F3 – Financial Strategy 4 March 2011

Financial Pillar

F3 – Financial Strategy 4 March 2011 – Friday Session Instructions to candidates

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to begin using your computer to produce your answer or to use your calculator during the reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or subquestions).

ALL answers must be submitted electronically, using the single Word and Excel files provided. Answers written on the question paper and note paper will not be submitted for marking.

You should show all workings as marks are available for the method you use.

The pre-seen case study material is included in this question paper on pages 2 to 7. The unseen case study material, specific to this examination, is provided on pages 8 and 9.

Answer the compulsory question in Section A on page 11. This page is detachable for ease of reference.

Answer TWO of the three questions in Section B on pages 14 to 18.

Maths tables and formulae are provided on pages 21 to 25.

The list of verbs as published in the syllabus is given for reference on page 27.

Your computer will contain two blank files – a Word and Excel file.

Please ensure that you check that the file names for these two documents correspond with your candidate number.

 The Chartered Institute of Management Accountants 2011

F3 – Financial Strategy

You are allowed three hours to answer this question paper.

DEF Airport Pre-seen case study Overview DEF Airport is situated in country D within Europe but which is outside the Eurozone. The local currency is D$. It is located near to the town of DEF. It began life in the 1930s as a flying club and was extended in 1947, providing scheduled services within central Europe. A group of four local state governments, which are all in easy reach of the airport (hereafter referred to as the LSGs), took over the running of the airport in 1961. The four LSGs are named North (NLSG), South (SLSG), East (ELSG) and West (WLSG). These names place their geographical location in relation to the airport. In the early 1970s flights from the airport to European holiday destinations commenced with charter flights operated by holiday companies. In 1986, the first transatlantic flight was established and the airport terminal building was extended in 1987.

By 1989 the airport was handling 500,000 passengers per year which is forecast to increase to 3.5 million for both incoming and outgoing passengers in the current financial year to 30 June 2011. The airport mainly serves holidaymakers flying to destinations within Europe and only 5% of the passengers who use the airport are business travellers.

DEF Airport was converted into a company in 1990 and the four LSGs became the shareholders, each with an equal share. The company is not listed on a stock exchange. The airport has undertaken extensive development since 2000, with improvements to its single terminal building. The improvements have mainly been to improve the airport’s catering facilities and to increase the number of check-in desks. There has also been investment in the aircraft maintenance facilities offered to the airlines operating out of the airport.

Governance The Board of Directors has four Executive directors: the Chief Executive, the Director of Facilities Management, the Finance Director and the Commercial Director. In addition there is a Company Secretary and a Non-Executive Chairman. In accordance with DEF Airport’s Articles of Association, the Non-Executive Chairman is drawn from one of the four LSGs. The NonExecutive Chairman is the sole representative of all four LSGs. The Chairmanship changes every two years with each of the four LSGs taking turns to nominate the Chair.

The four LSGs have indicated that they may wish to sell their shareholdings in the airport in the near future. If any LSG wishes to sell its shares in the airport it must first offer them to the other three LSGs. Any shares that are not purchased by the other LSGs may then be sold on the open market. A local investment bank (IVB) has written to the Chairman expressing an interest in investing in the airport in return for a shareholding together with a seat on the Board.

Mission statement The Board of Directors drew up a mission statement in 2008. It states “At DEF Airport we aim to outperform all other regional airports in Europe by ensuring that we offer our customers a range of services that are of the highest quality, provided by the best people and conform to the highest ethical standards. We aim to be a good corporate citizen in everything we do.”

DEF Airport development plan The Board of Directors produced a development plan in 2009. The Board of Directors consulted with businesses in the area and followed central government airport planning guidelines. It was assumed that the views of other local stakeholders would be represented by the four LSGs which would feed comments to the Board through the Chairman.

The plan relates to the development of DEF Airport and its forecast passenger growth for the next two decades. The Board proposed that future development of the airport will be phased and gradual in order to avoid unexpected consequences for the local communities and industry.

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Strategic objectives The following strategic objectives have been established in the development plan: 1. Create a planning framework which enables DEF Airport to meet the demands of the forecast passenger numbers; 2. Reduce to a minimum the visual and audible impacts of the operation of the airport on the local environment; 3. Ensure that the airport is financially secure; 4. Improve land based access to the airport; 5. Minimise the pollution effects of the operation of the airport.

6. Maintain / increase employment opportunities for people living close to the airport.

By the year ending 30 June 2015, DEF Airport is expected to support about 3,000 local jobs and have a throughput of 5 million passengers per year, an increase of 1.5 million from the 3.5 million passengers forecast for the current financial year ending 30 June 2011. In order to accommodate the forecast increased number of passengers and attain the development objectives, it will be necessary for the airport to extend its operational area to the east of the land it currently occupies.

Financial objectives Extracts from DEF Airport’s forecast income statement for the year ending 30 June 2011 and forecast statement of financial position as at that date are presented in the Appendix. The four LSGs have made it clear to the Board of Directors that the airport must at least achieve financial self-sufficiency. The financial objectives of the airport are to ensure that: 1. The airport does not run at a loss; 2. All creditors are paid on time; 3. Gearing levels must not exceed 20% (where gearing is defined as debt to debt plus equity) and any long-term borrowings are financed from sources approved by the four LSGs. Corporate Social Responsibility A key feature of DEF Airport’s development plan is to develop “Sustainable Aviation” initiatives in order to reduce the effects of flying on the environment. One effect on the environment is that the airport is subject to specific planning restrictions affecting flights between the hours of 11 p.m. (2300 hours) and 7 a.m. (0700 hours) to reduce aircraft noise. Flights are permitted between these times, but must be specially authorised. Typically, flights between these times would be as a result of an emergency landing request.

A leading international consultancy, QEG, which specialises in auditing the corporate social responsibility (CSR) issues of commercial enterprises, has offered to provide a CSR audit to DEF Airport free of charge. QEG is based in the USA and hopes to expand by offering its services to European enterprises.

DEF Airport’s competitors TUV Airport is located about 100 kilometres away from DEF Airport and serves a highly populated industrial city. The Board of Directors of DEF Airport considers TUV Airport to be its main competitor. There are another three competing airports within 80 kilometres of DEF Airport. TUV Airport purchased one of these three competitor airports and subsequently reduced services from it in order to reduce the competitive threat to itself.

Airlines Airlines are keen to negotiate the most cost effective deal they can with airports. DEF Airport applies a set of standard charges to airlines but is aware that some of its competitor airports have offered inducements to airlines in order to attract DEF’s business.

Airlines across the world are facing rising fuel and staff costs as well as strong competition from within the industry. There has been an overall increase in customer demand for air travel in recent years and low-priced airlines have emerged and are threatening the well-established,

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traditional airlines. Consequently, the traditional airlines have begun to cut the number of destinations to which they fly.

There are several low-priced airlines that serve DEF Airport’s competitors, but only one, S, also operates out of DEF Airport. S is exploring ways in which it might increase its flights to and from DEF Airport.

DEF’s Board of Directors has been approached by a North American airline that wishes to operate services from DEF Airport. This airline specialises in flights for business and first class passengers. However, this airline insists that it would pay DEF Airport in US$. This is contrary to the airport’s policy of accepting payment only in D$, which is the local currency.

Analysis of revenue by business segment The forecast split of total revenue of D$23.4 million by business segment for the current financial year ending 30 June 2011 is: % Aviation income 48 Retail concessions at the airport 20 Car Parking 15 Other income 17 (Other income includes income from property rentals, and other fees and charges.)

DEF Airport offers discounts for prompt payment.

Aviation income In addition to the standard charges, which are set out below, there is a range of surcharges which are levied on airlines for such items as “noisy aircraft” (charged when aircraft exceed the Government limits for acceptable noise levels), recovery of costs and expenses arising from cleaning or making safe any spillages from aircraft and extraordinary policing of flights (for example, arrests made as a result of anti-social behaviour on aircraft).

Standard charges made by DEF Airport to the airlines: Charges per aircraft Landing charges – large aircraft: Landing charges – medium aircraft:

D$300 D$170

Parking charges for the first two hours are included in the landing charge. Thereafter, a charge of D$200 per hour is imposed for each large aircraft and D$250 per hour for each medium aircraft. The parking charge is lower for large aircraft because they take at least two hours to clean and refuel, so they almost always have to pay for an hour’s parking, and also because there is less demand for the parking areas used for large aircraft. Medium aircraft tend to take off again within one hour of landing. Approximately 10% of medium sized aircraft landings result in the airline incurring parking charges for one hour. This is normally either because their scheduled departure time requires them to park or because of delays imposed by air traffic restrictions, technical malfunctions or problems with passengers.

Charges per passenger Passenger Load: Flights to European destinations: Flights outside Europe:

D$1.60 per departing passenger D$4.00 per departing passenger

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D$1.20 per passenger arriving or departing

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Retail concessions DEF Airport provides the facilities for a range of shops, bureau de change (dealing in foreign exchange currency transactions for passengers), bars and cafes for the budget conscious passenger.

DEF Airport has a monopoly in the provision of retail concessions and therefore faces no competition.

Car parking Car parking is an important source of DEF Airport’s revenue. The airport has extended its own car parking facilities for customers over recent years. Car parks occupy a large area of what was green belt land (that is land which was not previously built on) around its perimeter. The land was acquired by the airport specifically for the purpose of car parking. A free passenger bus service is provided to take passengers to and from the car parks into the airport terminal building.

Competitors have established alternative car parking facilities off-site and provide bus services to and from the airport’s terminal. The parking charges made by the competitors are lower than those levied by the airport. Competitor car park operators offer additional services to passengers, such as car maintenance and valeting, which are undertaken while the car is left in their care.

DEF Airport does not have a hotel on its premises. There is a hotel within walking distance of the airport which offers special rates for passengers to stay the night before their flight and then to park their cars at the hotel for the duration of their trip.

Other income This heading contains a mixture of revenue streams. The Commercial Director reported that some have good growth prospects. Property rental income is likely to decline though as there has been much building development around the airport perimeter.

DEF Airport security Passengers and their baggage are required to go through rigorous security checks. There is a fast track service provided which can be accessed by all passengers at an extra charge. This is intended to speed up the security process. However, on some occasions this leads to passengers on the normal route becoming frustrated because they are required to wait in lengthy queues to pass through the security checks. Airport security staff are required by law to search all departing passengers and their baggage for suspicious or dangerous items. On the very rare occasions that they discover anything they report their concerns to the police. There are always several police officers on patrol at the airport at any given time and so the police can respond to any report very quickly.

In addition to passenger and baggage screening, DEF Airport security staff are responsible for the security of parked aircraft and airport property. They do this primarily by monitoring all arriving and departing vehicles and their drivers and by monitoring the many closed circuit television cameras that cover the airport.

The airport has had a good record with regard to the prevention of theft from passenger baggage. This is frequently a serious matter at other airports, but DEF Airport has received very few complaints that baggage has been tampered with. DEF Airport’s Head of Security regards the security of baggage as very low risk because of this low level of complaints.

The Head of Security at DEF Airport was appointed to his current role in 1990, when the airport was very much smaller than it is today. He was a police sergeant before he joined the airport staff. Immediately before his appointment he was responsible for the front desk of DEF town’s main police station, a job that involved managing the day-to-day activities of the other police officers on duty. He was happy to accept the post of Head of Security because the police service was starting to make far greater use of computers. He had always relied on a comprehensive paper-based system for documenting and filing reports.

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The Head of Security is directly responsible for all security matters at DEF Airport. In practice, he has to delegate most of the actual supervision of staff to shift managers and team leaders because he cannot be expected to be on duty for 24 hours per day or to manage the security arrangements in great detail while administering the security department. The overall responsibilities of the Head of Security have not been reviewed since his appointment.

Strategic options The Board of Directors is now actively considering its strategic options which could be implemented in the future in order to meet the strategic objectives which were set out in the airport’s development plan.

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APPENDIX 1 Extracts of DEF Airport’s forecast income statement for the year ending 30 June 2011 and statement of financial position as at 30 June 2011 Forecast income statement for the year ending 30 June 2011 Note Revenue Operating costs Net operating loss Interest income Finance costs Corporate income tax expense LOSS FOR THE YEAR

1

D$000 23,400 (25,450) (2,050) 70 (1,590) (130) (3,700)

Forecast statement of financial position as at 30 June 2011 D$000 ASSETS Non-current assets Current assets Inventories Trade and other receivables Cash and cash equivalents Total current assets Total assets

150,000 400 9,250 3,030 12,680 162,680

EQUITY AND LIABILITIES Equity Share capital Share premium Revaluation reserve Retained earnings Total equity Non-current liabilities Long term borrowings Current liabilities Trade and other payables Total liabilities Total equity and liabilities

2

17,700 530 89,100 23,200 130,530

3

22,700 9,450 32,150 162,680

Notes: 1. Operating costs include depreciation of D$5.0 million.

2. There are 17.7 million ordinary shares of D$1 each in issue.

3. The long-term borrowings comprise a D$6.3 million loan for capital expenditure which is repayable on 1 July 2015 and D$16.4 million owed to the 4 LSGs. This has no fixed repayment schedule and is not expected to be repaid in the next year.

End of Pre-seen Material The unseen material begins on page 8 TURN OVER

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SECTION A – 50 MARKS [You are advised to spend no longer than 90 minutes on this question]

ANSWER THIS QUESTION Question One Unseen case material Background Today’s date is 4 March 2011.

The directors of DEF Airport are considering the future development and management of the company’s on-site car parking business. DEF operates on-site car parking facilities close to the airport terminal buildings. Other operators offer off-site car parking some distance away. DEF has been facing increasing levels of competition from these off-site operators due primarily to their lower parking charges and additional services such as car maintenance and valeting.

Currently, on-site car parks are operating at approximately 80% of maximum occupancy and if nothing is done, this is set to decline further. In order to attempt to reverse this, the directors are considering an investment of D$ 4 million to improve services and provide a more regular, faster link to the terminal buildings. It is felt that because off-site facilities are some distance from the Airport that this will prove enough of an incentive to attract more passengers to park their cars at the Airport. However, there is also an urgent need to refurbish the terminal buildings and funds are not available for both investments.

The LSGs are under considerable financial pressure and are not able to invest additional funds in the business. Therefore any investment in the on-site car parks or terminal buildings would need to be financed by borrowings.

Financial information relating to DEF Airport Extracts from DEF Airport’s forecast financial statements for the year ending 30 June 2011 are set out in the pre-seen material on page 7. Financial and strategic objectives can be found on page 3.

Financial information relating to DEF’s car parks DEF car parking revenue in any year is directly linked both to the number of cars using the onsite car parking facilities managed by DEF and the average fee charged per car.

For the year ending 30 June 2011 In the year ending 30 June 2011, the total number of cars using either on-site car parking facilities provided by DEF or off-site facilities provided by competitors is forecast to be 1,400,000. DEF is expected to have a 50% share of this market (based on the number of cars) providing on-site car parking for 700,000 cars at an average fee of D$ 5 per car.

Operating costs for the car parking business in the year are forecast to be D$ 2.7 million (which includes a depreciation charge of D$ 0.2 million).

For the year ending 30 June 2012 and onwards assuming no investment Forecast data for the year ending 30 June 2012 and onwards indicate: • The total number of cars requiring either on-site or off-site parking is expected to increase by 6% in each of the years ending 30 June 2012 and 30 June 2013 and then to remain constant into the foreseeable future.

• DEF Airport’s share of the total car parking market, is expected to fall to: March 2011

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40% (of cars using both on-site and off-site airport parking) in the year ending 30 June 2012; o 35% in the year ending 30 June 2013 onwards into the foreseeable future.

In the year ending 30 June 2012, operating costs (before charging depreciation) are expected to be D$ 2.6 million and then increase by 4% a year in subsequent years.

DEF only expects to be able to increase its average car parking fee at a rate of 3% a year for the foreseeable future from a base level of D$ 5 in the year ending 30 June 2011. o

• •

For the year ending 30 June 2012 onwards assuming the investment is made The initial investment of D$ 4.0 million would be payable by DEF on 1 July 2011. This initial investment would be eligible for a 100% tax depreciation allowance, which would be claimed at the end of that financial year. It would also be subject to accounting depreciation on a straight line basis over ten years and can be assumed to have no residual value after ten years.

Relevant data assuming the investment goes ahead: • The total number of cars requiring either on-site or off-site car parking facilities would not be affected by the investment • DEF’s share of the market would be constant at 50% of all cars using car parking facilities.

• Annual operating costs would increase to D$ 3.1 million (before charging depreciation) in the year ending 30 June 2012 and increase by 4% a year in subsequent years.

• DEF expects to be able to increase average car parking fees by 4% a year.

Additional information • • • •

Cash flows can be assumed to equal profits (after adjusting for depreciation where appropriate) and to arise at the end of each year.

Corporate income tax is charged at 30% on taxable profits and is paid at the end of the financial year in which the taxable profit arises.

Assume that DEF will have sufficient taxable profits in future years to cover tax depreciation allowances.

DEF’s existing WACC of 12% is considered to be an appropriate nominal discount rate to use for investment appraisal and valuation purposes.

Alternative schemes for the operation of the on-site car parking facilities assuming DEF proceeds with its proposed investment to up-grade those facilities Two alternative schemes are being considered, following on from the investment: Scheme A: DEF would retain control of the on-site car parks.

Scheme B: DEF would lease both the land and the upgraded facilities used in the car park business to ABC, a third party operator, for a 10 year period from 1 July 2011. ABC would take over responsibility for operating the on-site car parking business for 10 years and all operating costs and revenues would be paid and retained by ABC. Ownership of the land would be retained by DEF. A lease payment would be paid by ABC to DEF at the end of each of the next 10 years.

The requirement for Question One is on page 11 which is detachable for ease of reference

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Required: (a)

Evaluate the importance of the car parking business to DEF as a whole with reference to the forecast results for the year ended 30 June 2011 only.

(6 marks)

(b) Calculate the present value on 1 July 2011 of the net cash flows of DEF’s car parking business over a 10 year time period assuming: (i) no investment in upgrading the on-site car parking facilities is made; (ii) the proposed investment to upgrade on-site car parking facilities is made.

(15 marks) Assume you are the Financial Controller of DEF. Write a report addressed to the Board of Directors regarding the proposed investment and subsequent operation of the on-site car parks as detailed below.

(c)

Advise the directors whether to proceed with the proposed investment to upgrade the on-site car parking facilities.

(5 marks)

(d)

Assuming the proposed investment in on-site car parking facilities goes ahead: (i) Recommend an appropriate annual lease payment to be made by ABC under Scheme B (based on a calculation of the payment at which Schemes A and B are equally attractive to DEF from a financial perspective over a 10 year period).

(6 marks) (ii) Advise the directors of DEF whether to choose Scheme A or Scheme B. As part of your answer you should: • Compare and contrast Schemes A and B with reference to DEF’s financial and strategic objectives.

• Discuss any real options attaching to each scheme.

(14 marks)

Additional marks available for structure and presentation in parts (a) to (d):

(4 marks)

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A Section B starts on page 14 TURN OVER

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Section B starts on page 14

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Section B starts on page 14

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SECTION B [You are advised to spend no longer than 45 minutes on each question in this section]

ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH Question Two Today’s date is 4 March 2011.

TM is a privately owned company which manufactures children’s toys and is based in a country in Asia which has the A$ as its currency. In the financial year to 31 December 2011 (assuming that there are no policy changes) it is expected that approximately 70% of TM’s revenue will be from sales to companies in its home market. The other 30% of revenue will be from sales to companies in a foreign country which has the euro (EUR) as its currency. Export sales are currently priced in A$.

Approximately 10% of TM’s home customers are cash buyers, the other 90% are on credit.

Export sales are all on credit. Some customers in both the home and export markets regularly exceed their agreed credit period. TM makes no charge for this but refuses repeat orders if customers regularly make late payments beyond their agreed credit period.

In order to increase export sales, TM is planning to make the following policy changes with effect from 1 April 2011: 1.

2.

Relax its credit terms in its export market by offering 90 days credit, an increase of 30 days on its normal terms in this market.

Invoice in euro rather than A$, converting the A$ price list to produce a euro price list at the current exchange rate of A$/EUR 0.4000 (A$1 = EUR 0.4000).

This euro price list will then be used for pricing export sales for the remainder of the year.

It is expected that these policy changes will result in an increase in export sales of one-third between the first and second quarters of 2011.

Provisional forecast results for TM (including both home and export sales) for the first two quarters of 2011, after taking into account the planned policy changes and using the exchange of A$/EUR 0.4000, are shown below: First quarter 2011 (1 January to 31 March) A$ thousands Revenue Cost of goods sold Purchases

5,750 3,163 2,150

6,325 3,529 2,350

Balances at 31 March 2011 A$ thousands Accounts receivable Accounts payable Inventory Raw materials Work in Progress Finished goods

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Second quarter 2011 (1 April to 30 June) A$ thousands

Balances at 30 June 2011 A$ thousands

5,000 1,800

7,000 2,600

1,500 740 420

1,700 860 500

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Additional relevant information is given below: • All purchases were, and will continue to be, sourced in the home country and paid for in A$.

• Net current assets are currently financed by an overdraft. This policy is under review.

There is concern that the value of the euro against the A$ may fall to A$/EUR 0.4600 at the beginning of the second quarter of 2011. However, other exchange rate forecasters predict that the exchange rate will remain unchanged. If the exchange rate were to change, the directors do not expect to be able to increase TM’s euro prices to reflect the devaluation of the euro in view of the current poor economic environment in Europe.

Required: (a)

Evaluate the likely impact of the movement in exchange rates from A$/EUR 0.4000 to A$/EUR 0.4600 on 1 April 2011 on the results for the second quarter of 2011, assuming that the exchange rate remains unchanged for the remainder of the quarter.

(6 marks)

(b)

(i)

Calculate the operating cycle of TM for:

• •

The first quarter of 2011.

The second quarter of 2011 using an exchange rate of A$/EUR 0.4000 as proposed in the policy change.

The second quarter of 2011 using an exchange rate of A$/EUR 0.4600 throughout the second quarter.

(9 marks)

•

(ii)

(c)

Briefly discuss whether the changes in any of the component parts of the cycle give cause for concern.

(3 marks)

Advise the directors of TM on an appropriate financing structure for net current assets and explain the benefits and potential problems of using euro denominated finance.

(7 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

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Question Three GOH is a local government organisation in Gohland, a country that has the G$ as its currency.

GOH is currently evaluating a proposed investment involving the construction and operation of a new health centre in the local region. Some fees will be collected from users of the centre but the majority of services will be provided free of charge.

The Gohland Government sets down strict guidelines to be used by all local government organisations in their appraisal of projects. In relation to investment projects of this nature the guidelines are that: • • • •

A discount rate of 4% should be used as this is the rate specified by the government for use in evaluating such projects.

Projects of this nature should be evaluated over a 15 year time horizon.

Discounted cash flow analysis should take into account both the capital investment and the opportunity cost of the land that is required by the project.

All costs, income and other benefits of the project should be identified and included in the appraisal. These should include the estimated value of benefits to society in terms of health impacts and also any environment and social impacts.

Financial figures for the proposed project The capital cost of the investment (buildings and equipment) is estimated at G$950 million and would be payable on 1 April 2011.

The health centre is to be built on a portion of land already owned by GOH. A developer has expressed an interest in buying the land at a price of G$250 million. This is considered a reasonable market value by GOH’s Estates Department.

The residual value of the land, buildings and equipment at the end of 15 years is difficult to forecast but the Estates Department thinks at that time the land will be worth approximately G$600 million and the buildings and equipment G$150 million.

Net future benefits (income and other benefits net of costs) for the new regional health centre for use in the NPV analysis are forecast to be as follows: Year ending 31 March G$ million

2012 90

2013 110

2014 120

2015 to 2026 130 per year

GOH’s financial director has just joined GOH from a private-sector company and has proposed that instead of using a discount rate of 4% a more commercial discount rate should be used based upon a private sector organisation.

He has identified a private health care company, JKL, which operates a number of health centres in Gohland, to be used as a proxy company for calculating a comparable private sector discount rate for GOH.

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JKL is currently funded as follows: Equity: 24.5 million shares quoted on the local market at G$13.00. JKL’s cost of equity is estimated at 9%.

Debt:

G$100 million of long dated bonds issued at par and paying a coupon rate of 5.5%. The debt is currently trading at G$95 per G$100 nominal.

Additional information: • The corporate income tax rate is 30% in Gohland.

• Net future benefits should be assumed to occur at the end of the year.

Required: (a)

(i)

Calculate the weighted average cost of capital of JKL. (4 marks)

(ii)

Advise on the appropriateness of using the WACC of JKL as the discount rate in GOH’s project appraisal, including reference to the differences in the financial and non-financial objectives between the public sector and private sector.

(8 marks)

(b)

(i)

Calculate the project NPV following Gohland government’s guidelines.

(5 marks)

(ii)

Advise GOH on other issues that need to be taken into account before deciding whether or not to proceed with the proposed project.

(8 marks)

(Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

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Question Four RED is a family run and owned company based in the United Kingdom which designs and manufactures state-of-the-art vacuum cleaners. It has grown steadily during the eight years since it was founded and the directors consider that the company is now of a suitable size to be listed on the Alternative Investment Market (AIM), which is a market for the shares of smaller companies.

The company is currently in the early stages of development of a new product that it is hoped will be highly successful and will significantly increase the company’s share of the vacuum cleaner market. Information about the product’s development will be made public at various stages during 2011. Information may also become public knowledge through other means as more people and organisations become involved in the testing and implementation of production of the new product.

Significant amounts of new funding will be required to finance the final development, production and launch of this product but the existing shareholders are now not able to provide this.

Therefore the directors of RED are planning to raise the necessary funds by means of a bond issue followed by an IPO (initial public offering). The bond issue is planned for the middle of 2011 and the IPO towards the end of the year.

Required: (a)

Compare and contrast the features of a private placing and a public issue for the bonds and advise the directors of RED which method would be most appropriate.

(12 marks)

(b)

(i)

Describe the three forms of the efficient market hypothesis and state which form is most likely to apply in practice.

(4 marks)

(ii)

Advise the directors of RED on what steps can be taken to improve the chances of a successful IPO issue and a high share price after the issue. Your answer should include reference to the efficient market hypothesis.

(9 marks) (Total for Question Four = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

(Total for Section B = 50 marks)

End of Question Paper Maths Tables and Formulae are on Pages 21 – 25

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Maths Tables and Formulae are on Pages 21 – 25

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MATHS TABLES AND FORMULAE Present value table

-n

Present value of 1.00 unit of currency, that is (1 + r) where r = interest rate; n = number of periods until payment or receipt.

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820

2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673

3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0.705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

Financial Strategy

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March 2011

Cumulative present value of 1.00 unit of currency per annum 1−(1+ r )− n  Receivable or Payable at the end of each year for n years  r



Periods (n) 1 2 3 4 5



1% 0.990 1.970 2.941 3.902 4.853

2% 0.980 1.942 2.884 3.808 4.713

3% 0.971 1.913 2.829 3.717 4.580

4% 0.962 1.886 2.775 3.630 4.452

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212

7% 0.935 1.808 2.624 3.387 4.100

8% 0.926 1.783 2.577 3.312 3.993

9% 0.917 1.759 2.531 3.240 3.890

10% 0.909 1.736 2.487 3.170 3.791

6 7 8 9 10

5.795 6.728 7.652 8.566 9.471

5.601 6.472 7.325 8.162 8.983

5.417 6.230 7.020 7.786 8.530

5.242 6.002 6.733 7.435 8.111

5.076 5.786 6.463 7.108 7.722

4.917 5.582 6.210 6.802 7.360

4.767 5.389 5.971 6.515 7.024

4.623 5.206 5.747 6.247 6.710

4.486 5.033 5.535 5.995 6.418

4.355 4.868 5.335 5.759 6.145

11 12 13 14 15

10.368 11.255 12.134 13.004 13.865

9.787 10.575 11.348 12.106 12.849

9.253 9.954 10.635 11.296 11.938

8.760 9.385 9.986 10.563 11.118

8.306 8.863 9.394 9.899 10.380

7.887 8.384 8.853 9.295 9.712

7.499 7.943 8.358 8.745 9.108

7.139 7.536 7.904 8.244 8.559

6.805 7.161 7.487 7.786 8.061

6.495 6.814 7.103 7.367 7.606

16 17 18 19 20

14.718 15.562 16.398 17.226 18.046

13.578 14.292 14.992 15.679 16.351

12.561 13.166 13.754 14.324 14.878

11.652 12.166 12.659 13.134 13.590

10.838 11.274 11.690 12.085 12.462

10.106 10.477 10.828 11.158 11.470

9.447 9.763 10.059 10.336 10.594

8.851 9.122 9.372 9.604 9.818

8.313 8.544 8.756 8.950 9.129

7.824 8.022 8.201 8.365 8.514

11% 0.901 1.713 2.444 3.102 3.696

12% 0.893 1.690 2.402 3.037 3.605

13% 0.885 1.668 2.361 2.974 3.517

14% 0.877 1.647 2.322 2.914 3.433

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274

17% 0.855 1.585 2.210 2.743 3.199

18% 0.847 1.566 2.174 2.690 3.127

19% 0.840 1.547 2.140 2.639 3.058

20% 0.833 1.528 2.106 2.589 2.991

6 7 8 9 10

4.231 4.712 5.146 5.537 5.889

4.111 4.564 4.968 5.328 5.650

3.998 4.423 4.799 5.132 5.426

3.889 4.288 4.639 4.946 5.216

3.784 4.160 4.487 4.772 5.019

3.685 4.039 4.344 4.607 4.833

3.589 3.922 4.207 4.451 4.659

3.498 3.812 4.078 4.303 4.494

3.410 3.706 3.954 4.163 4.339

3.326 3.605 3.837 4.031 4.192

11 12 13 14 15

6.207 6.492 6.750 6.982 7.191

5.938 6.194 6.424 6.628 6.811

5.687 5.918 6.122 6.302 6.462

5.453 5.660 5.842 6.002 6.142

5.234 5.421 5.583 5.724 5.847

5.029 5.197 5.342 5.468 5.575

4.836 4.988 5.118 5.229 5.324

4.656 7.793 4.910 5.008 5.092

4.486 4.611 4.715 4.802 4.876

4.327 4.439 4.533 4.611 4.675

16 17 18 19 20

7.379 7.549 7.702 7.839 7.963

6.974 7.120 7.250 7.366 7.469

6.604 6.729 6.840 6.938 7.025

6.265 6.373 6.467 6.550 6.623

5.954 6.047 6.128 6.198 6.259

5.668 5.749 5.818 5.877 5.929

5.405 5.475 5.534 5.584 5.628

5.162 5.222 5.273 5.316 5.353

4.938 4.990 5.033 5.070 5.101

4.730 4.775 4.812 4.843 4.870

Periods (n) 1 2 3 4 5

March 2011

22

Financial Strategy

FORMULAE Valuation models (i)

Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the exdiv value: d

P0 =

k pref

(ii)

Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

d P0 =

ke (iii)

Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value:

d1

P0 =

ke (iv)

or

−g

d 0 [1 + g ] ke

−g

Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interest value: P0 =

P0 =

or, without tax: (v)

P0 =

i [1 − t ] k d net

i kd

Total value of the geared entity, Vg (based on MM):

Vg = Vu + TB (vi)

Future value of S, of a sum X, invested for n periods, compounded at r% interest:

S = X[1 + r] (vii)

n

Present value of 1⋅00 payable or receivable in n years, discounted at r% per annum:

1 PV =

(viii)

n

Present value of an annuity of 1⋅00 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV =

(ix)

[1 + r ]

1 1 1−  n r  [1 + r ]

  

Present value of 1⋅00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:

1 PV =

r (x)

Present value of 1⋅00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum:

1 PV =

Financial Strategy

23

r −g

March 2011

Cost of capital (i)

Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

kpref =

d P0

(ii)

Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price P0:

kd net =

i [1 − t ] P0

(iii)

Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

ke =

d P0

(iv)

Cost of ordinary (equity) shares, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g% per annum:

ke =

d1

or

+g

ke =

d 0 [1 + g ]

P0 (v)

+g

P0

Cost of ordinary (equity) shares, using the CAPM: ke = Rf + [Rm – Rf]ß

(vi)

Cost of ordinary (equity) share capital in a geared entity :

keg = keu + [keu – kd] (vii)

Weighted average cost of capital, k0 or WACC

WACC = ke (viii)

 VE   VD    + k d [1 − t ]   VE + VD  VE + VD 

Adjusted cost of capital (MM formula):

Kadj = keu [1 – tL]

(ix)

or

   VD [1 − t ]  VE   + ßd   VE + VD [1 − t ]  VE + VD [1 − t ] 

Regear ß:

ßg = ßu + [ßu – ßd]

(xi)

r* = r[1 – T*L]

Ungear ß:

ßu = ßg (x)

VD [1 − t ] VE

VD [1 − t ] VE

Adjusted discount rate to use in international capital budgeting (International Fisher effect) 1 + annual discount rate B$

=

Future spot rate A$/B$ in 12 months' time

1 + annual discount rate A$ where A$/B$ is the number of B$ to each A$

March 2011

24

Spot rate A$/B$

Financial Strategy

Other formulae (i) Expectations theory:

1 + nominal countryB interest rate Future spot rate A$/B$ = Spot rate A$/B$ x

1 + nominal countryA interest rate

where: A$/B$ is the number of B$ to each A$, and A$ is the currency of country A and B$ is the currency of country B (ii) Purchasing power parity (law of one price):

1 + countryB inflation rate Future spot rate A$B$ = Spot rate A$/B$ x

1 + countryA inflation rate

(iii) Link between nominal (money) and real interest rates: [1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate] (iv) Equivalent annual cost:

PV of costs over n years Equivalent annual cost =

n year annuity factor

(v) Theoretical ex-rights price:

1 TERP =

N +1

[(N x cum rights price) + issue price]

(vi) Value of a right:

Theoretica l ex rights price − issue price N where N = number of rights required to buy one share.

Financial Strategy

25

March 2011

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March 2011

26

Financial Strategy

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper.

It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE Level 1 KNOWLEDGE What you are expected to know.

Level 2 COMPREHENSION What you are expected to understand.

VERBS USED

DEFINITION

List State Define

Make a list of Express, fully or clearly, the details of/facts of Give the exact meaning of

Describe Distinguish Explain

Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning or purpose of Recognise, establish or select after consideration Use an example to describe or explain something

Identify Illustrate Level 3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate Demonstrate Prepare Reconcile Solve Tabulate

Level 4 ANALYSIS How are you expected to analyse the detail of what you have learned.

Analyse Categorise Compare and contrast

Level 5 EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Financial Strategy

27

Put to practical use Ascertain or reckon mathematically Prove with certainty or to exhibit by practical means Make or get ready for use Make or prove consistent/compatible Find an answer to Arrange in a table

Construct Discuss Interpret Prioritise Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between Build up or compile Examine in detail by argument Translate into intelligible or familiar terms Place in order of priority or sequence for action Create or bring into existence

Advise Evaluate Recommend

Counsel, inform or notify Appraise or assess the value of Advise on a course of action

March 2011

Financial Pillar

Strategic Level Paper

F3 – Financial Strategy

March 2011

Friday Session

March 2011

28

Financial Strategy