

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Marks
31.2 Advantages and disadvantages of each method max 10
31.3 Explanation of issues regarding purchase by:
Cash 3
Share-for-share exchange 3
Loan stock-for-share exchange 3
max 6
34
REPORT
To: The board of directors
From: An Accountant
Subject: Possible offer for LSL
£6.5m
31.1 Net assets valuation (historic) per share £3.10
2.1m
(£6.5m + 15.5m – 11.8m + 3.0m – 3.6m)
Net assets valuation (revalued) per share £4.57
2.1m
£4.6m  9
Price earnings valuation per share £19.71
2.1m
As LSL is not a quoted company, and its shares are less marketable, this price should be
marked down (by, say, 30%), to (£19.71 – 30%) £13.80
(4  (£5.9m + £1.5m)) – (1.2  3.0)+2.8
EV/EBITDA valuation £13.71
2.1m
As LSL is not a quoted company and its shares are less marketable, this price should be
marked down (by, say, 30%) to (£13.71 – 30%) £9.60
£1.1m/6%
Dividend yield valuation per share £8.73
2.1m
As LSL is not a quoted company, and its shares are less marketable, this price should be
marked down (by, say, 30%), to (£8.73 – 30%) £6.11
£24.401m
Discounted Cash Flow valuation per share (W1) £11.62
2.1m
WORKINGS
(1) Discounted cashflow
20X1 20X2 20X3 20X4
£m £m £m £m
Pre-tax cash flows (£m) 4.600 4.300 5.200 5.700
Less corporation tax at 17% (0.782) (0.731) (0.884) (0.969)
After-tax cash flows (£m) 3.818 3.569 4.316 4.731
Tax saving – capital allowances (W2) 0.110 0.090 0.074 0.000
Disposal of pool (proceeds) 1.985
Total cash flows 3.928 3.659 4.390 6.716
14% discount factor 0.877 0.769 0.675 0.592
Present value 3.445 2.814 2.963 3.976
Total present values (20X1–20X4) 13.198

Plus potential sale in 20X4 (4  £4.731m  0.592) 11.203
Final present value of future cash flows 24.401

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(2) Capital allowances

£m £m £m £m
WDV b/f 3.600 2.952 2.421 1.985
WDA @ 18% (0.648) (0.531) (0.436) (0.000)
WDV/disposal 2.952 2.421 1.985 1.985
Tax saving (WDA  17%) 0.110 0.090 0.074 0.000

31.2 Explanation of each of the methods (advantages/disadvantages)
Net assets basis (historic) – this is a historic cost and so doesn't have any real merit to it.
Net assets basis (revalued) – as above, but it does take into account the latest asset values.
Intangible assets are not easily included in this situation which would mean that an under-
valuation would arise.
Price earnings valuation – income based measure, which has advantages over asset-based.
However, is it reasonable to take the industry average P/E ratio? How similar is LSL to other
printing firms? Also it's based on this year's earnings only.
EV/EBITDA valuation – another income based measure, based on this year's earnings. As
with the P/E valuation, is it reasonable to take the printing industry average multiple when
we do not know how similar LSL is to other printing firms? The multiple for an individual firm
can vary from the industry average with various factors such as its competitive position, cash
flows, capital intensity or management reputation etc.
Dividend yield valuation – income based measure again. Is it reasonable to take the industry
average yield? How similar is LSL to other printing firms? Also it ignores dividend growth.
Discounted Cash Flow valuation – this is probably the best method to adopt, ie, value a firm
by discounting its expected future cash flows. However there are problems with estimating
those cash flows – what about synergistic benefits arising from a takeover? Also, what is an
acceptable discount rate and for how many years ahead is it reasonable to estimate the
cash flows? Finally, the LSL sale value in 20X4 is based on an estimate which makes up
45.9% (£11,203/£24,401) of the total value calculated under this method – how accurate will
this be?
31.3 Explanation of issues regarding purchase by:
 Cash
– Certain amount received
– Possible tax issues
 Share-for-share exchange
– No tax issues immediately
– Uncertain amount received
– Dealing costs
 Loan stock for share exchange
– More assured return than with shares
– Shareholders may prefer equity
This question had the lowest average % mark in the paper, but overall was done well.
The question was based around the proposed takeover of a private company by a plc. Part 31.1
for 18 marks required candidates to calculate the value (per share) of the private company using
a range of methods (six in total). Part 31.2 was worth eight marks and asked candidates to
explain the advantages/disadvantages of using each of those valuation methods. Part 31.3 was
worth six marks and it tested the candidates' understanding of the various means by which the
target company's shareholders could be remunerated for their shares.

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Part 31.1 was reasonably straightforward and many candidates scored good marks. However, a
number of them struggled to identify the net assets figures as required and quite a few were
unable to calculate the dividend yield correctly. In the latter case, too many candidates
attempted to use a dividend growth figure in their answers, which was incorrect. The present
value (PV) method of valuation was done reasonably well, but too few candidates were able to
correctly calculate the capital allowances in full and/or the four year multiple figure as required.
Part 31.2 was generally answered well, but too few candidates produced sufficiently detailed
comments on the PV method of valuation.
Part 31.3 was not done as well as expected and too many candidates failed to answer the
question, either basing their answer from the plc's point of view or giving a very general answer
and failing to apply their knowledge to the scenario.
32 Tower Brazil plc (September 2014)

Marking guide
Marks
32.1 Theoretical ex-rights price:

Funds to be raised by rights issue 1
Market value 1
TERP calculation 1
3
32.2 (a) Current EPS 1.5
Current earnings plus debenture interest saved 2
New earnings 1
New EPS 1
(b) New EPS if EPS reduces by 10%
New total shares 1
Current shares in issues 1
New shares to be issued 0.5
Rights issue price/share 0.5
Rights issue would be unsuccessful as above current 1
market price 1.5
11
32.3 Gearing level (BV) 1
Gearing level (MV) 2
Advise whether there is gearing problem max 3
Gearing theory max 3
9
32.4 Dividend policy and share price 7
Impact of special dividend 2
9
32.5 Ethical implications 3
35

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32.1 Theoretical ex-rights price

£m
Funds to be raised by rights issue: 60%  £46,750  1.10 30.855
Current market capitalisation 16.50m £4.20 69.300

1 for 2 rights issue 8.25m £3.74 30.855
24.75m 100.155
TERP = £100.155/24.75m £4.05/share
32.2 (a) Current earnings per share (£5.825m – £0.480m)/16.5m £0.324

£m
Current earnings figure (£5,825m – £0.480m) 5.345
plus: Debenture interest saved (£28.050m  5%  83%) 1.164
New earnings figure 6.509
New EPS £6.509m/24.75m £0.263
(b) If EPS reduces by 10%, then new EPS is £0.324  (1 – 10%) £0.2916
New total shares £6.509m/£0.2916 22,322m
Current shares in issue 16.500m
New shares to be issued 5.822m
Rights issue price/share £30.855m/5.822m £5.30
As this is above the current market price (£4.20) the rights issue would not be
successful.
32.3
Gearing level (BV) £54,750/£97,670 56.1%
Gearing level (MV) Equity MV £69,300

PSC MV 6,400
Debt MV (£46,750  1.10) 51,425
127,125 £57,825/£127,125 45.5%
So gearing at MV is under 50%. Gearing would be a problem if it was causing WACC to rise
(tax advantage outweighed by debenture holders and shareholders wanting a higher
return) and MV to fall.
Gearing theory – Traditional view/Modigliani & Miller (MM) view/Modern view – balance
between tax benefits and bankruptcy costs.
32.4 Dividend policy and share price – Traditional view/MM and irrelevance theory/Modern view
– including signaling, clientele effect and agency theory.
Impact of special dividend – the market is not in favour of such dividends generally, ie, the
share price may well fall as a result, and so it seems to defeat the object of retaining profit
for investment.
32.5 Unpublished information of a price sensitive nature should remain confidential, not be
disclosed and not be used to obtain a personal advantage.

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This question had the second highest average mark on the paper and the majority of candidates
did well enough to 'pass' it.
In the scenario the board of a UK manufacturer was concerned about the company's gearing
levels. The board is considering either (a) a rights issue to buy back debt or (b) reducing future
dividend payments.
In part 32.1 for three marks candidates were required to calculate the company's theoretical ex-
rights price. Part 32.2 was worth 11 marks. Half of these were allocated to 32.2(a) which required
candidates to calculate next year's EPS figure (based on the fact that some of the debt would
have been repaid). Part 32.2(b) required candidates to calculate and explain the implications for
the rights issue of restricting the change in the company's EPS to 10%. Part 32.3 for nine marks
asked candidates to calculate the company's current gearing levels and then advise the board,
with reference to their calculations and generally accepted theory, whether or not the company
had a gearing 'problem'. Part 32.4 was a more discursive section and candidates were asked to
explain (again with reference to generally accepted theory) the possible impact of a change in
dividend policy on the company's share price. Finally, for three marks, part 32.5 tested the
candidates' understanding of the ethical implications facing an ICAEW Chartered Accountant
when in possession of price-sensitive information.
In part 32.1 most candidates scored full marks, but many failed to calculate correctly the market
value of the debt being redeemed via the rights issue.
Part 32.2(a) was reasonably well done, but many candidates struggled with (or ignored) the
calculation of the adjustment to the interest charge caused by the debenture redemption. Also,
as noted in previous papers, many candidates calculated, incorrectly, the earnings figure before
preference dividends.
Part 32.2(b) was also reasonably well done, but many candidates tried to adjust the earnings
figure rather than, as was required, the number of shares.
In part 32.3 it was the calculation of gearing using market values that caused most problems
(again, as in previous papers). A disappointing number of candidates included retained
earnings in their market value of equity figure. Most candidates' understanding of the theory of
gearing and market value were good, but, in general, there was too little application of this
understanding to the actual scenario.
Part 32.4 was mostly done well, but too few candidates gave a sufficient range of points
regarding the 'real world' impact of the dividend policy and most candidates ignored the
special dividend.
In general part 32.5 was answered well.

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33 Brennan plc
Marking guide
Marks
33.1 Sales calculations 1.5
Operating profit 1
Tax 1
Working capital investment 1.5
Non-current asset investment 1.5
Discount rate 1
Post year six cash flows 1.5
Short-term investments 1
Comment 3
13
33.2 1–2 marks per valid comment max 7
20
33.1
Year
1 2 3 4 5 6
Sales (£m) (W1) 212.00 224.72 238.20 252.50 267.65 283.70
Op profit (15%) 31.80 33.71 35.73 37.87 40.15 42.56
Tax at 17% (5.41) (5.73) (6.07) (6.44) (6.83) (7.24)
Working capital investment (W1) (0.84) (0.89) (0.94) (1.00) (1.06) (1.12)
Non-current asset investment (W1) (1.44) (1.53) (1.62) (1.72) (1.82) (1.93)
Free Cash Flows 24.11 25.56 27.10 28.71 30.44 32.27
Factor 9% (W2) 0.917 0.842 0.772 0.708 0.650 0.596
PV 22.11 21.52 20.92 20.33 19.79 19.23
PV of cash flows years 1–6 = £123.9m
Post year 6 cash flows (in perpetuity) = 32.27/0.09  0.596 = £213.7m
Total SVA value = £123.9m + £213.7m + £2.5m = £340.1m
The majority of the value calculated (63%) comes from the residual value, which is based on
the assumption of zero growth in cash flows from year 6. This is highly dependent on the
growth being as predicted in the period of competitive advantage.
The SVA value is significantly higher than the market capitalisation of £250 million. This may
be caused by the market assuming a lower growth rate or a higher discount rate than those
used in the SVA calculation.
WORKINGS
(1)
Year
0 1 2 3 4 5 6
Sales (increasing at 6%) 200.00 212.00 224.72 238.20 252.50 267.65 283.70
Increase in sales 12.00 12.72 13.48 14.29 15.15 16.06
Working capital (7%) 0.84 0.89 0.94 1.00 1.06 1.12
Non-current asset investment (12%) 1.44 1.53 1.62 1.72 1.82 1.93
(2) Discount factor = 3 + 0.75(11 – 3) = 9%

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33.2 The current market capitalisation of Brennan is below its net assets value which suggests
that Brennan plc may be worth more if it was liquidated. However this assumes that the net
book value of assets matches the market value of the assets and this may not be the case in
reality. This does give a possible explanation for the low market capitalisation of Brennan,
the market may see no future in the company and is already valuing it on a break up basis.
There are other factors which may cause the market to place such an apparently low
valuation on Brennan.
The dividend policy offers a relatively low payout of 10%. If there are no plans to reinvest
retained earnings then cash balances will be substantial. This could also help to explain the
high net assets valuation.
The stock market may be suspicious of the level of control exercised by the founding family.
The founding family appears to control the board and also own a substantial number of
shares and as such they may be able to dominate the smaller shareholders. The market may
view the current management as less able than similar companies due to this family
dominance and this affects the valuation.
Brennan is currently all equity funded, which the market may think is inadvisable and does
not allow Brennan to exploit the advantage of debt being cheaper than equity due to the
tax shield.

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Risk management
34 Fratton plc (June 2011)

Marking guide
Marks
34.1 (a) Forward market:
Forward rate 1
Net receipt 1
Money market:
Euro borrowing 1
Sterling conversion 1
Interest 1
Option market:
Type of option 1
Number of contracts 1
Premium in euros 1
Premium in sterling 1
Scenario 1: Option not exercised 1
Scenario 1: Sterling receipt 1
Scenario 2: Option exercised 1
Scenario 2: Gain on option 1
Scenario 2: Sterling receipt 1
14
(b) Transaction costs 1
Exact date does not need to be known 2
Cannot tailor contracts 1
Hedge inefficiencies 1
Limited number of currencies 1
More complex than forwards 1
7
34.2 (a) Buy a 3–6 FRA at a fixed rate 1
Calculation of amount bank to pay Fratton 1
Payment on the underlying loan 1
Net payment on the loan 1
4
(b) Sell three-month interest rate futures 1
Calculation of gain 1
Futures outcome 1
Payment in the spot market 1
5
30
34.1 (a) Forward market

Bank sells £ at €1.1856/£
Forward rate = €1.1797 (1.1856 – 0.0059)
So €2,960,000/1.1797 = £2,509,112.49

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Money market
To hedge a euro receivable, Fratton needs to create a euro liability which, with interest,
will exactly equal the receivable in three months' time:
€2,960,000/1.004 = £2,948,207.17
Convert to £ at spot (1.1856) to give £2,486,679.46.
Which with three months' interest at 0.2875% gives £2,493,828.66.
Options
Fratton should enter into a call option to buy £ at €1.18/£
Number of contracts = €2,960,000/1.18 = £2,508,475/62,500 = 40.14 = 40 contracts
The premium would be €60,000 (0.024  62,500  40)
Which at spot would cost £50,654.28 (60,000/1.1845)
Scenario 1:
Spot on expiry €1.12/£ – Exercise price €1.18/£ – intrinsic value: nil – exercise? No
£ receipt at spot = €2,960,000/1.12 = £2,642,857.14 (net £2,592,202.86)
Scenario 2:
Spot on expiry €1.20/£ – Exercise price €1.18/£ – intrinsic value: €0.02 per £ – exercise?
Yes
Gain on option of €50,000 (0.02  62,500  40)
Sell €3,010,000/1.20 = £2,508,333.33 (net £2,457,679.05)
(b) Advantages:
 Transaction costs of futures should be lower and they can be traded.
 The exact date of receipt or payment of the foreign currency does not need to be
known because the futures contract does not have to be closed out until the
underlying transaction takes place (subject only to the expiry date of the futures
contract).
Disadvantages:
 The contracts cannot be tailored to the user's exact requirements.
 Hedge inefficiencies are caused by standard contract sizes and basis.
 Only a limited number of currencies are available with futures contracts.
 The procedure for converting between two currencies neither of which is the $ is
more complex with futures compared to a forward contract.
34.2 (a) As a borrower Fratton should buy a 3–6 FRA and can thereby fix a borrowing rate of
2.60%.
At 3.00% rates have risen, so the bank will pay Fratton £2,500 (2.5m  {3.00%-2.60%} 
3/12). Payment on the underlying loan will be 3%  2,500,000  3/12 = £18,750
Net payment on the loan: £16,250 (18,750 – 2,500) – an effective rate of 2.60%
(b) Fratton will need to sell three-month £ interest rate futures contracts.
Fratton will need to sell five contracts (2,500,000/500,000  3/3)
Sell at 97.20 and buy at 97.00 for a gain of 0.20%.
Futures outcome: 0.20%  500,000  3/12  5 = £1,250
Payment in the spot market: 2,500,000  3%  3/12 = £18,750 – £1,250 = £17,500
(=2.80%)
ICAEW 2019 Risk management 221

lOMoARcPSD|5019904
This two-part question combined the interest rate and exchange rate risk management elements
of the Financial Management syllabus and was generally well answered by the well-prepared
candidates. There is now significant evidence that candidate performance in this relatively new
area is increasing to the levels seen in other areas of the syllabus. The average mark achieved
was 20.3/30 (67.6%).
The first part of the question required candidates to illustrate how they would hedge foreign
exchange risk in the scenario set out in the question using the forward market, the money
market and the options market. For the most part, this was well answered although weaker
candidates often made fundamental errors in the choice of exchange rate in the first part and
then often chose the wrong type of option to hedge the foreign exchange exposure.
Part 34.1(b) of the question required candidates to discuss the advantages and disadvantages of
using futures contracts as opposed to forward contracts to hedge foreign exchange risk. For the
most part this posed few problems for stronger candidates.
The second part of the question required candidates to illustrate the use of a forward rate
agreement to manage interest rate risk. Again, this was generally well answered and confirmed
the continuing improvement amongst most candidates in this area of the syllabus.
The final part of the question required candidates to illustrate the use of interest rate futures
contracts to manage interest rate risk. The vast majority of candidates scored well on this
question, although the most common omission was the identification of the actual interest rate
achieved as a result of the transaction.
35 Sunwin plc (December 2012)

Marking guide
Marks
35.1 Type of contract 1
Value of one contract 1
Number of contracts needed 1
Premium 1
If index rises – abandon 1
Outcome if index rises 1
Gain if index falls 1
Outcome if index falls 1
8
35.2 (a) Type of contract 1
Futures outcome 1
Net outcome 1
Effective interest rate 1
Hedge efficiency 1
6

lOMoARcPSD|5019904
Marks
(b) Type of contract 1
Premium cost 1
Case 1 – exercise 0.5
Case 1 – futures outcome 1
Case 1 – effective interest rate 2
Case 2 – do not exercise 0.5
Case 2 – effective interest rate 2
9
(c) 1 mark per point max 3
26
35.1 Sunwin requires an option to sell – a December put option with an exercise price of 5,000.
Portfolio value = £5.6m Exercise price = 5,000
Value of one contract = 5,000  £10 = £50,000
Number of contracts required = £5.6m/50,000 = 112 contracts
Premium: 70 points  £10 per point  112 contracts = £78,400
(a) If the index rises to 5,900, the put option gives Sunwin the right to sell @ 5,000, so the
option would be abandoned (with zero value).
Overall position: £
Value of portfolio 6,608,000
Gain on option –
Less premium (78,400)
6,529,600
(b) If the index falls to 4,100, the put option gives Sunwin the right to sell @ 5,000, so the
option would be exercised (value = £9,000 {900  £10}  112 contracts = £1,008,000).
Overall position: £
Value of portfolio 4,592,000
Gain on option 1,008,000
Less premium (78,400)
5,521,600
35.2 (a) Sunwin needs to sell a three-month contract

Number of contracts = 4m/0.5m  9/3 = 24 contracts
Futures outcome:
Selling at the opening rate of 96 and buying at the closing rate of 95 yields a gain of 1%
Therefore 1%  0.5m  3/12  24 = £30,000
Net outcome:
Spot market £4m  4.5%  9/12 = (£135,000) plus the futures receipt of £30,000 =
(£105,000)
Effective interest rate 105,000/4m  12/9 = 3.5%
Hedge efficiency:
Increase in spot rate = 1.5% so increase in interest = £60,000 (1.5%  4m)  9/12 =
£45,000
So the hedge efficiency = 30,000/45,000  100 = 66.7%
(b) Traded interest rate options on futures:
Sunwin requires a March put option with a strike price of 96.25 (100 – 3.75)
The number of contracts required = 4m/0.5m  9/3 = 24 contracts @ 0.18%
So the premium = 24  0.18%  0.5m  3/12 = £5,400

lOMoARcPSD|5019904
Case 1:
Spot price 4.4%
Futures price 95.31
Strike price 96.25
Exercise? Yes
Gain on future 0.94% therefore 0.94%  0.5m  3/12  24 = £28,200
Borrowing cost at spot £132,000
Option (£28,200)
Premium £5,400
Effective interest rate £109,200/4m  12/9 = 3.64%
Case 2:
Spot price 2.1%
Futures price 97.75
Strike price 96.25
Exercise? No
Gain on future –
Borrowing cost at spot £63,000
Option –
Premium £5,400
Effective interest rate £68,400/4m  12/9 = 2.28%
(c) (1) The time period to expiry of the option – the longer the time to expiry, the more
the time value of the option will be.
(2) The volatility of the underlying security price – the more volatile, the greater the
chance of the option being 'in the money', which increases the time value of the
option.
(3) The general level of interest rates (the time value of money) – the time value of an
option reflects the present value of the exercise price.
Following its introduction into the syllabus at the last review, this subject area was initially very
challenging for many candidates. However, at this sitting and in a reflection of an emerging
trend on the paper in more recent sittings, candidates' grasp of the material appears to get
stronger and stronger, so much so that it was this question, rather than the traditional NPV
question, that provided many candidates with the basis of their pass on the paper.
Most candidates performed strongly on part 35.1 of this question, although where errors were
made they primarily related to incorrect calculation of the number of contracts and the premium.
The only real areas of weakness in most candidates' responses to part 35.2 were in their being
unable to effectively calculate hedge efficiency (many candidates simply did not even make an
attempt to do so) and in the mis-calculation of time-period adjustments and, consequently,
premiums. However, overall candidate strength in this area of the syllabus is pleasing to see.

lOMoARcPSD|5019904
36 Padd Shoes Ltd (March 2014)

Marking guide
Marks
36.1 (a) Sterling receipt if rupee weakens by 1% 2

(b) Option 2.5
(c) Forward contract 2.5
(d) Money market hedge 3
10
36.3 Government stability 1

Political and business ethics 1
Economic stability 1
Import restrictions 1
Remittance restrictions 1
Special taxes, regulations for foreign companies 1
Trading risks – physical risk, credit risk, liquidity risk etc 1
Maximum 5
36.4 Option 2
FRA 2
No hedge 1
Recommendation 2
7
30
36.1
INR 200,000,000
Sterling receipt at spot rate = £2,094,394
95.4930
(a) Sterling receipt if rupee INR 200,000,000 INR 200,000,000
£2,073,658
weakens by 1% (95.4930  1.01) 96.4479
INR 200,000,000
(b) Option (@ exercise price) £2,093,145
95.5500
Less cost (£8,000)
£2,085,145
(c) Forward INR 200,000,000 INR 200,000,000
£2,089,438
contract (95.4930 + 0.2265) 95.7195
Less cost (£4,500)
£2,084,938
(d) Money Market Hedge

INR 200,000,000
Borrow in rupees INR 197,628,450
1.012
INR 197,628,450
Convert @ spot rate £2,069,560
95.4930
Lend in sterling £2,069,560  1.008 £2,086,116

lOMoARcPSD|5019904
36.2 Padd's directors' attitude to risk is important.

The interest rates and the forward rate discount suggest that the rupee will weaken. A
weaker rupee will produce less sterling on conversion, so hedging may be worthwhile.
The worst case scenario from 36.1 is if the rupee weakens by 1% over the next three
months.
The MMH (which would give a fixed sterling amount) gives the highest sterling figure,
followed closely by the OTC option, with which there is some flexibility for the directors.
The forward contract (which would also give a fixed sterling amount) produces a
comparatively poor sterling remittance. It has a high arrangement fee.
Were sterling to remain at spot rate then this would give the best outcome and a
strengthening of the rupee would enhance the sterling receipt even more.
36.3 Government stability
Political and business ethics
Economic stability
Import restrictions
Remittance restrictions
Special taxes, regulations for foreign companies
Trading risks – physical risk, credit risk, liquidity risk etc
36.4
LIBOR + 1 4% 7%
Option
Exercise? Indifferent Yes
Rate (4%) (4%)
Premium (0.75%) (0.75%)
(4.75%) (4.75%)
Annual interest payment (on £8.5m) (£403,750) (£403,750)
FRA
Pay at LIBOR +1 (4%) (7%)
(Payment to)/receipt from bank (0.5%) 2.5%
(4.5%) (4.5%)
No hedge
Pay at LIBOR + 1 (4%) (7%)
If LIBOR is 3% then it's better not to hedge and at 6% the FRA seems to be the cheapest
option.
It also depends on the board's attitude to risk.
The FRA eliminates down side risk (rates rising) as well as upside risk (rates falling).
The average mark for this question was the highest in the paper, equated to a clear pass and so,
overall, was done well.
This was a four-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK footwear manufacturer/exporter and included relevant
exchange rates and interest rates. The question tested (a) candidates' understanding of foreign
exchange risk management, (b) the more general risks associated with trading overseas and (c)
how to hedge against interest rate movements.

lOMoARcPSD|5019904
Part 36.1 for 10 marks required candidates to calculate (a) the impact of a strengthening of
sterling on a proposed export contract and (b) the outcome of three possible hedging strategies
for that contract. Part 36.2 was worth eight marks and here candidates had to advise the
company's board as to which hedging technique was preferable (if any), based on their
calculations in part 36.1. Part 36.3 for five marks asked candidates to advise the company of the
risks (non-currency) to consider when trading abroad. Finally, in part 36.4 for seven marks,
candidates had to recommend whether or not the company, which has borrowed a large
amount, should hedge against the impact of interest rate movements on that loan.
Part 36.1 was very similar to past exam questions but despite this many candidates did not get
all of the calculation marks available. Typical errors were (a) using a call option rather than a put
and (b) ignoring contract costs.
The discussion in 36.2 was, in many cases, brief and very basic for eight marks.
Part 36.3 was, as expected, answered well.
Part 36.4 caused many students difficulty. Too few of them produced sufficient workings to
enable them to produce suitable recommendations.
37 Stelvio Ltd (June 2014)

Marking guide
Marks
37.1 (a) Forward contract:

Forward rates 1.5
Cost of payment 0.5
Currency futures:
Sell £ on futures exchange 1
Number of contacts to sell 1
Profit 2
Net payment 1
OTC option:
Option premium 1
Total cost with interest 1
Spot price on 30 Sep 1
Cost of payment 1
11
(b) Discussion of advantages and disadvantages 9
(c) Explanation of whether to hedge 4
37.2 (a) Interest rate differentials 2

Rates achieved through swap 2
Cash flows 1
max 4
(b) Difference in interest rates 1
LIBOR 1
2
30

lOMoARcPSD|5019904
37.1 (a) The forward contract:

The forward rates are calculated by deducting the premium from the spot rate:
Spot rates $/£ 1.6025
Forward premium 0.0021
Forward rates $/£ 1.6004
The payment will cost $940,000/$1.6004 = £587,353.
Currency futures:
Since we need to buy $ we will sell currency futures contracts (ie, selling £ on the
futures exchange). The number of contracts to sell: ($940,000/$1.5995)/£62,500 = 9.40
contracts.
Rounding the number of contracts to 9 (or 10).
On 30 September the futures will be closed out and bought at $1.5005. This will result
in a profit of ($1.5995 – $1.5005)  (£62,500  9) = $55,688.
Net payment ($940,000 – 55,688)/$1.5002 = £589,463.
Over the counter call option:
Option premium = ($940,000)  4p = £37,600
The total cost with interest = £37,600  (1 + 0.06  4/12) = £38,352.
The spot price on 30 September is $/£1.5002 so Stelvio would exercise its option.
The cost of the payment would be ($940,000/$1.6100) + £38,352 = £622,202.
(b) The forward contract and futures contracts both lock Stelvio into an exchange rate and
do not allow for upside potential.
Forwards:
 Tailored specifically for Stelvio
 However, there is no secondary market
Currency futures:
 Not tailored so one has to round the number of contracts
 Requires a margin to be deposited at the exchange
 Need for liquidity if margin calls are made
 However, there is a secondary market
OTC currency options:
 The options are expensive
 There is no secondary market
 However, the options allow Stelvio to exploit upside potential and protect
downside risk
(c) Students should mention interest rate parity, purchasing power parity and expectations
theory. The forward rate is an unbiased predictor of the future spot rate. Therefore,
Fred Hughes (FH) could lose or gain depending on how the spot price moves, he
cannot be confident in estimating the exposure. FH's attitude to risk could also be
mentioned and that, as Millar once stated, 'not to hedge is to speculate'.
37.2 (a) First it is necessary to calculate the interest rate differentials:
Stelvio Zeta Differentials
Fixed rates 5% 3% 2%
Floating rates LIBOR + 3% LIBOR + 2% 1%
Net differential 1%
This net differential will be shared 0.5% each

lOMoARcPSD|5019904
The interest rates that can be achieved through the swap are:
Stelvio Zeta
The fixed market rate for Stelvio 5.0% –
The floating market rate for Zeta – LIBOR + 2%
Less the differential 0.5% 0.5%
Rates achieved through the swap 4.5% LIBOR + 1.5%
Cash flows would be: LIBOR from Zeta to Stelvio and fixed of 1.5% from Stelvio to Zeta
(b) If LIBOR remains at 0.60% without the swap Stelvio would pay 0.60% + 3% = 3.6%.
With the swap Stelvio would be paying 4.5%.
LIBOR will have to rise to 4.5% – 3% = 1.5% for the swap to breakeven in interest terms.
This was a five-part question which tested the candidates' understanding of the risk
management element of the syllabus. In part 37.1 of the question the scenario was that a
company had not hedged foreign exchange rate risk before and the managing director was
considering using certain techniques to hedge. However he was not convinced that it was
necessary and felt that he could estimate his exposure by looking at forward rates. In part 37.2 of
the question candidates were required to demonstrate hedging the interest rate risk of a long-
term loan.
Part 37.1(a) was well answered by many candidates. However, it was disappointing to note the
following common errors made by a large minority of candidates on what should have been
very straightforward, well rehearsed calculations which have been examined many times before:
using the incorrect rate to calculate the number of futures contracts; making the incorrect
decision on whether to buy or sell the contracts at the current date; incorrectly using techniques
applicable to interest rate futures when dealing with currency futures; offsetting the gain on
futures in $ against the £ payment; omitting the interest on the OTC options premium, which is
payable upfront; treating the OTC option as a traded option and in some cases applying the
currency futures contract size to the OTC currency option.
Part 37.1(b) was well answered by many candidates, however easy knowledge marks were often
missed and it is estimated that two to three very basic marks were lost by weaker candidates.
In part 37.1(c), weaker candidates only described interest rate parity and purchasing power
parity and made no reference to the scenario of the question and the managing director's views.
As expected this was a discriminator.
Part 37.2(a) was well answered by many candidates but again weaker candidates lost two to
three basic marks by not being able to calculate the swap gain and revised borrowing rates.
These were basic calculations examined many times before.
Part 37.2(b) was well answered by the better candidates and was, as expected, a discriminator.

lOMoARcPSD|5019904
38 JEK Computing Ltd (September 2014)

Marking guide
Marks
38.1 Exchange rate % change 1
Estimated spot rate 31/12/X4 1
2
38.2 (a) Sterling receipt at estimated spot rate at 31/12/X4 2
(b) Forward contract 2
Money market hedge 3
Option 3
max 9
38.3 Outcomes 3
MMH and forward contract give best outcomes 3
Advise based on whether JEK is prepared to risk £ weakening 3
max 8
38.4 Forward exchange contract 2

Currency option 2
6
38.5 Interest rate parity explanation 2
Forward rate of exchange and comment 3
5
30
38.1
Exchange rate (€/£) 30 June 20X4 1.1150 – 1.1463
30 September 20X4 1.1832 – 1.2165
Change 0.0682 – 0.0702
6.12%
% change (three months) 0.0702
1.1463
Estimated spot rate at 31/12/X4 1.2165  1.0612 1.2909
38.2 (a)
€15,109,000
Sterling receipt at estimated spot rate at 31/12/X4 £11,704,237
1.2909
(b)
€15,109,000 €15,109,000
Forward contract £12,440,510
(1.2165 – 0.0020) 1.2145
less: Cost 15,109,000  £0.002 (£30,218)
£12,410,292
Money Market Hedge
€15,109,000
Borrow in euros €14,981,655
1.0085
€14,981,655
Convert @ spot rate £12,315,376
1.2165

lOMoARcPSD|5019904
Lend in sterling £12,315,376  1.008 £12,413,899

€15,109,000
Option (a put option @ exercise price) £12,435,391
1.2150
less: Cost 15,109,000  £0.012 (£181,308)
£12,254,083
38.3
Outcomes (in order) £
Spot rate at 30/9/X4 (as per question) 12,420,000
Money Market Hedge 12,413,899
Forward contract 12,410,292
OTC option 12,254,083
Estimated spot rate at 31/12/X4 11,704,237
The best outcome is if the current spot rate does not alter. The worst is if sterling continues
to strengthen at 2% per month and given the lower margin, the contract may make a loss as
the receipt would be significantly less than £12.42 million. However, interest rates suggest
that sterling will weaken (forward rate premium), which would be of benefit to JEK (higher
sterling receipt), but the results are all still below the £12.42 million.
The MMH and the forward contract give the best outcomes, but the latter has expensive
(fixed) costs (£0.002/€). The option has a very high fixed cost (£0.012/€), but it may be that
sterling will weaken and it could be abandoned, to JEK's benefit.
If JEK's board is prepared to risk that sterling will weaken then it would be best not to
hedge as none of the hedging methods produces £12.42 million ie, they all result in a
reduction of, or elimination of, an already low margin. If not, the MMH would be the best
option albeit with a reduced margin but hopefully this can be recovered from the follow-on
contracts potentially available.
38.4 Forward exchange contract (FC)
If JEK's bid is not successful, but the company has signed up to a forward exchange
contract, then JEK will have an obligation to sell €15.109 in three months' time. It will
therefore have to buy that sum of euros, which, if the pound has weakened, will cost an
increased amount of sterling.
Money market hedge (MMH)
JEK would have to repay the euro borrowing at 31 December 20X4, but would need to
convert this back from sterling.
Any profit or loss on FC or MMH depends on the spot rate on 31 December 20X4.
Currency option – at worst, this would not be taken up, but JEK would incur the £181,308
cost. JEK may exercise option if profitable to do so on 31 December 20X4 – this depends
on spot rate at that date.
38.5 The principle of interest rate parity (IRP) means that if an investor places money into a
currency with a high interest rate s/he will be no better off after conversion back into their
domestic currency using a forward contract than if they had left the money invested at the
domestic interest rate.
1+ Average euro interest rate
Average spot rate  = Forward contract rate
1+ Average sterling insterest rate
1.0075
1.19985  = 1.1977
1.00925

lOMoARcPSD|5019904
Average forward contract premium is 0.00225 and (1.19985 – 0.00225) = 1.1976.

As these two rates are almost identical it would appear that IRP is working.
The average mark for this question was the lowest in the paper and equated to a marginal 'fail'
and so, overall, was not done well.
This was a five-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK computer services company which was tendering for the sale of
a euro contract and its board was considering hedging against a weakening of the euro despite
having not yet won the tender. The question tested candidates' understanding of (a) foreign
exchange risk management and (b) the principle of interest rate parity.
Part 38.1 for two marks required candidates to estimate a future spot rate based on recent
changes. Part 38.2 for nine marks required them to calculate the company's sterling receipt from
the tender contract based on three hedging strategies. In part 38.3 for eight marks candidates
had to advise the company's board as to the advantages/disadvantages of each of the
strategies, based on their calculations in part 38.2, assuming that the tender bid was successful.
In part 38.4 they had to explain the implications for the company if the tender bid was
unsuccessful. Finally, for part 38.5 candidates were required to explain the principles of interest
rate parity, making use of the interest and forward contract rates given in the question.
Foreign exchange risk management is regularly tested in the examination, but despite this many
candidates did not get all of the calculation marks available. In part 38.1 the weaker scripts failed
to calculate the growth rate or applied it (2% per month) once, but not three times as required.
In part 38.2, as expected, most candidates did well, but quite a few used, erroneously, the
estimated spot rate from part 38.1 rather than the current spot rate given in the question. Many
candidates failed to identify the OTC currency option as a put and many also treated it as a
traded option.
Part 38.3 was not done well and too often candidates relied on textbook theory rather than
referring to the figures calculated.
In general part 38.4 was also done poorly and too few candidates were able to explain the
implications of losing the tender bid.
Overall the responses to part 38.5 were good, but many candidates used annual rather than
quarterly interest rates in their calculations.
39 Lambourn plc (Sample paper)

Marking guide
Marks
39.1 (a) Net currency exposure 1
Forward rate 1
Cost of payment 2
(b) Type of option and strike price 1

Calculation of premium 1
Decision to exercise 1
Gain on future 1
Total cost 1

lOMoARcPSD|5019904
Marks
(c) Sell December contracts 1
Futures outcome 1
Spot market outcome 1
(d) Deposit amount 1

Sterling equivalent of deposit amount 1
Total cost including interest 1
17
39.2 (a) December contracts 1
Put option 1
Strike price 1
Calculation of premium 1
Decision to exercise 1
Gain on future 1
Gain outcome 1
Net position 1
Effective interest rate 1
10
(b) Basis risk 1.5
Rounding 1.5
3
30
39.1 (a) Lambourn's net foreign currency exposure is the net $ payment due = $1,550,000.
The sterling payments and receipts can be ignored.
The forward rate would be 1.6666 – 0.0249 = $1.6417/£.
The cost of the payment would therefore be 1,550,000/1.6417 = £944,143.
(b) The current spot rate is $1.6666/£ so Lambourn should buy December put options on
£ with a strike price of $1.67 as $1.65/£ and $1.63/£ are worse than current spot rate.
Number of contracts = $1,550,000/1.67/31,250 = 29.7 = 30 contracts
Premium = 30  31,250  0.0555 = $52,031 at spot ($1.6666) would cost £31,220
Outcome if the spot rate is $1.6400/£: Exercise the option
Option $1.67 Spot $1.64 so profit of ($0.03  30  31,250) = $28,125
Convert $1,550,000 – $28,125 = $1,521,875/1.64 = £927,973 + £31,220 = £959,193
Alternatively:
This will realise 31,250  30  $1.67 = $1,565,625
Excess $ = $15,625 which at spot would realise £9,496 (15,625/1.6454)
Cost = (31,250  30) + 31,220 – 9,496 = £959,224
(c) Sell December futures @ 1.6496
$1,550,000/1.6496 = £939,622
Therefore 939,622/62,500 = 15.03 = 15 contracts
Futures market outcome:
Sell at 1.6496
Buy at 1.6400
Profit 0.0096  15  62,500 = $9,000
Spot market outcome: Buy $1,541,000 @ $1.6400/£ = £939,634

lOMoARcPSD|5019904
(d) Lambourn requires $1,550,000 in six months' time – the company therefore needs to
deposit $1,546,135 now (1,550,000/1.0025).
To buy $1,546,135 now will cost £927,718 (1,546,135/1.6666).
The cost of this payment with six months' interest is £941,634 (927,718  {1+0.015}).
39.2 (a) Contract: December
Contract type: Put option
Strike price: 96.25 (to cap the interest rate at 3.75% pa)
Number of contracts: £1.5m/£0.5m  6/3 = 6 contracts
Premium: December put options at 96.25 = 0.96%
Therefore: 6  0.96%  £500,000  3/12 = £7,200
Closing prices:
Case 1 Case 2
Spot price 4.4% 2.1%
Futures price 95.31 97.75
Outcome:
Options market:
Strike price (sell) 96.25 96.25
Closing price (buy) 95.31 97.75
Exercise? YES NO
Gain on future 0.94% N/A
Outcome 0.94%  £500,000  3/12 N/A
 6 = £7,050
Net position:
Borrow at spot rate 33,000 15,750
Gain from option (7,050) N/A
Option premium 7,200 7,200
£33,150 £22,950
Interest rate 33,150/1,500,000  12/6 22,950/1,500,000  12/6
= 4.42% pa = 3.06% pa
(b) Futures may give less than 100% efficiency because of:
 basis risk – the price of a future may differ from the spot price on a given date.
Basis is nil at expiry but before then the change in the spot rate is not matched by
the change in the futures price preventing a hedge from being 100% efficient.
 rounding – frequently the number of contracts has to be rounded as dealing in
fractional contracts is not possible. This can also cause inefficiency.
This risk management question produced the highest average mark of the three questions. This
reflects the fact that a firm knowledge of the techniques involved provides candidates with a
good opportunity to score highly on such questions, particularly when (as many do) they benefit
from the application of the 'follow-through' principle when such questions are marked. As usual,
however, there was very little middle ground – the failing candidates on the paper overall had
little or no grasp of the techniques involved in this question and scored poorly.
The most common errors in part 39.1 were a failure to correctly calculate the firm's net
transaction exposure, often including the sterling amounts, incorrect identification of the correct
type of option, a failure to accurately calculate the number of contracts and the use of the wrong
rate when calculating the premium.
Part 39.2 was generally well answered.

lOMoARcPSD|5019904
40 American Adventures Ltd (December 2013)

Marking guide
Marks
40.1 (a) Net exposure 1
Forward contract 2
Currency futures 4
Currency options 7
17
(b) Advantages and disadvantages of each method 11

max 8
40.2 (a) FRA and interest rate 1
Payment 1
Total cost 1
(b) Receipt 1
Total cost 1
5
30
40.1 (a) The net exposure to FOREX should be hedged by matching payments and receipts:
$3.5 – $2.250 = $1.25 million payment.
A forward contract:
The exchange rate for the four-month forward contract is calculated by adjusting the
spot rate by the premium: $1.5154 – $0.0012 = $1.5142.
The cost of the payment in £ is: $1,250,000/1.5142 = £825,518.
This will be the cost of the payment no matter what the spot rate is on 31 March 20X4.
Currency futures:
To hedge an unexpected strengthening of the $ against the £ the March 20X4 futures
will be sold on 30 November 20X3 at $1.5148.
The number of contracts to sell is:
($1,250,000/$1.5148)/£62,500 = 13.20 Round to 13 contracts resulting in a slightly
under hedged position.
At 31 March 20X4 the currency futures contracts will be closed out and the
$1.25 million purchased on the spot market.
Closing out the contracts:
The futures price at close out is $1.5153. To buy back at this price will result in a loss on
our futures trade of: $1.5148 – $1.5153 = –$0.0005
The total loss is: $0.0005(£62,500  13) = $406.25.
The relevant spot exchange rate on 31 March 20X4 is $1.5150.
The total cost of the payment plus the loss on futures is:
($1,250,000 + $406.25)/$1.5150 = £825,351

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A money market hedge:

A money market hedge is achieved by borrowing in £ and making a deposit in $:
The amount to deposit in $ is: $1,250,000/(1 + 0.0225/3) = $1,240,695
This amount will be purchased at the spot rate on 30 November 20X3:
$1,240,695/$1.5154 = £818,724
The total cost together with interest is: £818,724(1 + 0.047/3) = £831,551.
Currency options:
Since we are a UK company using sterling options priced in $ we will hold Put options
(ie, to sell £).
The number of contracts is: ($1,250,000/$1.56)/£10,000 = 80.13 Round to 80 contracts
resulting in a slightly under hedged position.
The premium is: (80  $0.0615  £10,000)/$1.5154 = £32,467
Since this is payable upfront the total cost plus interest (AA has an overdraft so it will be
borrowing in order to pay the premium) is:
£32,467(1 + 0.047/3) = £32,976
The options will be exercised since the spot rate on 31 March 20X4 of $1.5150 is worse
than the exercise price of $1.5600.
Since we slightly under hedged our position this will result in a shortfall of:
$1,250,000 – (80  $1.5600  £10,000) = $2,000. This can be purchased on the
spot market:
$2,000/$1.5150 = £1,320.
This will result in a total £ cost of: (80  £10,000) + £32,976 + £1,320 = £834,296
[Alternatively for last three marks: profit on option = 1.56 – 1.515=0.045  80  10,000
= $36,000
(36,000 – 1,250,000)/1.515 = (801,320) + (32,976) = (834,296)]
(b) The forward contract, futures and money market hedges lock AA into an exchange
rate, however they do not allow for the upside potential of the $ weakening against £.
Points that candidates may mention in relation to each include:
The forward contract and money market hedge:
 Tailored specifically to AA
 No secondary market so difficult to unwind the hedge
Currency futures:
 Not tailored so may leave an amount under or over hedged
 Requires a margin to be deposited at the futures exchange
 There is a secondary market so easy to unwind the hedge
 Basis risk
Traded currency options protect AA from downside risk and allow the company to take
advantage of the upside potential of the $ weakening against the £.

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Points that candidates may mention include the following:

 Currency options are costly
 Not tailored so may leave an amount under or over hedged
 There is a secondary market so easy to unwind the hedge, however the options
may be worth less when sold back to the market
Any other sensible point will be awarded marks.
40.2 The appropriate FRA is a 4 v 7 and relevant interest rate is 3.58%.
The interest rate is 3.58%
(a) A borrowing rate of 3% means that AA pays the bank:
(3.58% – 3.00%)  £1 million  3/12 = £1,450.
The interest on the loan is: £1 million  3%  3/12 = £7,500.
A total cost of: £7,500 + £1,450 = £8,950.
(b) A borrowing rate of 4% means that the bank pays AA:
(4% – 3.58%)  £1 million  3/12 = £1,050
The interest on the loan is: £1 million  4%  3/12 = £10,000.
A total cost of: £10,000 – £1,050 = £8,950.
This was a three-part question that tested the financial risk element of the syllabus.
Part 40.1 (a) for 17 marks required candidates to calculate the results of hedging foreign
exchange rate risk using forwards, futures, the money markets and traded currency options. Part
40.1 (b) for eight marks required candidates to describe the relative advantages and
disadvantages of using various methods to hedge the FOREX.
Part 40.2 for five marks required candidates to demonstrate how an FRA can be used to hedge
interest rate risk.
Part 40.1(a) was well answered, however a number of candidates made errors when calculating
the number of futures and options contracts, also some candidates made incorrect decisions
regarding whether to buy or sell futures when setting up the hedging position. When hedging
with options some candidates chose to use calls rather than puts.
Most candidates answered part 40.1(b) well.
Part 40.2 was well answered, however a disappointing number of candidates did not show the
net interest paid by the company.

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41 Hammond Beamish Software Ltd (September 2010)

Marking guide
Marks
41.1 (a) Strengthening of sterling – calculation 1½

Weakening of sterling – calculation 1½
3
(b) Forward contract calculation 2
Money market hedge calculation 4
Option calculation 2
8
(c) 1–2 marks per relevant point max 8
41.2 (a) Difference between differences 1

Split of potential gain between parties 2
New net payment under interest rate swap 3
Both parties pay less than available fixed and variable rates 2
8
(b) Counterparty risk 1
Position or market risk 1
Transparency risk 1
3
30
41.1 (a) Strengthening of sterling = 1.1084  1.01 = €1.1195/£

€3,500,000/1.1195 = £3,126,396
Weakening of sterling = 1.1084  0.99 = €1.0973/£
€3,500,000/1.0973 = £3,189,647
(b)
Forward contract Spot rate 1.1084
Less premium (0.0040)
1.1044
Sterling receivable €3,500,000/1.1044 £3,169,142
Money market hedge
The company wants to use its €3.5 million receipts in three months' time to pay off a
money market loan in euros.
Euro borrowing rate (3 months) 3.4%/4 = 0.85%
Size of euro loan now (€3,500,000  1/1.0085) €3,470,501
Convert euros into sterling at spot rate:
Receipt (€3,470,501/1.1084) £3,131,091
Invest at 3.9%/4 = 0.975% for three months: Interest £30,528
Total sterling receipts £3,161,619
Option
Type of contract Call
Number of contracts €3.5m/(1.102  £62,500) = 50.8 So 51 contracts
Premium 0.0205  £62,500  51 = €65,344 at 1.1026 = £59,264

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€
Option market
Prevailing exchange rate in 3 months 1.1035
Have right to buy £ for 1.1020
Intrinsic value of option (€/£) 0.0015
Exercise? Yes
Value of options: €0.0015  £62,500 = €93.75 per contract

Number of contracts = 51
Gain on contracts = 51  €93.75 = €4,781
Net outcome
Spot market receipt 3,500,000
Options gain 4,781
3,504,781
£
Converted at closing spot rate (1.1035) 3,176,059
Premium (59,264)
Net sterling receivable 3,116,795
(c) Spot rate gives a sterling value of £3,157,705 (€3,500,000/1.1084).

From part 41.1(a), strengthening of sterling would reduce receipt to £3,126,396, whilst
weakening of sterling increases sterling receipt to £3,189,647. So it would be
preferable if sterling depreciated.
Interest rates (and thus the forward rate premium) suggest a weakening of sterling in
the three months ahead. The forward contract is preferable to the money market
hedge (£7,523 higher) and the option (£52,347 higher).
However the option includes upside potential if the exchange rate moves in
Hammond's favour, which the forward and the money market hedge do not.
The option is expensive and there may be cash flow implications of paying the
premium upfront.
Management's attitude to risk is important here. If sterling is expected to weaken then
perhaps ignore hedge and go with the spot rate.
Alternatively as margins are low, the hedging gives more security as the rate of
depreciation is not guaranteed.
41.2 (a)
SWI HD Difference
Fixed 9.2% 10.8% 1.6%
Variable LIBOR + 1.0 LIBOR + 1.4 0.4%
Difference between differences 1.2%
This potential gain can be split evenly, ie, 0.6% to each party, which means that SWI
would pay LIBOR + 0.4% (LIBOR + [1.0% – 0.6%] and HD would pay fixed 10.2% (10.8%
– 0.6%).
The interest rate swap would look like this:
SWI HD
Currently pays (9.2%) (LIBOR + 1.4)
HD pays SWI (bal fig) 8.8% (8.8)
SWI pays HD (LIBOR ) LIBOR
New net payment (LIBOR + 0.4) (10.2%)

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SWI and HD would both pay at less (0.6% in each case) than their available fixed and
variable rates.
LIBOR = 8.4% SWI HD
New net interest rate (LIBOR + 0.4) 8.8% pa 10.2% pa
Interest on £24m pa £2,112k £2,448k
Alternatively
£'000 Rate £'000 £'000 Rate £'000
Interest paid now 24,000 (9.2%) (2,208) 24,000 (9.8%) (2,352)
HD pays SWI 8.8% 2,112 (8.8%) (2,112)
SWI pays HD (8.4%) (2,016) 8.4% 2,016
New interest
payment (2,112) (2,448)
(b) Counterparty risk – counterparty defaults before completion

Position or market risk – unfavourable market movements once swap established
Transparency risk – accounts become misleading
Part 41.1(a) was straightforward, but a disappointing number of candidates were unable to
calculate a 1% increase and then a 1% decrease in the value of sterling.
Parts 41.1(b) and (c) were generally well answered, although many candidates did not relate
their answers to the scenario.
Part 41.2 was answered well. The main problem area for candidates was that many of them did
not make the variable leg of the swap at LIBOR as required in the question.
42 Bridge Engineering plc (December 2015)

Marking guide
Marks
42.1 Intrinsic value:

Calculation of value of call options 1
Calculation of value of put options 1
Time value – deduct intrinsic value from the option premium 2
4
42.2 Explanation of each of the three factors:
Time period to expiry 1
Market price volatility 1
General level of interest rates 1
3
42.3 Explanation of the two factors:
Exercise price 1
Share price 1
2

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Marks
42.4 How Bridge can protect itself:
Put options 1
Choice of exercise price 1
Calculations 2
4
42.5 To hedge against a rise in LIBOR:
Date of option 0.5
Put option 0.5
Exercise price 0.5
Calculation of number of contracts 1.5
Premium payable 1
Effective interest rate scenario (a):
Exercise? 0.5
Gain 1
Total interest payable 0.5
Net cost of the loan 1
Effective interest rate 0.5
Effective interest rate scenario (b):
Exercise? 0.5
Total interest payable 0.5
Total cost 1
Effective interest rate 0.5
10
42.6 Advantages of traded interest rate options:
Hedge downside risk, and take advantage of upside 1
FRAs and interest rate futures lock in the interest rate 1
Options set a maximum interest rate 1
Liquid market, can be closed out if not needed 1
Disadvantages of traded interest rate options:

Cost of the premium 1
Margin requirements 1
Contracts are standard sizes so may not fit perfectly 1
FRAs can be tailor made 1
Max 7
30
42.1 Intrinsic value

Only options that are in the money have an intrinsic value.
For the call options:
The call options with an exercise price of 280p are in the money and have an intrinsic value
of 7p (287 – 280).
The call options with an exercise price of 290p are out of the money and have a zero
intrinsic value.
For the put options:
The put options with an exercise price of 290p are in the money and have an intrinsic value
of 3p (290 – 287).

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The put options with an exercise price of 280p are out of the money and have a zero
intrinsic value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:
Calls Puts
Exercise price January March January March
280 1.5 9 1.5 10.5
290 2.5 11 2.5 13.0
42.2 The three factors that affect the time value of the options on Stickle's shares are:
 the time period to expiry of the option. The longer the time to expiry, the more the
option is worth.
 the volatility of the market price of Stickle's shares. For example, if Sickle's share price
becomes more volatile this will increase the probability of the options becoming either
in the money or, if they are already in the money, becoming deeper in the money. This
would increase the value of the options.
 the general level of interest rates. The exercising of the option will be at some point in
the future, and so the value of the option depends on the present value of the exercise
price. For example, for the call options on Stickle's shares if interest rates rise the
options will become more valuable.
42.3 The factors that affect the intrinsic value of the options on Stickle's shares are:
 The exercise price:
– For a call option: The lower the exercise price in relation to the share price the
higher will be the intrinsic value and this will make the option more valuable.
– For a put option: The higher the exercise price in relation to the share price the
higher will be the intrinsic value and this will make the option more valuable.
 The share price:
– For a call option: As the share price rises the option becomes deeper in the
money and more valuable as the intrinsic value increases. The reverse is the case
for a fall in the share price.
– For a put option: As the share price falls the option becomes deeper in the money
and more valuable as the intrinsic value increases. The reverse is the case for a rise
in the share price.
42.4 Bridge can protect itself against a fall in the Stickle share price by holding put options that
expire on 31 March 20X6.
The choice of exercise price will depend on the level of cover required and how much
premium Bridge is willing to pay.
If the Stickle share price is 250p at the end of March the results of holding put options will
be as follow:
With an exercise price of 280p
Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the put options 280 – 250 = 30p
Premium: 10.5p
The maximum loss: 37 – 30 + 10.5 = 17.5p
Alternative: 287 – 280 + 10.5 = 17.5p

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With an exercise price of 290p

Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the options 290 – 250 = 40p
Premium: 16p
Maximum loss: 37 – 40 + 16 = 13p
Alternative: 287 – 290 + 16 = 13p
42.5 To hedge against a rise in LIBOR from 0.62% pa during the period from 31 December 20X5
to 31 July 20X6, Bridge will need to hold September put options with an exercise price of
99.38 (100 – 0.62).
Using options on three month interest rate futures to hedge a seven month period, the
number of contracts to be held is: (£20 m/£0.5 m)  (7/3) = 93.33; round to 93 contracts.
This leaves the company slightly under hedged.
The premium payable is: 93  0.52%  0.5m  3/12 = £60,450.
The results of the hedge on 31 July 20X6 are as follows:
(a) LIBOR is 0.80% pa and the futures price is 99.15.
Exercise the options? Yes, since the exercise price is 99.38 and more than the futures
price.
Gain on futures: 99.38 – 99.15 = 0.23%. 0.23%  0.5m  93  3/12 = £26,738.
Borrowing cost: 0.80 + 4.00 = 4.80% pa.
Total interest payable to the bank: 20m  0.048  7/12 = £560,000
Net cost of the loan including the option premium:
560,000 + 60,450 – 26,738 = £593,712
The effective interest rate is: (593,712/20m)  (12/7) = 5.09% pa
Alternative: LIBOR + 4.00 – Gain on exercise + premium = 0.80 + 4.00 – 0.23 + 0.52 =
5.09% pa
(b) LIBOR is 0.40% pa and the futures price is 99.66
Exercise the options? No, since the exercise is 99.38 and less than the futures price.
Borrowing cost: 0.40 + 4.00 = 4.40% pa
Total interest payable to the bank: 20m  0.044  7/12 = £513,333
Total cost including the option premium: 513,333 + 60,450 = £573,783
The effective interest rate is: (573,783/20m)  (12/7) = 4.92% pa
Alternative: LIBOR + 4.00 + premium = 0.40 + 4.00 + 0.52 = 4.92% pa
42.6 The advantage of using options on interest rate futures rather than FRAs or interest rate
futures is that Bridge can hedge the downside risk (LIBOR rising) and take advantage of
upside potential (LIBOR falling).
Both FRAs and interest rate futures will lock Bridge into an estimate of LIBOR on 31 July
20X6.
The options will set a maximum on the interest rate that Bridge will have to pay.
The major disadvantage of using options on interest rate futures is the cost of the premium.
Both options on interest rate futures and interest rate futures are traded instruments and
there is a liquid market. Should Bridge not require the loan on 31 July 20X6 it can close out
the contracts.

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There will be margin requirements, and there is the possibility of having to meet margin
calls.
With both these instruments basis risk exists and it is not possible to construct a perfect
hedge, since the contracts are in standard sizes of £500,000.
FRAs on the other hand are over-the-counter instruments, and can be tailor made to
Bridge's requirements.
The disadvantage of FRAs is that there is no liquid market for them should Bridge not need
to borrow the £20 million on 31 July 20X6.
This was a six-part question that tested candidates' understanding of the risk management
element of the syllabus. The scenario was that a company had used derivative instruments to
hedge risk that locked the company into one rate or asset price. The finance director of the
company wished to know more about the use of financial options in risk management. Two risks
in particular that the finance director was concerned about were the risks associated with buying
shares and the interest rate risk associated with taking out loans.
There were many weak answers to part 42.1 of the question, but there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. Part 42.2
was poorly answered, which is surprising since this has been examined before. However, again,
there were some excellent answers.
There were many weak answers to part 42.3 of the question, however there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. In part
42.4, many students successfully applied the knowledge that they had acquired from their
studies of FTSE 100 index options. However basic errors included using calls instead of puts and
picking the incorrect month of exercise. Part 42.5 has been examined before, yet there were
many basic errors which included using calls instead of puts, an incorrect number of contracts,
the wrong date for the contracts and an inability to calculate an effective interest rate.
Part 42.6 was well answered by the majority of candidates.

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March 2016 exam answers
43 Aranheuston Pharma plc (March 2016)

Marking guide
Marks
43.1 Net present value of the AP525 product:

Sale of old equipment 0.5
Calculation of tax due on sale 1
New equipment cost and subsequent sale 1
Calculation of tax relief on equipment 2
Sales 1
Variable costs 1
Rent 1
Fixed costs 1.5
Taxation 2
Working capital 2
Discount factor 1
Ignore depreciation, head office costs, interest (1 mark each) 3
Conclusion 1
18
43.2 Sensitivity:
Variable costs 0.5
Taxation 1
Discount factor 1
Correct calculation of sensitivity and appropriate conclusion 2.5
5
43.3 Shareholder value analysis:
Value drivers 2
Methodology 2
Key features of the approach 2
6
43.4 Agency theory/conflicts:
(a) Takeover
Empire building, vested interests (1 mark per valid point) 3
(b) Debt levels (1 mark per valid point) 3

Time horizons (1 mark per valid point) 3
max 6
35
ICAEW 2019 March 2016 exam answers 245

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43.1
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Old equipment – Sale 70,000
Tax due (1) (11,900)
New equipment cost/sale (1,150,000) 100,000
Tax relief on equipment (2) 35,190 28,856 23,662 90,792
Sales (3) 2,705,040 742,846
Variable costs (4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (5) (164,800) (169,744) (174,836)
Taxation (6) 13,600 41,616 (204,584) (55,694)
Working capital (7) 0 (267,800) 193,537 74,263
Net cash flow after taxation (1,123,110) (442,128) 1,216,049 536,971
8% factor 1.000 0.926 0.857 0.794
PV (1,123,110) (409,411) 1,042,154 426,355
NPV (64,012)
Ignore depreciation as it is not a cash flow.

Ignore HO costs as they are allocated – and therefore not incremental cash flows.
Ignore interest as it is part of the cost of capital.
AP525 produces a negative NPV, and so should not be undertaken as it would reduce
shareholder wealth.
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
(1)
WDV b/f 0
Balancing charge 70,000
WDV/sale 70,000
Tax (17%  balancing 11,900

charge)
(2)
Equipment purchase/WDV 1,150,000 943,000 773,260 634,073
WDA @ 18%/Bal.allowance (207,000) (169,740) (139,187) (534,073)
WDV/sale 943,000 773,260 634,073 100,000
Tax
(17%  WDV/Bal.allowance) 35,190 28,856 23,662 90,792
(3)
Sales (March 20X6 prices) 2,600,000 700,000
Inflate at 2% pa  (1.02)2  (1.02)3
"Money" sales income 2,705,040 742,846
(4)
Variable cost 1,180,000 220,000
(March 20X6 prices)
Inflate at 3% pa  (1.03)2  (1.03)3
"Money" variable cost 1,251,862 240,400

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(5)
Fixed costs
(March 20X6 prices) 290,000 290,000 290,000
less: HO cost allocation (130,000) (130,000) (130,000)
160,000 160,000 160,000
Inflate at 3% pa  1.03  (1.03)2  (1.03)3
"Money" fixed costs 164,800 169,744 174,836
(6)
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) _ (164,800) (169,744) (174,836)
Trading profit/(loss) (80,000) (244,800) 1,203,434 327,610
Tax reclaim/(payable) @ 17% 13,600 41,616 (204,584) (55,694)
(7)
Total working capital 0 260,000 70,000 0
 1.03  (1.03)2
"Money" total working capital 0 267,800 74,263 0
Incremental working capital 0 (267,800) 193,537 74,263
43.2 PV of variable costs

31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Variable costs (1,251,862) (240,400)
Taxation @ 17% 212,817 40,868
Net cash flow after taxation (1,039,045) (199,532)
8% factor 0.857 0.794
PV (890,462) (158,428)
Total PV of variable costs (£890,461 + £158,428) £(1,048,890)
£(64, 012)
% change in variable costs required 6.1%
£(1, 048, 890)
Thus, ignoring all other factors, variable costs would need to fall by 6.1% before the NPV
became positive and the AP525 was viable. This is a relatively small change required to
make the NPV positive.
43.3 With shareholder value analysis (SVA), a company's value is based on the present value of
its future cash flows, so it is forward-looking. This is theoretically the most superior valuation
method. SVA considers seven value drivers, which link to (or drive) company strategy:
(7) List of capital
Predictions are very difficult, as cash flows are technically in perpetuity. Once a company's
period of competitive advantage is over then its growth rate is much slower and a terminal
(residual) value is calculated, based on its cash flows to perpetuity. This terminal value is
often the major part of the overall value of the company.

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Once the total value of the company has been calculated, based on the future cash flows
and value drivers, then, to calculate the value of equity, it is necessary to add the value of
any short-term investments held and deduct the market value of any debt held.
43.4 (a) A takeover – eg, empire building by directors, making acquisitions which are not in the
shareholders' best interest (negative NPV). Or, alternatively, a takeover might lead to
the directors being made redundant, so they would avoid a takeover which would have
been in the shareholders' best interest (positive NPV).
(b)  Debt levels – it is an all-debt financed equipment purchase here, but the directors
are likely to be cautious over risk and may prefer lower levels of debt than would
be at the optimal level (where share price maximised) for the shareholders.
 Time horizons – directors may take a short-term view of the firm as their
performance is usually judged in the short-term. However, shareholder wealth is
affected by the long-term performance of the company. Thus directors might turn
down a possible investment that has short-term losses, but a long-term positive
NPV. This would not occur in the case of AP525, as it has a negative NPV.
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good indeed.
This was a four-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. In the scenario a pharmaceutical company was considering
the development of a new product and the possible takeover of a competitor. In part 43.1, for
18 marks, candidates were required to calculate the net present value of the proposed product
development. They were given forecast life-cycle data for the new product and had to take
account of non-relevant cash flows, inflation rates and corporation tax implications. Secondly, for
five marks, they were required to calculate the sensitivity of that decision to the variable costs of
the product. For a further six marks they were asked to outline how Shareholder Value Analysis
(SVA) could be used when valuing a target company. Finally, for six marks, candidates were
required to apply their understanding of agency theory to three specific elements of the
scenario.
Part 43.1 was very well answered by most candidates. However, common errors noted were:
 no balancing charge calculated on the old equipment to be disposed of.
 rental costs (fixed) were inflated and/or in arrears, not in advance.
 tax savings from negative cash flows in Year 0 and Year 1 were omitted.
 working capital – did not net to zero, was applied to the wrong years, the inflation
calculations were poor.
Also, many candidates lost marks for not explaining why depreciation, head office costs and
interest charges were not relevant cash flows. ‘Not relevant' was insufficient. In part 43.2 the
sensitivity calculations were generally fine. The most common errors were (a) using sales or
contribution figures rather than variable costs and (b) missing out the effect of taxation in the
calculations.
As in previous papers the candidates' understanding of SVA was generally poor. A
disappointing number of them concentrated, wrongly, on NPV rather than PV and discussed
SVA in regard to a project and not the valuation of a target company. Thus, many candidates did
not mention terminal value. Agency theory was generally answered well. The weakest area here
was candidates' explanation of the conflicts that might arise in relation to short-term versus long-
term performance appraisal in the context of the project. Too many used a takeover context
instead.

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44 Oliphant Williams plc (March 2016)

Marking guide
Marks
44.1 Calculation of gearing ratio:

Book value 1.5
Market value 1.5
3
44.2 Gearing and share price:
View on gearing 2
Comparison of book value and market value 2
No industry comparison available 1
Reduction in gearing will have positive effect on share price 1
6
44.3 Impact of rights issue:
Calculation of funds needed for debenture redemption 2
Calculation of TERP 3
Value of a right 0.5
Current value of 10,000 shares 0.5
(a) Effect of taking up the rights 1
(b) Effect of selling the rights 1
(c) Effect of ignoring the rights 1
9
44.4 OW share price:
Current EPS 1
Current PE ratio 1
Calculation of new earnings figure 2
New EPS 1
MV per share post rights 1
Commentary 1
7
44.5 Dividend policy:
M&M theory 2
Traditional theory 2
Other theories 2
Change in dividend policy likely to have effect 1
7
44.6 Ethical implications:
Objectivity 1
Integrity 1
Professional behaviour 1
3
35

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44.1
Long term finance Book value Market value
£m £m
Ordinary share capital 96.0 326.4
retained earnings (RE) 43.8 n/a
Preference share capital (PSC) 28.0 50.4
3.5% debentures 160.0 168.0
327.8 544.8
Total fixed return capital (debentures + PSC) 188.0 218.4
Gearing % 188.0 57.4% 218.4 40.1%

327.8 544.8
44.2 The main theories of gearing and market value are the traditional view, M&M 1958 and
1963.
The modern view is that the optimum gearing level (where company value is maximised) is
a balance between the benefits of the tax shield and bankruptcy costs. The impact on OW's
WACC (and value) depends on where its optimum gearing level is.
OW's gearing at book value is over 57%; this is rather high and may depress OW's market
value.
However, gearing at market value is 40%. This is much lower, which may have a positive
effect on the value of OW's shares.
It is hard to say where OW's optimal gearing level is likely to be, as there are no industry
comparisons.
If OW's gearing level is currently above its optimal level, then a reduction in its gearing will
have a positive effect on its share price and vice versa.
44.3 Total funds needed for debenture redemption = £160m  50%  110.40/100 £88.32m
Shares
m £m
Currently 192.0 £1.70 326.400
Rights issue (2 for 5) 76.8 £1.15 88.320
268.8 £1.5429 414.72
TERP = £1.5429
Value of a right = £1.5429 – £1.15 £0.3929
Current wealth 10,000  £1.70 17,000
(a) Take up rights £ £
Investment ex-rights 10,000  7/5  1.5429 21,600
Cost of extra shares 10,000  2/5  £1.15 (4,600) 17,000
(b) Sell rights
Investment ex-rights 10,000  1.5429 15,429
Sale of rights 10,000  2/5  £0.39 1,571 17,000
(c) Ignore rights
Investment ex-rights 10,000  1.5429 15,429
44.4 OW's current earnings per share (EPS) £21.12m/192.0m £0.11
OW's current p/e ratio £1.70/£0.11 15.5
[or £326.4m/£21.12m = 15.5 for 2 marks]

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£m
OW's current earnings 21.120
plus: Interest saved (after tax) £160m/2  3.5%  83% 2.324
OW's new earnings 23.444
OW's new earnings per share (EPS) £23.444m/268.8m £0.0872

OW's MV/share post-rights £0.0872  15.5 £1.35
Thus if OW's P/E ratio remains unchanged post-rights, its market value will fall (from
£1.70 per share) by approx. £0.35 per share (20.6%). This fall has been caused by a dilution
in the EPS figure (the extra shares have outweighed the impact of the debenture interest
saved).
However the debenture redemption will cause a fall in gearing. This decline in gearing may
prompt an increase in OW's p/e ratio (because of lower financial risk).
44.5 M&M theory – share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities (positive NPV's).
Any loss in dividend income will be offset by gains in the share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or
capital gains in the future. Cash now is more certain than cash in the future.
Supplementing these main theories:
 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on OW's share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change,
Communication with them is important.
44.6 ICAEW provides ethical guidance that will ensure that recipients of corporate finance
advice can rely on the objectivity and integrity of advice given to them by members. The
other ethical principle at risk here is that of professional behaviour.
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a "pass" standard in the question, however.
element of the syllabus and there was also a small section with an ethics element to it. It was
based around a design company which was planning to restructure its balance sheet. This would
be achieved by financing the redemption of long-term debt via a rights issue of ordinary shares.
Part 44.1 of the question, for three marks, required candidates to calculate the current gearing
levels of the company, using both book and market values. In part 44.2 for six marks, they were
asked to discuss the impact of a change in the company's gearing levels on its share price.
Candidates were expected to make reference to relevant theories and their calculations from
part 44.1. Part 44.3 for nine marks required the candidates to calculate the theoretical ex-rights
price (TERP) of the company and the impact of the proposed rights issue on the wealth of a
shareholder holding 10,000 of the company's shares. Part 44.4 (seven marks) tested candidates'
understanding of (a) the company's P/E figure and (b) the impact of the debt redemption on the
company's earnings figure. Part 44.5, again for seven marks, required candidates to apply their
understanding of dividend policy theory to the scenario. Finally, for three marks, part 44.6
required candidates to comment as an ICAEW Chartered Accountant on the ethical implications
of issuing misleading information to shareholders.

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Many candidates' answers to part 44.1 were disappointingly weak. Typical errors were: (a) not
including preference shares as debt (contra to the study manual and past questions) and (b)
ignoring retained earnings in their book value calculations, but including it in their market value
calculations.
In part 44.2 many candidates only scored three marks by focussing just on the theory of gearing
and company value. Those scoring higher marks noted that there was a lack of industry
comparison available in the question and, better still, noted the importance of where the
company is now in relation to its optimum gearing level.
In part 44.3 a significant number of candidates calculated a TERP in excess of the current market
value – clearly this is wrong. This was mainly because they assumed that the par value of ordinary
shares was £1 (not 50p) and insisted that the share price was £3.40, not £1.70, as given in the
question. Many candidates did not calculate the correct debenture redemption figure. Most
candidates did well with the impact of the rights issue on the shareholder's wealth, but many
calculated a large increase in wealth when it should be zero or a loss from doing nothing.
Candidates' performance in part 44.4 was very variable indeed and was probably the weakest
set of answers on the whole paper. Very few candidates adjusted the company's earnings figure
for saved interest (less tax). A disappointing number calculated the P/E ratio, wrongly, as follows:
£1.70/£21.12m.
Part 44.5 was answered very well, as expected. Part 44.6, also, was answered well, but a high
number of candidates included money laundering in their answers – not relevant here.
45 Tully Carlisle Ltd (March 2016)

Marking guide
Marks
45.1 (a) Hedging strategies:
Forward contract 2
OTC currency option 3
8
(b) Advice on hedge:
Use of spot rates to analyse costs 3
Conclusion re options 1
Effect of continually weakening rouble on spot rate 1
Advantages of options (flexibility) 2
Other factors to consider (risk attitudes, political risk) 2
9
(c) Three month forward rate:
Interest rate parity 2
Calculation of 3 month forward rate using IRP formula 2
Calculation of discount 1
5
45.2 Interest rate swap:
Calculation of interest rate differences 1
Details of swap 2
Net new rate for TC 1.5
Net new rate for SSM 1.5
Details of new interest payments 2
8
30

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45.1 (a) Forward contract
Payment in sterling would R145.6m R145.6m

(£1,834,677)
be (78.81+ 0.55) (79.36)
plus: arrangement fee 145.6  £40 (£5,824)
(£1,840,501)
Money market hedge
Payment in sterling would R145.6m R145.6m R143,589,740 lent

be (1+ (5.6% / 4)) 1.014
Converted at spot rate R143, 589, 740 (£1,821,973)

78.81
Borrowed at 3.6% p.a. £1,821,974  (3.6%/4) (£16,398)
(£1,838,371)
OTC currency option

A call option would be used (ie, at 79.85R/£)
R145.6m
Payment in sterling would be (£1,823,419)
79.85
plus: Option premium 145.6  £90 (£13,104)
(£1,836,523)
R145.6m
(b) Sterling payment at spot rate (£1,847,481)
78.81
R145.6m
Comparative payment at earlier dates 31/12/X4 (£1,832,599)
78.81
R145.6m
31/12/X5 (£1,903,019)
78.81
Stronger sterling gives the lowest payment, and weaker sterling the highest.
The forward contract discount suggests a weakening of the rouble. It has weakened
from December 20X5 to February 20X6, so this may be a trend.
In order (lowest to highest cost)
Option (£1,836,523)
Money market hedge (£1,838,371)
Forward contract (£1,840,501)
Spot (£1,847,481)
The option gives the best outcome (it has a slightly lower cost than the money market
hedge and the forward contract). However, if the rouble continued to weaken then the
sterling cost would fall further. For example, a 1% increase in the spot value of sterling
over the next three months would make this the lowest sterling payment
(145.6mR/(78.81  1.01) = £1,829,146.
An option gives flexibility (the ability to abandon, or to take advantage of any upside)
unlike the money market hedge or forward contract (which are both fixed, binding, and
have no upside/downside).
The directors' attitude to risk is important, as is a consideration of issues such as the
potential for political risk associated with operations in Russia.

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1+Average rouble interest rate (3mths)

(c) Average spot rate  = Forward contract rate (3mths)
1+ Average sterling interest rate (3mths)
The rouble interest rates are higher than those of sterling. Using the interest rate parity
(IRP) equation above, the value of sterling against the rouble will rise. The rouble's loss
of value is called a discount.
Average UK rate 3.25% pa or 0.8125% per 3 months
Average Russian rate 6.1% pa or 1.525% per 3 months
Average spot = (90.62 – 78.81)/2) + 78.81 = 84.715
Forward = 84.715  (1.01525/1.008125) = 85.31 ie, a discount of 0.6
Average discount given = 0.59, so IRP is working
45.2
TC SSM Difference
Fixed 5.2% 6.4% 1.2%
Variable LIBOR + 1.2 LIBOR + 1.6 0.4%
Difference between differences 0.8%
This potential gain can be split evenly, ie, 0.4% to each party. This means that TC would pay
LIBOR + 0.8% (LIBOR + [1.2% – 0.4%] and SSM would pay fixed 6.0% (6.4% – 0.4%).
The interest rate swap would look like this:
TC SSM
Currently pays (5.2%) (LIBOR + 1.6)
TC pays SSM (LIBOR) LIBOR
SSM pays TC (balancing figure) 4.4% (4.4)
New net payment (LIBOR + 0.8) (6.0%)
TC and SSM would both pay at less (0.4% in each case) than their available fixed and
variable rates.
TC SSM
New net interest rate (LIBOR + 0.8) 4.3% pa 6.0% pa
£'000 £'000
Interest on £18.5m pa (795.5) (1,110.0)
Alternatively
£'000 Rate £'000 £'000 Rate £'000
Interest paid now 18,500 (5.2%) (962.0) 18,500 (5.1%) (943.5)
SSM pays TC 4.4% 814.0 (4.4%) (814.0)
TC pays SSM (3.5%) (647.5) 3.5% 647.5
New interest
payment (795.5) (1,110.0)

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The average mark for this question was very good and most candidates demonstrated a good
understanding of this area of the syllabus.
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus. In the scenario a construction company was investigating
firstly how it might manage its exposure to foreign exchange rate risk and then whether a
proposed interest rate swap on borrowed funds was worthwhile. Part 45.1(a) for eight marks
required candidates to calculate the sterling cost arising from a range of hedging techniques
applied to a large Russian purchase contract. In part 45.1(b) for nine marks, candidates were
required to advise the company's board whether it should hedge the Russian (rouble) payments.
Part 45.1(c) for five marks required candidates to explain, with relevant workings, the concept of
interest rate parity (IRP). In part 45.2, for eight marks, the company was planning to swap its
borrowings from a fixed rate to a variable rate of interest and candidates were asked to provide
workings for the board demonstrating how the swap would work and calculating the resultant
annual interest payments.
Most candidates' answers to part 45.1(a) were very good, but the most common error noted was
that a minority of candidates used the wrong approach with regard to the call option. Answers to
part 45.1(b) were not as good as hoped. Too many candidates discussed recent spot
movements or forward contract versus money market hedge versus option, rather than both. In
part 45.1(c) the concept of IRP was, in most cases, answered well, but many candidates used
12-month rather than three-month figures. A minority of candidates did not mention IRP, and so
scored zero.
In part 45.2, the interest rate swap was done very well and most candidates scored maximum
marks. The weakest area was with the initial overall saving on interest cost (0.8%), which a small
percentage of candidates did not calculate correctly.

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June 2016 exam answers
46 Zeus plc (June 2016)

Marking guide
Marks
46.1 Valuation using NPV:

Gross profit calculation 3
Selling and admin costs 1.5
After tax operating cash flows 1
New equipment 0.5
Tax saved on capital allowances 2.5
Working capital 2.5
Continuing value 3
Discount factor 10% 0.5
NPV 0.5
15
46.2 Multiple of current earnings:
Profits after tax 1
Use of mean P/E ratio 1
2
46.3 Advantages and disadvantages of valuation methods:
Advantages of NPV valuation 0.5
Disadvantages of NPV valuation 0.5
Advantages of mulitples valuation 0.5
Disadvantages of multiples valuation 0.5
Reservations regarding the NPV valuation – 0.5 marks each 2
Reservations regarding the mulitples valuation – 0.5 marks
each 2
max 5
46.4 Offer for sale 1
Offer for subscription 1
2
46.5 Underwriting:
Explanation of underwriting 1
Advantages for Zeus 2
Disadvantages for Zeus 2
max 4
46.6 Suggestions:
2 marks each for any two:
MBO
Private equity (MBI)
Sell to another internet company
Demerger
Liquidation max 4
46.7 Ethical issues:

Identification of threats 1
Ways to mitigate them – 0.5 marks each 2
3
35

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46.1
0 1 2 3 4
£m £m £m £m £m
Gross profit 111.21 133.85 161.10 193.90
Selling and administration (73.50) (77.18) (81.04) (85.09)
Operating cash flows 37.71 56.67 80.06 108.81
Tax 17% (6.41) (9.63) (13.61) (18.50)
After tax operating cash flows 31.30 47.04 66.45 90.31
New equipment (10.00)
Tax saved on CA's 0.31 0.25 0.21 0.17 0.77
Working capital (26.00) (5.29) (6.37) (7.67) 45.33
Continuing value 1,013.48
Net cash flows (35.69) 26.26 40.88 58.95 1,149.89
PV factors at 10% 1.00 0.91 0.83 0.75 0.68
Present value (35.69) 23.90 33.93 44.21 781.93
NPV 848.28
Gross profit = £92.4 million (140  66%)
Gross profit year:
1 = 92.4  1.18  1.02 = £111.21 million
2 = 111.21  1.18  1.02 = £133.85 million
3 = 133.85  1.18  1.02 = £161.10 million
4 = 161.10  1.18  1.02 = £193.90 million
Selling and administration £70 million (72 – 2) increasing at 5% pa, as depreciation is not a
cash flow.
Continuing value = (90.31  1.01)/(0.10 – 0.01) = £1,013.48 million
Ignoring balance sheet asset values (valuing the income that the assets generate)
Capital allowances and the tax saved thereon
Cost/WDV CA Tax
£m £m £m
0 10.00 1.80 0.31
1 8.20 1.48 0.25
2 6.72 1.21 0.21
3 5.51 0.99 0.17
4 4.52 4.52 0.77
Working capital
Total Increment
£m £m
0 (26.00) (26.00)
1 (31.29) (5.29)
2 (37.66) (6.37)
3 (45.33) (7.67)
4 45.33
46.2 Profits after tax at 30 June 20X6 = £10 million.
The value of Venus based on the mean p/e ratio = £550 million (10  55).
ICAEW 2019 June 2016 exam answers 257

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46.3 The advantages of the NPV valuation are that it values the future cash flows of the company
and takes into account both risk and the time value of money. However it has the
disadvantage that the inputs into the model are critical in arriving at a reliable estimate of
the value of Venus.
The major advantage of the multiples valuation is that it values Venus by comparison to its
peers, and reflects the future growth potential of the market. However the disadvantages
are that no company is truly comparable with another, and establishing a maintainable
earnings figure is problematic.
In relation to Venus, reservations include:
For the NPV valuation: Is 18% growth realistic for the next four years? How has this figure
been estimated? Does the 10% discount factor truly reflect the risk of the company? Is it
reasonable to calculate the continuing value by treating the fourth year after tax operating
cash flow as a growing perpetuity? How has the 1% growth figure been calculated? Is it
reasonable to assume that the gross profit percentage will increase by 10%?
For the multiples valuation: The p/e ratio of 55 is the mean of a sample of comparable
companies, but what is the spread of p/e ratios, and have outliers been excluded? Is taking
historic earnings realistic – should prospective earnings be calculated instead?
46.4 With an offer for sale shares in Venus would be sold to an issuing house, which would then
offer the shares for sale to the general public.
With an offer for subscription (or direct offer) the shares in Venus would be offered directly
to the public ie, not through an issuing house.
46.5 Underwriting is a form of insurance, which ensures that all securities are sold and Zeus can
be certain of obtaining the funds required.
The danger for Zeus of not using a underwriter for the IPO is that there might be insufficient
demand for all the securities to be issued. This is especially important when a fixed issue
price is set in advance of the issue date, and the market is volatile. The market appetite for
Venus's stocks might be less than expected, especially with the value placed on the
company, which depends on high future growth.
The major disadvantage of underwriting is the cost. The cost depends on the characteristics
of the company issuing the security and the state of the market. With a company such as
Venus, the cost is likely to be at the upper end of the scale. Fees usually range from 1% to
2% of the total finance to be raised.
Another disadvantage of underwriting is that it may signal that the company is not confident
in the issue being fully taken up.
46.6 A management buy-out is a possibility. However due to the value of and risk associated with
Venus it is more likely that a private equity firm would be interested in being involved in a
management buy-in. Private equity firms have access to large amounts of debt.
Zeus could sell-off Venus to another internet company that is involved in the fashion
industry and is seeking to expand.
With an MBO, MBI or sell-off, Zeus would receive cash but there may be difficult
negotiations regarding the price. In addition, the shareholders of Zeus would not be able to
participate in the future growth of Venus.
Zeus could spin-off (or demerge) Venus; the existing shareholders would then hold shares
in the demerged company as well as in the remaining group. Shareholders could then
participate in the growth of Venus as an independent company.
Liquidation or selling of the assets would generate cash, but this would be a last resort.

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46.7 For SA there is an issue of confidentiality here, and a potential conflict of interest. This can
be resolved by:
 the use of different partners and teams for different clients.
 taking the necessary steps to prevent the leakage of confidential information between
different teams and sections within the firm's "Chinese walls".
 regular review of the situation by a senior partner or compliance officer not personally
involved with either client.
Advising clients to seek additional independent advice, where it is appropriate.
This was a seven-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is divesting
itself of a division by offering it to the public through an Initial Public Offering.
Part 46.1 was well answered by many candidates. Common errors that weaker candidates made
were: including operating cash flows in time zero; incorrect calculation of the continuing value;
adding the 18% growth and 2% price increase figures together instead of compounding them;
omitting to explain why certain inputs were not to be included in the cash flows; applying a non-
marketability discount to the final valuation.
Part 46.2 was also well answered by the majority of candidates. However, many candidates
applied a non-marketability discount to the p/e ratio, which was inappropriate for the valuation
of an IPO. Responses to part 46.3 were mixed and often did not relate to the scenario of the
question despite the requirement specifically asking for this. Very few students submitted
correct answers to part 46.4 of the question, and often made up definitions.
Responses to part 46.5 were mixed, with a lot of candidates showing that they did not
understand what underwriting means. Responses to part 46.6 were good, although often
candidates did not consider the scenario of the question. Part 46.7 were well answered by the
majority of candidates. However, as in previous sittings, a number of candidates did not use the
language of ethics.
47 Ross Travel plc (June 2016)

Marking guide
Marks
47.1 (a) Calculation of WACC using Gordon growth model:

Ex-div share price 0.5
Shares in issue 0.5
Total earnings calculation 1
Total dividends 0.5
Retentions 1
Calculation of rate of return 2
Calculation of growth rate 0.5
Cost of equity 1
Cost of debt 3
MV of equity 1
MV of debt 1
12

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(b) Calculation of WACC using CAPM:

Cost of equity 1
Cost of debt 1
2
47.2 Limitations of the Gordon growth model:
One mark per point to a maximum of 3
47.3 WACC for appraisal of Happytours:

Explanation of need to reflect risk 3
Degearing of the beta for the new sector 1.5
Regear using Ross's capital structure 1.5
New cost of equity 0.5
Calculation of WACC 0.5
max 6
47.4 New debentures:
Higher yield likely to be required: risk, coupon rate;
maturity 2
Calculation of issue price 4
Calculation of nominal value to be issued 1
7
47.5 Convertible debentures:
Explanation and features of convertible debentures 3
Advantages – 0.5 marks each 2.5
Disadvantages – 0.5 marks each 1
max 5
35
47.1 (a) WACC using the Gordon growth model:

The growth rate = g = r  b Where r = the current accounting rate of return
b = the proportion of profits after tax retained
The profits after tax = the current ex-div share price  the earnings yield  the number
of shares in issue.
The ex-div share price = 565p (576p – 11p)
The number of shares in issue = 640m (£32m/£0.05)
The total earnings = £216.96m (565p  0.06  640m)
Total dividends = £70.40m (11p  640m)
Retentions = £146.56m (£216.96m – £70.40m) b = 67.55% (£146.56m/£216.96m)
r = Earnings/Opening equity capital employed = £216.96/(£3,104m – £146.56m) =
7.33%
g = 7.33%  67.55% = 4.95% say 5%
ke = (d1/MV) + g = (11p(1.05)/565p) + 0.05 = 7%
The cost of debt (kd) =
Year Cash Flow 1% PV 5% PV
0 (105) 1 (105.00) 1 (105.00)
1–4 6 3.902 23.41 3.546 21.28
4 100 0.961 96.10 0.823 82.30
14.51 (1.42)

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The yield to maturity is a little under 5% = 1 + ((14.51/(14.51 + 1.42)  (5 – 1)) = 4.64%

kd = 3.85% (4.64  (1 – 0.17))
Market values:
Equity = £3,616m (565p  640m)
Debt = £638.4m (£608m  1.05)
WACC = (7%  3,616 + 3.85%  638.4)/(3,616 + 638.4) = 6.5%
(b) WACC using the CAPM:
ke = 2 + (0.65  5) = 5.25%
kd = 3.85%
WACC = ((5.25%  3,616) + (3.85%  638.4))/(3,616 + 638.4) = 5%
47.2 Particular issues are as follows:
 The model relies on accounting profits.
 It assumes that b and r remain constant.
 It can be distorted by inflation.
 It relies on historic information.
 It assumes that all new finance is from equity or that gearing is held constant.
47.3 The discount rate to appraise the Happytours project must reflect its systematic risk. Ross
operates in the public transport sector; the holiday and sightseeing sector of the
transportation industry is likely to have a higher systematic risk since it relies more on
discretionary spending than the public transportation sector.
The discount rate should also reflect the financial risk of Ross; in this case the finance will be
raised in such proportions that the market value gearing will remain constant.
A beta factor from a company operating in the new sector should be selected to reflect the
systematic risk. However gearing adjustments are likely to be necessary.
Equity beta of the new sector = 1.3.
Degear the beta factor: 1.3  (1/(1 + (1  0.83)) = 0.71.
Regear the beta factor using Ross's capital structure:
0.71  ((3,616 + (638.4  0.83)/3,616) = 0.81.
Ross's current equity beta is 0.65 and the equity beta for the new industry sector is 0.81,
which reflects its higher systematic risk.
ke becomes = 2 + (0.81  5) = 6.05%
WACC = ((6.05%  3,616) + (3.85%  638.4))/(3,616 + 638.4) = 5.72%
47.4 The yield to maturity that investors in the debentures will require should reflect the riskiness
of the debentures, the coupon rate and the maturity date. The new debentures have a
longer maturity date and a lower coupon rate than Ross's current debentures. Therefore it is
likely that investors in the new debentures will require a higher yield to maturity than
investors in the existing debentures.
The issue price of the new debentures is arrived at by discounting their cash flows at an
appropriate yield to maturity.
Using the yield to maturity of the current debentures of 4.64%, the issue price will be:
5
Annuity factor for five years at 4.64% = (1 – 1/(1 + 0.0464) )/0.0464 = 4.373%
(Note: If an annuity factor and discount factor at 5% are used, full marks will be given.)
5
The issue price per £100 nominal value = (4  4.373) + 100  1/1.0464 = £97.20

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The total nominal value that will have to be issued to raise £75 million = £75m/0.972 =
£77.16 million.
47.5 Convertible debentures are fixed return securities that can be either secured or unsecured.
They may be converted, at the option of the holder (and sometimes the company) into
ordinary shares in the same company at a future date, or a series of future dates.
The coupon on convertible debentures is normally lower than on redeemable debentures
because of the value of the conversion rights.
Advantages for Ross include the following:
 Obtaining finance at a lower rate of interest than on redeemable debentures
 Encouraging possible investors with the prospect of a future share in profits
 Introducing an element of short-term gearing
 Avoiding the problem of redemption if the conversion rights are taken up
 Being able to issue equity cheaply if the debentures are converted
Disadvantages for Ross include the following:
 Dilution of control if the conversion rights are taken up
 Uncertainty as to whether the conversion rights will be taken up and the debentures
have to be redeemed in cash
element of the syllabus. The scenario of the question was that a company is expanding its
operations into a different sector of its market.
There were many basic errors in part 47.1(a), which really should not be occurring given how
many times this has been set. The errors included the inability to calculate numbers correctly;
incorrectly calculating the number of shares in issue; not calculating the ex-div share price
and/or the ex-interest debenture price; for the cost of debt calculating positive and negative
values and interpolating outside of the range calculated; no tax adjustment for the cost of debt
and using book values for the WACC calculation. In part 47.1(b) it was disappointing to see that
many candidates were deducting the risk free rate from the market risk premium. Also a number
of candidates were using the 1.3 equity beta from the sightseeing tour sector rather than Ross's
existing equity beta of 0.65.
Part 47.2 was well answered by the majority of candidates. Answers to part 47.3 were mixed and
often there were no reality checks made, with some candidates clearly demonstrating that they
have a very shallow knowledge of the topic. Errors included calculating unrealistic equity betas
(over 300 in one script); degearing using Ross's market values and regearing the gearing ratio of
the holiday and sightseeing tour sector; regearing using book values despite the formulae sheet
stating market values; degearing and regearing with the same debt/equity ratio and ending up
with a different figure from the start; when regearing changing the gearing ratio, even though
the question states that this will not change; very brief or non-existent explanations of the
rationale.
Despite part 47.4 being set before, and with a very similar detailed example in the Study
Manual, most candidates made a poor attempt. Few candidates used the redemption yield of
the existing debentures, which they had calculated in part 47.1(a); there were only brief or no
explanations of the terms of the debenture issue.
Part 47.5 were well answered by the majority of candidates, but some answers gave
explanations of Modigliani and Miller, which was not relevant to this question.

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48 Heaton Risk Management (June 2016)

Marking guide
Marks
48.1 (a) Sterling receipt using forward contract:

Appropriate forward rate 1.5
Calculation of sterling receipt 0.5
Sterling receipt using currency futures:
September futures 1
Loss arising 1
Calculation of sterling receipt 1
Sterling receipt using OTC currency option:
Call option 1
Premium 1
Cost of lost interest 1
Exercise the option 1
Net sterling receipt 1
11
(b) Hedging techniques:
Forwards and futures do not allow for upside potential 1
Options protect against downside 1
Options allow benefit from upside 1
Option premium is expensive 1
Other advantages and disadvantages – 0.5 marks each 4
Recommendation for Orchid 1
9
48.2 August put options 1
Exercise price 1
Number of contracts 0.5
Premium 0.5
(a) Let options lapse 1
Overall position 0.5
(b) Exercise the option 1
Calculation of gain 1
Overall position 0.5
7
48.3 Factors affecting time value of options:
Three factors:
Identification of each – 0.5 marks each 1.5
Explanation – 0.5 marks each 1.5
3
30
48.1 (a) Forward contract:

The appropriate forward rate = $/£ 1.5392 (1.5402 – 0.0010)
This will result in a sterling receipt of = £1,624,220 ($2,500,000/$1.5392)

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Currency futures:
Orchid will buy September futures to hedge the dollar receipt.
The number of contracts = ($2,500,000/$1.5379)/£62,500 = 26.01 (round to 26
contracts)
The futures contracts will be closed out on 30 September 20X6 resulting in a loss of:
$9,588 ((1.5379 – 1.5320)  26  £62,500).
The sterling receipt will be: £1,625,065 (($2,500,000 – $9,588)/£1.5325))
Orchid will use a call option to buy sterling with an exercise price of $1,5300.
The premium will cost: £75,000 ($2,500,000  £0.03)
The cost including interest lost on surplus cash deposits = £75,900 (£75,000  (1+ 0.36
 4/12))
If the spot rate for buying sterling on 30 September 20X6 is $/£1.5325, Orchid will
exercise the options and buy sterling at $/£1.5300.
The sterling receipt will be = £1,633,987 ($2,500,000/$1.5300)
The net receipt after taking the option premium and lost interest into account =
£1,558,087 (£1,633,987 – £75,900)
(b) The sterling receipt for each of the three hedging techniques:
Currency futures £1,625,065
OTC currency option £1,558,087
The forward contract and futures contracts both lock Orchid into an exchange rate and
do not allow for the upside potential of the dollar strengthening against sterling more
than expected.
The options however protect Orchid against the downside risk of sterling
strengthening against the dollar and allow for the upside potential of the dollar
strengthening against sterling; however, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include the
following.
Forwards:
Tailored specifically for Orchid
However there is no secondary market should the customers not pay Orchid
Currency futures:
Not tailored so one has to round the number of contracts
Requires a margin to be deposited at the exchange
Need for liquidity if margin calls are made
However there is a secondary market
Basis risk exists
There is no secondary market
It is unlikely that the dollar is going to strengthen enough to cover the cost of the
option premium, and so it is not recommended that the company use foreign currency
options. There is very little difference between the receipt using forwards or futures
(£845).
Since there is potential for margin calls using futures, it is recommended that Orchid
use forward contracts to hedge its foreign currency risk.

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48.2 To protect the current value of the portfolio over the next three months Sheldon should
hold August put options with an exercise price equal to the current FTSE 100 index of
6,525.
The number of contracts = 148 (£9,657,000/6,525  £10)
The premium will cost = £235,320 (159  £10  148)
(a) Sheldon should let the options lapse since the Index has gone up and is higher, at
7,075, than the exercise price of the put option.
Overall position £
Portfolio value 10,471,000
Less option premium (235,320)
10,235,680
(b) Sheldon should exercise the options since the index has fallen to 5,875, which is below
the put option exercise price.
The gain on exercising the options = £962,000 ((6,525 – 5,875)  £10  148)
Overall position £
Portfolio 8,695,000
Gain on options 962,000
Original value 9,657,000
Less option premium (235,320)
9,421,680
48.3 The three factors that affect the time value of the FTSE 100 options are:
 Time to maturity – For example: The longer the time to maturity the more chance there
is that the option will be in the money at expiry. Also there will be a greater interest
element in the option value.
 The risk free rate – For example: The level of the risk free rate will affect the interest
element in the options value. The higher it is the more interest element.
 Volatility – For example: Higher volatility will increase the option value since there is
more chance of the option being in the money, or deeper in the money, at expiry.
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that a risk management company is
giving advice to two clients: to one client, on hedging foreign exchange rate risk and to the
second on hedging the fall in the value of a portfolio of FTSE 100 shares.
Part 48.1(a) was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold; treating an
over the counter option like a traded option; confusing puts and calls. There were average
responses from a lot of candidates to part 48.1(b), often without any reference to the numbers
calculated in part 48.1(a); however there were some excellent answers. There were some
excellent answers to part 48.2 from the majority of candidates. Weaker candidates confused
calls and puts and demonstrated that they clearly did not know the difference between the two.
There were many excellent answers to part 48.3, with a good understanding of the factors that
contribute to the time value of options. However weaker candidates tended to only give one
correct factor and then made up the other two.

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September 2016 exam answers
49 Northern Energy Ltd (September 2016)

Marking guide
Marks
49.1 FRA 2
Option 2
No hedge 1
Interest rate swap not applicable 1
Appropriate commentary 3
9
49.2 (a) Currency futures contracts 5
(b) OTC currency option 3
(c) Forward contract 2
(d) Money market hedge 3
13
49.3 Spot rate calculations 2
Appropriate commentary – 1 mark per point 6
8
30
49.1
LIBOR + 2 7% 9%
FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on £9.5m) (£688,750) (£688,750)
Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
No hedge
Pay at LIBOR + 2 (7%) (9%)
An interest rate swap would not be appropriate here as it is short-term and would in all
likelihood be very difficult to arrange.
If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest
interest figure. The figures are not conclusive, and the board's attitude to risk will be
important. The FRA eliminates downside risk (rates rising) as well as upside risk (rates
falling).

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49.2 (a) Currency futures contracts

Dollars will be purchased. Therefore sell £ on futures exchange.
Contracts to be sold = £4.8m/1.5095/£62,500 = 50.9, (round to 51 [or 50])
At 31/1/X7 Buy futures at 1.4945
Sell futures at 1.5095
Profit 0.015  51  $62,500 $47,813
$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate ($4,752,187)/1.4895 (£3,190,458)
(31/1/X7)
(b) OTC currency option
If the spot rate at 31/1/X7 was $1.4895 then the option would be exercised.
A call option would be used (ie, at $1.5020/£)
Receipt in sterling would be $4.8m (£3,195,739)
1.502
plus: Option premium 4.8m  £0.011 (£52,800)
(£3,248,539)
(c) Forward contract

Payment in sterling $4.8m $4.8m (£3,191,913)
(1.5150 – 0.0112) 1.5038
plus: Arrangement fee 4.8m  £0.004 (£19,200)
(£3,211,113)
(d) Money market hedge
Payment in sterling $4.8m $4.8m $4,743,083 lent
would be [1+ (3.6% / 3)] 1.012
Converted at spot rate $4,743,083 (£3,130,748)
1.5150
Borrowed at 6.9% p.a. £3,130,748  (72,007)
(6.9%/3)
(£3,202,755)
49.3
Sterling payment at spot rate 30/9/X6 $4.8m (£3,168,317)
1.5150
Sterling payment at spot rate 31/1/X7 $4.8m (£3,222,558)
1.4895
The forward contract premium suggests a strengthening of the $. A weaker £ means a
higher payment, and vice versa for a stronger £.
Order (cheapest first)
Spot at 30/9/X6 £3,168,317
Currency futures contracts £3,190,458
MMH £3,202,755
Spot at 31/1/X7 £3,222,558
OTC option £3,248,539
ICAEW 2019 September 2016 exam answers 267

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Thus three of the four hedging results lie between the two spot rates.
The futures contracts give gives best outcome (lower than the MMH, FC and OTC).
However, if the dollar were to weaken by January 20X7 (against expectations) then it might
be best to not hedge at all.
Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no
upside/downside). Futures contracts can be cheaper (lower transaction costs), but contracts
cannot be tailored to user's exact requirements.
The directors' attitude to risk is also important in deciding which strategy to pursue.
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good. This was a three-part question which tested the candidates'
understanding of the risk management element of the syllabus. In the scenario a UK electricity
generator was considering hedging (1) the interest costs of a large loan and (2) its exposure to
foreign exchange rate risk on a planned purchase from an American supplier. In part 49.1, for
nine marks, candidates were required to calculate the interest payments that would arise on its
planned loan were it to make use of an FRA, an option or a swap. Two different rates of LIBOR
were given to the candidates. Candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates. Part 49.2 was worth
13 marks and asked candidates to calculate the sterling cost arising from a range of hedging
techniques applied to the American purchase. Finally in part 49.3, for eight marks, candidates
were required to advise the company's board whether it should hedge the American (dollar)
payments.
Part 49.1 was answered well by many candidates. However, common errors made were:
• candidates based their calculations on a borrowing period of six months rather than 12
(the loan was to be taken out for 12 months, starting in six months' time).
• the majority of candidates failed to calculate the implications of not hedging the borrowing
and so comparisons were difficult.
• a significant number of candidates abandoned the option when LIBOR was 5% because
they compared 5% v 6.5% instead of 7% v 6.5% ie, they failed to recognise that the
company was borrowing at LIBOR + 2% pa.
Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing
(ie, 12 months). Most candidates' answers to part 49.2 were very good, but the most common
errors noted were:
• currency futures – many chose the wrong date for calculating the number of futures
contracts, bought futures instead of sold them and calculated the profit on the futures trade
in £ instead of $.
• OTC currency options – far too many candidates exercised puts rather than calls.
The forward contract calculations were generally very good as were those for the money
market hedge. The main stumbling blocks with the latter were (1) choosing the wrong
interest rate and (2) using three months rather than four. The advice given by candidates on
the foreign exchange hedging in part 49.3 was generally good, but, if candidates did not
calculate the relevant spot rates then they lost marks. The performance of overseas
candidates in this section was, overall, very poor.

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50 Roper Newey plc (September 2016)

Marking guide
Marks
50.1 (a) Dividend growth rate 1.5

Cost of equity 0.5
Cost of redeemable debt 4
Cost of irredeemable debt 2
WACC calculation 2
11
(b) Cost of equity 1
WACC 1
2
50.2 Advice that 7% is an inappropriate rate, with reasons
3
50.3 Reasons for using CAPM
5
50.4 Calculation of ungeared beta 1.5
Geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Reasons for using a new WACC, and how it is calculated 4
10
50.5 Explanation of APV 4
35
50.1 (a)
Ordinary dividend per share in 20X6 (£3,797,500/15,500,000) 24.5 pence
Ordinary dividend growth rate = £0.201/£0.245, which over four years 5% p.a.
Cost of equity (ke) = (d1) + g (£0.245  1.05) 9.95%
+ 5%
MV £5.20
Cost of preference shares (kp) d (£540,000/9m) £0.06 5.55%
=
MV £1.08

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Cost of redeemable debt (kdr)

0 (103.00) 1.000 (103.00) 1.000 (103.00)
1–3 4.00 2,884 11.54 2.829 11.32
3 100.00 0.942 94.20 0.915 91.50
NPV 2.74 NPV (0.18)
IRR = 3% – (0.18/(2.74 + 0.18)) = 2.94%

less: Tax at 17% (2.94%  83%) = 2.44%
Cost of irredeemable debt (kdi) £5  83% 4.32%
£96
WACC
Total MV's
£'000 Cost  weighting WACC
Equity 15.5m  £5.20 80,600 9.95%  80,600/106,615 7.52%
Pref. shares 9m  £1.08 9,720 5.55%  9,720/106,615 0.51%
Red. debt £6.5m  103/100 6,695 2.44%  6,695/106,615 0.15%
Irred. debt £10.0m  96/100 9,600 4.32%  9,600/106,615 0.39%
26,015 1.05%
Total market value 106,615 8.57%
50.1 (b)
Cost of equity (1.2  (9.5% – 1.9%)) + 1.9 = 11.02%
Weighted cost of equity 11.02%  80,600/106,615 8.33%

Weighted cost of debt (as above) 1.05%
WACC 9.38%
50.2 Roper is using 7% as its hurdle rate. In fact a more accurate figure would be 8.57% (say 9%)
or 9.38% (say 10%). This means it could be making poor investment decisions. If it takes on
a project with an IRR of 8% this will be destroying shareholder value as the IRR is less than
the company's cost of capital.
50.3 CAPM theory:
Systematic vs unsystematic risk, and portfolio theory
Beta – a measure of systematic risk against market average
CAPM gives an alternative cost of equity which is used to calculate the WACC
50.4 New market geared beta = 1.9
New market ungeared beta = 1.9  90 (1.9  90) 1.54
(90 + (25  83%)) 110.75
Better Deal's geared beta = 1.54  (£80.600m + 9.720 + (£16.295m  83%)) 1.98
£80.600m
So, cost of equity = (1.98  (9.5% – 1.9%)) + 1.9 = 16.95%
Cost of debt = 6%  83% 4.98%
WACC = (16.95%  £80,600/£106,615)) + (4.98%  £26,015/£106,615)) = 14.03%
It would be unwise to use the existing WACC (9.38%) as Roper's plan involves
diversification and therefore a change in the level of systematic risk. Thus a new WACC
must be calculated. Systematic risk is accounted for by taking into account the beta of the
petroleum market and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then "re-geared" by taking into account the
level of gearing of the new funds being raised.

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Cost of new debt (which is higher than existing because of the increased risk discussed
above) is used.
Using this, the new WACC can be calculated.
50.5 Adjusted PV (APV) – if the capital structure changes maybe the cost of capital will as well
(M&M 1963). If new debt is raised to finance/part-finance a new investment, what is the new
cost of capital? To find this one needs to know the new MV of the company's shares and to
know this one needs to know the NPV. This cannot be calculated without the new cost of
capital. So it's a conundrum, unless a simplifying assumption is made as in this question ie,
the finance is issued in such a way as to leave the gearing unchanged.
Thus use the APV approach:
1 Calculate the base cost of the project – assume that the company is not geared.
2 Calculate the PV of the tax shield (tax saved via interest payments)
Combine 1 and 2. If APV is positive, then proceed.
This question had, marginally, the lowest percentage mark on the paper. The majority of
candidates achieved a 'pass' standard in the question, however.
element of the syllabus. It was based around a UK engineering company which was planning to
diversify into the UK fracking industry. As a result various calculations regarding its current and
future cost of capital were deemed necessary. Part 50.1 of the question, for 13 marks, required
candidates to calculate the current weighted average cost of capital (WACC) of the company
using (1) the dividend growth model and (2) the CAPM. In part 50.2, for three marks, candidates
were asked to explain whether the company should continue to use its existing hurdle rate for its
decisions on large-scale investments. Part 50.3, for five marks, required candidates to explain
the underlying logic of employing the CAPM within a WACC calculation. Part 50.4 was worth
10 marks. Here, candidates were tested on their ability to re-work their CAPM calculations, which
was necessary because of the company's proposed diversification into fracking, which would
alter the level of systematic risk. Finally, in part 50.5, for four marks, candidates were asked to
explain the circumstances in which it would be appropriate to use the adjusted present value
approach to investment appraisal.
Most candidates did well in part 50.1, but common errors were:
• inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
• not using the market value (MV) when calculating the cost of preference shares.
• for the cost of redeemable debentures – not using the ex-interest MV, choosing four years
to redemption rather than three, inaccurate IRR calculation from NPV's.
• irredeemable debentures – not using the ex-interest MV, using the post-tax coupon rate as
the cost of debt.
Combining the costs of the redeemable and irredeemable debt, rather than treating them
separately.
Part 50.1(b) was done very well. Only a few candidates failed to calculate the CAPM correctly.
Part 50.2 was generally well answered and most candidates were able to identify the key issue –
ie, Roper could be making poor investment decisions. In part 50.3 too few candidates answered
the question fully and concentrated more on a discussion of de-gearing/re-gearing. In part 50.4
the de-gearing/re-gearing calculations were mostly done well, but too many candidates'
explanation of their approach here concentrated on 'how' rather than 'why' it was done. Part
50.5 was, overall, done well and candidates demonstrated a reasonable understanding of APV.

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51 Darlo Games Ltd (September 2016)

Marking guide
Marks
51.1 (a) Net assets at historic cost 1

Revalued net assets 2
P/E ratio 1
Discount for lack of marketability 0.5
Dividend yield 1
Discount for lack of marketability 0.5
PV of future cash flows:
To 20X9 2
Post 20X9 2
Calculation of WDAs and tax 4
14
(b) Advantages of each method 5
Disadvantages of each method 5
10
51.2 SVA explanation 4
Assessment of information 4
8
51.3 Ethical issues around confidentiality 3
35
51.1 (a)
Per
share
Net Assets £4,998 £10.00
(historic cost)
500
Net Assets (£4,998 +£3,150 +£3,370 – £2,400 – £3,200) £5,918 £11.84
(revalued) 500 500
P/E ratio (£2,340  10) £23,400 £46.80

500 500
Less (say) 30% for lack of marketability of

shares £32.76
Dividend yield (£740/ 8%) £9,250 £18.50
500 500
Less (say) 30% for lack of marketability of

shares

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PV of future cash flows y/e 20X7 y/e 20X8 y/e 20X9 Total
£'000 £'000 £'000 £'000 £'000
Pre-tax cash profits 2,900 3,000 3,100
Tax at 17% (W2) (465) (487) (422)
Net cash flow 2,435 2,513 2,678
  
12% factor 0.893 0.797 0.712
PV 2,174 2,003 1,907 6,084
Post 20X9 net cash
inflows 2,000
Discounted to infinity  1/12%

16,667
Discounted to PV from
20X9  0.712
11,867
Total PV of future cash
flows 17,951
£17,951/500 £35.90
W1
WDV b/f 920 754 618
WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0
W2
Pre-tax cash profits 2,900 3,000 3,100
WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482
Tax due at 17% (465) (487) (422)
(b) Net Assets (historic cost) – tends towards low historic values, so an undervaluation.
Intangibles are ignored. Earnings potential and future earnings are ignored.
Net Assets (revalued) – as above, except that the asset values used are current.
P/E ratio – Looks at earnings. Will it be a majority stake? If so, then control will be
gained, so shares for this controlling stake should cost more. In this scenario it gives a
much higher value than assets. However, are these earnings stable into the future? Is
the company over-reliant on the two successful games from 20X3? Future earnings –
are there new games planned? Will they be successful?
Dividend yield – this is based on dividend income and is applicable where it's to be a
minority stake. Are these dividends stable? Will there be dividend growth?
PV of future cash flows – considers cash flows not profits and estimates forwards. These
are large estimates, especially the terminal value. Is it over-reliant on the two successful
games (as above)?
Overall – a value close to £30/share should be a minimum price.

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51.2 SVA is an alternative method of calculating the value of a company, based on future cash
flows and seven "value drivers". These value drivers can, in most cases, be managed by the
company and so the influence of company strategy will be evident.
Value driver Information available
Length of project Yes
Sales growth rate Implied
Profit margin Implied
Fixed assets investment Implied
Working capital investment No
Tax rate Yes
Discount rate Yes
51.3 An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client's or employer's affairs, however gained, is
confidential. That information should then:
 be kept confidential;
 not be disclosed, even inadvertently such as in a social environment; and
 not be used to obtain personal advantage.
decisions element of the syllabus and there was also a small section with an ethics element to it.
In the scenario a software development company was considering investing in a company that
designs games for use on computers and mobile phones. Candidates were given financial
information relating to the target company.
Part 51.1(a) was worth 14 marks and required candidates to calculate the value of one share in
the target company using five different valuation methods. In part 51.1(b), for 10 marks,
candidates had to explain, making reference to their previous calculations, the advantages and
disadvantages of using each of the valuation methods. In part 51.2, for eight marks, candidates
were required to explain the reasoning underpinning the shareholder value analysis (SVA)
method of valuation. They also had to explain whether SVA could be used to value this particular
target company, bearing in mind the information provided. Finally, in part 51.3, for three marks,
candidates had to explain the ethical issues arising for an ICAEW Chartered Accountant who is
privy to price-sensitive information which is not in the public domain.
Generally part 51.1(a) was answered well. A surprising number of candidates were unable to
calculate the share value based on the net asset basis (historic cost), but were able to calculate it
with the net asset basis revalued. The P/E and dividend yield valuations were generally done
very well. Most candidates scored well using the PV of future cash flows method of valuation.
Candidates' discussion was limited to mainly knowledge in part 51.1(b) – few considered
whether the techniques were suitable for a majority/minority holding despite being guided in
that direction in the question. The vast majority of candidates ignored the 'elephant in the
room', ie, the fact that the target company's computer games had a limited life of three to five
years and the successful games were three years old.
In general candidates' understanding of the theory of SVA was good, but too few were able to
explain adequately whether it could be used in this particular scenario. Candidate's
understanding of the ethical issues was generally good.

lOMoARcPSD|5019904
December 2016 exam answers
52 Ribble plc (December 2016)

Marking guide
Marks
52.1 Net present value calculation:
Contribution 3
Rent, managers costs, consultancy saved 4
Contribution lost 2
Fixed overhead 2
Tax, working capital, capital allowances 6
20
52.2 (a) Sensitivity to sales revenue:
Contribution 1
Tax and discount factor 1.5
PV calculation 0.5
Sensitivity and conclusion 1
4
(b) Sensitivity to the residual value of equipment:
Maximum loss of scrap value 0.5
Increase in the balancing charge 1
PV calculation 0.5
Sensitivity and conclusion 1
3
52.3 Real options:
1 mark to identify, and 1.5 marks to explain
(two real options required) 2.5  2 5
52.4 Ethical issues identified (1 mark each point) 3
35
52.1
0 1 2 3 4
Units million 0.096 0.115 0.098 0.083
Selling price £ 299.00 299.00 299.00 299.00
Variable costs per unit £ –164.45 –172.67 –181.3 –190.37
Contribution per unit £ 134.55 126.33 117.7 108.63
ICAEW 2019 December 2016 exam answers 275

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£m £m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Rent –1 –1 –1 –1
Managers lump sum 0.1 –0.12
Managers salary –0.12 –0.12 –0.12 –0.12
Consultancy saved 0.05 0.05
Contribution lost –0.24 –0.29 –0.25 –0.21
Fixed overhead –0.30 –0.31 –0.32 –0.33
Taxable –0.9 11.31 12.86 9.84 8.24
Tax @ 17% 0.15 –1.92 –2.19 –1.67 –1.40
Working capital –1 –0.2 0.18 0.15 0.87
Machinery and equipment –24.00 4
Tax saved on CAs 0.73 0.60 0.49 0.40 1.16
Cash flows –25.02 9.79 11.34 8.72 12.87
Discount factor @ 10% 1 0.909 0.826 0.751 0.683
PV –25.02 8.90 9.37 6.55 8.79
NPV 8.59
The NPV is positive and Ribble should therefore accept the project to increase shareholder
wealth.
Marks are awarded for not including the research and development costs of £100,000 and
allocated fixed overheads, since they are sunk costs and allocated costs respectively.
Units:
1 8,000  12 = 96,000
2 96,000  1.2 = 115,200
3 112,200  (1 – 0.15) = 97,920
4 97,920  (1 – 0.15) = 83,232
Lost contribution:
1 (96,000 units/10)  £25 = £240,000
2 (115,200 units/10)  £25 = £288,000
3 (97,920 units/10)  £25 = £244,800
4 (83,232 units/10)  £25 = £208,080
Working capital
cumulative Increment
0 –1 –1
1 –1.2 –0.2
2 –1.02 0.18
3 –0.87 0.15
4 0 0.87

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Cost/WDV CA Tax @ 17%

0 24.00 4.32 0.73
1 19.68 3.54 0.60
2 16.14 2.91 0.49
3 13.23 2.38 0.40
4 10.85
Sale 4.00 6.85 1.16
52.2 Sensitivity to sales revenue:
1 2 3 4
£m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Contribution lost –0.24 –0.29 –0.25 –0.21
Total 12.68 14.24 11.28 8.81
Total  (1 – 0.17) 10.52 11.82 9.36 7.31
Discount factor @ 10% 0.909 0.826 0.751 0.683
PV 9.56 9.76 7.77 4.99
Total PV = 32.08
Sensitivity NPV/PV
(8.59/32.08) 27%
Given the risky nature of this project, the board of Ribble might consider the project to be
too sensitive to changes in the sales revenue.
Sensitivity to the residual value of equipment:
£m
Maximum loss of scrap value 4
Increase in the balancing charge  17% –0.68
Net cash flows 3.32
PV @ 10% ( 0.683) 2.27
Although this represents 26% (2.27/8.59) of the overall NPV, the project is insensitive to the
residual value, since there would be a substantial NPV even if the value fell to zero.
52.3 Ribble has:
The option to delay the project for one year to see whether the competitor launches their
hoverboard onto the market.
The option to abandon the project should sales levels be below those estimated eg, if the
rival company's hoverboard is launched and proves to be more popular than the
Ribbleboard.
There is a follow on option in that Ribble could expand if the competitor's product fails
and/or sales of the Ribbleboard are better than expected.
Candidates might also state growth or flexibility options.
52.4 The CEO should disregard the comments that Ribble should continue to manufacture an
unsafe hoverboard. The CEO should act with integrity and ensure that he is not corrupted
by self-interest. He should be objective and not come under the undue influence of other
board members. He should act with professional competence and exercise sound and
independent judgement.

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This was a four-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is
considering launching on to the market a new version of an existing product.
Part 52.1 was well answered by many candidates, but the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; only taking account
of half of the relevant costs; not stating that research and development costs should be ignored;
not stating that allocated overheads should not be included in the NPV computations.
Responses to part 52.2 were mixed, with many candidates not taking into account all the
relevant cash flows and many ignoring taxation. There were few candidates who made
meaningful comments regarding the sensitivity of the project to changes in the inputs.
Responses to part 52.3 were good, although some candidates wasted time by mentioning more
than the required two real options.
Responses to part 52.4 question were also mixed, and many did not relate to ethical issues,
instead discussing commercial issues. Where the ethical issues were discussed, a number of
candidates did not use the language of ethics.
53 Bristol Corporate Finance (December 2016)

Marking guide
Marks
53.1 (a) CAPM calculation 1
(b) Discount calculation 2

TERP 1
Discussion 2
5
(c) Yield to maturity calculation 2
Issue price 2
Total nominal value 1
Discussion 2
7
(d) Interest cover calculation 1.5

Gearing 1.5
Advantages and disadvantages – max of 3
Commentary on gearing – max of 3
Commentary on cost of capital – max of 3
Advice 2
Maximum available 12
53.2 (a) Sources/forms of finance – 0.5 mark each point 3
(b) Exit routes – 0.5 mark each point 2
(c) Financial information – 0.5–1 mark each point 5

35

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53.1 (a) The cost of capital = Ke = 3 + (1.1  (8 – 3)) = 8.5%

(b) A 1 for 2 rights issue will require 40/2 = 20 million new shares to be issued.
The price per share = £70 million/20 million = £3.50
A discount on the current market price of: (5.00 – 3.50)/5.00 = 30% (or £1.50)
The theoretical ex-rights price is:
Number of shares Value per share £ Number  Value £
Existing shares 2 5.00 10.00
New shares 1 3.50 3.50
Total shares 3 Total value 13.50

Theoretical ex-rights price = £13.50/3 = £4.50.
The actual share price will depend on the market's reaction to the rights issue eg,
whether it is fully taken up, and whether the proceeds are invested in positive net
present value projects.
If we were told the net present value of the projects this could be incorporated in the
theoretical ex-rights price of £4.50, giving a more realistic estimate of the actual share
price post rights issue.
(c) The yield to maturity of the Wood plc debentures is calculated as follows:
The ex-interest price of the debentures = 110 – 7 = £103
Timing Cash Flow Factors at PV Factors at PV
Years £ 5% £ 10% £
0 (103) 1 (103) 1 (103)
1–4 7 3.546 24.82 3.170 22.19
4 100 0.823 82.30 0.683 68.30
4.12 (12.51)
IRR = 5 + (4.12/(4.12+12.51)  5 = 6.24% Say 6%
The issue price is:
Timing Cash Flow Factors at PV
Years £ 6.00% £
1–10 7 7.360 51.52
10 100 0.558 55.80
Issue price 107.32
The total nominal value will be: 70/(107.32/100) = £65.22 million.

Wood plc has similar risk to Middleton so it may be reasonable to assume that
debenture holders would require the same yield to redemption in return for investing
with either company. But how similar is similar? Eg, how comparable is Wood to
Middleton in terms of gearing? However the Wood plc debentures have only four
years until redemption, whilst the Middleton debentures mature in 10 years. It is likely
that debenture holders would require a higher yield to redemption for investing in the
Middleton debentures to compensate them for the risk of investing for a further six
years.
(d) The gearing and interest cover ratios of Middleton immediately after the debenture
issue will be as follows:
Interest cover: Interest 65.22  7% = £4.57m. Interest cover = 25.00/4.57 = 5.47 times
Gearing by market values assuming the current market price per share:
Market capitalisation 40  5 = £200m. Gearing (D/E) 70/200 = 35%

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In time both interest cover (more operating profits) and gearing (greater equity value)
are likely to improve with the acceptance of positive NPV projects and any favourable
market reaction to the issuance of debt and its tax shield (see below).
General advantages and disadvantages of debt v equity, points that candidates might
mention include: Control issues; obligation to return capital; interest v dividends
(including tax relief); issue costs; liquidation of the investment (can the investor get out
easily?); risk/reward.
Note: Candidates might also comment on EPS and produce the following figures:
Current EPS 51.9p (20.75m/40m)
EPS with a rights issue 34.6p (20.75m/60m)
EPS with a debenture issue 42.4p (( 25 – 4.57)  0.83))/40m
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 5.47 times.
Gearing is between the industry maximum and average of 40% and 30% respectively,
interest cover is between the industry minimum and average of five and six
respectively. Since this is the first time that Middleton has borrowed both shareholders
and the stock market might be concerned and prefer these ratios to be around the
averages or better. Some shareholders might be attracted to investing in Middleton
because currently it has no gearing. However if the £70 million is to be invested in
positive NPV projects both shareholders and the stock market should welcome the
company borrowing.
Borrowing should reduce the current 8.5% cost of capital of the company since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. Also the company receives tax relief on the interest that it pays. Because there
is increased financial risk when a company borrows the shareholders may require a
higher return but this is unlikely to offset the cheaper proportion of debt finance. The
company value should increase as a result of the cost of capital reducing and new
funds being invested in positive NPV projects.
Advice: It would be prudent for the company to restrict its borrowing to the industry
average gearing level especially since its interest cover would be near to the minimum
for the industry. I would advise the company not to borrow the full £70 million, perhaps
this could be achieved by revising its plans for raising the finance. For example an issue
of both debt and equity to ensure that gearing and interest cover ratios are more
favourable. Or selling surplus assets.
53.2 (a) The source and form is typically:
The management team invest in equity (Candidates may mention that the funding for
this can be raised from various sources for example: Family; savings; sale
of/refinancing of personal assets; etc)
A venture capital provider will invest in equity and debt
Other financiers – for example banks would provide loans
(b) The various parties who invest in the MBO will require an exit route, typically after
between three to five years. This may be in the form of:
 selling the company to a third party
 a secondary MBO or MBI
 floating the company on the Stock Exchange
 if the company is not successful the least desirable exit would be liquidation

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(c) The financial information section of the business plan will typically include:
 an historic financial analysis
 the amount and timing of the finance required
 key risks and a contingency plan
 anticipated gearing
 the purpose of any finance required
The following forecasts should be included:
 cash flow in months for the first year of the plan
 revenue forecasts in months or longer for the first year with evidence
 financial forecasts in quarterly or annual intervals up to five years
Often a project appraisal and sensitivity analysis will be included.
This was a seven-part question that tested the candidates' understanding of the financing
options element of the syllabus. The scenario of the question was that a corporate finance firm is
giving advice to two clients. Client one (53.1) is a company seeking to raise additional funds and
client two (53.2) is a management buyout team.
Part 53.1(a) of the question was well answered by the majority of candidates. However in the
CAPM equation a surprising number did not deduct the risk free rate from the market return.
Part 53.1(b) of the question was also well answered by the majority of candidates. However,
considering that the area has been examined many times before some basic errors were made
which included: incorrectly calculating the number of new shares to be issued; not calculating
the discount that the rights price represents on the current share price of the company (despite
this being specifically asked for).
Also, many candidates were unable to comment on whether and why the actual share price
might not be equal to the theoretical ex-rights share price after the rights issue.
Responses to part 53.1(c) of the question were mixed and, since the topic has been examined
many times before, rather disappointing. Candidates were asked to calculate the yield to
redemption (YTR) of debentures that a similar company to the client company already had in
issue. They then had to use the YTR that they had calculated to price a new debenture issue, and
to calculate the total nominal value of the new issue. Common errors included: using the cum-
interest debenture price in the YTR computation; attempting to calculate the YTR on the new
issue; deducting tax from the YTR; incorrectly calculating the total nominal value of the new
issue; many mathematical errors in the YTR computations; calculating, and using, the interest
yield of the debentures rather than the YTR for the new issue, using the coupon rate to calculate
the issue price (and not arriving back at the par value!); for the new issue, using the cost of
equity to calculate the issue price.
Also comments on whether the YTR of the similar company was appropriate to use for the client
company were poor.
Responses part 53.1(d) were extremely disappointing considering that similar questions have
been asked before. In the scenario the candidates were provided with average and maximum
gearing ratios for the industry sector that the client operated in, and also a definition of gearing
as debt/equity by market values. Also the candidates were given the average and minimum
interest cover for the industry. Candidates were instructed in the question requirement to refer
to this data when discussing whether the client company should raise the finance required by
debt or a rights issue.
Many candidates gave very generic answers to this part of the question, just brain dumping the
advantages and disadvantages of debt and equity without referring to the industry data or the
scenario of the question. Disappointingly a large number of candidates also gave a detailed
description of Modigliani and Miller's theory on capital structure without any reference to the

lOMoARcPSD|5019904
traditional theory and how it might or might not be appropriate. However it was alarming to see
many candidates calculating the gearing ratio as debt/(debt + equity) and then comparing their
number with the industry data, which had been calculated in a different way. In one instance a
candidate calculated the gearing ratio using both methods and then picked the most favourable
when comparing with the industry data. This lack of understanding is not acceptable from
candidates sitting a finance examination. Also few candidates gave supported advice on how
the additional finance should be raised.
Turning to interest cover, there were some basic errors made here which included: calculating
interest cover on profits after tax; incorrect interest calculations not using the total nominal value
to be raised.
Responses to part 53.2(a) were poor, with few candidates showing an understanding of how a
management buyout is financed. Responses to part 53.2(b) were also poor, and few candidates
described realistic exit routes for the financiers that contribute to the funding of a management
buyout.
Responses to part 53.2(c) were mixed, and many candidates described areas such as business
strategy, which would not appear in the financial information section of a business plan.
54 Orion plc (December 2016)

Marking guide
Marks
54.1 (a) Forward contract 2
(b) Currency futures:

Buy 1
Profit 2
Sterling receipt 1
5
(c) OTC option:
Premium 1
Lost interest 1
Choose to exercise 1
Sterling receipt 1
4
54.2 Advantages and disadvantages:
Forwards 2
Futures 3
Options 2
Advice 1
8
54.3 Explanation of interest rate parity 2
Calculation of forward rate and explanation of discount 3
5
54.4 Explanation of economic risk 2
Application to Orion 2
Risk mitigation – 0.5 mark each for identifying and explanation 2
6
30

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54.1 (a) The forward rate is: $/£ 1.4430 (1.4340 + 0.0090)
This results in a sterling receipt of £3,465,003 ($5,000,000/$1.4430)
(b) Orion should buy March sterling futures (ie, to buy £ with $).
The number of contracts to buy is: ($5,000,000/$1,4410)/£62,500 = 55.52 contracts.
Round to 56 contracts. Slightly over hedged. (Full marks given if 55 contracts used.)
On 31 March the futures will be closed out and sold at $1.4487. This will result in a
profit of: ($1.4487 – $1.4410)  (£62,500  56) = $26,950
Sterling will be purchased on the spot market and the total receipt will be: ($5,000,000
+ $26,950)/$1.4490 = $3,469,255
(c) Over the counter option:
The option premium is $5,000,000  3p = £150,000.
The premium with interest lost is £150,000  (1 + 0.03  4/12) = £151,500
If the spot price on 31 March is $/£1.4490 Orion will exercise the options.
The sterling receipt will be ($5,000,000/$1.4390) – £151,500 = £3,323,135
54.2 The forward contract and futures contracts both lock Orion into an exchange rate and do
not allow for upside potential.
Forwards:
 Tailored specifically for Orion
 No secondary market
Currency futures:
 Not tailored, so need to round the number of contracts
 Requires a margin to be deposited at the exchange
 Secondary market
 The options are expensive
 No secondary market
 However the options allow Orion to exploit upside potential and protect downside risk
Advice:
Without hedging, the sterling receipt would be £3,450,656 (5,000,000/1.4490)
The OTC option results in a much lower receipt at £3,323,135.
Both the forwards and futures result in a higher sterling receipt, with the futures being
marginally better resulting in a receipt of £3,469,255 compared to £3,465,003.
Since futures require margins, and they are not a perfect hedge due to rounding and basis
risk, it is recommended that a forward contract is used as it is much simpler for a similar
result.
54.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are
possible if the rates out of alignment. The forward rate tends to be an unbiased predictor of
the future spot exchange rate.

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The forward rate in four months is calculated as follows:

Middle spot rate  (1 + the middle US interest rate)/(1 + the middle UK interest rate) =
Forward rate.
$1.4338  (1 + 0.05  4/12)/(1 + 0.0315  4/12) = $1.4426
Because the dollar is depreciating against sterling it is at a discount.
The discount is $0.0088 (1.4426 – 1.4338). The spread increases or decreases this, in this
case $/£ 0.0086 – 0.0090.
54.4 Economic risk is the risk that longer-term exchange rate movements might reduce the
international competiveness of a company. It is the risk that the present value of a
company's future cash flows might be reduced by adverse exchange rate movements.
Orion is an importer and exporter. It buys its raw materials in euros, exports the sports
nutrition products to the USA and receives payment in dollars.
If over a period of several years the pound appreciates against the dollar and depreciates
against the euro the sterling value of Orion's income will fall and its cash flows decline.
Points that can be mentioned to mitigate economic exposure include:
 diversify operations world-wide both for purchasing raw materials and selling its
products.
 market and promotional management; the company must carefully decide in which
markets to operate.
 product management; economic exposure may mean high-risk product decisions.
 pricing strategy must respond to the risk of fluctuations in exchange rates.
 production management; economic exposure may influence the supply and location of
production.
element of the syllabus. The scenario of the question was that of a company reviewing its foreign
exchange rate risk hedging strategy.
Part 54.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; treating an over the counter option like a
traded option; calculating the option premium in $ rather than £; omitting interest on the option
premium.
There were a lot of average responses to part 54.2, some without any reference to the numbers
calculated in part 54.1. Many candidates did not give a firm conclusion. However there were
some excellent answers.
Responses to part 54.3 were mixed, with many candidates demonstrating a lack of
understanding of interest rate parity. Very often computations did not make sense and were very
difficult to follow.
Few candidates gave adequate answers to part 54.4, and showed little knowledge of what
economic risk is. However again there were some excellent answers.

lOMoARcPSD|5019904
55 Sentry Underwood plc (March 2017)

Marking guide
Marks
55.1 Forecast income statements:

Sales 0.5
Variable costs 1
Fixed costs 0.5
Interest 1.5
Tax 0.5
Dividends 1.5
6
55.2 Earnings per share 2
Gearing calculation 4
6
55.3 Increase in sales required:
Current EPS 0.5
Target profit before tax 1.5
Interest added back 1
Fixed costs added back 1
Contribution/sales ratio 1
Target sales figure 1
6
55.4 Rights issue v debenture issue
1 mark per valid point up to a maximum of 8 8
55.5 Explanation of dividend policy theory 6
55.6 Identification of relevant ethical issues 3

35
55.1
Rights issue Debt issue
£m £m
Sales (£78.5m  1.20) 94.200 94.200
Variable costs (72%  sales) (67.824) (67.824)
Fixed costs (£13.85m + £2m) (15.850) (15.850)
Profit before interest 10.526 10.526
Interest (Workings) (1.421) (3.021)
Tax @ 17% (1.548) (1.276)
Profit after tax 7.557 6.229
Dividends payable (4.920) (3.000)
Retained earnings 2.637 3.229

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WORKINGS
£20,3m  7% 1.421 1.421
£20.0m  8% 1.600
1.421 3.021
55.2
Rights issue Debt issue
£m £m
Ordinary share capital (additional 8m shares) 20.500 12.500
Share premium (8m new shares  £1.50) 12.000 0.000
Retained earnings 13.923 14.515
46.423 27.015
Debentures 20.300 40.300
Total long term funds 66.723 67.315
Profit before tax £7.557 £6.229

Shares 20.500 12.500
£0.369 £0.498
Gearing £20.300 £40.300

£66.723 £67.315
30.4% 59.9%
55.3
Current EPS £5.568m £0.445m
12.500
£0.445m

20.500
Target earnings £9.123m
Add back tax (17%) ÷ 83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
Target contribution £28.263m
Contribution/sales ratio ÷ 28%
Target sales £100.939m
Current sales £78.500m

Target sales/current sales 1.286
(£100.939m/£78.500m)
Thus sales would need to increase by 28.6% or £22,439m
55.4 Sentry's current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights
issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue
increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue
option (30.4% compared to 59.9%). It's also lower than Sentry's current level of gearing
(46.0% [£20,300/44.086]).

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However if one takes the market value into account then the current gearing figure (34.5%)
is much lower. Current MV of equity = 40.000m (£3.20  12.5m). Current MV of debt =
£21.112 million (1.04  £20.3m). (£21.112/[£21.112 + £40.000]) = 34.5%
The interest cover ratio of 7.4 is higher than that for the debenture issue (3.5) and the
existing figure (5.7).
The rights issue (£20m) represents 50% of Sentry's current market capitalisation (£3.20 
12.500 = £40m). This could deter current shareholders from investing and so there might
be a dilution of shareholders (and control).
Debenture issue:
This creates a very high level of gearing (59.9%) and the interest cover is 3.5 (compared to
the current cover figure of 5.7). So the extra financial risk taken on might concern the
shareholders.
It would need sales to increase by 29% for the EPS under the rights issue to remain at its
current level – is this achievable? Roger Smyth's comments suggest otherwise.
Other issues to consider:
The current debentures are due to be repaid in 20X9–20Y0. This will create additional
financial pressure.
Issue costs – the cost of issuing debentures is likely to be cheaper.
Tax shield – the debenture issue would give Sentry more chance to take advantage of the
tax shield and its WACC may fall accordingly, unless the gearing level was then deemed by
investors to be too high.
55.5 Reference to main dividend policy theory:
M&M theory – share value is determined by future earnings and the level of risk. The
amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities (ie, those with positive NPV's).
Any loss in dividend income will be offset by the gains in share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or
capital gains in future. Cash now is more certain than in the future.
Supplementing these main theories:
 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on Sentry's share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change, ie,
communication with them is effective.
55.6 ICAEW provides ethical guidance that will ensure that shareholders can rely on the
objectivity and integrity of information given to them by members. The other ethical
principle at risk here is that of professional behaviour.
This question was, generally answered well and most candidates achieved a 'pass' standard.
element of the syllabus and there was also a small section with an ethics element to it.

lOMoARcPSD|5019904
In the scenario a listed UK drinks manufacturer planned to raise £20 million to finance a major
change in the company's trading strategy. This additional funding would be raised either via a
rights issue or a debenture issue. In part 55.1, for six marks, candidates were required to
prepare a forecast income statement for both of these methods of funding. Part 55.2 was also
worth six marks and asked candidates to calculate (a) the EPS and (b) the gearing ratio for both
methods of funding. Part 55.3, for six marks, tested sensitivity analysis – what level of sales would
be necessary to maintain the EPS at its current level. Part 55.4 was worth eight marks. It brought
together the three parts above and required candidates to discuss the implications for the
shareholders of the two funding methods. Part 55.5, for six marks, tested candidates'
understanding of dividend theory. Finally, in part 55.6, for three marks, candidates had to
explain the ethical issues arising for an ICAEW Chartered Accountant who is aware of a plan to
overstate the company's forecast sales figures.
Part 55.3 was a good discriminator and, whilst many candidates were able to work backwards to
a forecast sales figure, a large minority scored very poorly here.
Most candidates did very well in part 55.1 and the majority scored full marks. The most common
errors occurred with the estimated variable costs, interest charges and dividend payments. A
small minority of candidates were unable to calculate the number of new shares issued via the
rights issue and used, erroneously, a 1 for 1 issue (rather than dividing £20 million by the issue
price of £2.50).
Part 55.2 was generally well answered, but a number of candidates were unable to identify the
earnings figure from the income statement and used the retained profit figure instead. A
significant number of candidates were unable to calculate the correct gearing ratios. Typical
errors here were: (a) calculating debt/equity instead of debt/debt + equity, despite instructions
to the contrary, (b) omission of forecast retained profits, (c) addition of par value of new shares
rather than sum raised and (d) using market values rather than book values, again contrary to the
instruction given.
Overall the answers to part 55.4 were disappointing. Too many candidates said little beyond the
fact that EPS and gearing would move up/down, depending on the funding method chosen.
Very few considered the impact on interest cover or the required size of the equity issue. The
discussion of financial risk was, generally, limited and too many candidates spent too much time
on M&M theories.
Part 55.5 was, overall, answered very well, although some candidates discussed capital structure
theory here. Part 55.6 was, in general, answered very well.

lOMoARcPSD|5019904
56 White Rock plc (March 2017)

Marking guide
Marks
56.1 (a) Relevant money cash flows
Newcastle sales & contribution 2
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Working capital 0.5
Machinery sale 0.5
Tax saving on machinery 1
Lease cancellation 0.5
Tax saving 0.5
Newcastle working capital 1.5
Discount factor 1
Irrelevant costs: lease, head office, fixed 2
11
London sales 1
London variable costs 1
London fixed costs 1
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Lease payments 0.5
Tax saved on lease 0.5
Machinery sale 0.5
Tax saving 1.5
London working capital 1.5
Discount factor 1
10
56.1 (b) Advice 1
56.2 Divisible and indivisible projects:

Project rankings 2
NPV with divisible projects 2
NPV with indivisible projects 2
6
56.3 EMH and behavioural factors:

Explanation of EMH – levels of efficiency 4
Examples of irrational behaviour 4
Maximum available 7
35

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56.1(a)
Closure March 20X7 : 20X7 20X8 20X9
y0 y1 y2
£m £m £m
Newcastle sales (W1) 1,326.000 1,575.900
Newcastle VC's (sales  35%) (464.100) (551.565)
Tax on profit (W2) (146.523) (174.137)
Factory closure (1,600.000)
Tax on closure (@ 17%) 272.000
WC reversal 800.000
Machinery sale 1,700.000
Tax saving on machinery (W3) 238.000
Lease cancellation (3,000.000)
Tax saving on cancellation 510.000
Newcastle working capital (W4) (132.600) (24.990) 157.590
Total cash flows (1,212.600) 690.387 1,007.788
Discount factor 1.000 0.901 0.812
PV (1,212.600) 621.970 817.943
NPV 227.314
Newcastle lease will be paid anyway, so the cost is irrelevant.

Allocated Head Office costs are irrelevant as they are not incremental.
Newcastle factory-wide fixed costs are irrelevant as they are incurred
anyway.
W1
Newcastle sales £1.3m  1.02 1,326.000
£1.5m  1.02  1.03 1,575.900
W2
Newcastle contribution
(sales  65%) 861.900 1,024.339
Tax @ 17% 146.523 174.137
W3
WDV 3,100.000
Balancing Allowance (1,400.000)
Sale 1,700.000
Tax saved (17% 

£1,400,000) 238.000
W4
Working capital (132.600) (157.590) 0.000
Balance b/f 0.000 132.600 157.590
Increment (132.600) (24.990) 157.590

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20X7 20X8 20X9

Closure March 20X9 : y0 y1 y2
£m £m £m
London sales (W1) 7,344.000 5,778.300
London variable costs (sales  40%) (2,937.600) (2,311.320)
London fixed costs (W2) (1,428.000) (1,470.840)
Tax on profit (W3) (506.328) (339.344)
Factory closure (2,300.000)
Tax on closure 391.000
Lease payments (1,800.000) (1,800.000)
Tax saved on lease 306.000 306.000
Machinery sale 600.000
Tax saving on machinery (W4) 94.860 77.785 252.355
London working capital (W5) 65.600 156.570 577.830
Total cash flows (1,639.540) 1,212.427 1,483.981
Discount 1.000 0.901 0.812
PV (1,639.540) 1,092.277 1,204.432
NPV 657.169
W1
London sales £7.2m  1.02 7,344.000
£5.5m  1.02 
1.03 5,778.300
W2
London fixed costs £1.4m  1.02 (1,428.000)
£1.4m  1.02 
1.03 (1,470.840)
W3
London contribution (sales  60%) 4,406.400 3,466.980
less: London fixed costs (1,428.000) (1,470.840)
London 'profit' 2,978.400 1,996.140
Tax on 'profit' @ 17% (506.328) (339.344)
W4
WDV 3,100.000 2,542.000 2,084.440
WDA (558.000) (457.560) (1,484.440)
WDV/sale 2,542.000 2,084.440 600.000
Tax saved (WDA  17%) 94.860 77.785 252.355
W5
Working capital (734.400) (577.830) 0.000
Balance b/f 800.000 734.400 577.830
Increment 65.600 156.570 577.430
56.1(b) White should choose March 20X9 for closure of the London factory as it has the higher
NPV and will enhance shareholder wealth the most.

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56.2
Project 1 2 3 4 Total
£'000 £'000 £'000 £'000 £'000
Investment required (£m) 6,000 4,500 4,700 3,850 19,050
Net Present Value 621 563 869 622
NPV/£ invested £0.104 £0.125 £0.185 £0.162

Ranking 4 3 1 2
Divisible projects 1 2 3 4 Total

£'000 £'000 £'000 £'000 £'000
Invested 1,950 4,500 4,700 3,850 15,000
NPV 202 563 869 622 2,256
Funds used 32.5% 100% 100% 100%

of of of of
P1 P2 P3 P4
Indivisible projects
Using trial and error:

1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 6,000 4,500 3,850 14,350
NPV 621 563 622 1,806
1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 6,000 4,700 3,850 14,550
NPV 621 869 622 2,112
1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 4,500 4,700 3,850 13,050
NPV 563 869 622 2,054
The highest NPV is achieved via the combination of projects 1, 3 and 4. This would
generate an NPV of £2,112,000.
56.3 The efficient markets hypothesis (EMH) holds that stock markets are considered in the main
to be efficient, ie, all share prices are 'fair'. Investment returns are those expected for the
risks undertaken. Information is rapidly and accurately incorporated into share values.
When share prices at all times rationally reflect all available information, the market in which
they are traded is said to be efficient. In efficient markets investors cannot make consistently
above-average returns other than by chance.
An efficient market is one in which share prices reflect all of the information available. There
are three levels of efficiency:
Weak form – prices only change when new information about a company is made available.
There are no changes in anticipation of new information. Information arrives in a random
manner (the random walk theory) and so the chartist theory (technical analysis) will not hold
up here. The market is efficient in the weak form if past prices cannot be used to earn
consistently abnormal profits.

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Semi strong form – prices reflect all information about past price movements and all
knowledge that is publicly available/anticipated. The market can anticipate price changes
before new information is formally announced. The market is efficient in the semi-strong
form if publicly available information (eg, historical share prices, dividend announcements)
cannot be used to earn consistently abnormal profits.
Strong form – share prices reflect all information about past price movements, all
knowledge that is publicly available/anticipated and from insider knowledge available to
specialists or experts. The market is efficient in the strong form if all information (private and
public) cannot be used to earn consistently abnormal profits.
Behavioural finance questions the validity of the EMH and posits that investors' irrational
behaviour may affect share price movements. Examples of irrational behaviour are:
Overconfidence Representativeness Narrow framing
Miscalculation of probabilities Ambiguity aversion Positive feedback
Cognitive dissonance Availability bias Conservatism
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a 'pass' standard in the question, however.
It was based around a UK cosmetics manufacturing company which has three factories (in
London, Newcastle and Manchester). In part 56.1 of the question, for 22 marks, the company
had decided to close the London factory and relocate some of its production to the Newcastle
factory. Its board is not sure of the best closure date (20X7 or 20X9). Candidates were given
financial information about the two factories and were asked to calculate the relevant money
cash flows associated with closing the London factory (a) in 20X7 and (b) in 20X9. From these
calculations candidates were required to calculate the NPV for each scenario. Part 56.2, for six
marks, considered the Manchester factory and tested candidates' understanding of capital
rationing. Part 56.3, for seven marks, required candidates to explain the key principles of the
Efficient Market Hypothesis and the influence of behavioural factors.
As expected, parts 56.1(a) and 56.1(b) were a very effective discriminator. A good number of
candidates did really well here, but a significant minority really struggled and were unable to
identify the relevant cash flows adequately. This was largely due to an inability to stand back and
think the scenario through carefully before diving in and doing the calculations. Typical errors
made were:
 The inclusion of opportunity costs (despite instructions to the contrary)
 Including irrelevant cash flows, eg, leases, head office costs, fixed costs
 Inaccurate inflation adjustments
 Poor working capital calculations
 Too many candidates mixed together the London and Newcastle sales/contribution figures
 Many candidates considered only 20X7 cash flows for the 20X7 closure date and will have
lost marks
Most candidates scored well in part 56.2 and the most common error was a failure to apply the
trial and error approach for the indivisible projects.
Part 56.3 was answered well by most candidates.

lOMoARcPSD|5019904
57 ST Leonard Foods (March 2017)

Marking guide
Marks
57.1 Net payment due 1
No hedge 2
OTC option 3
Forward contract 2
11
57.2 Hedging advice comparing the methods
under each exchange rate 8
57.3 Rates payable with LIBOR 4% 2

Rates payable with LIBOR 6% 2
Annual interest calculation 1
Conclusion 2
7
57.4 FRAs v futures – 1 mark per valid point 4
30
57.1
Net payment due at 30/6/X7 = €1,750,000 – €600,000 €1,150,000
Spot rate @ 30/6/X7 Spot rate @ 30/6/X7

€1.1875 – 1.1960/£ €1.2745 – 1.2860/£
Do not hedge €1,150,000 (£968,421) €1,150,000 (£902,314)

1.1875 1.2745
OTC option €1.1875 – €1.2745 –

1.1960 1.2860
Call option
Exercise option Yes No
Rate 1.2540 1.2745
Sterling payment €1,150,000 €1,150,000

1.2540 1.2745
(£917,065) (£902,315)
plus: Premium cost
(€1,150k/€100  £0.70) (8,050) (8,050)
Total cost (£925,115) (£910,365)

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Money market hedge

Lend euros now €1,150,000 €1,150,000 €1,143,709
1 + (2.2%/4) 1.0055
Convert at spot rate €1,143,710 (£903,975)

1.2652
Sterling borrowed at 4.6% pa 903,975  [1 + (4.6%/4)] (£914,370)
Forward contract
Sterling payment €1,150,000 1,150,000 (£913,133)
(1.2652 – 0.0058) 1.2594
Arrangement fee (5,500)

(£918,633)
57.2 In summary
Spot rate – €1.1875/£ Spot rate – €1.2745
Do not hedge (£968,421) (£902,314)
OTC option (£925,115) (£910,365)
MMH (£914,370) (£914,370)
Forward contract (£918,633) (£918,633)
Sterling payment @ current spot rate €1.150m/1.2652 (£908,947)
The forward rate suggests that the euro will strengthen (sterling will weaken) over the next
three months. STL would prefer sterling to be stronger (purchases are then cheaper).
With an exchange rate of €1.1875/£
Sterling is much weaker, and the MMH and forward contract produce the lowest sterling
payments.
With an exchange rate of €1.2745/£
Sterling is stronger, and the option and no hedge produce the lowest sterling payments.
Once the exchange rate exceeds €1.2577/£ (€1.150,000/£914,370) then the option
produces a lower payment than the MMH (and also, therefore, the forward contract).
Directors' attitude to risk is also important in deciding which approach to take.
57.3
LIBOR 4% LIBOR 6%
FRA Option No hedge FRA Option No hedge
Pay (5.0%) (5.0%) (5.0%) (7.0%) (5.2%) (7.0%)
(Pay)/refund (0.8%) 1.2%
Premium (0.5%) (0.5%)
Total (5.8%) (5.5%) (5.0%) (5.8%) (5.7%) (7.0%)
£'000 £'000 £'000 £'000 £'000 £'000

Annual interest (243.6) (231.0) (210.0) (243.6) (239.4) (294.0)
At the lower LIBOR rate it is best not to hedge, but with LIBOR at 6% the option is slightly
cheaper than the FRA.

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57.4 FRA's allow lenders/borrowers to fix a rate of interest. The bank will pay/receive any
difference between the agreed rate and the actual rate paid/received (see workings in 57.3
above).
Interest rate futures are similar to FRA's in that they are contracts on an interest rate, but the
terms, amounts and periods are standardised.
Entitlement to interest rate receipts is bought with futures and the promise to make to
interest rate payments is sold with futures.
The pricing of an interest rate futures contract is calculated as (100–r), so if the rate in a
futures contract is 5% then the contract will be priced at 95. Profits/losses on the buying and
selling of futures are offset against the moves in interest rates.
Most candidates demonstrated a good understanding of this area of the syllabus and this
question had the highest average mark on the paper
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus.
In the scenario a UK frozen food company was considering hedging its exposure to (a) foreign
exchange rate risk on a planned €1.15 million (net) payment (three months ahead) and (b)
interest rate risk on a £4.2 million loan from its bank (also three months ahead).
Part 57.1 was worth 11 marks and asked candidates to calculate, at two spot rates, the sterling
cost arising from a list of hedging techniques that could be applied to the euro payment. In part
57.2, for eight marks, candidates were required to advise the company's board whether it
should hedge the euro payment. In part 57.3, for seven marks, candidates were required to
calculate the annual interest payments that would arise on its planned loan were it to make use
of an FRA, an option or to not hedge at all. Two different rates of LIBOR were given to the
candidates. From these calculations, candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates given. Finally in part
57.4, for four marks, candidates were asked to explain how FRA's differ from interest rate
futures.
Part 57.1 was generally answered well. However, a minority of candidates added the euro
receipt to the euro payment or kept them separate and so will have lost marks. One disturbing
error, which occurred too frequently, was that candidates calculated two different MMH and
forward contract results using the two future spot rates given, rather than a single result for each,
based on the current spot rate. Also, many wasted time by recalculating the correct MMH and
forward contract results for the second set of spot data, rather than just stating 'no change'. The
examining team has no explanation for this as many similar questions have been set in the past
without these issues occurring. With the currency option, the most common errors were (a)
choosing a put rather than a call option and (b) using a traded option rather than an OTC.
Overall, part 57.2 was disappointing in that too few candidates went beyond only comparing the
best outcome at each spot rate. Most answers here needed to demonstrate a deeper
understanding of the issues involved.
In part 57.3 many candidates scored full marks, which was good to see. However, a number of
candidates lost marks as they were confused by the timings in the scenario. Rather than calculate
the annual interest cost as required, they calculated, incorrectly, a three month cost, ie, between
now and when the loan is to be taken out.
Overall, part 57.4 was answered well.

lOMoARcPSD|5019904
58 Brighton plc (June 2017)

Marking guide
Marks
58.1 NPV calculation:

Contribution 3
Costs 1.5
Recognition of sunk costs 0.5
Rent forgone 1
Tax 1
New equipment/capital allowances 3
Working capital 2.5
Discount factor 1
NPV conclusion 1.5
15
58.2 PV of contribution 2.5
Sensitivity % 0.5
Conclusion 1
4
58.3 Listing the seven value drivers 2
Application to the scenario 4
6
58.4 1 mark for each option, 1 mark for application 4
58.5 1.5 marks for each example 3
58.6 State and apply the relevant principles 3

35
58.1
0 1 2 3 4
£m £m £m £m £m
Contribution 2.97 3.18 2.92 2.68
Fixed overheads –0.10 –0.10 –0.11 –0.11
Selling and administration –0.50 –0.52 –0.53 –0.55
Rent forgone –0.40 –0.40 –0.40 –0.40
Operating cash flows –0.40 1.97 2.16 1.88 2.02
Tax 17% 0.07 –0.33 –0.37 –0.32 –0.34
After tax operating cash flows –0.33 1.64 1.79 1.56 1.68

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0 1 2 3 4
£m £m £m £m £m
New equipment –8.00
Tax saved on CA's 0.24 0.20 0.16 0.13 0.62
Working capital –1.00 –0.07 0.09 0.08 0.90
Net cash flows –9.09 1.77 2.04 1.77 3.20
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value –9.09 1.61 1.68 1.33 2.19
NPV –2.28
The project has a negative NPV therefore it should not proceed.

Contribution:
1. 5,500  12  £100  45% = £2.97m
2. 2.97  1.02  1.05 = £3.18m
3. 3.18  1.02  0.90 = £2.92m
4. 2.92  1.02  0.90 = £2.68m
Fixed overheads only 50% incremental: £0.2m  0.5 = £0.1m
1. 0.1
2. 0.1  1.03 = 0,103
3 0.103  1.03 = 0.106
4.0.106  1.03 = 0.109
Selling and administration:
1. 0.50
2. 0.50  1.03 = 0.515
3. 0.515  1.03 = 0.531
4. 0.531  1.03 = 0.546
Marketing costs and centrally allocated costs are a sunk costs and therefore not included.
Capital allowances and the tax saved thereon.
Cost/WDV CA Tax
0 8.00 1.44 0.24
1 6.56 1.18 0.20
2 5.38 0.97 0.16
3 4.41 0.79 0.13
4 3.62 3.62 0.62
Working capital
Total Increment
0 –1 –1
1 –1.07 –0.07
2 –0.98 0.09
3 –0.9 0.08
4 0.9
The discount factor should be calculated as follows:
(1.07  1.025) –1 = 0. 0968 It is acceptable to round this to 0.10 (10%).

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58.2
£m £m £m £m
Sensitivity:
Contribution  (1– 0.17) 2.47 2.64 2.42 2.22
PV factors 0.909 0.83 0.75 0.68
PV 2.25 2.18 1.82 1.52
Total PV 7.77
Sensitivity
– 2.28/7.77 = –29.3%
Sales revenue will have to increase by 29.3% to arrive at a zero NPV. The project is therefore
relatively insensitive to revenue changes.
58.3 SVA is the process of analysing the activities of a business to identify how they will result in
increasing shareholder wealth.
Answers should outline the seven drivers and relate them to the project and its negative
NPV:
Sales growth rate – can this be increased, are the estimates realistic.
Operating profit margin – can the 45% contribution be improved by reducing costs.
Investment in non-current assets – can the cost of the project be reduced, perhaps by
leasing plant and machinery.
Investment in working capital – can the project operate with less investment in working
capital without causing liquidity problems.
Cost of Capital – is the cost of capital at its optimum level.
Life of projected cash flows – is the project life cycle correct and is there any value in cash
flows beyond the fourth year.
Corporation tax rate – is the company tax efficient.
58.4 The project has a negative NPV, which signals that Brighton should reject it. The real options
are as follows (any TWO):
A follow-on option – investing into this competitive market now will allow Brighton to invest
more in the future, perhaps when other competitors have left the market.
An abandonment option – Brighton might commence the project with a view to future
investment. However, if it is apparent that the sector is not going to offer future
opportunities, Brighton can abandon the project at any time eg, by selling out to a rival.
A timing option – Brighton could delay its investment and wait and see if competitors leave
the market, making it more attractive to invest later on.
A growth option – As well as manufacturing overseas, Brighton also has the opportunity to
expand overseas via acquistion.
A flexibility option – Manufacturing overseas would perhaps give the flexibility to access
overseas markets more easily.
58.5 The over-riding objective of companies is to create long-term wealth for shareholders.
However this can only be done if we consider the likely behaviour of other stakeholders. For
example (TWO only):
Employees – cutting employee benefits in pursuit of creating short-term profits could have
long-term detrimental effects on shareholder wealth, for example if the company has high
staff turnover which affects productivity or service levels.

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Creditors – delaying payments to creditors could have repercussions for future supplies,
which could reduce longer- term shareholder wealth.
Managers – if managers and employees are not motivated adequately, the costs of
inefficiencies will be borne by shareholders.
58.6 The directors of Brighton should develop an ethical policy in respect to using overseas
manufacturers where labour is cheap and safety standards for employees may be low. This
should relate to not using suppliers who make use of child labour or slave labour, or who
employ people in dangerous working conditions. In relation to this, the principles of
integrity, objectivity and professional behaviour are relevant.
This was a six-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was a company considering
launching a new product on to the market.
Part 58.1 was well answered by many candidates, however the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; not stating that
research and development costs should be ignored because they are a sunk cost; not stating
that allocated fixed overheads should not be included in the NPV computations.
Responses to part 58.2 were mixed, with many candidates basing calculations on sales rather
than contribution, and many ignoring taxation. There were few candidates who made
meaningful comments regarding the sensitivity of the project to changes in the inputs.
Responses to part 58.3 were also mixed, with weaker candidates merely listing the seven drivers
with no application to the scenario.
Responses to part 58.4 were good, but some candidates listed all real options rather than just
stating two as per the requirement. Only the first two are marked. Responses to parts 58.5 and
58.6 were also good.
59 Easton plc (June 2017)

Marking guide
Marks
Cost of debt 4
MV equity 1
MV debt 1
WACC 1
8
59.2 Explanation 2
De-gearing 1.5
Re-gearing 1.5
Cost of equity associated with the project 1
6
59.3 Overall equity beta 1.5
Cost of equity 1
WACC 1.5
Commentary 2
6

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Marks
59.4 2 marks for definitions; 0.5 marks for each examples 6
59.5 Portfolio theory 1

Stock market reaction 1.5
Shareholder reaction 1.5
4
59.6 Identification of APV 1
Description of its application - 1 mark per point 4
5
35
59.1 The current WACC using CAPM is calculated as follows: Ke = 2 + 0.45 (9 – 2) = 5.15%
Kd using linear interpolation:
The ex-interest debenture price is £105 (109 – 4).
Timing Cash Flow Factors at PV Factors at PV
Years £ 1% £ 5% £
0 (105) 1 (105) 1 (105)
1–8 4 7.652 30.61 6.463 25.85
8 100 0.923 92.30 0.677 67.70
17.91 (11.45)
IRR = 1 + (17.91/(17.91 + 11.45)  4 = 3.44%
Kd = 3.44  (1 – 0.17) = 2.86%
The ex div share price is 252p – 10p = 242p.
The market value of equity is: 242p  (5m/0.01) = £1,210m. The market value of debt is:
£200m  (105/100) = £210m. The debt equity ratio is: 0.15:0.85
The current WACC is: (5.15%  0.85) + (2.86%  0.15) = 4.81%
59.2 The cost of equity should reflect the systematic risk of the project. An equity beta from a
listed company operating veterinary practices can be used as a surrogate in the CAPM.
Since the gearing ratio of the surrogate is materially different to Easton, gearing
adjustments will have to be made.
De gearing to find Ba: 0.80 = Ba (1 + (3  0.83)/7) Solving for Ba. Ba = 0.59
Gearing up to reflect the gearing ratio of Easton to find Be: Be = 0.59 (1 + (0.15  0.83)/0.85)
Solving for Be. Be = 0.68
The Ke to reflect the systematic risk of the project = 2 + 0.68 (9 – 2) = 6.76%
59.3 The overall Be of Easton will reflect the systematic risk of both pet-related products and
veterinary practices.
The overall Be = (0.45  0.75) + (0.68  0.25) = 0.51
Ke = 2 + 0.51 (9 – 2) = 5.57%. The overall WACC = (5.57%  0.85) + (2.86%  0.15) = 5.16%
Easton's WACC has increased to 5.16% from 4.81%. An increase in the WACC is associated
with a reduction in value, but assuming that the project has a positive NPV this could result
in an increase in value.

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59.4 Systematic risk is the type of risk that all companies are exposed to, no matter which market
sector they operate in. Systematic risk cannot be eliminated through diversification.
Examples of systematic risk include: interest rate changes, economic recession, oil price
changes and wars.
Unsystematic risk is the risk that affects a particular market sector or individual company.
Most of this risk can be diversified away by investing in a portfolio of randomly selected
securities. Examples of unsystematic risk include: the chairman resigning, strikes by the
employees of a company or changes in regulations that affects a particular market sector.
59.5 Portfolio theory shows that the only logical portfolio to hold is one which is fully diversified.
The reaction of each group might be:
The stock market might not welcome the diversification, since diversified companies usually
trade at a conglomerate discount. The stock markets might assume that Easton does not
have the expertise to operated veterinary practices.
Shareholders who hold a well-diversified portfolio would not welcome Easton diversifying
its operations (as they already regard themselves as well-diversified without this), so the
market value might fall.
59.6 If the financing of the project results in a change in the capital structure of Easton, the
WACC/NPV should not be used. An alternative project appraisal technique is APV.
The project will be appraised as if it were only financed by equity, to arrive at a base case
NPV. The base case NPV is then adjusted for the present value of the costs and benefits of
the actual type of finance used, including the present value of the tax shield on interest paid.
The discount rate will be the all equity discount rate using the Ba for the project: 2 + 0.59 (9 –
2) = 6.13%
element of the syllabus. The scenario of the question was a company considering diversifying its
activities, and calculating the WACC that should be used to appraise the diversification. Also
there is debate about whether the company should be diversifying in the first place, and how the
markets and shareholders might react.
Responses to part 59.1 were good. However a number of candidates made basic errors when
calculating the cost of debt, with a surprising number not able to carry out interpolation
correctly. Strangely, some candidates correctly calculated the cost of equity using the CAPM, but
then used this number in the DVM as growth. They then attempted to use the DVM model to
calculate the cost of equity.
Responses to part 59.2 were disappointing, but there were some excellent answers.
Common mistakes were: de-gearing the company's existing equity beta; de-gearing the correct
beta but re-gearing using book values rather than market values. Explanations of the rationale
for calculating the cost of equity for the project were poor.
Responses to part 59.3 were mixed. A number of candidates did not calculate the overall equity
beta of the company, and used the equity beta from part 59.2. Explanations of the effect of a rise
in the overall WACC of the company were poor. Responses to part 59.4 were poor, and many
candidates were confused about what the terms systematic and unsystematic risk mean. Often
students quoted incorrect examples of each risk.
Responses to part 59.5 were also mixed, with many candidates not able to demonstrate a good
grasp of the topic area. Few candidates mentioned that diversified companies often trade at a
conglomerate discount.
Responses to part 59.6 were reasonable. Many candidates were able to identify APV and
describe the process. However, few candidates calculated the appropriate discount rate.

lOMoARcPSD|5019904
60 Lake Ltd (June 2017)

Marking guide
Marks
60.1 Forward contract 2
Currency futures 4
OTC currency options 5
14
60.2 Implications of hedging techniques 3
Advantages and disadvantages 5
Recommendation 2
10
60.3 2 marks for each risk identified and explained 4
Ways to mitigate the risks 2
6
30
60.1 Forward contract:

The appropriate forward rate is $/£1.3110 (1.3092 + 0.0018). The sterling receipt will be
£991,609 (£1,300,000/$1.3110).
Money market hedge:
Borrow in US$ against the receipt due in three months:
Borrow $1,288,085 = (1,300,000/(1 + 0.037/4)
Buy £ spot = £983,871 (1,288.085/1.3092)
Total receipt of £991,497 (983,871  (1 + 0.031/4))
Currency futures:
Lake will buy September futures to hedge the $ receipt.
The number of contracts to buy is = ($1,300,000/$1.3105)/£62,500 = 15.87 round to 16.
The futures contracts will be closed out on 30 September 20X7 resulting in a profit of:
$12,500 ((1.3230 – 1.3105)  16  62,500)
The sterling receipt will be: £990,566 ((1,300,000 + 12,500)/1.3250).
Lake will use a call option to buy £ with an exercise price of $/£1.3200. The premium will
cost = £26,000 (1,300,000  0.02).
Together with interest the premium will cost £26,208 (26,000  (1 + 0.032/4))
If the spot rate for buying £ with $ on 30 September is $/£ 1.3250 the option will be
exercised. The total receipt will be = £958,640 ((1,300,000/1.3200) – 26,208).

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60.2 The four hedging techniques result in sterling receipts of:

Forward contract £991,609
A money market hedge £991,497
Currency futures £990,566
OTC currency option £958,640
The forward contract, money market hedge and futures contracts all lock Lake into an
exchange rate. The options protect Heaton against the downside risk of the £ strengthening
against the $, and allow for the upside potential of the $ strengthening against the £.
However, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for Lake.
However there is no secondary market should the customers not pay Lake.
Money market hedge:
The money market hedge is the same as a forward contract. However it is more difficult to
arrange and might use up Lake's credit lines, on the other hand it does allow Lake to
decrease its overdraft immediately.
Currency futures:
Not tailored so one has to round the number of contracts.
Requires a margin to be deposited at the exchange.
Need for liquidity if margin calls are made.
However, there is a secondary market.
Basis risk exists.
There is no secondary market.
Advice to Lake:
Spot is $1,300,000/$1.3250 = £981,132
It is unlikely that the dollar is going to strengthen enough to cover the cost of the option
premium, so it is not recommended that the company uses foreign currency options. There
is very little difference in the receipt using forwards, the money markets and futures, and
they are all better than spot.
Since there is potential for margin calls using futures, and the use of credit lines using the
money markets, it is recommended that Lake uses forward contracts to hedge its foreign
currency risk.
60.3 Risks that students might identify and explain are (two only):
 physical risk – the risk of goods being lost or stolen in transit, or the documents
accompanying the goods being lost.
 credit risk – the possibility of payment default by the customer.
 trade risk – the risk of the customer refusing to accept the goods on delivery, or
cancellation of the order in transit.
 liquidity risk – the inability to finance the credit given to customers.
 other risks that would be given marks include political risk and cultural risk.

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These risks may be mitigated with the help of banks, insurance companies, credit reference
agencies and government agencies such as the UK's Export Credits Guarantee Department.
Other ways to reduce these risks include risk transfer. Lake might be able to agree a
contract obligating the courier to pay for losses in excess of its statutory liability.
This was a three-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was a company that has recently started
exporting to the US, and a member of staff is asked to give advice to the board on hedging
FOREX, and other risks associated with overseas trading activities.
Part 60.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; choosing put options rather than call
options; treating an over the counter option like a traded option; calculating the option premium
in US$ rather than £; omitting interest on the option premium.
There were average answers to part 60.2 from a lot of candidates, some without any reference to
the numbers calculated in 60.1. Many candidates did not give a firm conclusion, but there were
some excellent answers.
Responses to part 60.3 were mixed, with many candidates demonstrating a lack of knowledge of
overseas trading risks. Even though the requirement stated that the risks identified should be
other than FOREX, a number of candidates quoted this as one of their two risks.

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61 Merikan Media plc (September 2017)

Marking guide
Marks
61.1 (a) Valuation:
P/E ratio 2
Dividend yield 2
EBITDA 5.5
Net assets at historic cost 1
Net assets revalued 1.5
12
(b) 1 point per valid point on each of the valuation methods 7
Advice on price range 1
8
61.2 (a) SVA:
Sales and operating margin 2
Tax and depreciation 2
Non-current assets 2
Working capital 1
Terminal value 2.5
Present values 0.5
Short term investments 1
Long term debt 1
12
(b) Methods to fund MBO – 1 mark per point 3
35
61.1 (a)
Total Value per

value share
£'000 £
P/E ratio £6,391,000  8.5 = 54,324 /3,500 15.52
Lower marketability
(25% discount, say) 11.64
Dividend yield £1,750,000/5% = 35,000 /3,500 10.00

Lower marketability

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Total Value per

value share
£'000 £
Enterprise value £'000
Profit before interest &
tax 8,100
Depreciation 3,500
Amortisation 1,200
EBITDA 12,800  6.5 = 83,200
less: Debt at MV 8,000  £110% = (8,800)
74,400 /3,500 21.26
Lower marketability
Net assets – historic cost
Ordinary share capital 3,500
30,706 /3,500 8.77
8.94
Net assets – revalued
Historic cost (as above) 30,706
Non-current assets (£37,800 – £36,310) 1,490
Current assets (£4,200 – £4,316) (116)
Debentures (£8,000 – £8,800) (800)
31,280 /3,500
(b) Asset valuations are the lowest. They are historic figures and balance sheet-based, with
no intangibles. Merikan is buying Coastal to run it, not to break it up.
P/E and enterprise value are the most relevant as they are forward-looking and based
on profits/earnings.
Using the dividend yield is acceptable, but it is a 100% purchase and the yield
calculation is only relevant for minority interests. Also, this method ignores growth. So
a price range of £12 to £16 per share looks reasonable.
61.2 (a)
Terminal
20X7 20X8 20X9 20Y0 value
£m £m £m £m £m
Sales 70.0 73.5 75.7 77.2 77.2
Operating margin 5.9 6.8 6.9 6.9
Tax (17%) (1.0) (1.2) (1.2) (1.2)
Depreciation 1.5 1.5 1.5 1.5
Operating cash flows 6.4 7.2 7.3 7.3
Replacement non-current assets (1.5) (1.5) (1.5) (1.5)
Incremental non-current assets (0.2) (0.1) 0.0 0.0
Incremental working capital (0.2) (0.1) (0.1) 0.0
Free cash flows 4.5 5.4 5.7 5.8
Discount factor (8%) 0.926 0.857 0.794 0.794
4.6
/8%
Present values 4.2 4.7 4.5 57.2
Total present value 70.6
plus: Short-term investments 0.7
less: Long-term debt
(£10m  £95%) (9.5)
Market value of equity 61.8
So GB's equity is worth approximately £61.8m

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(b) Methods by which management might fund its MBO:

From management's equity
From venture capitalists – via equity and debt
Borrowing from bank(s) – debt
This question was generally answered poorly and a very slim majority of candidates achieved a
pass standard. It was a four-part question that tested the candidates' understanding of
investment decisions. In the scenario a UK-listed media group is planning to (1) purchase an
unquoted commercial radio company and (2) sell all of its shares in an unquoted newspaper
company via a Management Buy Out (MBO).
Many candidates did well in part 61.1(a) and some scored full marks. However, overall this was
not answered as well as expected. A considerable number of candidates were unable to
calculate the company's net assets and/or earnings figures, which was very disappointing. The
enterprise value (EV) calculation was a recent addition to the syllabus. Overall this was answered
reasonably well, but many candidates did not attempt it at all. Part 61.1(b) was, overall, done
well, but to score high marks here candidates needed to consolidate valuation theory with the
figures that they had calculated.
For part 61.2(a) there was a wide range of answers. Some candidates did really well here, whilst
others produced very little. The figures themselves were not difficult, and a methodical approach
would have generated a good mark. There was evidence of time pressure, as there were many
incomplete answers. Part 61.2(b) was done well by most candidates. A similar question to this
was set recently, but many candidates did poorly because they failed to concentrate their
answers on the directors behind the MBO, rather than the company itself.
62 Ramsey Douglas Motors plc (September 2017)

Marking guide
Marks

WACC 1
10
62.2 Current market value of redeemable debentures 2
Effect of rise in yield 1
3
62.3 Use of WACC figure – 1 mark per valid point 5
62.4 Identification of key ethical issues 3

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Marks
62.5 Calculation of appropriate WACC:
Calculation of ungeared beta 1.5
Calculation of geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Appropriate commentary 4
10
62.6 Application of EMH theory – 1 mark per point 4
35
62.1
Cost of equity (ke) = (d1) (£5,440  1.03)

+g + 3% 11.54%
MV £65,600
Cost of preference shares (kp) = d £640 5.93%

MV £10,800
(£275  83%)
Cost of irredeemable debt (kdi) = 3.80%
£6,000

Year Cash flow 4% factor PV 5% factor PV
£'000 £'000 £'000
0 (4,200) 1.000 (4,200.0) 1.000 (4,200.0)
1–3 240 2,775 666.0 2.723 653.5
3 4,000 0.889 3,556.0 0.864 3,456.0
NPV 22.0 NPV (90.5)
IRR = 4% + (22/(22 + 90.5)) = 4.20%
less: Tax at 17% (4.20%  83%) = 3.49%
WACC
Total MV's Cost  weighting WACC
£'000 £'000
Equity 65,600 11.54%  65,600/86,600 8.74%
Pref. shares 10,800 5.93%  10,800/86,600 0.74%
Irredeemable debt 6,000 3.80%  6,000/86,600 0.26%
Redeemable debt 4,200 3.48%  4,200/86,600 0.17%
21,000 1.17%
Total market value 86,600 9.91%
62.2 From 62.1 above:

Year Cash flow 5% factor PV
£'000 £'000
1–3 240 2.723 653.5
3 4,000 0.864 3,456.0
Present value 4,109.5
Thus current market value would be £4,109.5/£4,000 = £102.74%

Yield increases to 5% and market value falls to £102.74%. It is an inverse relationship.

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62.3 When using WACC to appraise projects the following assumptions are implied:
(1) Ramsey's historic proportions of debt and equity are not to be changed
(2) Ramsey's systematic business risk is not to be changed
(3) The finance is not project-specific (eg, cheap government loans)
In this case the finance is of a material size, being 11% of total funds at market value
(£9.5m/£86.6m) and the historic gearing does not appear to be met (it is 50:50 ignoring
project NPV).
The systematic business risk, as far as we are aware, does not change as it is still the same
industry.
It is not project-specific finance.
Therefore it is unwise to use the existing WACC, but the after-tax cost of the bank loan is not
the WACC either, as this ignores the required returns of shareholders.
62.4 Ethical guidance – key areas of ethical concern regarding the press release:
Integrity – members need to show honesty, fair dealing and truthfulness.
Objectivity – members must not succumb to the undue influence of others.
Interest of shareholders and owners must be taken into account – members must not let
their own self-interest influence their actions.
(2.10  72) (2.10  72)
New market ungeared beta = = 1.77
(72 + (16  83%)) 85.28
1.77  (£65.6m + £10.8m + (£10.2m  83%))

Ramsey's geared beta = 2.29
£65.6m
So, cost of equity = (2.29  (9.15% – 2.25%)) + 2.25 = 18.05%
Cost of debt = 9%  83% 7.47%
WACC = (18.05%  £65.6m/£86.6m) + (7.47%  £21.0m/£86.6m)) = 15.48%
It would be unwise to use the existing WACC (9.91%) as Ramsey's plan involves
diversification, and therefore a change in the level of systematic risk (beta rises to 2.29 from
1.25). Thus a new WACC must be calculated. Systematic risk is accounted for by taking into
account the beta of the driverless cars market, and this is then adjusted to eliminate the
financial risk (level of gearing) in that market. The resultant ungeared beta is then
're-geared' by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed
above) is used.
62.6 Markets set prices based on the information available. If the market 'takes fright' at the
proposed investment in driverless cars, then the market value of Ramsey's shares will fall
and may not recover. It all depends on the market's view of the company's likely future
success.
Efficiency does not mean that prices return to a 'normal level'. Markets have no memory.
Efficiency means that shares cannot be bought cheaply and then sold quickly at a profit.
Share prices are 'fair', and investment returns are those that would be expected for the risks
undertaken.

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This was a six-part question that tested the candidates' understanding of financing options, with
a small ethics element. It was poorly done and had the lowest percentage mark on the paper.
The majority of candidates failed to reach a 'pass' standard. It was based around a UK-listed car
manufacturer that was considering investing in (1) a computerised manufacturing system and (2)
the development of driverless cars.
There were many very good answers to part 62.1, with candidates securing the full marks
available. The calculation of WACC has been examined frequently. However, in this exam
candidates were, not for the first time, given total figures, rather than unit figures, to work with.
Many candidates, when given the total nominal value and the nominal value per share or
debenture, were incapable of deducing the number of shares or debentures in issue. Also a
significant number altered the share and debt values to make them ex-div, despite the fact that
the question stated that all dividends and interest due for the year had already been paid.
Part 62.2 was a good test of candidates' understanding of the market price and yield of
redeemable debt. Generally, it was answered very poorly. Many candidates commented that if
the redemption yield of the debt were to increase then so would the price of that debt, thus
totally misunderstanding the relationship between required return and value.
Candidates' responses to part 62.3 were also very disappointing. Too many candidates restricted
their answers to a discussion about the impact on the company's gearing levels, without taking
into account the wider aspects of when to employ the current WACC figure. In part 62.5 most
candidates scored well with the de-gearing and re-gearing calculations, but only a few were able
to work through to the end of the calculations.
Part 62.6 caught out the majority of candidates – they were unable to apply EMH theory to this
practical example. Responses that centred on the three forms of efficiency and/or behavioural
aspects scored poorly.
63 Jenson Grosvenor plc (September 2017)

Marking guide
Marks
63.1 Currency option 3

Forward contract 2
Strengthening sterling 1
9
63.2 Hedging advice – 1 mark per relevant point 7
63.3 Explanation of relevant economic risk 3
63.4 Advantages of using currency futures – 2 marks

Disadvantages of using currency futures – up to 4 marks
Maximum available 4
63.5 Call options intrinsic value 1

Put options intrinsic value 1
Time value 2
4
63.6 Factors affecting the time value – 1 mark per point 3
30

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63.1
£ £
(a) OTC currency option
Put option £5,200,000 3,200,985
1.6245
Cost £5,200,000 = 52,000  £0.75 (39,000)

100 3,161,985
(b) Forward contract

1.6385 + 0.0085 = 1.6470 £5,200,000 3,157,256
1.6470
Fee £5,200,000 = 52,000  £0.35 (18,200)

100 3,139,056
(c) Money market hedge

Borrow C$ £5,200,000 £5,133,268
1.013
Convert @ spot £5,133,268 3,132,907

1.6385
Lend @ UK 3,132,907
 1.007 3,154,837
(d) Strengthening £
1.6385  1.05 = 1.7204 £5,200,000 3,022,509
1.7204
63.2
Conversion at spot rate £5,200,000 £3,173,634
1.6385
If £ strengthens 3,022,509
Option 3,161,985
Forward 3,139,056
Money market hedge 3,154,837
The current spot rate gives best result.
The worst result is from the strengthening £, and the forward contract discount predicts a
strengthening of the £.
C$ is depreciating, and £ strengthening, which is bad for UK exporters. The forward contract
provides certainty, as does the money market hedge.
An option gives flexibility, but it is expensive.
63.3 Jenson's imports are purchased mostly in euros. If exports were, for example, mostly in
Canadian dollars then Jenson would be disadvantaged by both a strong euro and a weak
dollar (as in 63.1 and 63.2 above).
63.4 Advantages of using currency futures over forward contracts:
 Lower transaction costs
 The exact date of receipt or payment does not have to be known

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Disadvantages of using currency futures over forward contracts:

 The contracts cannot be tailored to the user's exact requirements.
 Hedge inefficiencies (due to needing a whole number of contracts, and basis risk) may
occur.
 Only a limited number of currencies can make use of futures contracts.
 If neither currency is $US, then this can complicate matters.
63.5 Intrinsic value

Only options that are in the money have an intrinsic value.
For the call options:
The call options with an exercise price of 355p are in the money and have an intrinsic value
of 10p (365p – 355p).
The call options with an exercise price of 370p are out of the money and have a zero
intrinsic value.
For the put options:
The put options with an exercise price of 370p are in the money and have an intrinsic value
of 5p (370p – 365p).
The put options with an exercise price of 355p are out of the money and have a zero
intrinsic value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:
Calls Puts
Sept Oct Sept Oct
355 1.0 11.0 2.0 13.5
370 3.5 14.0 4.0 15.5
63.6 The time value of the options will be affected by:
 the time period to expiry of the options.
 the volatility of the market price of the underlying item.
 the general level of interest rates.
Most candidates demonstrated a reasonable understanding of this area of the syllabus and this
question had the highest average mark on the paper. It was a six-part question which tested the
candidates' understanding of the risk management element of the syllabus.
The scenario was centred on a UK-based manufacturer of industrial pumps. The company was
considering hedging its exposure to (1) foreign exchange rate risk on a C$5.2 million receipt
(three months ahead) from a Canadian customer and (2) a fall in the value of a large quoted
shareholding.
Foreign exchange risk is a regular topic in this examination, and part 63.1 was generally
answered well. However, many candidates lost marks unnecessarily, eg, choosing a call rather
than a put option, failing to deal with fees correctly, or choosing the wrong interest rates for the
MMH. Over half of the candidates believed that strengthening sterling meant getting less
foreign currency.

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Generally part 63.2 was answered adequately, but bearing in mind how frequently this is
examined, it was disappointing. Too few candidates went beyond only comparing the best
outcome at each rate. Answers here needed to demonstrate a deeper understanding of the
issues involved. Many candidates stated, wrongly, that interest rates indicated that sterling would
weaken. Also too few commented on the negative impact of a stronger pound on an exporter.
In part 63.3 few candidates scored full marks. Those that did explained how a strengthening
pound when exporting and a weakening pound when importing would both be bad for the
company in question. Part 63.4 was generally answered well, but many candidates just listed the
advantages and disadvantages of currency futures and/or a forward contract, rather than
answering the question as set. Part 63.5 has been examined before, albeit rarely. A minority of
candidates answered it well and scored full marks, but most were unable to calculate the values
required. Part 63.6 was answered well and most candidates scored full marks.

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December 2017 exam answers
64 Innovative Alarms (December 2017)

Marking guide
Marks
64.1 (a) NPV calculation:
Contribution/contribution lost 5
Fixed overheads 1
Tax charge 1
Sale proceeds 2
Working capital 2
Machinery and equipment 1
Tax saved on capital allowances 2
PV and recommendation 2
16
64.1 (b) Disadvantages of sensitivity analysis 3
Simulation 3
Total possible marks 6
Marks available 4
64.1 (c) Discussion of real options – abandonment, follow-on 4
64.1 (d) Ethical issues

3
64.2 Replacement after one year 1
Replacement after two years 2
Replacement after three years 2.5
Recommendation and limitations 2.5
8
35
64.1 (a)
Units pa 30,000
0 1 2 3
Units 000's
( 1.06) 30.00 31.80 33.71
Selling price £ ( 1.03) 399.00 410.97 423.30
Contribution per unit £

(see skilled) 159.6 164.39 169.32
£'000 £'000 £'000 £'000
Contribution 4,788.00 5,227.60 5,707.78
Contribution lost (1,500.00) (1,637.70) (1,788.15)
Fixed overhead (500.00) (525.00) (551.25)
Taxable 0 2,788.00 3,064.90 3,368.38
Tax @ 17% 0 (473.96) (521.03) (572.62)

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£'000 £'000 £'000 £'000

Sale proceeds 9,759.88
Working capital (2,000.00) (183.60) (200.45) (2,384.05)
Machinery and equipment (8,000.00) 2,000.00
Tax saved on CAs 244.80 200.74 164.60 409.86
Cash flows (9,755.20) 2,331.18 2,508.02 (17,349.55)
PV @ 10% (9,755.20) 2,119.25 2,072.74 13,034.97
NPV (£'000) 7,471.76
The Defender project has a positive NPV, which will increase shareholder wealth. The
project should therefore be accepted.
Working capital
Year Cumulative Increment
£'000 £'000
0 (2,000.00) (2,000.00)
1 (2,183.60) (183.60)
2 (2,384.05) (200.45)
3 2,384.05

Year Cost/WDV CA Tax
£'000 £'000 £'000
0 8,000.00 1,440.00 244.80
1 6,560.00 1,180.80 200.74
2 5,379.20 968.26 164.60
3 4,410.94
Sale (2,000.00) 2,410.94 409.86
Contribution lost
The contribution of the other product is:
£
Selling price 175
Materials and skilled labour (150)
Contribution 25
Contribution lost per unit of the defender (50)
Year 1 = (50)  30 = (1,500.00)

Year 2 = (50)  1.03  31.80 = (1,637.70)
Year 3 = (50)  1.032  33.71 = (1,788.15)
The skilled labour cost of £15 per hour is common to both alternatives, so may be
ignored. In year 1 the contribution on the Defender is £189.60 ignoring labour. The
contribution lost is £40  2 = £80 ignoring labour. The net gain is £189.60 – £80 =
£109.60 per Defender. If labour costs are included in the figures as above the net gain
is the same ie, £159.60 – £50 = £109.60.
If the gross figures are used in the NPV then they are as follows:
Defender 5,688 6,210 6,781
Lost contribution 2,400 2,620 2,861

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Which nets to the same as shown in the NPV calculation above

Sale proceeds £'000
Contribution 5,707.78
Contribution lost (1,788.15)
Net Contribution 3,919.63
Net contribution  3  (1 – 0.17) 9,759.88

(b) The disadvantages of sensitivity analysis are as follows:
 It ignores probability. It only identifies how far a variable needs to change to result
in a zero NPV; it does not look at the probability of such a change.
 It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to address the weaknesses of sensitivity analysis. The main
advantage is that it allows the effect of more than one variable changing at the same
time to be assessed. This gives more information about the possible outcomes and
their relative probabilities and it is useful for problems that cannot be solved
analytically. However it should be noted that simulation is also not an optimising
technique and does not point directly to a correct decision.
(c) Abandonment option: If the defender project is not successful it is unlikely the team
will buy the rights to manufacture the new alarm system. Therefore Innovative has the
option to abandon and sell the assets.
Follow on option: Rather than sell the rights to manufacture the new alarm system
there might be the opportunity to launch a second (and third and so on) version, which
could be highly profitable, or could lose money, for Innovative.
The mention of growth options rather than follow on options would also gain marks.
(d) There is a clear conflict of interest regarding the computation of the sale proceeds of
the rights to manufacture the Defender after the time horizon of three years.
Since the finance director will be a member of the team he should act with integrity
and have the interests of shareholders in mind. In these circumstances he should not
be involved in negotiating the price that the team will buy the rights for. He should be
objective and demonstrate professional behaviour.
64.2 Replacement after one year (£):
(30,000) + (22,500 – 500)/1.15 = (10,870) Annual equivalent cost (AEC) = (10,870)/0.870 =
(12,494)
Replacement after two years (£):
2
(30,000) + (500)/1.15 + (17,000 – 2,500)/(1.15) = (19,471) AEC = (19.471)/1.626 =
(11,975)
Replacement after three years (£)
2 3
(30,000) + (500)/1.15 + (2,500)/(1.15) + (12,000 – 3,500)/(1.15) = (26,736)
AEC = (26,736)/2.283 = (11,710)
The optimal replacement period is that which gives the lowest AEC; in this case, replacing
the vans after three years is preferable.

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Limitations include the following:

 Changing technology, leading to obsolescence
 Changes in design
 Inflation – affecting estimates and the replacement cycles
 How far ahead can estimates be made and with what certainty
 Ignores taxation
Examiner's comments
This was a five-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that of a company launching
a new product onto the market, and also considering how often it should replace its fleet of
delivery vans. 64.1(a) was well answered by many candidates, but there were common errors:
incorrect calculation of contribution; timing errors for cash flows; incorrect calculations of the
contribution lost; incorrect calculations of the value of the rights at the end of the project and in
some cases ignoring it altogether; not explaining why the project should be accepted; not
providing workings so no marks could be awarded when the figure presented was incorrect.
Responses to 64.1(b) were mixed, with many candidates not able to adequately explain the
disadvantages of sensitivity analysis. The question only asked for disadvantages, but many
candidates wasted time by stating advantages. The explanations of simulation as an alternative
to sensitivity analysis were poor. Responses to 64.1(c) and (d) were good. However some
candidates did not read the question and stated real options which did not apply at the end of
the project. Responses to question 64.2 were mixed.
65 Peel Kitchens plc (December 2017)

Marking guide
Marks
65.1 Dividend valuation model:
Ordinary dividend growth 1.5
Ex-div share price 1
Cost of equity 0.5
Cost of debt 4
WACC calculation 2
CAPM 1
10
65.2 Systematic risk unchanged 2.5
Explanation 2.5
5
65.3 Calculations (max 3 marks if no use made of historic information) 6
Discussion and advice 6
12
65.4 Identification and explanation of APV 2
Calculation of discount rate 1
3
65.5 Identification of 50% payout ratio over time 2
Appropriate discussion 3
5
35

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65.1 (a) Growth can be estimated by ordinary dividend growth for the past four years,
excluding the special dividend as a one-off:
(1/4)
Growth = (25.2/19.80) – 1 = 0.0621 or 6.21%
Shares in issue = 180m (90  2)
20X7 dividends per share = 14p (25.20/180)
Ex div share price = 278p (292 – 14)
Ke = (14(1.0621)/278) + 0.0621 = 0.1156 or 11.56%
Kd is calculated as the yield to maturity of the 7% debentures  (1 – t):
The ex-interest debenture price is £104 (111 – 7)
Years Cash Flow Factors PV Factors PV
£ 5% 10%
0 (104.00) 1 (104.00) 1 (104.00)
1 to 5 7.00 4.329 30.30 3.791 26.54
5 100.00 0.784 78.40 0.621 62.10
4.70 (15.36)
The yield to maturity = 5 + (4.7/(4.7 + 15.36)  5) = 6.17%

Kd = 6.17  (1 – 0.17) = 5.12
The market value of debt and equity =
Debt £495.04m (476  1.04).
Equity £500.40m (278p  180m)
Total debt and equity = £995.44m
WACC = ((11.56  500.40) + (5.12  495.04))/995.44 = 8.35%
(b) Using the CAPM
Ke = 3 + 1.3  6 = 10.80%
WACC = ((10.80  500.40) + (5.12  495.04))/995.44 = 7.98%
65.2Ungear existing activities: Peel's equity beta of 1.3 = Ba(1 + 50(1 – 0.17)/50), so Ba = 0.71
Supply of domestic appliances ungeared: This has an equity beta of 1.1 = Ba(1 + 40(1 –
0.17)/60) so Ba=0.71.
So the systematic business risk does not change, which may mean that the existing WACC
as calculated in 65.1 applies.
However, the use of WACC/NPV assumes that, over the life of the project, the gearing ratio
of Peel will remain constant and that the project is marginal. Peel is considering financing a
diversification that represents 20% (200/995) of the company's total market value of debt
and equity, which cannot be considered marginal. As gearing is likely to change, the
existing WACC cannot be used. The finance is not project specific (eg, from a government
loan) so that condition for using the existing WACC is met.
65.3 Gearing (D/E by market values):
The current gearing ratio is 99% (495.04/500.40)
Gearing if the finance is raised with debt = 139% ((200 + 495.04)/500.40)
Gearing if the finance is raised with equity = 71% (495.04/(200 + 500.40))
(Note: This assumes no change in the share price as a result of the diversification. In the
longer term, a positive NPV would affect the ratios calculated.)

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Interest cover (best and worst case, as PBIT varies)

Current:
20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 33.32 33.32
Interest cover 2.37 2.82
Interest cover if debt is raised:
Total interest will equal £45.32m (33.32 + (200  6%))
20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 45.32 45.32
Interest cover 1.74 2.08
EPS (although not explicitly required, students may also calculate and comment on EPS)
Current: 20X4 37.8/180 = 21p
20X7 50.4/180 = 28p
Equity: 20X4 37.8/280 = 13.5p
20X7 50.4/280 = 18p
Debt: 20X4 (78.86 – 45.32)0.83/180 = 15.5p
20X7 (94.04 – 45.32)0.83/180 = 22.5p
The decision to raise the finance wholly by debt or equity will radically change Peel's
gearing ratio and interest cover.
Interest cover: Since 20X3 Peel has been operating with an interest cover between the
average of 2.4 and maximum of 3 for the industry sector that it operates in. Currently Peel
has an interest cover of 2.82, which is near the maximum. Interest cover will be unchanged
if Peel raises equity, however if debt is raised the interest cover will be 2.08, which is near to
the minimum of 2 for the industry sector. In previous years, interest cover would have been
below the minimum.
Gearing ratio: Peel is currently operating with a gearing ratio of 99%, which is around the
average for the industry of 100%. If the company raises debt finance the gearing ratio will
rise to 139%, which is above the industry maximum of 135%; if equity is raised the gearing
ratio will fall to 71%, which is below the industry minimum of 80%.
Given the above, the reaction of the financial markets is likely to be unfavourable if Peel
raises the finance by an issue of debentures. The share price could fall and also the cost of
debt increase. Shareholders are also likely to be concerned if the finance is raised by debt,
and it is unlikely that they would approve the diversification if it were financed in such a way.
Raising the finance by equity would make the company much safer in terms of financial risk.
However, shareholders might be concerned about potential control issues, unless the funds
are raised by way of a rights issue. The financial markets might consider that the company is
not using spare debt capacity.
Given the potential financial risks involved, it would be prudent for Peel to raise the finance
by an issue of shares, or a combination of debt and equity, to keep the gearing ratio and
interest cover more in line with the 20X7 figures.
65.4 If the finance is raised by either debt or equity, then the gearing of Peel will radically
change. In these circumstances, WACC/NPV is not a suitable investment appraisal
technique to use. An alternative technique would be Adjusted Present Value (APV), which
assumes that the project is financed purely by equity. The resultant NPV of cash flows is

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then adjusted for the actual benefits and costs of the finance used. A suitable all equity
discount rate, which reflects the systematic risk of the project, would be:
Taking the equity beta of a company in the domestic appliance sector we calculate the
asset beta and use it in the CAPM (65.2 above).
The all equity discount rate using CAPM = 7.26% (3 + (0.71  6)).
65.5 Since dividends are rising and falling with profits, it would appear that Peel has a policy of
maintaining a constant dividend payout ratio. The dividend payout ratios have been:
20X3 20X4 20X5 20X6 20X7
£m £m £m £m £m
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividend 19.80 18.90 22.50 21.60 25.20
Payout ratio 50% 50% 50% 50% 50%
(Note: Candidates are not required to calculate the payout ratio for all years, but a clear
identification of a 50% payout across the period given is required.)
A listed company seeks to give ordinary shareholders a constant dividend with some
growth. This cannot be achieved by having a policy of maintaining a constant payout ratio,
since dividends rise and fall with profits. Peels current dividend policy is not usually
considered appropriate for a listed company and may lead to a fluctuating share price (this
is known as the signalling effect).
Examiner's comments
This was a five-part question that tested understanding of financing options. The scenario of the
question was that of a company diversifying its operations and raising finance by either debt or
equity. Candidates were also asked to discuss the company's dividend policy. Responses to part
65.1 were mixed. Many candidates did not consider whether their answers were reasonable, for
example using a cost of equity of 50% in their WACC computations. There were basic errors in
many calculations.
Answers to 65.2 were disappointing, with many candidates demonstrating that they do not know
the basic assumptions regarding the use of WACC. Hardly any candidates mentioned that since
the company is raising a large amount of capital by either debt or equity the gearing might not
remain constant and that, because of its size, the project could not be considered marginal.
Most candidates centred their discussion of systematic risk, which they assumed would change.
However if some very basic calculations were carried out it could be seen that the systematic risk
of the new project was the same as existing projects.
Responses to 65.3 were extremely disappointing despite an almost identical question being
asked in a recent past paper. The question gave industry gearing and interest cover figures, so
that candidates could perform analysis looking at current gearing and interest cover, and then
gearing and interest cover after raising the new finance by either debt or equity. Five years'
historic information was also given to calculate interest cover figures. It was very disappointing
that a large number of candidates did not use this information or calculated the gearing in a
different way to that specified, or used book values despite the question stating market values
had been used. In addition many candidates did not consider the likely reaction of shareholders
and markets to the finance being raised by either debt or equity. Finally, a large number of
candidates wasted time explaining the theories of M & M when theory was not asked for in the
question.
Responses to 65.4 were mixed, with many candidates identifying APV as an alternative to
WACC/NPV. However few candidates calculated the discount rate that should be used in APV.
Again this has been examined many times before. Responses to 65.5 were also mixed, with
many candidates not able to demonstrate a good understanding of dividend policy. Few
candidates used the historic information to establish the company's current dividend policy.
Many repeated theory, despite this not being required.

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66 Jewel House Investments Ltd (December 2017)

Marking guide
Marks
66.1 (a) Forward rate and resulting receipt 2
OTC option 4
6
66.1 (b) Advantages and disadvantages of each 2.5
Advice and recommendation 2.5
Marks available 4
66.1 (c) Discussion of futures – half mark per point 2
66.2 (a) Identification of value and number of contracts 3

Loss on portfolio 1.5
Gain on futures contracts 1.5
6
66.2 (b) Reasons why hedge is not efficient (1 mark per point) 2
66.3 (a) Interest rate differential 1

Rates and flows achieved through swap 3
4
66.3 (b) Calculations 2
66.3 (c) Advantages – 1 mark per point 4

30
66.1 (a) The forward rate is: $/£ 1.2526 (1.2492 + 0.0034)
This results in a sterling receipt of £6,386,716 ($8,000,000/$1.2526)
Over the counter option:
The premium with interest lost is £160,000  (1+0.03  4/12) = £161,600.
If the spot price on 31 March is $/£1.2700, Orion will exercise the options.
The sterling receipt will be ($8,000,000/$1.2400) – £161,600 = £6,290,013.
(b) The forward contract locks Jewel into an exchange rate and does not allow for upside
potential.
Forwards:
 Tailored specifically for Jewel.
 There is no secondary market.
 The options are expensive.
 However, the options allow Jewel to exploit upside potential and protect
downside risk.

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Advice:
Without hedging, the sterling receipt would have been £6,299,213
($8,000,000/$1.2700).
The currency option results in a sterling receipt of £6,290,013, which is marginally
worse than the spot rate on 31 March 20X8. However the forward contract results in a
higher sterling receipt of £6,386,716.
It is recommended that a forward contract is used to hedge any unanticipated fall in
the value of the dollar.
(c) Futures are possibly not appropriate, since they have the following disadvantages:
 Not tailored, so it is necessary to round the number of contracts
 Basis risk exists
 Require a margin to be deposited at the exchange
 A need for liquidity if margin calls are made
However, there is a secondary market and if the client decides not to invest it would be
possible to close out the position, which could result in a gain or loss on the futures
trade.
66.2 (a) The value of one contract = 7,195  £10 = £71,950
March contracts will be sold.
The number of contracts = £100,000,000/£71,950 = 1,389.85. Rounded to 1,390.
On 31 March the portfolio value will fall to:
£100,000,000 (7,010/7,261) = £96,543,176, representing a fall of £3,456,824.
Since there is a loss on the portfolio, there will be a gain on the futures contracts.
The futures position will be closed out and the gain will be =
(7,195 – 7,010)  £10  1,390 = £2,571,500.
(b) The hedge is not 100% efficient due to:
Basis risk ie, the futures price at 30 November is not the same as the FTSE 100.
The rounding of the number of contracts.
66.3 (a) First it is necessary to calculate the interest rate differentials:
Jewel Nevis Differentials
Fixed rates 6.5% 5.0% 1.5%
Floating rates LIBOR + 4% LIBOR + 3.5% 0.5%
Net differential 1.0%
This net differential
will be shared 0.50% each
The interest rates that can be achieved through the swap are:
Jewel Nevis
Fixed market rate 6.5% ----
Floating market rate ---- LIBOR + 3.5%
Less the differential 0.5% 0.5%
Rates achieved through the swap 6.0% LIBOR + 3.0%

Cash flows would typically be: LIBOR from Nevis to Jewel and fixed of 2.0% from Jewel
to Nevis.

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(b) Jewel is paying 4.36% (0.36 + 4) on its floating rate borrowings, and would be paying a
fixed rate of 6% through the swap. The initial difference in interest rates is 1.64% (6.00 –
4.36)
For the floating rate to equal the fixed rate of 6% achieved through the swap, LIBOR
would have to rise to 2% (1.64 + 0.36).
(c) The advantages to Jewel of an interest rate swap include the following:
 The arrangement costs are significantly less than terminating an existing loan and
taking out a new one.
 Interest rate savings are possible, either out of the counterparty or out of the loan
markets by using the principle of comparative advantage.
 They are available for longer periods than the short-term methods of hedging
such as FRAs, futures and options.
 They are flexible since they can be arranged for tailor-made amounts and periods.
They are also reversible.
 It is possible to obtain the type of interest rate, fixed or floating, that the company
wants.
 Swapping to a fixed interest rate assists in Jewel's cash flow planning.
Examiner's comments
This was an eight-part question that tested the candidates' understanding of the risk
management element of the syllabus.
Part 66.1(a) was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included: using the incorrect spot rate; deducting the forward discount;
not including interest on the option premium, or including interest but taking a whole year;
treating the OTC option as a traded option.
Part 66.1(b) produced average answers from a lot of candidates, some without any reference to
the numbers calculated in part 66.1(a). Many candidates did not give a firm conclusion.
Responses to question 66.1(c) were good.
Responses to 66.2(a) and (b) were also good, however some candidates made some basic
errors as follows: incorrect calculation of the number of contracts and the value of one contract
by using the current index price and not the current futures price; incorrect computation of the
loss on the portfolio; stating that contracts should be initially bought not sold; incorrect
computation of the gain on futures by using the current index price and not the futures price.
Responses to 66.3 were good, but many candidates did not read the question when they
demonstrated the cash flows that would typically occur when the swap was implemented.

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67 Wells Bakers plc (March 2018)

Marking guide
Marks
67.1 (a) Cost of equity (dividend valuation model) 3
WACC calculation 4
14
67.1 (b) Cost of equity (CAPM) 1
WACC calculation 1
2
67.2 Appropriate discussion of directors' views 6
67.3 Geared/ungeared beta calculations 3

Cost of equity 1
Cost of debt 1
WACC 1
Discussion 4
10
67.4 Ethics – points re confidentiality 3
35
67.1 (a) Cost of equity (ke)

£1.716m 1/3
Dividend growth rate = = 1.093 over 3 years, so 1.093 – 1 = 3% pa
£1.570m
£1.716m
Latest dividend (d0) = £0.26
6.6m
Ex div market value per share = (£3.46 – £0.26) = £3.20
(d1) (£0.26  1.03)
Cost of equity (ke) +g + 3% 11.36%
MV (£3.20)
d1 £0.07
Cost of preference shares (kp) 5.19%
MV £1.34
(i – t) (£6  83%)
Cost of irredeemable debt (kdi) 4.70%
MV £106
0 (96) 1.000 (96.000) 1.000 (96.000)
1–3 4 2,723 10.892 2.673 10.692
3 100 0.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)

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IRR = 5% + (1.292/(1.292 + 1.308)) = 5.50%

less: Tax at 17% (5.50%  83%) = 4.57%
WACC
Total MVs
£m £m Cost  weighting WACC
Equity (6.6m  £3.20) 21.120 11.36%  21.120/25.470 9.42%
Pref. Shares (1m  £1.35) 1.350 5.19%  1.35/25.470 0.28%
Irredeemable debt (£1.2m  1.06) 1.272 4.70%  1.272/25.470 0.23%
Redeemable debt (£1.8m  0.96) 1.728 4.57%  1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 10.24%
(b) Cost of equity (ke) using the CAPM

Expected market return 10.8%
less: Expected risk-free return (2.4%)
Expected risk premium 8.4%
Applying Wells' beta to the risk premium 1.25  8.4% 10.5%

plus: Expected risk-free return 2.4%
Cost of equity (ke) 12.9%
WACC
Total MVs
£m £m Cost  weighting WACC
Equity (6.6m  £3.20) 21.120 12.90%  21.120/25.470 10.70%
Pref. Shares (1m  £1.35) 1.350 5.19%  1.35/25.470 0.28%
Irredeemable debt (£1.2m  1.06) 1.272 4.70%  1.272/25.470 0.23%
Redeemable debt (£1.8m  0.96) 1.728 4.57%  1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 11.52%
67.2 Phil Turner – to use the cost of preference shares would be completely wrong, as it is only
one element of the firm's total long-term finance and 7% is the coupon rate, not the current
cost.
Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into
account. It makes sense to use Wells' current WACC figure for the investment appraisal if:
(1) the historical proportions of debt and equity will not change.
(2) the systematic business risk of the firm will not change.
(3) the new finance is not project-specific.
Regarding the above, the bank borrowing will not change the gearing as sufficient equity
will be raised to maintain the gearing at its current level. The systematic business risk of the
firm is likely to change as it is moving into a different market. The finance is not project-
specific.
(1.80  77) (1.80  77)

New market ungeared beta = 1.44
(77 + (23  83%)) 96.09
1.44  (£21.12m + £1.35m + ( £3m  83%))

Wells' geared beta = 1.70
£21.12m
So, cost of equity = (1.70  (10.80% – 2.40%)) + 2.40 = 16.7%

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Cost of debt = 8.5%  83% 7.06%

WACC = (16.70%  £21.12m/25.47m) + (7.06%  £4.35m/£25.47m)) = 15.05%
It would be unwise to use the existing WACC, as Wells' plan involves diversification and
therefore a change in the level of systematic risk (beta rises from 1.25 to 1.70). Thus a new
WACC must be calculated. Systematic risk is accounted for by taking into account the beta
of the retail bakery market and this is then adjusted to eliminate the financial risk (level of
gearing) in that market. The resultant ungeared beta is then 're-geared' by taking into
account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased systematic risk
discussed above) is used.
67.4 You work for Wells and are party to confidential information which, if made public, could
influence the market price of Wells' shares.
An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client's or employer's affairs, however gained, is
confidential.
That information should then:
 be kept confidential
 not be disclosed, even inadvertently such as in a social environment
 not be used to gain personal advantage
Examiner's comments
This was a four-part question that tested candidates' understanding of the financing options
element of the syllabus, and there was also a small section on ethics. In the scenario a UK-listed
bakery company was planning to open a number of retail outlets across the UK. This investment
would cost the company £17 million, which would be raised in such a way as to not alter its
existing gearing ratio. In part 67.1, for 16 marks, candidates were required to calculate the
company's current WACC from the information given, based on (1) the dividend growth model
and (2) the CAPM. The majority of candidates did really well in part 67.1(a) and many scored full
marks. Typical errors made were (1) incorrect number of years used in the dividend growth
calculation (2) not adjusting the cum-div and cum-int market prices (3) forgetting the tax
adjustment in the cost of debt and (4) not using market values in the WACC calculation.
Part 67.2 was worth six marks and required candidates to respond to recent comments made by
three of the company's directors about the best discount rate to use when appraising the
£17 million investment. Overall, candidates' answers to part 67.2 were disappointing. The
comments made were rather general and so marks will have been lost. Too few scripts
considered the conditions that need to apply for the current WACC to be used, ie, gearing and
systematic risk to remain unchanged, and any new finance is not project-specific.
Part 67.3, for 10 marks, tested the candidates' understanding of (and the need for) de-gearing
and re-gearing beta within the CAPM calculation in the given scenario. It was good to see that
the numerical and discursive elements of part 67.3 were both done well by a good number of
candidates. Where candidates scored badly, it was clear from their calculations that many did
not understand the logic of de-gearing and then re-gearing. Also many were unable to explain
the theory underpinning for those calculations. This is an area of the syllabus that has been
examined regularly recently. Part 67.4 was worth three marks, with particular reference to the
issue of confidentiality and it was answered well.

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68 Hunt Trading plc (March 2018)

Marking guide
Marks
68.1 (a) Sell June futures 1
Profit/loss on futures 4
Interest cost 1
Total cost 1
8
68.1 (b) Options cost – 1 mark for each scenario 3
68.1 (c) Recommendation 2
68.2 (a) No hedge 2

Forward contract 2
7
68.2 (b) Summary of various payments 2
Forward contract discussion 2
Money market hedge discussion 2
Directors' attitude to risk 1
7
68.2 (c) Differences identified – 1 mark per point 3
30
68.1 (a) Futures

Sell June futures
£4,500,000
No of contracts:  6/3 = 18
£500,000
(a) (b) (c)
Interest rate 7.50% 8.00% 5.50%
Opening rate 93.2 93.2 93.2

Closing rate 92.2 91.8 94.1
Movement 1.0 1.4 (0.9)
P/L on futures 18  £500,000  3/12 2,250,000 2,250,000 2,250,000

  
1.0% 1.4% (0.9%)
= = =
Profit/(loss) on futures £22,500 £31,500 (£20,250)
Interest cost = £4.5m  6/12 =£2,250,000  7.5% (£168,750)
8.0% (£180,000)
5.5% (£123,750)
Total cost (146,250) (148,500) (144,000)

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(b) Options
(a) (b) (c)
Interest rate 7.50% 8.00% 5.50%
Take up option Y Y N
Interest cost % 7.30% 7.30% 5.50%
Interest cost = £4.5m  6/12 = £2,250,000  7.3% (£164,250)

7.3% (£164,250)
5.5% (£123,750)
Premium (£4,500,000  0.2%) (£9,000) (£9,000) (£9,000)
Total cost (£173,250) (£173,250) (£132,750)
(c) If interest rates increase, then futures are less costly than options.
If rates fall, then options are lower cost.
68.2 (a) (1) Sterling weakens by 5%
Spot rate = €1.1764  0.95 = €1.1176

€1,700,000/1.1176 (£1,521,144)
(2) Forward contract
€
Spot rate 1.1764
plus: Forward contract discount 0.0059
1.1823
£
(£1,700,000)/1.1823 (1,437,875)
plus: Arrangement fee (4,600)
(£1,442,475)
(3) Money market hedge

(€1,700,000) (€1,700,000)
Lend euros now (€1,666,667)
(1+ 8% / 4) 1.05
€1,666,667
Convert at spot rate (£1,416,752)
1.1764
Sterling borrowed at 6.6% pa (£1,416,752)  [1 + (6.6%/4)] (£1,440,128)
(b) In summary
At spot rate (€1,700,000/1.1764) (£1,445,087)
Sterling weakens by 5% (£1,521,144)
Forward contract (£1,442,475)
Money market hedge (£1,440,128)
The forward rate suggests that the euro will weaken (sterling will strengthen, rather
than weaken by 5%) over the next three months. This is good for UK importers such as
Hunt, as supplies would get cheaper.
The money market hedge gives the lowest price, based on these rates, but if sterling is
likely to strengthen then perhaps do not hedge at all (but there are no guarantees).
The directors' attitude to risk is also important when giving advice on which strategy to
pursue.
(c)  OTCs are, typically, purchased from a bank.
 OTCs are tailor-made and so will lack negotiability.

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 Traded options are for standardised amounts and can be traded and a profit/loss
made.
 Traded options are not available in every currency.
Examiner's comments
This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company's need to borrow £4.5 million of short-term finance via a bank loan and
its plan to hedge the interest costs of that loan. In the second half of the question the company
had agreed to purchase €1.7 million of timber from a Finnish supplier. Candidates had to
investigate the foreign exchange risk implications of this contract for the company. In part
68.1(a) of the question, for eight marks, candidates were required to calculate the cost to the
company if it used traded sterling interest rate futures to hedge its interest rate risk. Part 68.1(b),
for three marks, required candidates to calculate the cost to the company if it used OTC interest
rate options to hedge the risk. Part 68.1(c) was worth two marks and asked candidates to
conclude, based on their calculations, which of the hedging methods should be chosen. For part
68.1 there were many very good answers with candidates demonstrating a thorough
understanding of the techniques involved. Those areas where candidates struggled were: (1) a
failure to identify that the company would sell interest rate futures (2) charging 12 months
interest rather than six (3) using six months, rather than three months, in the futures gain/loss
calculation and (4) a failure to calculate the option premium correctly (a very common error).
Part 68.2(a) for seven marks asked candidates to calculate the (sterling equivalent) payment to
the Finnish supplier if (1) there was a weakening of sterling and (2) two hedging techniques were
employed. In part 68.2(b), also for seven marks, candidates were required to advise the
company's board whether it should hedge the euro payment. Finally, part 68.2(c), for three
marks, asked candidates to identify the differences between traded currency options and OTC
currency options. Part 68.2 was, overall, done well. The calculations in part (a) were good, but
typical errors included (1) choosing the wrong exchange rate (2) strengthening rather than (as
required) weakening sterling and (3) subtracting the forward contract fee from the overall cost of
the transaction. Foreign exchange risk management is an area of the syllabus that is examined
regularly and so candidates' answers to the discussion in part (b) were disappointing. There was
a lack of depth to the candidates' conclusions and too many commented, erroneously, that a
forward contract discount meant that sterling would be weakening.
69 Bishop Homes Ltd (March 2018)

Marking guide
Marks
69.1 Construction costs and land clearance 1.5
Sales 1
Rental income 2
Bad debts 1
New staff 1
Extra costs 1
Tax 1.5
Green machine and tax 3
Net cash flows 2
Discount factors 2
PVs 1
NPV 1
18

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Marks
69.2 Sales and tax 1.5
Discount factors 0.5
Sensitivity 1
Minimum selling price 1
4
69.3 Incremental construction costs 1
Tax 2
Discount factors 1
5
69.4 Sensitivity analysis v simulation – 1 mark per point 4
69.5 Explanation of real options 1

Identification of appropriate real options – 1.5 marks per point 3
4
35
69.1
20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£'000 £'000 £'000 £'000 £'000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 0 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436
The development produces a positive NPV and so should be accepted as it will enhance
shareholder wealth.
WORKINGS
(1) Rental income (Y2) = 175  £5,940 = £1,039,500

Bad debts (Y2) = 1.5%  £1,039,500 = £15,592
Extra costs (Y2) = 3%  £1,039,500 = £31,185
Rental income (Y3) = 350  £5,940 = £2,079,000
Bad debts (Y3) = 1.5%  £2,079,000 = £31,185
Extra costs (Y3) = 3%  £2,079,000 = £62,370

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(2)
20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£'000 £'000 £'000 £'000 £'000
Construction (8,550) (8,550)
(75/500  £57m)
Land clearance (1,400)
Sales 25,500 25,500
Rental income 1,040 2,079 2,079
Bad debts (16) (31) (31)
New staff (46) (92) (92)
Extra costs (31) (62) (62)
Taxable (loss)/profit (1,400) 16,950 17,897 1,894 1,894
Tax at 17% 238 (2,882) (3,042) (322) (322)
(3)
20X9 20Y0 20Y1
Y1 Y2 Y3
£'000 £'000 £'000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100
Tax saving (17%  WDA) 37 30 120
(4)
6% annuity factor for Y4 – Y20 Y20 11.470 or 10.477
Y4 (2.673)  0.840
8.797 8.801
69.2
Y1 Y2 Total
£'000 £'000 £'000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804
1, 436
Sensitivity = 3.7%
38,804
Minimum selling price = (£340,000 – 3.7%) £327,420

69.3
Y0 Y1 Y2 Total
£'000 £'000 £'000 £'000
Incremental construction costs (35,000) 19,000 19,000
Tax on costs (£8.55m  3/57  17%) (77) (76)
Total cash flows (35,000) 18,923 18,924
6% factors 1.000 0.943 0.890
PV (35,000) 17,844 16,842 (314)
The NPV would decrease by £314,000, and so it is less likely that Bishop's board would
proceed with the development.

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69.4 Sensitivity analysis advantages:

 It facilitates subjective judgment (by management for example).
 It identifies areas critical to the success of a project, eg, sales volume, materials price.
 It is relatively straightforward.
Sensitivity analysis disadvantages:
 It ignores probability.
 It does not point to a correct decision.
Simulation advantages:
 More than one variable at a time can be changed.
 It takes probabilities into account.
Simulation disadvantages:
 It is not a technique for making a decision.
 It can be time consuming and expensive.
 Certain assumptions that need to be made could be unreliable.
69.5 NPV analysis only considers cash flows related directly to a project. A project with a
negative NPV could be accepted for strategic reasons. This is because of (real) options
associated with a project that outweigh its negative NPV.
With regard to the Garthwick development the following options could be identified (two
only required):
Follow-on options – future development of mixed (rental/private) developments.
Growth options – Bishop could build a few properties and then build more later, if necessary.
Flexibility options – Bishop could sell some of its rented properties rather than rent them
and vice versa.
Abandonment options – Bishop could sell all the properties and quit the development after
two years.
Timing options – Bishop could delay the start of the clearance and development.
Examiner's comments
The scenario was based around a UK property company that builds low-cost houses for sale and
for rent. The company had the opportunity to invest in a new development of 500 identical low-
energy houses on one of its vacant sites. The company planned to use a house-building firm to
construct the houses over a two year period. Part 69.1 was worth 18 marks and required
candidates to make use of the information given and calculate the NPV of the proposed
investment. It was a difficult NPV calculation and so it was good to see that, overall, candidates
did well here. The main areas of difficulty were: (1) the tax calculation for the allowable building
costs (2) the timing of the cash flows and (3) the need to include cash flows (and then discount
them) for Years 4 to 20. Parts 69.2 and 69.3, for four marks and five marks respectively, tested
candidates' proficiency with, and understanding, of sensitivity analysis. Part 69.2 was also done
well, but some candidates used the price per house figure rather than the total sales figure and
so will have lost marks. Part 69.3 was a more difficult proposition and candidates' answers here
were very variable. Those who produced a set of calculations revised from part 69.1 scored well,
but too many produced a discussion rather than calculations. Part 69.4 was worth four marks and
here candidates were asked to compare the strengths and weaknesses of sensitivity analysis with
those of simulation. Part 69.4 was, overall, done well and a majority of candidates scored full
marks. In part 69.5, again for four marks, candidates had to explain the concept of real options
and to identify two real options that could apply to the development in question. In part 69.5
most candidates were able to identify examples of real options from the scenario, but too few
explained the more general issue of real options, ie, that of turning a negative NPV into a
positive one.

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70 Helvellyn Corporate Finance (June 2018)

Marking guide
Marks
70.1 (a) Enterprise value 4.5
P/E ratio 1.5
Net assets historic 1
Net assets revalued 1
8
70.1 (b) Discussion of asset v income based measures 3
Recommendation 1
4
70.1 (c) Discussion of SVA, including drivers and problems 3
70.2 (a) Proposal 1:

Sales 1
Contribution 1
Redundancy 0.5
Tax 1
Working capital 1.5
Plant and equipment 0.5
WDA's 1.5
PV 0.5
Proposal 2 – proceeds net of tax 1
Proposal 3 – after tax PV 1.5
10
70.2 (b) 2 marks for each – one advantage, one disadvantage 6
70.2 (c) Comparison of PVs and advice on limitations 3

Recommendation 1
4
35
70.1 (a) Enterprise value

EBITDA = £10,000 (3,500 + 6,000 + 500)
Enterprise value = £65,000 (10,000  6.5)
Net debt = £34,000 (41,000 – 7,000)
The total value of equity = £31,000 (65,000 – 34,000)
The value of one share = £10.33 (31,000/3,000)
Price earnings ratio
EPS = 70.53p (2116/3000)
The value of one share = £8.53 (70.53  12.1)
Net assets (historic)
The value of one share = £5 (15,000/3,000)
Net assets (re-valued)
The value of one share = £7 ((15,000 + 59,000 – 53,000)/3,000)

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(b) The range of values is from £5 to £10.33.

It is unlikely that the board of Evans would be happy with an issue price based on net
assets, either historic or re-valued. The major problem with asset valuations is that they
do not reflect the earning capacity of the assets. The board is more likely to be happy
with an issue price based on income, either P/E ratio or enterprise value, which range
from £8.53 to £10.33.
So an issue price in this range is likely to be acceptable.
I would suggest an issue price of £10 per share. (Candidates may suggest a different
price; any supported price would be given marks.)
(c) Shareholder value analysis (SVA) would be a useful additional valuation methodology
since it is based on the future free cash flows that the company generates. The free
cash flows are forecasted using seven value drivers (sales growth; operating profit
margin; tax rate; investment in non-current assets; investment in working capital; cost
of capital; life of cash flows). The cash flows will be forecast over a planning horizon,
typically three to five years, and then a terminal value calculated.
Problems with this technique include: estimating the inputs into the model; estimating
growth; the length of the planning horizon; the terminal value dominates the valuation.
70.2 (a) Proposal 1
20X9 20Y0 20Y1
£m £m £m
Sales 22.50 20.25 18.23
Contribution 13.50 12.15 10.94
Redundancy (0.50)
Pre-tax 10.44
Tax @ 17% (2.30) (2.07) (1.78)
Working capital 0.20 0.18 1.62
Plant and equipment 9.00
WDAs 0.09 0.08 (1.19)
Total 11.49 10.34 18.09
Factors @ 10% 0.909 0.826 0.751
Present value 10.44 8.54 13.59
Total present value = £32.57 million

Working capital
20X9 2  0.10 = 0.20
20Y0 1.8  0.10 = 0.18
20Y1 1.62
WDAs
3,000
(540)@17% = 0.09
2,460
(443)@17% = 0.08
2017
9,000
6,983@17% = (1.19)
Proposal 2
Sale proceeds net of tax = £31.54 million (38  (1 – 0.17))
Proposal 3
2
The present value of the payments = 15 + 13/(1.1) + 13/(1.1) = £37.56 million
After tax = £31.18 million (37.56  (1 – 0.17)

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(b) Winding down operations

Advantages include keeping control – should the company decide to keep Supercover
in business it can do.
Disadvantages include the use of estimates of sales and resale values. The operations
may take longer than three years to wind down.
Selling to another company
Advantages include being paid upfront, and no long term involvement.
Disadvantages include the possible difficulty in finding a buyer; the buyer may wish to
buy Supercover for a cheaper price.
MBO
The main advantage is that Huzzey has a buyer.
The disadvantage is that the sale proceeds are to be paid over two years. If Supercover
goes into liquidation or has cash flow difficulties, the full sale proceeds may not be
received.
(c) The present values are:
Winding down operations £32.57 million
Selling to another company £31.54 million
MBO £31.18 million
To maximise shareholder wealth, Huzzey should wind down operations since it
produces the highest present value. However, the present value relies upon a number
of assumptions about sales volume, the release of working capital and the proceeds of
selling plant and equipment. The present value is not sufficiently higher to warrant
choosing it over the other two proposals, given these uncertainties and the fact that the
figures are pretty similar.
In present value terms there is little to choose between selling to another company or
an MBO. Since it might be difficult to find a buyer for Supercover, the preferred
proposal would be for the current management team of the company to buy it.
Examiner's comments
The scenario of the question was consideration of two tasks for a firm of corporate financiers:
Task 1 The valuation of a company that is considering an IPO.
Task 2 A quoted conglomerate is considering divesting itself of one of its subsidiaries.
Part 70.1 was well answered by many candidates, however the following were common errors:
for enterprise value: incorrect EBITDA; no deduction of debt and addition of cash to arrive at the
value of the shares; using the incorrect multiple; calculating a negative share price and making
no comment that this is not possible. For P/E ratio: using profits before tax. For net assets
(historic): using gross assets; using gross assets and only deducting long-term debt. For net
assets basis (re-valued): many candidates re-valued the non-current assets and then made the
same errors as for the net assets (historic) computations.
Overall a large number of candidates reduced their valuations to take into account non-
marketability. Since this is an IPO, such adjustments were not necessary.
Responses to question 70.1(b) were mixed. Many candidates only referred to their range of
values and did not recommend an issue price. The justification of the price was quite poor.
Responses to question 70.1(c) were good. However poorer candidates only stated what the
seven value drivers in SVA are, with no further explanation of the methodology. Responses to
70.2(a) were generally good. However a large number of candidates attempted to calculate the

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Net Present Values and not the Present Values of each of the proposed divestment methods.
Responses to 70.2(b) were mixed, with candidates often struggling to state sensible advantages
and disadvantages. Responses to 70.2(c) were mixed; many candidates simply picked the
highest present value with little other consideration.
71 Blackstar plc (June 2018)

Marking guide
Marks
71.1 (a) Share price calculations 2

TERP calculation and discussion 3
5
71.1 (b) Yield to maturity calculation 3
Debenture issue price 3
Discussion 2
Marks available 7
71.1 (c) Numerical analysis 4

Advantages of debt v equity 3
Reaction of shareholders and the market 5
Advice 2
Marks available 12
71.2 (a) Special dividend 2

Share repurchase 2
4
71.2 (b) Blackstar's dividend policy 2
Evaluation of alternatives 2
4
71.3 Ethics – issues and safeguards 3
35
71.1 (a) The number of new shares to be issued = 40 million (60  2/3)
The price per share = £3.75 (150/40)
This represents a discount on the current share price of 50% or £3.75. (3.75/7.50)
The theoretical ex rights price is:
Number of shares Value per share Number  value
£ £
Existing shares 3 7.50 22.50
New shares 2 3.75 7.50
Total shares 5 Total value 30.00

The theoretical ex rights price = £6.00 (30/5)

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The actual share price will depend on the market's reaction to the rights issue, eg,
whether it is fully taken up, and whether the proceeds are invested in positive net
present value projects. The net present value of the projects could be incorporated in
the theoretical ex-rights price of £6.00, giving a more realistic estimate of the actual
share price post rights issue.
(b) The yield to maturity of Blue's debentures is:
The ex-interest price of Blue's debentures is £104 (109 – 5)
Timing Cash Flow Factors @ 1% PV Factors @ 5% PV
Years £ £
0 (104) (104) (104)
1–5 5 4.853 24.27 4.329 21.65
5 100 0.951 95.10 0.784 78.40
15.37 (3.95)
IRR (Yield to maturity) = 1 + (15.37/(15.37 + 3.95))  4 = 4.18% Say 4%

The issue price of Blackstar's debentures will be:
-7
The annuity factor for seven years (2018 to 2025) = (1 – (1.04) )/0.04 = 6.002
7
The seven year present value factor at 4% = 1/(1.04) = 0.760
The issue price = 6  6.002 + 100  0.760 = £112.01
The total nominal value of the debentures to be issued = 150/1.1201 = £133.91
million. Say £134 million.
Blackstar and Blue are in the same industry sector, so it is reasonable to assume that
the yield to redemption of 4% is acceptable. However the financial risk of Blue might
be different to Blackstar and this should be reflected in the yield to redemption.
Blue's debentures mature in five years, and Blackstar's debentures mature in seven
years. It is likely that investors in Blackstar's debentures would require a higher yield to
redemption than 4%.
(c) The gearing and interest cover ratios of Blackstar immediately after the debenture
issue will be as follows:
Interest cover: Interest £134m  6% = £8.04m. Interest cover = 50.00/8.04 = 6.21 times
Gearing by market values assuming the current market price per share:
Market capitalisation 60m  £7.50 = £450m. Gearing (D/E) 150/450 = 33%
Current EPS 69.2p (50(1 – 0.17)/60)
EPS with a rights issue 41.5p (50(1 – 0.17)/100m)
EPS with a debenture issues 58p (50 – 8.04)(1 – 0.17)/60m
In time both interest cover (more operating profits) and gearing (greater equity value)
are likely to improve, with the acceptance of positive NPV projects and any favourable
market reaction to the issuance of debt and its tax shield (see below).
Advantages and disadvantages of debt versus equity include consideration of control
issues; obligation to return capital; interest payments versus dividend payments
(including consideration of tax relief); issue costs; liquidation of the investment (can the
investor get out easily?); risk versus reward.
Analysis:
The company will have a gearing ratio of 33% and an interest cover of 6.21 times.
Gearing is between the industry maximum and average of 35% and 25% respectively,
but near to the maximum; interest cover is between the industry minimum and average
of 6 and 8 respectively, but near to the minimum.

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Since this is the first time that Blackstar has borrowed, both shareholders and the stock
market might be concerned and prefer these ratios to be near the industry averages or
better. Some shareholders might be attracted to investing in Blackstar because
currently it has no gearing. However if the £150 million is to be invested in positive
NPV projects both shareholders and the stock market should welcome the company
borrowing.
Borrowing should reduce the current cost of capital of the company, since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. The company also receives tax relief on the interest that it pays. Because there
is increased financial risk when a company borrows, the shareholders may require a
higher return but this is unlikely to offset the effect of cheaper debt finance. The
company value should increase as a result of the cost of capital reducing, and new
funds being invested in positive NPV projects.
It would be prudent for the company to restrict its borrowing to the industry average
gearing level, especially since its interest cover would be near to the minimum for the
industry. I would advise the company not to borrow the full £150 million; perhaps this
could be achieved by revising its plans for raising the finance. For example, an issue of
both debt and equity would help to ensure that gearing and interest cover ratios are
more favourable. Selling surplus assets is another possible source of finance.
71.2 (a) A special dividend is a 'one off' dividend payment in addition to the ordinary dividend.
A share repurchase is an alternative to dividend payments. Instead of paying dividends
a company may consider using the cash to repurchase issued shares.
(b) Blackstar's current dividend policy is unlikely to be appropriate for a listed company,
since dividends will rise and fall with profits and may cause signalling issues.
It is more usual for a listed company to pay a constant dividend with some growth. So
both directors A and B are correct in stating that Blackstar should do this. However,
shareholders are unlikely to be happy with the company leaving surplus cash in the
bank where returns will be lower than the company's cost of capital. Surplus cash
should be returned to shareholders in the form of a special dividend or share
repurchase.
71.3 Professional accountants in public practice should be aware of the danger of a conflict of
interest. In its dealings with Goldwing and Blackstar, Evans could implement the following
safeguards:
 Use different partners and teams for the two clients.
 Take all steps to ensure that there is no leakage of confidential information between
the two teams.
 Ensure that there is regular review by a senior partner or compliance officer who is not
personally involved with either client.
 Advise the clients to seek additional independent advice where appropriate.
(Credit also given for mentioning integrity, objectivity and confidentiality.)
Examiner's comments
The scenario of the question involves giving advice to a listed client on two issues:
Issue 1 Whether to raise additional funding by debt or equity.
Issue 2 A review of dividend policy and also an ethical situation.

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Responses to 71.1(a) were quite good with many candidates scoring full marks. Weaker
candidates made some of the following mistakes: confusing a 2 for 3 rights issue for a 3 for 2
rights issue; not calculating the discount the rights issues represented on the current share
price; inadequate discussions on whether the actual share price is likely to be equal to the
theoretical ex-rights price.
Generally responses to 71.1(b) were disappointing, but there were some excellent responses.
Poorer candidates made some of the following mistakes: using the new debt issues terms to
calculate the YTM rather than Blue's; using the cum interest debenture price in YTM
computations; deducting tax from the YTM when calculating the issue price for the new
debenture issue; when interpolating arriving at two negative NPVs by discounting at 5% and
10%, then arriving at a YTM of more than 5%; incorrect calculations when calculating the
nominal value of the new issue.
Responses to 71.1(c) were extremely disappointing despite almost identical questions being
asked in recent papers. The question gave industry gearing and interest cover figures so that the
candidates could perform analysis looking at the gearing and interest cover should the company
decide to borrow. It was very disappointing that a large number of candidates did not use this
information or calculated gearing in a different way to that specified. In addition many
candidates did not consider the likely reaction of the shareholders and markets to the finance
being raised by either debt or equity. Finally, a large number of candidates wasted time
explaining the theories of M & M, when theory was not asked for in the question.
Responses to 71.2(a) were mixed, with a surprising number of candidates not knowing what a
special dividend is. Also the explanations of a share repurchase were poor.
Responses to 71.2(b) were mixed, with many candidates not able to demonstrate a good
understanding of dividend policy. Many candidates did not identify that the policy of
maintaining a constant payout ratio means that dividends will rise and fall with profits.
Comments on the views of the two directors were often confused and hard to follow. However,
again, there were some excellent responses. 71.3 was well answered, but a large number of
candidates did not recognise that there was a conflict of interest for Mitchells.
72 Tarbena plc (June 2018)

Marking guide
Marks
72.1 Net payment 1
Forward rate 1.5
Sterling equivalent 0.5
Sell September futures 1
Loss on futures on closeout 2
Dollar purchase 1
Call options to buy dollars 1
Option calculations 3
12
72.2 Advantages and disadvantages of hedging techniques 5
Advice 2
7

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Marks
72.3 Interest rate parity explanation 2
Calculations 3
5
72.4 Purchasing power parity explanation 3
72.5 Points re importance of translation risk – 1 to 2 marks each 3
30
72.1 The net payment = $4,000,000 (10,000,000 – 6,000,000)

The forward rate is: $/£ 1.3166 (1.3078 + 0.0088)
This is result in a sterling payment of £3,038,129 ($4,000,000/$1.3166)
Tarbena should sell Sept sterling futures (ie, to buy $ with £).
The number of contracts to sell is: ($4,000,000/$1.3096)/£62,500 = 48.87 contracts,
rounded to 49 contracts. This means that it is slightly over hedged. (Full marks also to be
given if 48 contracts are used.)
On 30 September, the futures will be closed out and bought at $1.3171. This will result in a
loss of:
($1.3096 – $1.3171)  (£62,500  49) = $(22,969)
Dollars will be purchased on the spot market and the total payment will be:
($4,000,000 + $22,969)/$1.3167 = £3,055,342
Over the counter option, call options to buy dollars will be used:
The premium with interest lost is £160,000  (1 + 0.0328  4/12) = £161,312.
If the spot price on 30 September is $/£1.3167 Tarbena will exercise the options.
The sterling payment will be ($4,000,000/$1.3170) + £161,312 = £3,198,518.
72.2 The forward contract and futures contracts both lock Tarbena into an exchange rate and do
not allow for upside potential.
Forwards:
 Tailored specifically for Tarbena.
Currency futures:
 Not tailored, so the number of contracts needs to be rounded.
 Requires a margin to be deposited at the exchange.
 There is a need for liquidity if margin calls are made.
 There is a secondary market.
 The options are expensive.
 Options allow Tarbena to exploit upside potential and protect downside risk.
Advice:
Without hedging, the sterling payment would be £3,037,898 ($4,000,000/1.3167).
The OTC option results in a higher payment of £3,198,518.
Both the forwards and futures result in a lower sterling payment of £3,038,129 and
£3,055,342, which are not materially different.

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Since futures require margins and they are not a perfect hedge due to rounding and basis
risk, it is recommended that a forward contract is used as it is much simpler for a similar
result.
Tarbena's attitude to risk is also important.
72.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are
possible if the rates out of alignment. The forward rate tends to be an unbiased predictor of
the future spot exchange rate.
The forward rate in four months is calculated as follows:
Middle spot rate  (1 + The middle US interest rate)/(1 + The middle UK interest rate) =
Forward rate.
Middle rates:
Spot $/£1.3079 ((1.2078 + 1.3080)/2)
Interest rates:
Dollar 5.9% ((6 + 5.8)/2)
Sterling 3.13% ((3.28 + 2.98)/2)
The forward rate = $1.3079  (1 + 0.059  4/12)/(1 + 0.0313  4/12) = $1.3169
Because the dollar is depreciating against sterling, it is at a discount.
The discount is $0.0090 (1.3079 – 1.3169). The spread increases or decreases this, in this
case $/£ 0.0088 – 0.0092.
72.4 Purchasing power parity (PPP) is the theory that in the long-term exchange rates between
currencies will tend to reflect the relative purchasing power of the currency of each country.
The theory is based on the idea that a basket of goods in one country will, after the effect of
the exchange rate, cost the same no matter where it is traded. It is sometimes called the law
of one price.
The impact of different inflation rates in different countries will cause prices to change at
different speeds. So even if parity is achieved, disequilibrium will be created. PPP predicts
that the disequilibrium will be removed by changes in the exchange rate.
72.5 There are opposing arguments as to whether translation exposure is important. The
arguments centre on whether the reporting of a translation loss will affect the company's
share price.
There is an argument that, to the extent that cash flows are not affected, translation
exposure can be ignored. Therefore there will be no effect on Tarbena's share price.
On the other hand, those who believe that accounting results are an important determinant
of the share price argue that translation losses should be reduced to a minimum, as
translation losses could reduce Tarbena's share price.
Examiner's comments
The scenario of the questions is that of a board wanting some clarification on forex issues. Part
72.1 was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: using the incorrect spot rate; deducting the forward discount;
incorrect computation for the number of futures contracts; making the incorrect decision of
whether to sell or buy futures; assuming that the futures loss was in £; choosing the put option
and not the call option; not including interest on the option premium, or including interest but
taking a whole year; treating the OTC option as a traded option; not netting receipts and

lOMoARcPSD|5019904
payments and presenting calculation on both transactions. 72.2 saw average answers from a lot
of candidates, some without any reference to the numbers calculated in part 72.1. Many
candidates did not give a firm conclusion. However there were some excellent answers.
Responses to 72.3 were mixed, with some good explanations of interest rate parity. However
many candidates did not perform computations, or computations were incomplete. Responses
to 72.4 were poor, with many candidates displaying no knowledge of what purchasing power
parity is. Responses to 72.5 were also poor and displayed no knowledge of what translation
exposure is, or what the likely effects are.

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73 Thomas Rumsey Group plc
Marking guide
Marks
73.1 Revised Economic Value:
Sales correct in summary calculation 1
Sales workings
Y1 Expected Value 1
Y1 Inflation 1
Y2 Expected Value 1
Y2 Inflation 1
Y3 Expected Value 1
Y2 Inflation 1
Variable Cost 1
Fixed Cost 2
Close down costs 1
Tax 1
Sale of Plant and Machinery 1
Tax saved on Plant and Machinery 2
Working capital 1
Discounting 1
Economic Value 1
18
73.2 Revised Economic Value:
Scrap value 1
Tax rebate 1
Discounting 1
New economic value 1
4
73.3 Ethics and fundamental principles:
Behave with integrity 1
Behave objectively with no conflict of interest 1
Behave professionally 1
3
73.4 Impact of real options:
Explain impact of real option on – NPV 1
Identify abandon real option and explain using scenario 2
Identify growth real option and explain using scenario 2
5
73.5 Shareholder Value Added (SVA)
Explain SVA 1
Advantage of SVA 1
Explain seven drivers of SVA 2
Disadvantage of predicting 1
Disadvantage of terminal value on SVA 1
Adjust SVA with short terms investments and debt 1
7
Max 5
35

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73.1
Y1 Y2 Y3
Year to 31/8/19 31/8/20 31/8/21
£'000 £'000 £'000
Sales (W1) 6,375 4,411 2,653
VCs (30%) (1,913) (1,323) (796)
FCs (W2) (1,122) (1,144) (1,167)
Close down costs (W3) (637)
Tax (W4) (568) (330) (9)
P&M sale 1,500
P&M tax saving (W5) 101 83 122
Working capital 200 300 1,300
Net cash flows 3,073 1,997 2,966
11% factors 0.901 0.812 0.731
PV 2,769 1,622 2,168
Economic value 6,559
WORKINGS
1
Y1 Y2 Y3
£'000 £'000 £'000 £'000
Sales (£7m  0.7) 4,900 (£5m  0.6) 3,000 2,500
(£4.5m  0.3) 1,350 (£4m  0.4) 1,600  (1.02)3
6,250 4,600  0.7 3,220 2,653
 1.02 (£4m  0.4) 1,600
6,375 (£3m  0.6) 1,800
3,400  0.3 1,020
4,240
 (1.02)2
4,411
2
£'000
Annual fixed cost cash flows = (£1.7m – £0.6m) £1.1m  1.02 1,122 (Y1)
2
Depreciation excluded as not a cash flow £1.1m  (1.02) 1,144 (Y2)
3
£1.1m  (1.02) 1,167 (Y3)
3
3 Close down costs = £0.6m  (1.02) £637,000
4
Y1 Y2 Y3
£'000 £'000 £'000
Sales 6,375 4,411 2,653
VCs (1,913) (1,323) (796)
FCs (1,122) (1,144) (1,167)
Close down costs (637)
Taxable profit 3,340 1,944 53
Tax payable @ 17% 568 330 9

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5
Y1 Y2 Y3
£'000 £'000 £'000
WDV b/f 3,300 2,706 2,219
WDA @ 18%/Balancing Allowance (BA) (594) (487) (719)
WDV/sale 2,706 2,219 1,500
Tax saving (WDA/BA  17%) 101 83 122
73.2
£'000
Scrap value = £1 million, therefore loss of cash = £1.5m – £1.0m 500
Tax rebate (balancing allowance)  83%
Discounted to Y0  0.731
Economic value decreases by 303
New economic value = £6,559 – £303 6,256
73.3 An ICAEW member is being asked to falsify the economic value of Snowdog and thus
mislead potential buyers, ie, Snowdog's directors. To do so would break the principles of
the ICAEW Ethical Guide which states, inter alia:
 A member should behave with integrity – ie, be honest and truthful. The member's
advice and work should not be influenced by the interests of other parties, which
would be the case here were s/he to overvalue Snowdog.
 A member should strive for objectivity in all professional and business judgements – ie,
there should be no bias, conflict of interest or undue influence of others. The member
has a conflict of interest here. S/he is being asked to act with bias in favour of one party
(Rumsey's directors) over another (Snowdog's directors).
 A member should behave professionally – ie, avoid any action that discredits the
profession. If the member falsified the valuation of Snowdog then the ICAEW's
reputation is at risk.
73.4 NPV analysis only considers cash flows related directly to a project. However, a project with
a negative (or low) NPV could be accepted for strategic reasons. This is because of (real)
options associated with a project that outweigh the poor NPV.
With regard to Snowdog two real options are:
 abandonment – if there is no MBO Snowdog could be closed before the three years
are up.
 growth (calling it follow on or timing also ok) – if Snowdog performs better than
expected it could be kept open longer than three years.
73.5 With SVA a company's value is based on the PV of its future cash flows, so it is forward-
looking.
The advantage is that this is theoretically the most superior valuation method compared
with earnings (which may be manipulated) or assets (which don't focus on the income
generated).
SVA considers seven value drivers, which link to (or drive) company strategy:
(7) Cost of capital

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The disadvantage is that predictions are very difficult as cash flows are technically in
perpetuity. Once a company's period of competitive advantage is over then its growth rate
is much slower and a terminal (residual) value is calculated, based on its cash flows to
perpetuity. This terminal value is often the major part of the overall value of the company.
Once the total value of the company has been calculated, based on the future cash flows
and value drivers, then, to calculate the value of equity, it is necessary to add the value of
any short-term investments held and deduct the market value of any debt held.
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a 'pass' standard in this question.
This was a five-part question that tested the candidates' understanding of the investment
The scenario was based on a UK manufacturer of computer hardware. The company's board has
decided to close down one of its subsidiary companies in three years' time. This is due to the
latter's recent poor performance. The board has learned that the subsidiary's senior
management would like to investigate the possibility of a management buy-out (MBO). The
board has decided that the subsidiary's buy-out price would be its current economic value,
based on predicted trading results for the next three years. Question 73.1 was worth 18 marks
and required candidates to make use of the information given and calculate the subsidiary's
economic value, based on discounted future cash flows. In question 73.2, for four marks,
candidates were asked to re-work their figures from question 73.1 because of a change in the
data provided. This tested their understanding of sensitivity analysis. Question 73.3 was worth
three marks and examined the Ethical Guide, with particular reference to the issues of integrity,
objectivity and professional behaviour. Question 73.4, for five marks, tested candidates'
understanding of real options and asked them to identify two real options that could apply to
the subsidiary as alternatives to the MBO. Finally, in question 73.5, again for five marks,
candidates had to explain the shareholder value analysis (SVA) approach to company valuation,
with its advantages and disadvantages.
For 73.1 the majority of candidates produced good answers. Relevant cash flows were, in the
main, correctly identified. However, the expected sales calculations did cause many candidates
problems. Common errors made by candidates were:
 poor expected value (EV) calculations for Year 2. Some candidates showed no real
understanding by producing an EV higher than any of the individual sales figures.
 no explanation of why depreciation is ignored in the cash flows.
 closure costs were ignored as irrelevant when they were not.
 the tax written down value brought forward was treated as a cash outlay.
 an extra writing down allowance was included in Year 0.
 the money discount rate (given) was increased by the inflation rate in the question.
73.2 was answered very well by most candidates. They demonstrated a good understanding of
the key factors involved in the sensitivity analysis.
Answers for 73.3 were very variable. Candidates who scored well will have explained why the
key ethical issues (integrity, objectivity and professional behaviour) are under threat in the given
scenario. Many candidates failed to do this and produced a 'shopping list', without explanation.
In addition a lot of candidates rolled integrity and objectivity into one issue rather than two.
73.4 was done well by the majority of candidates, but it was disappointing to see a number of
scripts where the candidate did not know the definition of a real option. Also, many candidates
did not apply their real option knowledge to the actual scenario. Instead, they listed many (some
irrelevant) options. Finally, some candidates gave more than the two options required in the
question.

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SVA has been examined many times recently and, as expected, most candidates produced very
good answers for 73.5. Typical errors here were: (a) not knowing the seven value drivers and (b)
applying SVA as if this was an investment appraisal, rather than a company valuation.
74 Heath Care plc

Marking guide
Marks
74.1 (a) Calculation of WACC using Gordon growth model:

Calc growth: opening shareholders' funds 1
Calc growth: r 1
Calc growth: b 1
Calc growth: r  b 1
Cost of equity 2
Cost of irredeemable debt cashflows 2
Cost of redeemable debt cashflows 2
IRR pre-tax 1
IRR post-tax 1
WACC: MV of equity  cost equity 1
WACC: MV of red debt  cost red debt 1
WACC: MV of irr debt  cost irr debt 1
WACC: MV of pref div  cost pref shares 1
17
(b) Calculation of WACC using CAPM:
CAPM 1
WACC: MV of equity  cost equity 1
WACC: Revised weightings and WACC 1
3
74.2 Explain Gordon growth model:
One mark per point to a maximum of 2
Explain diversification and beta:
Explain systematic risk – cannot be diversified away 1
Explain non-systematic risk – can be diversified away 1
Explain beta and how determined by market 1
Impact of risk on beta 1
max 5
74.3 WACC assumptions and APV:
Three WACC assumptions – 1 mark per assumption 3
Explain impact of high gearing with numbers 2
APV base case 1
APV PV of tax shield 1
APV adjustment 0.5
APV identification of total 0.5
max 6

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Marks
74.4 Portfolio theory:
Define portfolio 1
Investor spread investments to reduce risk 1
Investors can spread the risk themselves 1
Managers may want to diversify creating agency conflict 1
Heath's managers no experience of care home management 1
Some of Heath's investors may not be diversified 1
max 4
35
74.1 (a) Ke Dividend growth (g = br)

Opening equity capital employed = £2,520 – (£1,050 – £630) £2,100
r= £1,050 12.5%
(£6,300 + £2,100)
b= £420 0.4
£1,050
g=rb 12.5%  0.4 5%
ke = d1 + g (£630 / 6,300 )  1.05 8.13%
 5%
MV (£3.45 – £0.10)
Kp = d/mv £1  9% £0.09 5.89%

(£1.62 – £0.09) £1.53
Kdr Yr Cash Flow 4% PV 5% PV

£ £ £
0 (99) 1.000 (99.00) 1.000 (99.00)
1–3 4 2.775 11.10 2.723 10.89
3 100 0.889 88.90 0.864 86.40
1.00 (1.71)
IRR = approx 4.4%
Kdr = 4.4%  83% 3.65%
Kdi = i/mv £5  83% 4.41%

£94
WACC
MV Cost Weighting WACC
£'000
Ord. shares (6,300  £3.35) 21,105.0 8.13%  21,105.0/24,091.3 7.1
Pref. shares (750  £1.53) 1,147.5 5.89%  1,147.5/24,091.3 0.3
Redeemable debs
(680  £99%) 673.2 3.65%  673.2/24,091.3 0.1
Irredeemable debs
(1,240  £94%) 1,165.6 4.41%  1,165.6/24,091.3 0.2
24,091.3 7.7%

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(b)
Ke via CAPM = (8.25% – 3.35%)  1.4 = 6.86%
3.35%
10.21%
MV Cost Weighting WACC

£'000
Ord. shares (6,300  £3.35) 21,105.0 10.21%  21,105.0/24,091.3 8.9%
Pref. shares (750  £1.53) 1,147.5 5.89%  1,147.5/24091.3 0.3%
Redeemable debs
(680  £99%) 673.2 3.65%  673.2/24,091.3 0.1%
Irredeemable debs
(1,240  £94%) 1,165.6 4.41%  1,165.6/24,091.3 0.2%
24,091.3 9.5%
74.2 Gordon's Growth Model (GGM) is also known as Earnings Retention Model. Dividend
growth based on proportion of dividends that are retained and the rate of return on those
retained profits. Thus g = rb. The GGM is based on the premise that these profits are the
only source of funds. Growth is achieved by re-investing earnings. This is then put into the
Dividend Valuation Model to get the cost of equity, assuming the value of a share = PV of
growing future dividends.
CAPM – specific/unsystematic risk can be diversified away by investors, so it is assumed that
investors are rational and that they have a diversified portfolio. Systematic risk can't be
diversified away – macro-economic factors. A company's beta is calculated from the
performance of its share price against the market average and is taken as a measure of the
market's view of the risk attached to the security in question. The higher the perceived risk,
then the higher the beta figure and thus the higher the equity return required by investors.
74.3 When using WACC to appraise projects the following assumptions are implied:
(1) Heath's historic proportions of debt and equity are not to be changed (which they are –
see below).
(2) Heath's systematic business risk is not to be changed (it does not change as it's still the
same industry).
(3) The finance is not project-specific (eg, cheap government loans, which it is not).
In this case the finance is very substantial, ie, 42% of total funds at market value
(£10m/£24m) and as it would be borrowed money then this will affect the company's
gearing level significantly (it is only just over 12% at present and would increase to 38% @
MV).
APV – increased gearing may lead to a fall in WACC because of the tax shield on loan
interest. To find the new WACC requires the new MV of the company's shares. However this
requires the NPV of the proposed investment to be known, which needs the new WACC.
So:
(1) Calculate a base case value
(2) Calculate the PV of the tax shield
(3) Adjust for issue costs
Total up 1, 2 and 3 to give APV – if positive then proceed with investment.

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74.4 A portfolio is a combination of investments. Many investors attempt to reduce their risks by
holding a portfolio. The idea is that by investing in different securities they are 'not putting
all of their eggs in one basket'. It is better to spread investment risks.
Investors can spread the risk themselves (via their investment strategy) and do not need
managers to do it for them. Indeed managers may want to diversify in order to protect their
own jobs – which are not diversified. This creates agency conflict.
Heath's managers may well not know anything about running a care home (conglomerate
discount) and so it may be dangerous for investors to allow this investment.
Some of Heath's investors may not be diversified or may be unable to purchase certain
investments because they are private companies.
This question had the second highest percentage mark on the paper. A large majority of
candidates reached a 'pass' standard in the question.
This was a four-part question which tested the candidates' understanding of the financing
options element of the syllabus.
The question was centred on an online retailer of baby products which is based in the UK. The
company's market share has been falling and its board is investigating the possibility of
establishing a small chain of shops across the UK, at a cost of £10 million. This expansion could
be funded by a bank loan, thereby taking advantage of current low interest rates. An alternative
view within the board is that the company should invest in a completely different type of
business, in this case a chain of care homes. In question 74.1, for 20 marks, candidates were
required to calculate the company's current WACC figure, based on (a) Gordon's Growth Model
and (b) the CAPM. Question 74.2, for five marks, required candidates to compare and contrast
the two valuation methods above. In question 74.3 (six marks) candidates were asked to advise
the company's board whether the existing WACC figure (from question 74.1) should be used in
when appraising the proposed investment in shops. The candidates' understanding of the APV
technique was also tested here. Finally, question 74.4, for four marks, required candidates to
explain the portfolio effect and discuss the validity of the proposal to invest in a completely
different type of business.
The requirements of question 74.1 have been examined regularly in recent examinations.
Accordingly, many candidates produced very good answers, scoring heavily. As expected, for
candidates the most difficult element here was the calculation of the dividend growth rate
(based on g = b  r). It was clear that some candidates had no idea how to approach the
calculation of g = b  r. In addition many candidates calculated unrealistically high figures for g,
b and r (and then the cost of equity) without question. Elsewhere, it was disappointing to see a
number of candidates (wrongly) deducting the ordinary dividend for their preference share
calculations and using the ordinary dividend growth rate with preference dividends. Also, a
surprising number of candidates used 5% (the coupon rate) as the pre-tax irredeemable cost of
debt, omitting to take the current market value of the debt into account. Most candidates' IRR
calculations for the cost of redeemable debt were good. However, too many showed a lack of
understanding from here and produced an illogical IRR calculation from NPV figures that were
correct. The CAPM calculation for cost of equity was very straightforward and the vast majority of
candidates scored full marks. However a significant number did not put the right numbers in to
the CAPM and so did not calculate the correct cost of equity.
The overall standard of answers given for question 74.2, 74.3 and 74.4 (theory and advice) was
disappointing when compared to the accuracy of (most of) the calculations in question 74.1.
Whilst many scripts scored well in question 74.2, far too many were unable to explain the basics
of Gordon's Growth Model and the CAPM.

lOMoARcPSD|5019904
For 74.3, too few candidates explained the three conditions required to use the existing WACC
and then apply them to the given scenario. Generally, there was a good understanding of the
APV technique, but typical errors here were choosing the wrong cost of equity (it should be
ungeared) and then deducting (rather than adding) the PV of the tax shield.
For 74.4, most candidates showed a good understanding of portfolio theory. However, too
many failed to distinguish between company and investor portfolios in the scenario.
75 Eddyson Cordless Ltd

Marking guide
Marks
75.1 Hedging strategies:
No hedge 2
FTC outcome 1
FTC fee 1
MMH: Borrow 1
MMH: Convert 1
MMH: Lend and result 1
Option: strategy 1
Option: no of contracts 1
Option: cost of option premium 2
Option: decision 1
Option: gain 1
Option: due from customer 1
Option: convert to £'s 1
Option: net receipt 1
16
75.2 Advice on hedge:
Summary of hedging outcomes 1
Best outcome at $1.3350 2
Best outcome at $1.4050 2
Impact on Eddyson if dollar ($) strengthens 1
6
75.3 Interest rate parity:
State and explain interest rate parity 2
Average UK and US three month rates 1
Average spot rate 1
Calculation of forward rate/average premium 1
5
75.4 Economic risk:
96% UK sales so little exposure 1
Increase in economic risk as US sales increase 1
Weaker $ would be bad for Eddyson 1
3
30

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75.1 No hedge
Spot rate Spot rate
1.3350 1.4050
$2,300,000 $2,300,000
1.3350 1.4050
£1,722,846 £1,637,011
Forward contract (FC)
1.3775 – 0.0044 = 1.3731 $2,300,000 £1,675,042
1.3731
Fee $2,300,000 (£6,900)
= 23,000  £0.30
$100 £1,668,142
Money market hedge (MMH)

Borrow $ $2,300,000 $2,277,228
1.01
Convert @ spot £2,277,228 £1,653,160
1.3775
Lend @ UK £1,653,160

1.0115 £1,672,171
Option
Buying £s, so a November call option
No. of contracts = $2,300,000 £1,703,704 54.52 55 contracts
$1.35 £31,250
Cost of option 55  0.0199  31,250 $34,203 £25,048

1.3655
Future spot rate 1.3350 1.4050

Bought for (1.3500) (1.3500)
(Loss)/Profit (0.0150) 0.0550
So therefore Abandon option Take up option
Gain on option $0.0550

 31,250
 55
$94,531
Due from customer $2,300,000 $2,300,000

Gain on option 0 94,531
Due from customer $2,300,000 $2,394,531
Converted to £ ($2.3m/1.3350) £1,722,846 ($2,394,531/1.4050) £1,704,293

less: Cost of option (25,048) (25,048)
Net receipt £1,697,798 £1,679,245

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75.2
Spot rate Spot rate
1.3350 1.4050
No hedge £1,722,846 £1,637,011
FC £1,668,142 £1,668,142
MMH £1,672,171 £1,672,171
Option £1,697,798 £1,679,245
So with spot rate at 1.3350 (weakening £ and strengthening $) the best outcome for
Eddyson is not to hedge the dollar receipt.
With the spot rate at 1.4050 (strengthening £ and weakening $) the best outcome is to
hedge the dollar receipt via the traded option. The FC and the MMH both give a fixed
sterling receipt – the MMH produces a slightly higher figure. The FC and MMH are safest
techniques to use for a risk-averse board.
The £/$ interest rates and the forward contract premium indicate that the market is
expecting the dollar to strengthen (sterling to weaken). This would be good for Eddyson, an
exporter, as sterling receipts would be higher. The board's attitude to risk will be important
here.
75.3
1+ Average dollar interest rate (3 mos.)
Average spot rate  = Average forward rate
1+ Average sterling interest rate (3 mos.)
The dollar interest rates are lower than those of sterling. Using the interest rate parity (IRP)
equation above (which shows that differences in interest rates can not be exploited as
forward rate will adjust to offset any gains), the value of sterling against the dollar will fall.
The dollar's gain in value is called a premium. So, using the data in the question:
Average UK rate 5.10% pa or 1.01275% per three months.
Average US rate 3.6% pa or 1.009% per three months.
Average spot rate = 1.3715
Forward rate = 1.3715  1.009/1.01275 = 1.3664 ie, a premium of $0.0051/£
Average premium given = $0.0052/£ so IRP is working
75.4 Currently very little economic risk as the majority of Eddyson's sales are in the UK (96%).
However if more sales are to the US then economic risk would increase – $ sales and €
purchases.
A weakening $ and a strengthening € would both be bad for Eddyson.
This question had the lowest average mark on the paper, but most candidates achieved a 'pass'
standard.
The scenario here involved a UK manufacturer of home and garden appliances. The company
has recently received a large order from an American customer. Its board is considering whether
or not to hedge the foreign exchange rate risk. Question 75.1, for 16 marks, required candidates
to calculate the net sterling receipt for each of four possible strategies. These were (a) no hedge,
(b) a forward contract, (c) a money market hedge and (d) sterling traded currency options.
Question 75.2 was worth six marks and required candidates to advise the company's board,
based on their previous calculations. In question 75.3 (five marks) candidates needed to
demonstrate their understanding of interest rate parity. Question 75.4 was worth three marks.

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Here, candidates were asked to explain whether, taking into account the information provided,
additional sales to the US might expose the company to economic risk.
For most elements of 75.1 candidates scored well. Forward contracts (FC) and money market
hedges (MMH) are examined regularly and most candidates accrued full marks here. Candidates
need to make the best use of the spreadsheet provided in the examination. In a number of
instances candidates reduced their exchange rates to two decimal places, thus losing marks
unnecessarily. One common error amongst candidates was to add, rather than subtract, the
forward contract fee. It was disappointing to see that some candidates used the two future spot
rates given to calculate alternative sterling receipts for the FC and then also for the MMH. Both
of these hedging techniques produce one, fixed sterling figure each. As expected candidates
found the currency options element of the question more difficult. Whilst many of them scored
well, common errors noted were:
 choosing a put rather than a call option and then getting the exercise/abandon decision
wrong as well.
 calculating the wrong number of contracts, by failing to use the option exercise price.
 calculating the profit on exercising the option in sterling rather than in $.
 treating it as an OTC option rather than a sterling traded currency option.
Interest rate parity (IRP) has been examined fairly regularly and many candidates did well in 75.3.
However there were quite a few poor scripts and some candidates used 12 months rather than
three months when trying to prove that the IRP was working in this scenario.
75.4 produced a very varied set of answers. Whilst many candidates scored full marks here,
many scored zero, as they had no understanding of economic risk, frequently mentioning
(wrongly) the impact of tariffs, quotas and political unrest.

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Appendix

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฀
฀
358 Financial Management: Appendix ICAEW 2019

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Formulae and Discount Tables

Formulae you may require:
(a) Discounting an annuity
1 1 
The annuity factor: AF1 n = 1 – 
r  (1+ r)n 
Where AF = annuity factor

n = number of payments
r = discount rate as a decimal
(b) Dividend growth model:

D0 (1+ g)
ke = +g
P0
Where ke = cost of equity

D0 = current dividend per ordinary share
g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share
(c) Capital asset pricing model: rj = rf + ßj (rm – rf)

Where rj = the expected return from security j
rf = the risk free rate
ßj = the beta of security j
rm = the expected return on the market portfolio
 D(1 – T) 
(d) e = a 1+ 
 E 
Where e = beta of equity in a geared firm

a = ungeared (asset) beta
D = market value of debt
E = market value of equity
T = corporation tax rate
Note: Candidates may use other versions of these formulae but should then define the symbols
they use.
ICAEW 2019 Formulae and Discount Tables 359

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Discount Tables
Present value of
Interest Number of Present value of £1 receivable at
rate years £1 receivable at the end of each of
p.a. n the end of n years n years
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
10% 1 0.909 0.909
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
9 0.424 5.759
10 0.386 6.145
15% 1 0.870 0.870
2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
20% 1 0.833 0.833
2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
฀
10 0.162 4.192
360 Financial Management: Appendix ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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ICAEW 2019 Notes

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Notes ICAEW 2019

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