F3 May 2012 answers

Strategic Level Paper

F3 – Financial Strategy May 2012 examination

Examiner’s Answers Question One

Rationale This question begins by evaluating the recent financial performance and dividend policy of B. The question then moves on to look at a possible takeover target in order to acquire a number of supermarkets in a new market. Candidates are required to use a discounted cash flow approach to evaluate the potential added value that B could bring to these supermarkets as a result of a rebranding exercise. The question also tests candidates’ ability to identify and evaluate other risks and opportunities arising, concluding with advice on whether or not to proceed with the proposed acquisition and rebranding exercise.

Question One examines syllabus sections A1(b), A2(b) and (c) and C1 (a), (b), (d) and C2(a).

Financial Strategy

1

May 2012

Suggested Approach Part (a)(i) Calculate EPS, P/E ratios and dividend payout ratios for all five years from information in the scenario.

Part (a)(ii) • •

Provide additional calculations of growth in earnings and EPS Discuss key points as shown in the marking scheme

Part (a)(iii) • •

Recognise that the dividend objective has always been met Discuss other key points as shown in the marking scheme

Part (b) Provide a report structure for this part of the question – report heading, an introduction or purpose of report, and suitable sub headings.

Part (b)(i) • •

Provide a suitable layout for the figures (see suggested solutions) Calculate NPV of the 15 stores in A$, converting to EUR at the spot rate given in the question.

Part (b)(ii) • Discuss risks and opportunities of the proposed investment recognising the key points as highlighted in the marking scheme.

• Provide advice to the Board of B on how to proceed.

Requirement (a)(i)

Year 2007 2008 2009 2010 2011

Year 2007 2008 2009 2010 2011

(Given) Earnings (€m) 3,945 2,818 3,097 3,366 3,591

(Given) Number of shares (m) 1,284 1,284 1,350 1,350 1,350

(Given) Dividend per share (€) 1.54 1.54 1.54 1.62 1.65

Financial Strategy

(Calculate) Earnings per share (€) 3.07 2.19 2.29 2.49 2.66

(Calculate) Dividend paid (€m) 1,977 1,977 2,079 2,187 2,228

(Given) Share price (€) 47.38 25.45 28.68 29.44 31.37

(Calculate) P/E ratio 15.4 11.6 12.5 11.8 11.8

(Calculate) Dividend pay-out (as % of earnings) 50% 70% 67% 65% 62%

2

May 2012

Requirement part (a)(ii) Additional relevant calculations: Year

(Given) Earnings (€m)

2007 2008 2009 2010 2011

3,945 2,818 3,097 3,366 3,591

(From part (a)(i) Earnings per share (€) 3.07 2.19 2.29 2.49 2.66

(Calculate) Increase in earnings (29%) 10% 9% 7%

(Calculate) Increase in earnings per share (29%) 5% 9% 7%

General performance – earnings The analysis of earnings shows a major fall in earnings between 2007 and 2008 of 29%. This coincides with the down-turn in the global economy, probably exacerbated by the shortage of credit and large increases in competition in terms of pricing to attract reluctant consumers.

Earnings recovered slightly in 2009, showing a growth in total earnings of 10% but only 5% growth in earnings per share. Annual growth in earnings subsequently fell back to 9% in 2010 and to just 7% in 2011. Indeed, even in 2011, earnings have still not recovered to 2007 levels.

Market reaction – share price and P/E ratio The share price fell from €47.38 at the end of 2007 to €25.45 at the end of 2008 reflecting perhaps a lack of confidence in the future prospects of the group. However, since then the share price has steadily improved and now stands at €31.37. Looking at the P/E ratio we can see that it did indeed drop significantly in 2008 and then bounced back a little in 2009 before returning to its 2008 level in 2010 and 2011. It therefore seems to have stabilised, demonstrating continuing confidence in the future prospects of the group despite continuing difficult trading conditions.

Meeting financial objective re growth in earnings per share of 7% This objective was only met in 2010 and 2011. In 2009, earnings grew by 10% overall but earnings per share only grew by 5% which was, presumably, due to a share issue in that year.

Requirement (a)(iii) In 2008 and 2009, dividend per share was maintained at 2007 levels, despite a major drop in B’s earnings. The rationale for such a policy is likely to be to provide stability to shareholders. Indeed, dividend per share remained constant at €1.54 in 2008 despite falling earnings. A much higher dividend pay-out ratio of 70% (20% above the target of 50%) was required in order to maintain a stable dividend payment and continues to be high. There is, however, a risk attached to such a policy as it significantly reduces the value of funds available for re-investment which could damage long term growth prospects. It also increases the possible need for additional debt finance, which is not necessarily very easy to obtain in a period when credit is in short supply due to the economic downturn and increasing capital requirements for banks.

A steady dividend is usually reassuring to investors. However, in the case of B it has not been sufficient to avoid a large drop in share price in 2008. Overall, therefore, shareholders saw negative returns in 2008 after taking the drop in value of shares into account, despite a consistent dividend.

It is not immediately clear why B paid such a small increase in dividends of just 2% in 2011, but this could be partly to allow the dividend pay-out to begin falling back to pre-2008 levels and become closer to the target level of 50%. Such a policy would also help provide capital for the proposed expansion plans.

Financial Strategy

3

May 2012

Requirement (b) BRIEFING PAPER FOR THE BOARD OF B From: Mr X, Financial Director of B Date:

24 May 2012

Re: Proposed acquisition of Alpha Supermarkets Purpose The purpose of this briefing paper is to provide information regarding the potential financial benefit and other opportunities and also risks associated with the proposed acquisition of Alpha Supermarkets.

Requirement (b)(i) Calculation of added value for an average store: Year

0 A$ m (35.00)

1 A$ m (3.00) 30.00 (13.00)

2 A$ m (3.00) 33.60 (14.04)

3 A$ m 30.00 37.63 (15.16)

Tax Carry forward tax credit

(35.00) 11.20 (11.20)

14.00 (4.48) 4.48

16.56 (5.30) 5.30

52.47 (16.79) 1.42

NCF

(35.00)

14.00

16.56

37.10

Discount factor @ 15% PV

1.000 (35.00)

0.870 12.18

0.756 12.52

0.658 24.41

NPV (A$ million) Spot rate NPV (€ million)

14.11 7.5000 1.88

Investment Revenue Costs

The added value for a single store is therefore estimated at €1.88 million (A$14.11 million) For all 15 stores, this gives a total added value of €28.20 million (= 15 x €1.88 million)

Requirement (b)(ii) Potential Risks and Opportunities: The acquisition of Alpha supermarkets provides a foothold into a new country for B and brings with it both risks and opportunities.

A key point is that the acquisition of Alpha supermarkets on its own is only the first stage and is, in itself, not very material in terms of the size of B Supermarkets. Even if the supermarkets were to lose, say, 50% of their purchase value, this would only create a financial loss for B of the order of €75 million, just 2% of the 2011 annual profit of € 3,591 million. Although significant, this would not have a devastating effect on B.

Financial Strategy

4

May 2012

A major risk however is the potential for damage to B’s reputation if this acquisition goes badly wrong, which could have repercussions for its other markets as well as its future plans for expansion in Asia.

This risk is difficult if not impossible to quantify.

There are other, lesser risks in developing a business in a new country, even though B already has a presence in other parts of Asia. In summary, these could be: • Change of ownership: customers might not be happy with a change of ownership, which is a particular risk as B is a ‘foreign’ owner, and may choose to shop elsewhere.

• Foreign exchange risks. Expansion in the region would bring with it significant exposure to the value of the A$ against the euro, including translation risk (based on the changing value of the net investment in Country A) and actual cash-based transaction and economic risk due to changes in the euro value of remittances to B. • Political risk – how stable is the current government, what is the risk of government intervention in the project, what is the likelihood of future changes in the tax regime?

• There may also be exchange controls, restricting the amount, if any, of profits that can be repatriated or charging tax on such remittances.

• The unfamiliarity of the market brings added risk of failure, reduced to some extent by starting on a small scale by the acquisition of Alpha Supermarkets.

• Competitor risk may also prove to be important. Local companies operating in the same market may unite to attempt to remove B. For example, there might be price wars or intense competition of other forms from local supermarket chains that could threaten the success of the venture.

• Financing risk. Each stage of the expansion will require access to funds to buy stores or set up new ones and rebrand current stores. There is a risk that this funding is not forthcoming when required, either because of creditworthiness issues of B itself (eg high gearing) or lack of willingness or ability of lenders and financial markets to provide sufficient funds.

• Integration risk. Integrating IT systems and management control and reporting systems can cause problems. The co-operation of local staff is essential for success, including a willingness to embrace new systems and corporate culture.

On the other hand, the potential opportunities for future growth in earnings and dividends by further expansion in the region are huge. This supports financial objective 1. The opportunities arise from the follow on options after the acquisition of Alpha Supermarkets.

Advice whether to proceed B Supermarkets is best advised to go ahead with the acquisition of Alpha Supermarkets. The financial return from these 15 stores themselves is not expected to be very large in the short term, but the benefit from these stores over the longer term and, more importantly still, the potential for further growth in the region is so large that this opportunity is well worth pursuing.

This assumes, of course, that B has sufficient resources (staff and financial) to accommodate the implementation and rebranding and systems changes required. It also assumes that local staff are expected to be willing to co-operate with the required changes and there are no other insurmountable challenges to the success of the takeover.

Note that the likelihood of success is enhanced due to the extensive experience that B already has in foreign expansion and the fact that it already has a presence in Asia. _________________________________________________________________________________

Financial Strategy

5

May 2012

Question Two

Rationale This question tests understanding of issues relating to choice of capital structure in terms of balance of equity and debt funding. Calculations are required based on Modigliani and Miller theory with tax and candidates’ understanding of both the meaning and practical relevance of the calculation results is also tested.

Question Two examines syllabus sections B1(b), (c) and (d).

Suggested Approach Part (a)(i) Calculate the value of FF using each of funding structures A, B and C recognising that MM’s formula is required for B and C. Part (a)(ii) Calculate the WACC for each of funding structures A, B and C recognising that MM’s formula is required for B and C. Part (b) • •

Explain the results of your calculations Provide two graphs; one showing that, according to MM, value increases at different levels of borrowing, the other showing that WACC decreases as gearing increases.

Part (c) • •

Provide advice about which financing structure maximises shareholder wealth Briefly explain the limitations of MM’s theory

Requirement (a) Summary Total F$ value WACC

A F$ 440 million 9%

B F$460 million 8.61%

C F$448 million 8.84%

Requirement (a)(i) Workings: Funding structure A Entity Value = Original shareholder value + F$110 million value of the project = F$11 x 30 million shares + F$110 million = F$440 million Funding structure B Entity Value (D + E) = Vu + TB = F$460 million ( = F$440 million + (0.25 x F$ 80 million))

Financial Strategy

6

May 2012

Funding structure C Entity Value (D + E) = Vu +TB = F$448 million (= F$440 million + (0.25 x F$32million)) Requirement (a)(ii) WACC: Funding structure A WACC = keu = 9% Funding structure B WACC = keu(1 – tL) = 9% x (1 – (0.25 x 80/460)) = 8.61% Funding structure C WACC = keu(1 – tL) = 9% x (1 – (0.25 x 32/448)) = 8.84% Requirement (b)

Level of gearing

Level of gearing Under MM (with tax), increasing gearing increases the value of the company due to the tax relief available on debt and nothing else. Given that the value of the debt is determinable then the increase in value associated with the tax shield on the debt will flow to the equity providers and hence increase shareholder wealth.

Also, by introducing debt finance, the overall (weighted average) cost of capital falls. This is because the increasing cost of equity resulting from the additional debt being taken on is more than off-set by the impact of the tax shield on that debt.

Financial Strategy

7

May 2012

Requirement (c) I would advise that FF proceed with funding structure B as it gives the greatest value of shareholder wealth value without creating significant danger of financial distress due to the low gearing level created.

The value of FF and hence also shareholder wealth (since the value of debt remains constant) is increased largely due to the tax benefit in perpetuity that arises from the use of debt financing.

MM’s theory based on a number of assumptions which do not necessarily hold in practice. These assumptions include: • MM ignores the impact of financial distress at very high levels of gearing which will push up the cost of equity (and usually the cost of debt) to such an extent that the WACC will increase.

• MM is also based on unrealistic assumptions about perfect capital markets and perfect information.

However, these considerations are not important here as the level of debt being considered is quite small, being just approximately 20% of the value of the company. _________________________________________________________________________________

Financial Strategy

8

May 2012

Question Three

Rationale Question Three focuses on the short term funding issues of a company that is overtrading. It examines problems arising from declining margins and increasing working capital requirements and how these can best be addressed. It concludes with considering the key issues that might be of particular interest to a potential lender when assessing the creditworthiness of the business in such circumstances.

Question Three examines syllabus sections A2(d) and B1(a) & (e).

Suggested Approach Part (a)(i) • Calculate the value of: accounts receivable; accounts payable; and inventory if working capital days had remained unchanged, • Calculate what the overdraft would have been.

Part (a)(ii) • Calculate profit margin • Calculate working capital cycles • Discuss the key pressures on the components of working capital • Ensure the answer refers to KK Part (a)(iii) Provide recommendations for reducing funds tied up in working capital (Note – no discussion of the financing of WC is required) Part (b) Discuss key factors to assess credit worthiness as shown in the marking guide.

Requirement (a)(i) If working capital days had remained at the level of 31 October 2011 in the six month period to 30 April 2012, we would have expected accounts receivable, accounts payable and inventory days as follows on 30 April 2012: The accounts receivable balance would have been EUR 6.4 million (= (92 days x EUR 12.6 million) divided by the number of days in six months, ie: 182.5 days).

The accounts payable balance would have been EUR 3.6 million (= (69 days x EUR 9.6 million) divided by 182.5 days.

The inventory balance would have been EUR 5.3 million (= (100 days x EUR 9.6 million) divided by 182.5 days.

Therefore, the total investment in working capital at 30 April 2012 would have been EUR 8.1 million (= EUR (6.4 +5.3 – 3.6) million), compared to EUR 9.5 million (= EUR (7.1+5.6-3.2) million). This represents a difference of EUR 1.4 million and would have meant an overdraft balance as at 30 April 2012 of EUR 7.1 million rather than EUR 8.5 million.

Financial Strategy

9

May 2012

Requirement (a) (ii) In times of rapid expansion most businesses will face specific pressures on each of the elements of working capital (that is inventories, accounts receivable and accounts payable) and also on profit margins. Each of these is considered in more detail below Inventory KK’s inventory has increased from EUR 3.9 million on 31 October 2011 to EUR 5.6 million on 30 April 2012. Even without an increase in inventory days, KK would have required EUR 5.3 million of inventories on 30 April 2012, an increase of EUR 1.4 million from 31 October 2011 levels.

The greater the number of different products manufactured and sold the greater the burden on the inventory management systems. In the case of KK the expansion is as a result of new products and so a significant investment in inventories will be required in order to support the increase in sales.

Accounts Receivable KK’s accounts receivable balance has increased from EUR 4.8 million on 31 October 2011 to EUR 7.1 million on 30 April 2012. Even without an increase in accounts receivable days, the 30 April 2012 balance would have been expected to be EUR 6.4 million, an increase of EUR 1.6 million on 31 October 2011 levels.

With the launch of new products, KK is likely to have new business from both new and existing customers. Where additional revenue is from existing customers then there will obviously be an increase in the absolute value of the receivable given the higher volume but, all things being equal, the level of receivable days should stay the same. However, for new customers then potentially there could be additional risk of late payment or bad debt, especially if inadequate creditworthiness checks are made prior to making the sales, as a result of a lack of staffing.

Accounts Payable Expansion will obviously impact on payables, as we see in the case of KK where accounts payable have increased from EUR 2.7 million on 30 October 2011 to EUR 3.2 million on 30 April 2012. The precise impact on the working capital cycle will depend on the credit terms negotiated and taken.

We would have expected an accounts payable balance of the order of EUR 3.6 million on 30 April 2012 due solely to increased cost of sales and assuming accounts payable days remained unchanged. Indeed, KK’s accounts payable days have fallen from 69 days on 31 October 2011 to 61 days on 30 April 2012. This is contrary to what would have been expected from increased cost of sales and so it would appear that there has been some relaxation on paying suppliers and an indication that some suppliers have been paid early.

Pressure on profit margins This is particularly marked in cases where expansion has arisen as a result of a reduction in selling price to improve volumes. In the case of KK, however, this does not seem to be the case. We are told that the expansion has arisen because of the launch of new products. It is entirely possible that the new products are actually able to be sold at a premium to existing prices and therefore the margin could actually have improved. Based on the financial information for KK the gross margin in the six months to 31 October 2011 was 25.3% [(9.5-7.1)/9.5]compared to 23.8% [(12.6-9.6)/12.6]for the six months to 30 April 2012 – therefore indicating that the new business is actually at a potentially lower margin than the existing business.

Impact on employees Another general pressure arising from expansion relates to the impact on employees. If rapid expansion is not backed up with a commensurate increase in credit control resources then it’s highly likely that there will be issues in the management of working capital. Also, additional staff would need to be trained, which takes time. Therefore there could still be short term challenges in the effective management of working capital.

Pressure on overdraft From part (a)(i) we have established that had KK been able to maintain its working capital days through good management then the overdraft would only have grown by EUR 1.1 million, rather than

Financial Strategy

10

May 2012

EUR 2.5 million. In the face of on-going profits, increase in short term funding requirements together with the worsening of working capital days are classic signs of over-trading.

Requirement (a) (iii) It is important to ensure that sound management is in place to manage all aspects of working capital appropriately.

• In terms of inventory management, JIT systems could be set up – although this would require close working with suppliers.

• In terms of receivables management a factoring company could be used to ensure liquidity.

Alternatively a prompt payment discount could be offered to customers – although this would obviously have an impact on margins.

• In terms of payables management the key to minimising the cash impact would be to negotiate an extension of credit terms from suppliers, to the extent that is possible without causing any detrimental effect on the supplier relationship.

Requirement (b) When assessing the creditworthiness of KK, a potential lender will to a large extent be concerned with KK’s future prospects. To that end, the potential lender is likely to consider: •

• •

Any budgets or cash forecasts showing expected growth and its projected impact on profitability and cash flow. If future predictions are detailed, comprehensive and well documented, with sensible assumptions then the potential lender is more likely to extend credit. There may be some suspicion that prices are being dropped to promote sales volumes and that further falls in profit margin could affect the overdraft requirement. It is also important that profit margins are monitored closely and maintained within agreed limits. Note that, if the cost of sales and other costs had been controlled at a 33% increase, the overdraft position would have been improved by a further EUR 0.2 million.

(Workings: The net profit in the 6 months to 31 October 2011 is EUR 0.9 million, therefore a 33% increase would have increased profits to EUR 1.2 million. The actual profit for the 6 months to 30 April 2012 was EUR 1.0 million, a difference of EUR 0.2 million.)

The nature of the new business in terms of its sustainability.

The state of the economy in general and KK’s competitive position within the market place, again to assess the sustainability of the new business and the achievability of the forecasts.

Other factors which will also be considered include: • •

•

• •

The quality of management, both in terms of the success of their past decisions but also in relation to the quality of their forecasts.

The purpose for which the additional overdraft would be used. Given that an overdraft facility is short term finance then it will be important that it is matched to a short term investment – typically to support the fluctuating element of the working capital investment. If the overdraft is planned to be used for capital investment then the bank is unlikely to sanction the increase in overdraft.

The existing capital structure and specifically any loans already outstanding. In particular the bank will need to assess any repayment terms and restrictive covenants on such finance to ensure that either a repayment is not due in the immediate future or that covenants will not be breached.

In addition, the bank will consider short term liquidity measures such as the current or quick ratios and will look to monitor these on a continuous basis.

Lastly, reports from external credit agencies may be sought.

_________________________________________________________________________________

Financial Strategy

11

May 2012

Question Four

Rationale This question focuses on a proposed IT project and tests understanding of how to evaluate such projects. The question includes an investment appraisal computation based on discounted cash flow analysis of project costs. Candidates are also required to consider how best to evaluate and incorporate non-quantifiable benefits in the project appraisal exercise.

Question Four examines syllabus sections C1(a), (c) and C3(a).

Suggested Approach Part (a)(i) • Calculate NPV of the proposed IT project • Show NPV as a loss Part (a)(ii) Calculate additional cash flow requirement using the annuity factor for 4 years at 12% and “grossing” up at 52%.

Part (b)(i) • Discuss appropriateness of the DCF approach to this specific situation.

• Note key point that obtaining a discount rate is especially difficult.

Part (b)(ii) Provide advice on financial and strategic factors PP should consider before deciding whether to proceed.

Requirement (a)(i) DCF of project cash flows excluding possible new business: Year

Initial investment Maintenance costs One off redundancy costs Annual staff cost saving

0 USD '000 (600.0)

1-4 USD '000 (50.0)

(200.0) 100.0

Net Cash flow

(800.0)

50.0

DF at 12% Present value NPV before new business CF

1.000 (800.0) (648.1)

3.037 151.9

Financial Strategy

12

May 2012

Requirement (a)(ii) In order to break even, the PV of the net cash flows from the new business must be equal to USD 648.1k. Assuming that the benefit is spread evenly over the 4 years, we can use a four year annuity factor to estimate the annual cash flows required from new business.

A PV of USD 648.1k is equivalent to an annual net cash inflow of USD 213.4k a year for four years.

(Workings: USD 213.4k = USD 648.1k/3.037 where 3.037 = AF(4, 12%)) In this case, given that the new business is expected to generate a net cash inflows of 52% of new cash inflows, additional annual net cash inflows of USD 213.4k represent additional cash inflows of USD 410.4k a year. (Workings: USD 410.4k = USD 213.4k/52%).

Conclusion: the amount of additional revenue required to break even is USD 410.4k a year.

Requirement (b)(i) Use of conventional DCF approach Benefits: A conventional DCF approach is attractive in that it ensures that all projects are assessed on a similar basis. It can also help avoid the dangers of subjective judgment that is inevitable when ‘softer’ criteria are used in terms of qualitative benefits such as ‘improved information’.

Drawbacks: However, unlike most other types of project, the costs and benefits of IT projects are both tangible and intangible and it can be almost impossible to assign meaningful and valid figures to intangible costs and benefits. In addition, the risks involved in IT projects are difficult to ascertain and so it is not easy to arrive at an appropriate discount rate for use in the evaluation.

Some adjustment for risk is needed in the analysis. One approach would be to adjust the discount rate used in the DCF calculation to reflect the specific risk of such an IT project. An alternative approach would be to calculate the DCF by applying probabilities to different possible outcomes for new business and establishing an expected value. Sensitivity analysis could also be used to analyse the impact on the DCF result of changes in key input variables.

Requirement (b)(ii) Fit with business operational and strategic plans It is important to understand how the IT project fits within the overall strategic plans for the partnership and also how it contributes to meeting targets at the operational level.

IT systems should be treated as a strategic resource like other capital investments. If this particular investment is required as part of the strategic plans of the business, the question is not whether to go ahead but whether this particular system is the one that best meets the partnership’s needs (that is, a qualitative judgment) in the most cost effective manner (that is, a quantitative judgment).

Similarly, the IT investment may be an essential part of an operational plan and therefore there is little choice about whether or not to go ahead with the project. All that can be done is to fine tune it and choose the best system and system development/purchase approach.

Reputation and competitive position PP will clearly be more likely to be successful in generating new business if it has a good reputation in the market place, therefore analysis of market position is important. This is particularly important if PP faces strong competition from businesses operating in the same market.

Financial Strategy

13

May 2012

State of the industry and economic conditions in general The current state of the economy in which PP operates is also relevant, therefore this should also be considered. The partnership will only be successful in generating new business if the market is sufficiently buoyant and there is new business available.

Staffing issues PP needs to be confident that it has staff in place who have the necessary skills and/or experience to be able to successfully operate the new system. Suitable training should be arranged if required.

Conclusion In conclusion, analysis is required of the needs of the business, both at strategic and operational level, and whether or not the proposed IT system meets those needs. DCF analysis may therefore be of secondary importance if the project is essential to the successful development of the underlying business. Further analysis and market surveys may also be useful in pinning down likely new business levels more accurately. Finally, staffing issues need to be considered to ensure that staff have adequate skills and training required to both maintain and use the new system. ________________________________________________________________________________

Financial Strategy

14

May 2012