Financial Pillar
F3 – Financial Strategy 4 September 2010 – Saturday 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 open the answer book and start writing or use your calculator during this 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 6. 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 2010
F3 – Financial Strategy
You are allowed three hours to answer this question paper.
Aybe Pre-seen Case Study Background Aybe, located in Country C, was formed by the merger of two companies in 2001. It is a listed company which manufactures, markets and distributes a large range of components throughout Europe and the United States of America. Aybe employs approximately 700 people at its three factories in Eastern Europe and supplies products to over 0·5 million customers in 20 countries. Aybe holds stocks of about 100,000 different electronic components. Aybe is regarded within its industry as being a well-established business. Company Ay had operated successfully for nearly 17 years before its merger with Company Be. Company Ay can therefore trace its history back for 25 years which is a long time in the fast moving electronic component business. The company is organised into three divisions, the Domestic Electronic Components division (DEC), the Industrial Electronic Components division (IEC) and the Specialist Components division (SC). The Domestic and Industrial Electronic Components divisions supply standard electronic components for domestic and industrial use whereas the Specialist Components division supplies components which are often unique and made to specific customer requirements. Each of the three divisions has its own factory in Country C. Composition of the Board of Directors The Board of Directors has three executive directors, the Company Secretary and five nonexecutive directors. The Chairman is one of the five independent non-executive directors. The executive directors are the Chief Executive, Finance Director and Director of Operations. There is also an Audit Committee, a Remuneration Committee and a Nominations Committee. All three committees are made up entirely of the non-executive directors. Organisational structure Aybe is organised along traditional functional/unitary lines. The Board considers continuity to be a very important value. The present structure was established by Company Ay in 1990 and continued after the merger with Company Be. Many of Aybe’s competitors have carried out structural reorganisations since then. In 2008, Aybe commissioned a review of its organisational structure from a human resource consultancy. The consultants suggested alternative structures which they thought Aybe could employ to its advantage. However, Aybe’s Board felt that continuity was more important and no change to the organisational structure took place. Product and service delivery Customers are increasingly seeking assistance from their component suppliers with the design of their products and the associated manufacturing and assembly processes. Aybe’s Board views this as a growth area. The Board has recognised that Aybe needs to develop web-based services and tools which can be accessed by customers. The traditional method of listing the company’s range of components in a catalogue is becoming less effective because customers are increasingly seeking specially designed custom made components as the electronics industry becomes more sophisticated.
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Financial data Aybe’s historical financial record, denominated in C’s currency of C$, over the last five years is shown below.
Year ended 31 December: 2009 2008 2007 C$m C$m C$m 620 600 475 41 39 35 23 21 16
Revenue Operating profit Profit for the year
Earnings per share (C$) Dividend per share (C$)
0·128 0·064
0·117 0·058
0·089 0
2006 C$m 433 20 9
2005 C$m 360 13 5
0·050 0
0·028 0
Extracts from the 2009 financial statements are given at Appendix A. There are currently 180 million ordinary shares in issue with a nominal value of C$0·10 each. The share price at 31 December 2009 was C$0·64. No dividend was paid in the three years 2005 to 2007 due to losses sustained in the first few years after the merger in 2001. Aybe’s bank has imposed an overdraft limit of C$10 million and two covenants: (i) that its interest cover must not fall below 5 and (ii) its ratio of non-current liabilities to equity must not increase beyond 0·75:1. Aybe’s Finance Director is comfortable with this overdraft limit and the two covenants. The ordinary shareholding of Aybe is broken down as follows:
Institutional investors Executive Directors and Company Secretary Employees Individual investors
Percentage of ordinary shares held at 31 December 2009 55 10 5 30
The Executive Directors, Company Secretary and other senior managers are entitled to take part in an Executive Share Option Scheme offered by Aybe. Performance Review Aybe’s three divisions have been profitable throughout the last five years. The revenue and operating profit of the three divisions of Aybe for 2009 were as follows:
Revenue Operating profit
DEC Division C$m 212 14
IEC Division C$m 284 16
SC Division C$m 124 11
Financial objectives of Aybe The Board has generally taken a cautious approach to providing strategic direction for the company. Most board members feel that this has been appropriate because the company was unprofitable for the three year period after the merger and needed to be turned around. Also, most board members think a cautious approach has been justified given the constrained economic circumstances which have affected Aybe’s markets since 2008. While shareholders have been disappointed with Aybe’s performance over the last five years, they have remained loyal and supported the Board in its attempts to move the company into profit. The institutional shareholders however are now looking for increased growth and profitability. TURN OVER Financial Strategy
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The Board has set the following financial objectives which it considers reflect the caution for which Aybe is well known: (i) (ii)
Dividend payout to remain at 50% of profit for the year; No further equity shares to be issued over the next five years in order to avoid diluting earnings per share.
Capital budget overspends Aybe has an internal audit department. The Chief Internal Auditor, who leads this department, reports directly to the Finance Director. Investigation by the Internal Audit department has revealed that managers with responsibility for capital expenditure have often paid little attention to expenditure authorisation levels approved by the Board. They have justified overspending on the grounds that the original budgets were inadequate and in order not to jeopardise the capital projects, the overspends were necessary. An example of this was the building of an extension to the main factory at the DEC division that was completed in 2009 at a final cost of nearly C$3 million which was almost 50% over budget. The capital budget for the extension was set at the outset and the capital investment appraisal showed a positive net present value. It subsequently became apparent that the site clearance costs and on-going construction expenditure were under-estimated. These estimates were provided by a qualified quantity surveyor who was a contractor to Aybe. The estimates supplied by the quantity surveyor were accurately included in Aybe’s capital investment appraisal system which was performed on a spreadsheet. However, no regular checks were carried out to compare the phased budgeted expenditure with actual costs incurred. It came as a surprise to the Board when the Finance Director finally produced the capital expenditure project report which showed the cost of the extension was nearly 50% overspent. Strategic development Aybe applies a traditional rational model in carrying out its strategic planning process. This encompasses an annual exercise to review the previous plan, creation of a revenue and capital budget for the next five years and instruction to managers within Aybe to maintain their expenditure within the budget limits approved by the Board. Debates have taken place within the Board regarding the strategic direction in which Aybe should move. Most board members are generally satisfied that Aybe has been turned around over the last five years and were pleased that the company increased its profit in 2009 even though the global economy slowed down. Aybe benefited from a number of long-term contractual arrangements with customers throughout 2009 which were agreed in previous years. However, many of these are not being renewed due to the current economic climate. The Board stated in its annual report, published in March 2010, that the overall strategic aim of the company is to: “Achieve growth and increase shareholder returns by continuing to produce and distribute high quality electronic components and develop our international presence through expansion into new overseas markets.” Aybe’s Chief Executive said in the annual report that the strategic aim is clear and straightforward. He said “Aybe will strive to maintain its share of the electronic development, operational, maintenance and repair markets in which it is engaged. This is despite the global economic difficulties which Aybe, along with its competitors, has faced since 2008. Aybe will continue to apply the highest ethical standards in its business activities.”
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In order to facilitate the achievement of the strategic aim, Aybe’s Board has established the following strategic goals: 1. 2. 3. 4.
Enhance the provision of products and services which are demanded by customers; Invest in engineering and web-based support for customers; Maintain the search for environmentally friendly products; Pursue options for expansion into new overseas markets.
The Board has also stated that Aybe is a responsible corporate organisation and recognises the social and environmental effects of its operational activities. Concern over the rate of growth Aybe’s recently appointed Director of Operations and one of its Non-Executive Directors have privately expressed their concern to the Chief Executive at what they perceive to be the very slow growth of the company. While they accept that shareholder expectations should not be raised too high, they feel that the Board is not providing sufficient impetus to move the company forward. They fear that the results for 2010 will be worse than for 2009. They think that Aybe should be much more ambitious and fear that the institutional shareholders in particular, will not remain patient if Aybe does not create stronger earnings growth than has previously been achieved. Development approaches The Board has discussed different ways of expanding overseas in order to meet the overall strategic aim. It has, in the past, been reluctant to move from the current approach of exporting components. However the Director of Operations has now begun preparing a plan for the IEC division to open up a trading company in Asia. The DEC division is also establishing a subsidiary in Africa.
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APPENDIX A Extracts of Aybe’s Income Statement and Statement of Financial Position Income statement for the year ended 31 December 2009 2009 C$million 620 (579) ( 4) 37 ( 14) 23
Revenue Operating costs Finance costs Profit before tax Income tax expense PROFIT FOR THE YEAR Statement of financial position as at 31 December 2009
2009 C$million ASSETS Non-current assets
111
Current assets Inventories Trade and other receivables Cash and cash equivalents Total current assets Total assets
40 81 3 124 235
EQUITY AND LIABILITIES Equity Share capital Share premium Other reserves Retained earnings Total equity
18 9 8 75 110
Non-current liabilities Bank loan (8% interest, repayable 2015)
40
Current liabilities Trade and other payables Current tax payable Bank overdraft Total current liabilities Total liabilities Total equity and liabilities
73 8 4 85 125 235
End of Pre-seen Material The unseen material begins on page 8
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SECTION A – 50 MARKS [Note: the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION Question One Unseen material for Case Study Background Today’s date is 04 September 2010. The Specialist Components division (SC) of Aybe has been considering various alternative opportunities for expansion and has recently identified NN, a company operating in Europe, as a possible acquisition candidate. NN manufactures a relatively new product line that can be tailored to meet the specific needs of individual customers. This business model has, so far, proved to be highly successful. In many respects, it is considered to be a good ‘fit’ with SC’s business and it is considered that many of SC’s customers may be interested in NN’s products. At present SC has an average year-on-year growth in profit after tax of 3% whereas NN’s profit after tax is forecast to grow at a rate of 8% a year for the next 3 years and then at a steady rate of 3% in subsequent years. Should the acquisition go ahead, SC expects to achieve synergistic benefits that will result in an increase in NN’s current estimate for a year-on year growth in profits from 8% a year to a growth rate of 14% a year in each of the next 3 years. Growth would then revert to a steady state of 3% a year for year 4 onwards. The additional growth would be largely achieved by improved access to non-European markets for NN’s products. However, there are also expected to be exceptional one-off up-front costs arising from the integration of the two businesses in euro (EUR) of approximately EUR2.5million (that have no impact on the underlying operating profit). NN NN is privately owned. It has been trading for five years and has seen rapid growth in its reported profits. However, the cash flows are lagging behind the growth in profits. NN has four founding Directors, each of whom owns 20% of the company. The other 20% of the share capital is owned by a variety of small investors. The Directors are looking for ways to realise their investment and have expressed an interest in selling the company to Aybe. They have the backing of the minority shareholders. The Directors would be prepared to work for the SC division of Aybe if sufficiently attractive terms of employment were offered. Extracts from the latest annual financial statements for NN are as follows: Income statement for NN for the year ended 31 December 2009 EURmillion 40 (20) (4) 16 (6) 10
Revenue Operating costs Finance costs Profit before tax Income tax expense PROFIT FOR THE YEAR
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Statement of financial position for NN as at 31 December 2009 ASSETS Non-current assets Inventories and receivables Cash and cash equivalents Total assets
EURmillion 72 15 3 90
EQUITY AND LIABILITIES Share capital Retained earnings Non-current liabilities (bank borrowings at floating rate) Current liabilities Total equity and liabilities
5 30 45 10 90
Latest estimates for the year ending 31 December 2010 show profit for the year of EUR11million. Being a privately-owned company, there is no share price available for NN. However, a 5% parcel of shares was sold by private arrangement for EUR3million six months ago. A similar sized company to NN in the same market, QQ, has been identified for use as a proxy company for the purpose of valuing NN. QQ has a P/E ratio of 9, an equity beta of 1.7 and the same gearing as NN. QQ is, however, a somewhat more mature company than NN and has largely passed the early days of extraordinary returns and high risk. It is therefore considered appropriate to increase QQ’s cost of equity by a factor of 15% in order to arrive at an appropriate cost of equity for NN. (For example, a discount rate of 10% for QQ would be increased to 11.5% for NN). Debt beta can be assumed to be zero, the risk-free market rate is 2% and the market premium above the risk free rate is 6%. Pricing the bid The Finance Director of Aybe, Director A, has suggested that an initial offer of EUR75million should be made for the acquisition of NN for transfer of ownership on 01 January 2011. The acquisition would be funded by either issuing bonds or arranging bank borrowings. It is not yet clear whether the debt would be denominated in C$ or in EUR. The present bank borrowings of NN are subject to a bank covenant that would require the borrowings to be repaid as part of any acquisition agreement. In addition, Aybe’s current borrowings are subject to the following two bank covenants: (i) interest cover must not fall below 5 and (ii) the ratio of non-current liabilities to equity must not increase beyond 0·75:1 (based on market values of equity). Additional information: • The spot exchange rate is expected to be C$/EUR3.000 (C$1 = EUR3.000) on 01 January 2011 and the euro is expected to weaken against the C$ at approximately 3% a year thereafter. • Corporate tax is payable by both Aybe and NN at 30% for the year 2010 onwards and there is a double tax treaty in place under which no additional tax would be payable by Aybe on profits generated by NN. • On 01 January 2011, Aybe’s share price and non-current liabilities are forecast to be C$0.70 and C$45million respectively. The number of shares in issue is expected to remain unchanged at 180million shares.
The requirement for Question One is on page 11 which is detachable for ease of reference TURN OVER
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Required: (a)
(i)
Calculate a range of values for NN as at 01 January 2011 using: • The price achieved in the recent sale of a 5% parcel of shares. • P/E basis. • Discounted cash flow basis, ignoring potential synergistic benefits and integration costs. (11 marks)
(ii) Explain briefly the suitability of each method used in part (a)(i). (6 marks)
(b)
Assume you are an external consultant engaged by Aybe to evaluate the proposed acquisition of NN. Write a report, suitable for presentation to the Directors of Aybe, in which you: (i)
Evaluate the proposed initial offer price of EUR75million from the viewpoint of both the shareholders of NN and the shareholders of Aybe, concluding with advice on an appropriate adjusted offer price. (11 marks)
(ii)
Discuss the potential problems and issues that could arise from the integration of NN into the SC Division of Aybe. (7 marks)
(iii) Advise on issues that affect the choice of debt finance (bonds or bank borrowings, C$ or EUR), including their potential impact on Aybe’s bank covenants. (12 marks) Additional marks available for structure and presentation.
(3 marks)
(Total for Question One = 50 marks)
(Total for Section A = 50 marks)
End of Section A Section B starts on page 14
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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 [Note: the indicative time for answering this section is 90 minutes] ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH Question Two EM is a manufacturer of high value electronic equipment based in Country A in Asia. It has 285million shares in issue, which are, today, trading at A$15.65. EM is currently all-equity financed. It is proposing to invest in equipment for a new production line that will be introduced in 2011. The cost of the new equipment is A$360million and payment is due on 01 January 2011. The equipment is expected to have a useful life of four years and have negligible value at the end of the four years. The investment appraisal has shown a positive NPV using the company’s weighted average cost of capital. EM is considering three alternative methods of financing the purchase of the equipment. Alternative1 Purchase outright and fund with bank borrowings at an annual cost of 5.0% (after-tax). Interest payments would be made at the end of each year. Tax depreciation allowances would be available to EM on the cost of the equipment at a rate of 100% in the first year. Alternative 2 Take out a finance lease with a local finance house. The lease would have a four year term and ownership of the equipment would pass to EM at the end of the lease period without additional payment. Lease rentals would be A$105million per annum, payable at the end of each year. Tax relief would be available on the accounting depreciation plus the interest implicit in the lease rentals. Alternative 3 Purchase outright and undertake a rights issue at a discount of 15% on today’s share price. Other relevant information EM pays corporate tax at a marginal rate of 20% and tax is payable one year in arrears.
The requirement for Question Two is on the opposite page
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Required: Assume you work in the Treasury Department of EM.
(a)
Describe the role of the Treasury Department in the management of funding for major investments, making specific reference to the three alternative financing methods under consideration. (7 marks)
(b)
Advise the Finance Director on the appropriateness of each of the THREE proposed alternative methods of finance and recommend which, if any, should be chosen. In your answer, include a calculation of whether the outright purchase funded by bank borrowings or the finance lease is expected to be the cheaper source of debt funding. (18 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 MR is a large retail chain of retail stores operating in the USA. It sells top-of the-range, expensive clothes to a wealthy clientele throughout the country. Currently, MR only operates in the USA. Its current market capitalisation is US$760million and the current market value of debt is US$350million. At last month’s management meeting the marketing director explained that sales volume had increased slightly in the previous year, largely due to heavy discounting in most of its stores. The finance director expressed concern that such a strategy might damage the image of the company and reduce profits over the longer term. An alternative strategy to increase sales volume has recently been proposed by the marketing department. This would involve introducing a new range of clothing specifically aimed at the middle-income market. The new range of clothing would be expected to be attractive to consumers in Canada and Europe, giving the possibility of opening stores in Canada and possibly Europe in the longer term. Assume you are a financial manager with MR and have been asked to evaluate the marketing department’s proposal to introduce a new range of clothing. An initial investigation into the potential markets has been undertaken by a firm of consultants at a cost of US$100,000 but this amount has not yet been paid. It is intended to settle the amount due in three months’ time. With the help of a small multi-department team of staff you have estimated the following cash flows for the proposed project: • • • •
The initial investment required would be US$46million, payable on 01 January 2011. This comprises US$30million for non-current assets and US$16million for net current assets (working capital). For accounting purposes, non-current assets are depreciated on a straight line basis over three years after allowing for a residual value of 10%. Tax depreciation allowances can be assumed to be the same as accounting depreciation. The value of net current assets at the end of the evaluation period can be assumed to be the same as at the start of the period. Net operating cash flows (before taxation) are forecast to be US$14million in 2011, US$17million in 2012 and US$22million in 2013 and should be assumed to arise at the end of each year.
The following information is also relevant: • • • • •
The proposed project is to be evaluated over a three-year time horizon. MR usually evaluates its investments using a after-tax discount rate of 8%. The proposed project is considered to be riskier than average and so a risk-adjusted rate of 9% will be used for this project. Corporate tax is payable at 25% in the same year in which the liability arises. MR would need to borrow 50% of the initial investment cost . Ignore inflation.
MR’s primary financial objectives are: 1.
To earn a return on shareholders’ funds (based on market values) of 11% per annum on average over a three- year period.
2.
To keep its gearing ratio, (debt to debt plus equity based on market values), at below 35%.
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Required: (a) (i)
Calculate the net present value (NPV), internal rate of return (IRR) and (approximate) modified internal rate of return (MIRR) as at 01 January 2011 for the proposed project. (13 marks)
(ii)
Discuss the advantages and limitations of MIRR in comparison with NPV and IRR. (6 marks)
(b)
Evaluate the likely impact of the project on MR’s ability to meet its financial objectives assuming the project goes ahead. (6 marks) (Total for Question Three = 25 marks)
A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION
Section B continues on the next page
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Question Four Blue Blue is a multinational furniture retailer listed on its local stock exchange. It has experienced rapid growth in recent years, partly via acquisitions and partly by generic growth. A substantial proportion of the shareholders are institutional investors but there is also a significant proportion of shares held by private individuals. Blue follows a conservative dividend policy, paying a relatively low dividend with a small but steady growth in dividend levels. This has led to the accumulation of surplus funds. Mr B, a director of a major institutional shareholder of Blue, has recently requested that surplus funds be returned to shareholders. The Directors of Blue are currently considering this request. Green Green is a privately-owned, family-run small furniture retail chain with just 10 shareholders. Historically, Green’s dividend payouts have varied considerably year-on-year. Recent payouts have been between 10% and 50% of profit for the year, largely depending on investment opportunities available. In the current year, the shareholders have not been able to agree on an appropriate level of dividend. Mr G, one of the shareholders, is planning a major extension on his house and has requested a large dividend payment. However, the other shareholders wish to retain cash within the company for investment in future projects. Both Blue and Green have the primary financial objective of maximising shareholder value.
Required: (a)
Discuss the rationale behind both Blue and Green’s dividend policies and why a listed company such as Blue can be expected to have a different dividend policy to that of a private company such as Green. (9 marks)
(b)
Explain Modigliani & Miller’s dividend irrelevancy theory and its practical relevance to both Blue and Green in seeking to maximise shareholder value. (8 marks)
(c)
Advise the Directors of Blue and the Directors of Green on an appropriate response to each of Mr B and Mr G’s requests. (8 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 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
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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
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FORMULAE Valuation models (i)
Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the exdiv value:
d P0 =
k pref (ii)
Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 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 P 0 is the ex-div value: d1
P0 = ke
(iv)
or
−g
P0 =
d 0 [1 + g ] ke
−g
Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P 0 is the ex-interest value: P0 =
i [1 − t ] k d net
P0 =
or, without tax:
i kd
(v)
Total value of the geared entity, V g (based on MM):
V g = V u + TB (vi)
Future value of S, of a sum X, invested for n periods, compounded at r% interest: n
S = X[1 + r] (vii)
Present value of 1⋅00 payable or receivable in n years, discounted at r% per annum: PV =
(viii)
[1 + r ]
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
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: PV =
1 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: PV =
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1 r −g
September 2010
Cost of capital (i)
Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : d
k pref =
P0
(ii)
Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price P 0 :
k d 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 P 0 :
ke =
d P0
(iv)
Cost of ordinary (equity) shares, having a current ex-div price, P 0 , having just paid a dividend, d 0 , 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: k e = R f + [R m – R f ]ß
(vi)
Cost of ordinary (equity) share capital in a geared entity :
k eg = k eu + [k eu – k d ] (vii)
Weighted average cost of capital, k 0 or WACC
WACC = k e (viii)
VE VD + k d [1 − t ] VE + VD VE + VD
Adjusted cost of capital (MM formula):
K adj = k eu [1 – tL]
(ix)
or
VD [1 − t ] VE V + V [1 − t ] + ß d E VE + VD [1 − t ] D
Regear ß:
ß g = ß u + [ß u – ß d ]
(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$
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Spot rate A$/B$
September 2010
Other formulae (i) Expectations theory: Future spot rate A$/B$ = Spot rate A$/B$ x
1 + nominal countryB interest rate 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): Future spot rate A$B$ = Spot rate A$/B$ x
1 + countryB inflation rate 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: Equivalent annual cost =
PV of costs over n years n year annuity factor
(v) Theoretical ex-rights price: TERP =
1 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.
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September 2010
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September 2010
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.
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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
September 2010
Financial Pillar
Strategic Level Paper
F3 – Financial Strategy
September 2010
Saturday
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September 2010