May 2008 Examinations

Strategic Level

Paper P9 – Management Accounting – Financial Strategy

Question Paper 2

Examiner’s Brief Guide to the Paper 18

Examiner’s Answers 20

The answers published here have been written by the Examiner and should provide a helpful
guide for both tutors and students.

Published separately on the CIMA website (www.cimaglobal.com/students) from mid-September

is a Post Examination Guide for the paper which provides much valuable and complementary
material including indicative mark information.

© The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
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 Financial Management Pillar
Strategic Level Paper
P9 – Management Accounting –
Financial Strategy

P9 – Financial Strategy
21 May 2008 – Wednesday Morning Session
Instructions to candidates

You are allowed three hours to answer this question paper.

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 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 sub-
questions). The question requirements are highlighted in a dotted box.

ALL answers must be written in the answer book. Answers or notes written
on the question paper will not be submitted for marking.

Answer the ONE compulsory question in Section A on pages 2 to 5. The

question requirements are on page 5, which is detachable for ease of
reference.

Answer TWO of the four questions in Section B on pages 8 to 14.

Maths Tables and Formulae are provided on pages 17 to 21. These pages
are detachable for ease of reference.

The list of verbs as published in the syllabus is given for reference on the
inside back cover of this question paper.

Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.

Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.

© The Chartered Institute of Management Accountants 2008

SECTION A – 50 MARKS
[the indicative time for answering this Section is 90 minutes]

ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON

PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE

Question One

Background and organisational structure

Ancona International is an international advertising agency. Its shares are listed on the London
Stock Exchange. Its revenue has doubled on average every four years over the past 16 years,
which is satisfactory but unspectacular by industry standards. Its growth has come largely from
focusing on providing high quality services and advertising products to existing clientele; its
“churn” rate (the rate at which an entity replaces old customers with new ones) is low and it
enjoys considerable customer loyalty. The majority of new business comes from referrals by
existing customers. Ancona International usually does not bid for highly competitive, large
contracts which involve very high investment costs and which, generally, have only modest
chances of success.

The entity has its headquarters in the UK. Operations in other countries are established as
wholly-owned subsidiaries. Because of its international interests Ancona International prepares
its consolidated accounts in US$.

Proposals
The new Vice President of the USA subsidiary, Ancona USA, is Mr de Z. He does not agree
with the entity’s policy of growth through existing business and “word of mouth”. He wants to be
able to tender for major advertising contracts with leading USA entities. These tenders are,
typically, fiercely competitive and require substantial management time and effort to prepare.

The Chief Executive Officer (CEO) of Ancona International thinks such a move would change
the risk profile of the entity, although he recognises the merit of Mr de Z’s proposal. After much
discussion between the main board and the management of Ancona USA a proposal has been
made to allow Mr de Z and his fellow managers and other employees to take over the USA
business. This proposal would require shareholder approval, but Ancona International’s CEO is
confident he would get the support of most of, if not all, the institutional investors who account
for 80% of the entity’s shareholders.

Financial Information
Balance sheets at 31 March 2008 for Ancona International and its wholly-owned US subsidiary
are shown below:
All figures are in US$ millions Ancona International Ancona USA
(Group consolidated accounts)
Non-current assets 3,975 340
Current assets 550 95
Total assets 4,525 435

Equity
Common shares of US$1 350 5
Retained earnings 1,750 170
Total equity 2,100 175

Non-current liabilities
Secured 8% bonds repayable 2025 2,050
Undated borrowings from parent at variable rate 200
Current liabilities 375 60
Total liabilities 2,425 260

Total equity and liabilities 4,525 435

Note:
• Ancona International’s bonds are secured on its non-current assets.
• Figures for Ancona International include those for Ancona USA.

May 2008 2 P9
After-tax earnings for Ancona International for the year ended 31 March 2008 were US$680
million. This included earnings from the US operation of US$102 million. Ancona International’s
share price is currently US$18. Its debt is trading at par.

If Mr de Z’s proposal goes ahead, a new entity will be established to acquire the USA interests
of Ancona International to be named Zola Agencies Inc.

Forecast net cash flows for Ancona USA as part of Ancona International and as a separate
entity for the next five years have been prepared by the Finance Department at Ancona
International and are shown below:
All figures are in US$ millions Ancona USA Zola Agencies
(USA operation based (USA operation as
on current policies) a separate entity)
31 March 2009 2010 2011-13 2009 2010 2011-13
After-tax net cash flows 118 131 210 138 172 250
(assume = earnings)
Notes:
• These forecasts are in nominal terms.
• The 2011-2013 cash flows are assumed to remain constant in nominal terms each year.
• Cash flows beyond 2013 are considered too uncertain and have been ignored.
Other financial information
• Ancona International’s weighted average after-tax cost of capital is 12% nominal
compared with an industry average of 13%. The entity with policies and risk profile most
similar to those proposed for Zola Agencies is financed 100% equity and has a quoted
equity beta of 2⋅5.
• The risk free rate in the USA is currently 5% and the return on the market 9%. These
rates are not expected to change in the foreseeable future.
• Corporate taxes are payable at 30% in the year in which the liability arises.

Assume that the directors and management of Ancona International and the proposed Zola
Agencies have access to the same forecasts.

Financing of the deal

Information about two financing alternatives is shown below.

Alternative 1 Introduce a private equity investor

An investor has been identified, PE Capital. This entity will provide up to 95% of the capital
required. It expects a return on its investment averaging 30% per annum compound by
31 March 2013. Its most likely exit route will be by initial public offering (IPO). PE Capital has
two conditions: a director of PE sits on the board of Zola Agencies, and all earnings are to be
retained in the business for five years. Mr de Z and his colleagues are able to fund 5% of the
equity required.

Alternative 2 Obtain a consortium of funding of equity plus debt

DW bank, an investment bank based in Europe, has expressed interest in providing debt
finance of up to 75% of the capital requirement. This will be a complex structure combining
secured and unsecured borrowing and equity warrants, as follows:

$US250 million in euro debt secured on Zola Agencies current and non-current assets. The
interest rate will be 10% and the principal repayable in five years’ time. The balance of debt
required will be by unsecured borrowings at a variable rate, which currently would be 11%, with
equity warrants attached. The terms and conditions of the warrants have not yet been agreed.

Mr de Z and his colleagues will provide 5% of the total funding required as equity, as in
Alternative 1. They believe they can raise the additional 20% from a consortium of private
investors, mainly friends and business associates, who would require a regular dividend of at
least 20% of earnings.

May 2008 3 P9
 Requirements

(a)
(i) Calculate the present value of the forecast cash flows for Ancona USA, both as
part of Ancona International, and as a separate entity (Zola Agencies), based on
the information in the scenario and using discount rates that you consider
appropriate. Assume in your calculations:
• Finance for a separate US entity will be all-equity;
• You are conducting the valuations on 1 April 2008;
• Cash flows occur on 31 March each year.
(5 marks)

(ii) Discuss briefly your choice of discount rates and explain any reasons why they
might not be accurate. Support your explanation with additional calculations where
necessary.
(4 marks)
(b)
Assume you are an independent financial adviser retained by Ancona International to
advise on the sale of its USA operations. Write a report to the directors of Ancona
International that:

(i) Evaluates the interests of the various stakeholder groups in both Ancona
International and Ancona USA and how they might be affected by the sale of the
USA operations.
(7 marks)

(ii) Evaluates the economic and market factors that might impact on the negotiations
between Ancona International and Mr de Z.
(7 marks)

(iii) Recommends, with reasons, an appropriate valuation for the Ancona USA
operations. You should provide a range of values on which to base your
discussion, including the values calculated in part (a).
(8 marks)

(c)
Ancona International and Mr de Z eventually agree a purchase value of US$650 million
and 50 million shares are issued by Zola Agencies.

(i) Calculate:
• The value that would need to be placed on Zola Agencies at 31 March 2013 if
financing is as Alternative 1, and PE Capital is to receive its required return;
• The impact on earnings and earnings per share for the years ending 31 March
2009 and 2013 under Alternative 2.
(7 marks)
(ii) Evaluate the advantages and disadvantages of the two alternative methods of
finance being considered by Mr de Z and recommend the most appropriate source
in the circumstances. Provide additional calculations where necessary.
(9 marks)

Additional marks for structure and presentation for all of Question One (3 marks)
(Total for Question One = 50 marks)

May 2008 4 P9
SECTION B – 50 MARKS
[the indicative time for answering this Section is 90 minutes]

ANSWER TWO ONLY OF THE FOUR QUESTIONS

Question Two

You are a financial adviser working for a large financial institution. One of your clients, Dan, has
a portfolio currently worth £100,000. He has invested in good quality stocks that are spread
over diversified industries with an average beta of 1⋅2; a risk profile he is happy with. He holds
other assets, such as property and bank deposits, worth approximately £150,000 (excluding his
own home, on which he has a 75% mortgage).

He has recently inherited £40,000 which he intends to invest in equities. He has done some
research himself and is considering investing in the following entities in equal proportions.

Entity A is a large, listed entity in a mature industry. Dan already has 15% of his equity
investments in this industry sector.

Entity B is a relatively small entity whose shares have been listed on the UK’s Alternative
Investment Market for the past three years. Its main area of operations is bio-technology, a
sector in which Dan has no investments.

Market data for the shares of the two entities are as follows:

Entity Current share prices Beta P/E ratio

(buy price)
A 250 pence cum rights 1⋅1 10
B 500 pence cum dividend n/a * 20

* Your financial institution estimates a return of 15⋅8% is required on this stock.

Your transaction charges will be 2⋅5% of the capital amount.

Financial strategies of the two entities

Entity A is planning a rights issue. The terms will be 1 new share for every 4 held at a cost of
200 pence.

Entity B will allow investors registered at 30 June 2008 the option of taking a dividend of
45 pence a share or a scrip dividend of 1 share for every 10 shares held.

The policy of Entity B has been to offer scrip dividends as an alternative to cash dividends since
its shares were first listed three years ago.

The risk free rate is 5% and the return on the market is 11%. These rates are not expected to
change in the foreseeable future.

May 2008 5 P9
 Required:

(a) Calculate the risk and expected return of Dan’s equity investment portfolio if he
goes ahead with his proposed investments. Work to a maximum of 2 decimal
points in your calculations.
(5 marks)

(b)
(i) Explain the difference between systematic risk (or market risk) and unsystematic
risk (or specific risk) and, briefly, the meaning of beta and how it is measured.
(4 marks)

(ii) Discuss how and to what extent the beta of Entity A and the implied beta of Entity
B:
• Might affect Dan’s investment decision;
• Could be of interest to the directors of single entities such as A and B.

(6 marks)

(Total for Part (b) = 10 marks)

(c) Evaluate the implications for shareholder value of Entity A’s and Entity B’s
proposed financial strategies and advise Dan on how these strategies might affect
his investment decisions. Include appropriate calculations.
(10 marks)
(Including up to 6 marks for calculations)

(Total for Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION

Section B continues on the next page

May 2008 6 P9
Question Three

BEN is a large, listed entity based in a country in the eurozone. Its principal activity is the
manufacture and distribution of electrical consumer goods. Manufacturing operations are
located in the home country but goods are sold to wholesalers worldwide, priced in the
customer’s local currency. The group has experienced rapid growth in recent years and many
of its IS/IT systems need upgrading to handle larger volumes and increased complexity.

Group treasury is centralised at the head office and its key responsibilities include arranging
sufficient long-term and short-term liquidity resources for the group and hedging foreign
exchange exposures.

One of the first projects is a replacement treasury management system (TMS) to provide an
integrated IS/IT system. The new integrated TMS will record all treasury transactions and
provide information for the management and control of the treasury operations. It replaces the
current system which consists of a series of spreadsheets for each part of the treasury
operations.

BEN is considering the following choice of payment methods for the new integrated TMS:

Method 1
• Pay the whole capital cost of €800,000 on 1 July 2008, funded by bank borrowings.
• Pay on-going consultation and maintenance costs annually in arrears; these costs will
depend on the actual time spent supporting the system each year but are expected to be
of the order of €60,000 in the first year and, on average, to increase by 5% a year due to
inflation.
• The system is expected to have no resale value after five years although it could still be
usable within the entity.

Method 2
• Enter into an operating lease with the supplier, paying a fixed amount of €250,000 a year
in advance, commencing 1 July 2008, for five years. This fee will include consultation and
maintenance.
• At the end of five years there is an option to continue the lease agreement for a further
three years, paying for maintenance on a time and materials basis. This has not been
costed.

Other information
• BEN can borrow for a period of five years at a gross fixed interest rate of 8% a year.
• The entity is liable to tax at a marginal rate of 25%, payable 12 months after the end of
the year in which the liability arises (that is, a time lag of 1 year). This rate is not expected
to change.
• In Method 1, tax depreciation on the capital cost is available in equal instalments over the
first five years of operation.

May 2008 7 P9
 Required:

(a) Calculate and recommend which payment method is expected to be cheaper for
BEN in NPV terms.
(8 marks)

(b) Evaluate the benefits that might result from the introduction of the new TMS.
Include in your evaluation some reference to the control factors that need to be
considered during the implementation stage.
(8 marks)

(c) Advise the Directors of BEN on the following:

• The main purpose of a post-completion audit (PCA):

• What should be covered in a PCA of the TMS project;
• The importance and limitations of a PCA to BEN in the context of the TMS
project.
(9 marks)

(Total for Question Three = 25 marks)

A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION

Section B continues on the next page

May 2008 8 P9
Question Four

CM Limited (CM) is a private entity that supplies and distributes equipment to the oil industry in
the UK. It is evaluating two potential investments. Investment 1 would expand its operations in
the UK, Investment 2 would establish a base in Asia that would allow it to market and sell its
products to entities in a wider geographical area. The currency in the Asian country is the $.

CM does not wish to undertake both investments at the present time. Investment 1 would
require less capital expenditure than Investment 2, but its operating costs would be higher.
Profit forecasts for the two investments are as follows:

Year: 1 2 3
Investment 1 – all figures in £000s
Revenue 375 450 575
Production costs (excl. Depreciation) 131 158 201
Depreciation 267 267 266
Profit/(loss) before tax (23) 25 108

Investment 2 – all figures in A$000s

Revenue 1,300 1,450 1,650
Production costs (excl. Depreciation) 260 290 330
Depreciation 967 967 966
Profit/(loss) before tax 73 193 354

Additional information:

1 The capital expenditure required for Investment 1 is £1.1 million with an expected
residual value at the end of year three of £300,000. The capital cost of Investment 2 will
be A$2⋅9 million with no residual value.
2 CM depreciates the estimated net cost of its assets (initial cost less estimated residual
value) straight line over the life of the investment.
3 Tax depreciation is available on the equipment purchased for Investment 1 at 40% per
annum on the reducing balance basis. Capital expenditure for Investment 2 can be
written off for tax purposes in the year in which it is purchased.
4 Corporate tax rate in the UK is 25%. There are tax concessions in the Asian country.
The net effect is that CM would pay tax on profits generated in the Asian country at 10%.
No additional tax would be payable in the UK. Tax would be refunded or paid on both
investments at the end of the year in which the liability arises.
5 Investment 1 would be financed by internal funds. Investment 2 would be financed by a
combination of internal funds and loans raised overseas.
6 Assume revenue and production costs excluding depreciation equal cash flows.
7 The cash flow forecasts are in nominal terms. The entity’s real cost of capital is 8% and
inflation is expected to be 2⋅75% per annum constant in the UK.
8 CM evaluates all its investments over a three-year time horizon.
9 Cash flows are assumed to occur at the end of each year except the initial capital cost
which is incurred in year 0.
10 Operating cash flows for Investment 2 are in A$. The current exchange rate is £1 = A$2.
Sterling is expected to weaken against the A$ by 4⋅5% per annum over the next three
years.
11 CM’s expected accounting return on investment is 15%, calculated as average profits
after tax as a percentage of average investment over the life of the assets.

May 2008 9 P9
 Required:

(a) For each of the two investments, calculate

(i) The average annual accounting return on investment using average profit after
tax and average investment over the life of the assets;
(9 marks)

(ii) The NPV using an appropriate discount rate calculated from the information
given in the scenario.
(9 marks)

(Note: you should round the calculated discount rate to the nearest whole number).

(Total for Part (a) = 18 marks)

(b) Recommend, with reasons, which, if either, of the investments should be

undertaken. Discuss any non-financial factors that might influence the choice of
investment.
(7 marks)

(Total for Question Four = 25 marks)

A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION

Section B continues on the next page

May 2008 10 P9
Question Five

MAT is a manufacturer of computer components in a rapidly growing niche market. It is a

private entity owned and managed by a small group of people who started the business 10
years ago. Although relatively small, it sells its products world-wide. Customers are invoiced in
sterling, although this policy is being reviewed. Raw materials are purchased largely in the UK
although some are sourced from overseas and paid for in foreign currencies, typically US$.

As the newly-appointed Financial Manager, you are reviewing MAT’s financial records to identify
any immediate or longer-term areas of risk that require immediate attention. In particular, the
entity’s forecast appears to be uncomfortably close to its unsecured overdraft limit of £450,000.
Extracts from last year’s results and the forecast for the next financial year are as follows:
Last year Forecast
£000 £000

Non-current assets 3,775 4,325

Current assets
Accounts receivable 550 950
Inventory 475 575
Cash and marketable securities 250 100
Total current assets 1,275 1,625

Total assets 5,050 5,950

Total equity 3,750 4,050

Non-current liabilities
Secured bond repayable 2010 850 850
Current liabilities
Accounts payable 450 625
Bank overdraft 0 425
Total current liabilities 450 1,050

Total equity and liabilities 5,050 5,950

Revenue 4,500 5,750

Cost of goods sold 1,750 2,300
Profit before tax 1,050 1,208

Required:
Prepare a report to the Finance Director of MAT advising on whether the entity could be
classified as “overtrading” and recommending financial strategies that could be used to
address the situation.

Your advice and recommendations should be based on analysis of the forecast financial
position, making whatever assumptions are necessary, and should include brief reference
to any additional information that would be useful to MAT at this time.

(Total for Question Five = 25 marks)

(Up to 14 marks are available for calculations)

(Total for Section B = 50 marks)

May 2008 11 P9
 MATHS TABLES AND FORMULAE
Present value table
Present value of 1.00 unit of currency, that is (1 + r)-n where r = interest rate; n = number of periods until
payment or receipt.

Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

May 2008 12 P9
Cumulative present value of 1.00 unit of currency per annum
Receivable or Payable at the end of each year for n years ⎡
1−(1+ r )− n ⎤
⎢⎣ r ⎥⎦
Periods Interest rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

May 2008 13 P9
 FORMULAE

Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div
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 d 0 [1 + g ]
P0 = or P0 =
ke −g ke −g
(iv) Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interest value:
i [1 − t ]
P0 =
k d net

i
or, without tax: P0 =
kd

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

Vg = Vu + TBc

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

S = X[1 + r]n

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

1
PV =
n
[1 + r ]

(viii) 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:

1⎡ 1 ⎤
PV = ⎢
r ⎣
1−
n ⎥
[1 + r ] ⎦
(ix) 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 =
r −g

FORMULAE CONTINUE ON THE NEXT PAGE

May 2008 14 P9
Cost of capital

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

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

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

d1 d 0 [1 + g ]
ke = +g or ke = +g
P0 P0
(v) Cost of ordinary (equity) shares, using the CAPM:

ke = Rf + [Rm – Rf]ß
(vi) Cost of ordinary (equity) shares in a geared firm (no tax):
V
keg = k0 + [ko – kd] VD
E

(vii) Cost of ordinary (equity) share capital in a geared firm (with tax):

VD [1− t ]
keg = keu + [keu – kd] VE

(viii) Weighted average cost of capital, k0:

⎡ VE ⎤ ⎡ VD ⎤
k0 = keg ⎢ ⎥ + kd ⎢ ⎥
⎣ VE + VD ⎦ ⎣VE + VD ⎦
(ix) Adjusted cost of capital (MM formula):
Kadj = keu [1 – tL] or r* = r[1 – T*L]

In the following formulae, ßu is used for an ungeared ß and ßg is used for a geared ß:
(x) ßu from ßg, taking ßd as zero (no tax):

⎡ VE ⎤
ßu = ßg ⎢ ⎥
⎣ VE + VD ⎦
(xi) If ßd is not zero:

⎡ VE ⎤ ⎡ V
D
⎤
ßu = ßg ⎢ ⎥ + ßd ⎢ ⎥
⎣ VE + VD ⎦ ⎢⎣VD + VE ⎥⎦

(xii) ßu from ßg, taking ßd as zero (with tax):

⎡ VE ⎤
ßu = ßg ⎢ ⎥
⎣ VE + VD [1 − t ] ⎦

May 2008 15 P9
(xiii) Adjusted discount rate to use in international capital budgeting using interest rate parity:

1 + annual discount rate C$ Exchange rate in 12 months' time C$/euro

=
1 + annual discount rate euro Spot rate C$/euro

Other formulae

(i) Interest rate parity (international Fisher effect):

1 + nominal US interest rate

Forward rate US$/£ = Spot US$/£ x
1 + nominal UK interest rate

(ii) Purchasing power parity (law of one price):

1 + US inflation rate
Forward rate US$/£ = Spot US$/£ x
1 + UK 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 x cum rights price) + issue price]
N +1

(vi) Value of a right:

Rights on price − issue price

Value of a right =
N+1

or

Theoretical ex rights price − issue price

where N = number of rights required to buy one share.

May 2008 16 P9
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 VERBS USED DEFINITION
1 KNOWLEDGE
What you are expected to know. List Make a list of
State Express, fully or clearly, the details of/facts of
Define Give the exact meaning of

2 COMPREHENSION
What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something

3 APPLICATION
How you are expected to apply your knowledge. Apply To put to practical use
Calculate/compute To ascertain or reckon mathematically
Demonstrate To prove with certainty or to exhibit by
practical means
Prepare To make or get ready for use
Reconcile To make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table

4 ANALYSIS
How are you expected to analyse the detail of Analyse Examine in detail the structure of
what you have learned. Categorise Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct To build up or compile
Discuss To examine in detail by argument
Interpret To translate into intelligible or familiar terms
Produce To create or bring into existence

5 EVALUATION
How are you expected to use your learning to Advise To counsel, inform or notify
evaluate, make decisions or recommendations. Evaluate To appraise or assess the value of
Recommend To advise on a course of action

May 2008 17 P9
 The Examiner for Financial Strategy offers to future candidates and to tutors
using this booklet for study purposes, the following background and guidance on
the questions included in this examination paper.

Section A – Compulsory
Question One concerned an International Advertising Agency that was considering allowing the Chief
Executive of its USA operation to buy out that entity. This buyout would have allowed the USA operation to
pursue more profitable, but higher risk, ventures than the parent company had so far been willing to
consider.
In part (a), calculations of the PV of cash flows for the USA operation under two options were required.
First, if it continued as part of the UK-based group, and, second if it was subject to a management buy out
and continued as a separate entity. Part (a) further required discussion of the choice of discount rates to be
incorporated into the evaluation.
In part (b), candidates were required to write a report to the Directors of the parent entity evaluating the
proposal in terms of its effect on the various stakeholder groups, the economic and market factors that
might impact on negotiations and to make a recommendation of an appropriate valuation for the USA
operation.
In part (c), consideration of two possible methods of financing the management buyout and evaluation of
the advantages and disadvantages of these two methods were required.
This question tested knowledge and understanding of learning outcomes Syllabus Section A (iii); Syllabus
Section B (ii); and Syllabus Section C (i), (iii) and (iv).

Section B – Choice of two from four questions

Question Two concerned a financial adviser who was advising one of his clients on the investment of an
inheritance of £40,000 which the client intended to invest in equities. He was considering investment in the
shares of two publicly quoted entities.
In part (a) calculation of the risk and expected return of the client’s equity investment portfolio if he went
ahead with the proposed investment was required.
In part (b) explanation of the difference between systematic risk and un-systematic risk was required and
also discussion of how and to what extent the beta of the two entities:
• might affect the client’s investment decisions; and
• might be of interest to the directors of single entities such as those being considered for investment.
In part (c) evaluation of the implications for shareholder value of the two proposed investments was
required, with further calculations to support the discussion.
This question tested knowledge and understanding of learning outcomes Syllabus Section B (i) and (ii).
Question Three concerned a large listed entity whose principal activity was the manufacturing and
distribution of electrical consumer goods. The entity was now considering upgrading its information
technology system to handle the larger volumes and increased complexity of its planned growth. The entity
was considering two methods of paying for this new computer system.
In part (a) calculation and recommendation of which payment method was likely to be cheaper for the
entity were required.
In part (b) evaluation of the benefits that might have resulted from the introduction of this new system
together with some discussion of the control factors that need to be considered during the implementation
stage were required.
Part (c) required candidates to advise the directors of the investing entity on the purpose and content of a
post-completion audit.
The question tested knowledge and understanding of learning outcomes Syllabus Section D (iii) and (iv).
Question Four concerned a private entity that supplied and distributed equipment to the oil industry. It was
evaluating two potential investments one of which was in its home market and another which would allow it
to establish a base in an Asian market. The entity did not wish to undertake both investments at the
present time.
Part (a) required calculations, for both investment alternatives, of the ARR and the NPV.

May 2008 18 P9
Part (b) recommendations, with reasons, of which, if either, of the investments should have been
undertaken, including discussion of any non-financial factors that might have influenced the entity’s choice
of investment.
The question tested knowledge and understanding of learning outcomes: Syllabus Section D (i) and (ii).
Question Five concerned a private entity that manufactured computer components. It sold its products
worldwide although its customers were currently invoiced in sterling. The Financial Manager was
undertaking a review of a number of aspects of the entity’s finances, in particular its working capital
management and its forecast working capital financing requirements for the forthcoming year.
Candidates were required to prepare a report advising on whether the entity could be classified as
overtrading and, further, to recommend financial strategies that could be used to address the situation.
The question tested knowledge and understanding of learning outcomes: Syllabus Section A (iii), (iv) and
(v).

May 2008 19 P9
 Strategic Level

P9 – Management Accounting –
Financial Strategy
Examiner’s Answers

SECTION A

Examiner’s Note:
The answer to Question One is fuller than would be expected from a well-prepared
candidate. It has been provided for future candidates, and tutors, for study and
revision purposes.

Answer to Question One

(a)
(i) Discount rate for Zola Agencies using the proxy entity:

Ke = 5% + 2⋅5 (9% - 5%) = 15%

NPV of cash flows

Ancona USA Zola Agencies
Cash flow DF DCF Cash flow DF DCF
12% 15%

2009 118 0⋅893 105 138 0⋅870 120

2010 131 0⋅797 105 172 0⋅756 130
2011-13 210 (3⋅605 - 1⋅69) 402 250 (3⋅352 - 1⋅626) 432

Total 612 682

(ii) The discount rates used assume:

1 The WACC of Ancona International is a reasonable reflection of the risks involved in

Ancona USA under current policies. The debt equity ratios of Ancona International and
the subsidiary are the same, as shown below. These calculations are based on market
values (estimates in the case of Ancona USA) although as the debt in the subsidiary is a
loan from the parent there could be non-market factors involved.

May 2008 20 P9
Calculations of gearing: Ancona Ancona USA
Debt 2,050 200
(assume valued at par)
Equity 6,300 (US$18 x 350 million stock units) 612 (using NPV = MV)

8,350 812

Gearing = approximately 25% 25%

Use of the WACC of 12% therefore seems reasonable.

2 The use of 15% for Zola Agencies assumes equivalence of business risk with the entity
mentioned in the scenario. Assuming this to be true, then there is an argument for using
this rate as a reasonable approximation. However, it is possible comparison with a proxy
entity is not accurate.

(b)
Report to Directors of Ancona International
Date 23 May 2008
Subject Evaluation of potential divestment of Ancona USA to management

Introduction

I have been asked to advise on the potential sale of the USA operations. The report will
address:

• Interests of the various stakeholder groups;

• evaluation of economic and market factors;
• recommendation of valuation to be placed on USA operations.

(i) The effect on stakeholders

The main stakeholders to consider will be the shareholders of Ancona International, the
directors and employees of Ancona USA, creditors of both entities and, possibly, Ancona
International’s bankers.

Ancona International shareholders

• The shareholders bought shares in Ancona International recognising its policies in
respect of risk and return. Approximately 10% of the business is in the USA and
removing this might impact the risk profile and earning capacity and, hence, the value of
the entity.
• As key shareholders are expected to approve, presumably they are satisfied Ancona
International has sufficient alternative positive NPV investments available.

Directors and employees of Ancona USA

• This group of stakeholders in Ancona International is unlikely to be affected to any great
extent, other than by the overall impact on the level of earnings.
• Directors of Ancona USA appear willing to take the risk of the proposed management
buyout.
• Employees of Ancona USA might be adversely affected. Mr de Z and his co-directors
might take the opportunity to review current personnel and employment terms and
conditions. Some might be made redundant. This also has a cost to Zola Agencies. In
the long-term, the MBO and establishment of the new entity should provide increased
employment in the USA but, in the short-term, there could be losers.

May 2008 21 P9
Creditors (suppliers) and bankers
• Ancona International’s bankers are unlikely to be concerned as the bonds are secured on
Ancona International’s non-current assets. The sale of its USA operation will not impact
unduly on this. The lenders would only be concerned if the sale of the USA operation
made it less likely that the bonds could be secured. Ancona USA’s “banker” is the parent.
• The current ratio of Ancona International is 1⋅5 and Ancona USA 1⋅6, so trade creditors
seem well protected but the divestment is unlikely to affect this group of stakeholders.
• Some suppliers could be affected if purchasing policy for the US subsidiary is currently
controlled by Ancona International. This responsibility will pass to the new entity and it is
possible there will be some changes to terms of trade.

Customers
• The customers of Ancona USA may notice some changes, particularly if the intention is to
focus on obtaining contracts with leading US entities. The new entity may lose loyalty of
the existing customer base.

Other
• Other groups that could possibly be affected are government and local communities. It is
hard to see from the information available at present how either group will be significantly
affected one way or another.

Government
• UK government is unlikely to have an interest. US government may have an interest in
ensuring employment is maintained, depending on the size of operation and geographic
concentration.

There are no clear cut “winners” and “losers” although the main winners are likely to be Mr de Z
and his co-directors. The main losers, possibly, will be Ancona USA’s current employees and,
also possibly, Ancona USA’s suppliers.

(ii) The economic factors

The main economic factors that might impact on negotiations are interest rates, stock market
movement/sentiment, alternative investment opportunities, and regulatory controls.

Interest rates and inflation

• If financing is with Alternative 2, then Zola Agencies is exposed to risk of increase on its
variable rate loan.

• A change in US interest rates will affect the future cash flows of the USA operation and
the cost of capital. An increase in interest rates will reduce discretionary expenditure
such as advertising, and Mr de Z may argue that this should reduce the valuation placed
on Ancona USA. A significant change in interest rates would affect the discount rates
used in the calculations of NPV.

• High inflation will undermine confidence in the economy, making it harder to assess future
cash flows and again will cause Mr de Z to claim a lower valuation for Ancona USA.

Stock market movement/sentiment

• Key shareholders appear to be happy with the planned divestment, which implies they are
not likely to sell their shares and depress Ancona International’s share price.

• The risk of Ancona International may reduce with the sale of the US operation, but on the
other hand, the US operation makes a positive contribution to group earnings.

• However, if the non-shareholding market becomes aware of discussions the share price
could be affected. Whether this is up or down depends on how the market assesses the

May 2008 22 P9
 alternative investment opportunities available to Ancona International and the potential for
Zola Agencies.

Alternative investment opportunities

• Assuming a sale is agreed at or near one of the valuations calculated in part (a) then
Ancona International will have a large cash balance to invest. It could pay off some of its
debt, but the group is not overly indebted and this is not a good use of funds. The group
should evaluate alternatives before agreeing to divest what is a profitable subsidiary.

Regulatory controls
• There are unlikely to be any issues that would concern the competition authorities in
either UK or USA.

(iii) Recommendation of a value to be placed on Zola Agencies

There are at least three possible valuations that can be placed on Zola Agencies: net asset
value; cash flow-based valuations; and P/E basis.

US$ million Per currently issued stock unit

(5 million, all owned by Ancona Int.)

Net assets value 175 (435 - 260) 35

Cash flow based (1) 612 122⋅40
(Ancona USA)
Cash flow-based (2) 682 136⋅4
(Zola Agencies)
Market-based using Ancona
International P/E 949 * 189⋅8

* Ancona International’s P/E is 9⋅3 (stock price of US$18 divided by EPS of US$1⋅94).
Earnings to 31.3.2008 are US$102 million, multiplied by 9⋅3 = US$948⋅6 million.

The net asset value is likely to undervalue the entity, especially as there must be substantial
intellectual capital in the subsidiary which will not be captured in balance sheet figures.

If Ancona International retains the subsidiary then the market valuation using its own P/E should
be a close approximation of what it is worth, assuming Ancona USA continues with existing
policies. However, P/E ratios are determined by the market and suffer from two main flaws as a
method of valuation in the circumstances here:

(i) it is based on externally available information and internal information might be a better
guide to future value; and

(ii) it is subject to being affected by market-wide fluctuations.

If Ancona USA were a listed subsidiary and not wholly-owned by the parent then the use of its
P/E would be important because it would be a market price and a benchmark that could not be
ignored. The P/E basis here suggests a much higher valuation than the cash flow based
valuation performed by Ancona International. However, the cash flows do not place any value
on flows after 2013 (see further comment below).

The cash flow based methods are likely to be more accurate, but the following advantages and
disadvantages should be considered:

• They are based on fairly subjective estimates of growth;

• Cash flows beyond year have been ignored, as noted above, which will seriously under-
value the entity.
• The DVM could be used assuming a perpetuity beyond 2013, but would require too many
assumptions to allow an accurate calculation;

May 2008 23 P9
• The discount rates, while probably a good approximation, might be inaccurate. Some
sensitivity analysis could be performed here to determine the impact on a variety of rates
using different assumptions;
• Changes in the economic factors noted above could severely impact the cash flows in
one direction or another. A sensitivity analysis would also assist in determining the
impact of movements in this variable on the value of the cash flows/entity;
• In theory Mr de Z and colleagues should be prepared to pay up to a valuation of US$612
million (NPV of cash flows using the WACC).

Conclusion/recommendation

Based on the limited information available, a recommended value should be somewhere

between the two cash-flow based estimates, say US$650 million. Negotiations could focus
round this value. Clearly the financiers would want to review the valuation themselves and this
might impact on the final amount offered/agreed.
102
The US operation is currently contributing 15% of the group’s annual earnings ( /680). The
directors must have a clear idea of what the sale proceeds will be invested in, as that will
maintain shareholder value before agreeing a price with Mr de Z.

(c)
(i) The value that would need to be placed on Zola Agencies in 2013 if financing if PE
Capital is to receive its required return under Alternative 1:

US$ million
PE Investment: 617
Return (30% compound per annum) 1,674
Value required 2,291

This is for 95% of the business; the value of the entity on IPO would need to be approximately
US$2,400 million ignoring issue costs.

The impact on earnings and EPS under Alternative 2:

Approximately as follows, assuming the capital needed is US$650 million and that 75% is
required from the investment bank.

Preliminary workings for after tax interest payments: US$million

US$250million x 10% x (1 - 0⋅30) = 17⋅50
US$237⋅50million x 11% x (1 - 0⋅30) = 18⋅29
35⋅79

2009 2013
US$million US$million
Earnings 138 250
Interest (36) (36) (see workings above)
Earnings after interest 102 214

EPS US$ 2⋅0 4⋅3

(calculated as EAI divided by 50 million shares now in issue)

May 2008 24 P9
(ii) Finance with alternative 1 – PE Capital + Mr de Z

The main advantage of a private equity investor is that this investor shares in the risk – in fact
takes most of the risk. It may, or may not, require a dividend, but will require substantial returns
for the risk it is taking. In the scenario here, PE Capital has stated it requires all earnings to be
re-invested. As no interest or dividends are payable, the EPS will be US$2⋅7 in 2009 and US$5
in 2013 (US$138 million and US$250 million respectively divided by 50 million shares).

The consequence of reinvesting all earnings is that capital growth is encouraged. Although the
return required by PE appears substantial, the implied P/E ratio in 2013 is just under 10, which
is not excessive for such an industry (US$2⋅4 billion market capitalisation divided by US$250
million earnings).

The main disadvantages are that:

• If the exit route is by IPO the majority of the returns will go to PE. However, if this were
the only method of finance then Mr de Z and colleagues have limited choice if they want
to pursue the acquisition.
• Valuing shares for an IPO is difficult and the issue could be frustrated by market factors
beyond the control of the entity.

Finance with Alternative 2 – Bank + Mr de Z, colleagues and private investors

Finance from the investment bank allows equity investors (Mr de Z, colleagues and associates)
to retain a greater share of the business, but there is a high cost in terms of interest payments
that will impact on earnings and affect the overall risk of the business.

The value of the business is likely to be less in 2013 under this Alternative, than in Alternative 1,
because of the interest payments and the high cost of equity.

The private investors have stated that they will require an annual dividend of 20% of earnings,
although strictly this is a discretionary payment. It is also unusual for this type of private equity
investor to require such a high percentage of earnings to be paid out as dividends.

If earnings are US$138 in 2009 then the interest cover is adequate and by 2013 they will be
much more than adequate. (Times Interest Earned is 3⋅8 in 2009 and 6⋅9 in 2013). The
earnings should also be adequate to allow an annual reserve to be established to repay the
US$250 secured loan (principal) at the end of the five years.

Recommendation

A recommendation could be made for either alternative and there is no clear indication which
would be better for Mr de Z and/or his colleagues. Mr de Z is likely to base his decision on the
value of the business in 2013, the level of risk, the amount of ownership and control he retains
and likely exit strategies. Maximising value and minimising risk (to Mr de Z) would suggest
Alternative 1, but the amount of control and exit strategy options available are more
advantageous under Alternative 2.

May 2008 25 P9
SECTION B

Answer to Question Two

(a)

The average required return on Dan’s existing portfolio =

5% + 1⋅2 (11% - 5%) = 12⋅20%

Using the CAPM the beta for Entity B can be calculated as follows:

15⋅8% = 5% + ß(11% - 5%)

15⋅8% - 5% = ß x 6%
ß = 1⋅8

The risk and expected return can now be calculated as follows:

Entity Proportion Beta Weighted

% average
Current portfolio 72 (100/139) 1⋅2 0⋅86
A 14 (19⋅5/139) 1⋅1 0⋅15
B 14 (19⋅5/139) 1⋅8 0⋅25
1⋅26

Using the CAPM the average return = 5% + 1⋅26 (11% - 5%) = 12⋅56%

Note: An alternative equally acceptable presentational format is as follows:

Beta of portfolio = Wi ßi

Inv ß Inv x ß
Current portfolio 100⋅0 1⋅2 120⋅00
A 19⋅5 1⋅1 21⋅45
B 19⋅5 1⋅8 35⋅10
139⋅0 176⋅55

ß portfolio = 176⋅55/139 = 1⋅27

Expected return = 5 + (11 - 5)1⋅27 = 12⋅62%

There are slight rounding differences between the two approaches.

May 2008 26 P9
(b)
(i)

Unsystematic risk

Total
Risk

* Systematic risk

Number of securities in portfolio

Risk that cannot be diversified away is called systematic risk. This risk is due to economic
factors which affect the economy as a whole. Risk that can be reduced by diversifying the
securities in a portfolio is unsystematic risk. This risk relates to factors which are unique to an
entity or the entity's industry. Total risk is the combination of systematic and non-systematic
risk.

The total risk of a share can be measured by its standard deviation. Systematic risk of a share
is measured by its equity beta.

Beta is the measurement of systematic risk estimated by considering the volatility of an

individual share price movement against the movement in the market as a whole. This is
usually undertaken by plotting on a graph movements over time of the individual share price on
the vertical axis against movements in the market over the same time period on the horizontal
axis. Regression analysis is used to estimate the slope of the line, which is then referred to as
beta.

A company with an equity beta greater than 1 would be expected to have systematic risk
proportionately greater than the risk of the market. Conversely an equity beta which is less than
1 would suggest systematic risk for that company proportionately less than the risk of the
market. However, to use betas it is necessary to assume that betas calculated on the basis of
historic information are reliable indicators of current and future risks.

(ii)

Dan – Key Points

• An investor need only consider the systematic or market risk of securities if he holds a
well-diversified portfolio of stocks, which Dan does.

• Theory suggests that total risk is irrelevant if the portfolio of stocks held is sufficiently
large to enable full diversification of systematic or market risk. In practice total risk cannot
be ignored.

• The return on a security should reflect its risk. If Dan buys a stock which has an expected
return above or below that of the market, on the whole this is acceptable provided that
stock has a Beta of more or less than 1. This suggests that its returns are more or less
volatile than those of the market and we would expect a higher or lower rate of return.
The relevance of beta has to be viewed in the context of its effect on overall risk of the
portfolio.

May 2008 27 P9
• In respect of his proposed investment, the addition of Entity A and Entity B to the portfolio
will increase expected return from 12⋅2% to 12⋅62%. The risk as measured by beta will
rise from 1⋅2 to 1⋅27. Entity A has a beta of 1⋅1 – higher than the market, but below that
of his current investment portfolio and preferred risk profile. There is little diversification
benefit of this investment as Dan already has 15% of his equity investment in the industry
sector. It is not clear why he has chosen this stock. By investing in this entity Dan is
reducing the diversification of his portfolio as he will have 25% of his portfolio then
invested in the same industry sector as Entity A (34⋅5/139). The performance of his
portfolio is now more dependent on the performance of this sector. However, the
forthcoming rights issue might be the attraction.

• Dan does not currently have an investment in Entity B, or in this industry sector. The
expected return of his portfolio will increase with the investment in Entity B to compensate
for the higher risk. Entity B has an estimated beta of 1⋅8, much higher than that of the
market or Dan’s current portfolio. This beta and the return required possibly reflect the
illiquidity of the shares (AIM listed) as well as other risk factors. However, it has obvious
diversification benefits and Dan does not seem unduly risk averse.

Directors of Entities A and B – Key points

• Beta can indicate to an entity whether its share price appears under- or over-valued
relative to its risk as measured by beta. For example if its beta suggests a required return
of 10% but its expected return is 8% then its shares appear over-valued. Rational
shareholders would sell their shares and prospective purchases would wait until the share
price came into line.

• Whether an entity’s shares are under- or over-priced at a particular time may be irrelevant
on a day-to-day basis, although it might be important if that entity is considering, say, a
rights issue as Entity A is.

• To use betas it is necessary to assume that betas calculated on the basis of historic
information are reliable indicators of current and future risks.

• Single entities might not have the opportunity or desire to diversify away unsystematic
risk. However, beta is arguably still relevant as investors can (and are more able to)
diversify their portfolios to reduce unsystematic risk.

(c)
Implications for shareholder value

Key points

Entity A
• In theory, the financing of a business should have no impact on the value of an entity
other than the value of the tax shield (according to MM).
• Calculations of theoretical ex-rights price (TERP) assumes the new funds will be invested
at the entity’s existing cost of capital. If this is not the case, then a yield adjusted
calculation is necessary showing the overall effect on shareholder value and risk.
• Raising finance via a rights issue will affect gearing (all other things being equal) if the
entity has debt in its capital structure and raise the cost of capital.
Entity B
• Scrip or bonus issues raise no new funds but conserve cash if they are in lieu of
dividends.
• Entities usually have a stated or implied dividend policy as investors buy into entities with
policies that suit their requirements (the clientele effect). Entity B has had this policy
since flotation so it will be no surprise to investors.

May 2008 28 P9
• In risky, high-growth industries debt finance may not be available. The use of scrip issues
or bonus shares instead of cash dividends can have a favourable impact on shareholder
value if the cash is invested at the cost of capital.

Dan’s investment decisions

ENTITY A

The theoretical ex rights price (TERP) is:

1 “new” share 200p

4 “old” shares 1,000p
5 1,200

= 240p

The expected value of a right is 40p per new share or 10p per old share. As noted above, this
assumes Entity A will invest the proceeds at the existing cost of capital. If not, there are
implications for the value of his investment and the impact on the risk profile of his portfolio.

Number of shares to be bought: £19,500/250p = 7,800 shares

Dan would therefore be entitles to buy 1,950 shares at a cost of £3,900. This is not a
substantial sum of money and Dan might well be able to find the funds on top of his inheritance.
If he can’t then he could do one of the following:

1 Buy fewer shares in Entity B to release funds to purchase the rights.

2 Do nothing – this might have a negative impact on his wealth although the cash received
by the entity from “unaccepted” rights would mitigate the loss.
3 Sell the rights to another investor. A rational investor would pay no more than 40p per
right so Dan would receive, say, £780 less dealing costs. He would also have a smaller
percentage holding in the entity but this is unlikely to be of any relevance here.

ENTITY B

Number of shares to be bought £19,500/500p = 3,900 shares

Dan would be entitled to either a dividend of £1,755 or 390 scrip dividend shares. No money
would change hands and, all other things being equal, the share price would fall proportionately
but the total value of the holding would stay the same. Dan’s decision will be based on his
preference for income or capital gain and his tax situation. If he believes the company has
potential for high growth and he does not need income then he will probably opt for the scrip
dividend.

Your financial institution should be able to advise Dan on his actions in respect of both entities.

May 2008 29 P9
Answer to Question Three

(a)
The discount rate to be used in this type of evaluation is the after-tax cost of debt, which is 8% x
(1 - 0⋅25) = 6%

Year 0 1 2 3 4 5 6

Method 1

Purchase cost -800,000

Tax depreciation 40,000 40,000 40,000 40,000 40,000
Service costs -60,000 -63,000 -66,150 -69,458 -72,930
Tax relief @ 25% 15,000 15,750 16,538 17,364 18,233
Net costs -800,000 -60,000 -8,000 -10,400 -12,920 -15,566 58,233
DF @ 6% 1⋅000 0⋅943 0⋅890 0⋅840 0⋅792 0⋅747 0⋅705

DCF -800,000 -56,580 -7,120 -8,736 -10,233 -11,628 41,054

NPV -853,242

Method 2

Annual payments -250,000 -250,000 -250,000 -250,000 -250,000

Tax relief @ 25% 62,500 62,500 62,500 62,500 62,500
Net costs -250,000 -250,000 -187,500 -187,500 -187,500 62,500 62,500
DF @ 6% 1⋅000 0⋅943 0⋅890 0⋅840 0⋅792 0⋅747 0⋅705

DCF -250,000 -235,750 -166,875 -157,500 -148,500 46,688 44,063

NPV -867,875

On the basis of NPV analysis, BEN should choose Method 1 as it is less expensive.

(b)
Key points
• The managers need to be clear what they want the new system to do and should not be
over-ambitious about their requirements.

• The primary benefit is that one integrated system will replace a number of apparently
disparate legacy systems. It is not clear if the new system will be an “off-the-shelf”
system or will be bespoke for the entity. An off-the-shelf system may not match perfectly
the requirements of the entity and may require changes to the capture and processing of
data. On the other hand, a bespoke system may prove difficult to implement and
maintain. Upgrades to the system may be more difficult to manage.

• Greater security of data.

• More flexibility of operations – information needs change and require different solutions.

• Takes advantage of technological developments.

• May provide benefits that are cost-reducing or even income generating. For example, the
move to a single integrated system should lead to operational efficiencies and potential
staff savings. New management information may be available from the system that the
existing systems are not able to provide. Maintenance costs for the new system should
be lower than for the existing systems.

May 2008 30 P9
• Does the new system assist BEN meet its corporate objectives in any way? Have the
objectives of introducing a new system been clearly defined? – if not, how can success be
measured? (see further comments in part (c)).

• Can the system be adapted to decentralised function if BEN chooses to change it

treasury policy on centralisation?

Control
The PCA should provide a source of information that will help future management decision
making and should include an assessment of the reasons for any variance from the expected
performance, cost and time outcomes. This should improve project control and governance and
enable changes to be introduced to put the project back on track in a timely manner.

(c)
Key points

Purpose
A post-completion audit (PCA) can be defined as “an objective and independent appraisal of all
phases of the capital expenditure process as it relates to a specific project”. The main purposes
may be summarised as:

• Project control;
• Improving the investment process;
• Assisting the assessment of performance of future projects.

What is covered?
A major requirement of a PCA is that the objectives of the investment project must be clear and
an adequate investment proposal should have been prepared. The objectives should also be
stated, wherever possible, in terms that are measurable. If these have not been done before
the TMS was acquired then a PCA is not possible.

The key factors of importance of a PCA to BEN

• It enables a check to be made on whether the performance of the TMS corresponds with
the expected results. If this is not the case, the reasons should be sought. This could
form the basis for improvements in development of the system.

• It generates information, which allows an appraisal to be made of the managers who took
the decision to upgrade the system. Managers will therefore tend to arrive at more
realistic estimates of the advantages and disadvantages of the proposed investments.

• It can provide for better project planning in the future. If, in the evaluation, it is found that
the planning of the investment programme was poor, provision can be made to ensure
that it is better for future acquisitions.

Limitations
Sufficient resources are often not allocated to the task of completing PCAs so often are not
undertaken. They can be time consuming and costly to complete. They are sometimes seen as
tools for apportioning blame, so even where undertaken the lessons are often not disseminated
and are not then embedded in future projects. If undertaken by the managers of the project,
they may claim credit for all that went well and blame external factors for everything that didn’t.

May 2008 31 P9
Answer to Question Four
All figures are in £000 unless otherwise indicated
(a) Average accounting rate of return and NPV

INVESTMENT 1

Tax Depreciation allowances

Initial investment 1,100

Less: 40% writing down allowance 440 year 1
WDV 660
Less: 40% writing down allowance 264 year 2
WDV 396
Less: 40% writing down allowance 158 year 3
WDV 238
Residual value 300
Balancing charge 62 year 3

Calculation of post-tax profit

Year 1 2 3

Pre-tax profit (23) 25 108

Profit/loss before depreciation 244 292 374
(Revenue less production costs)
Deduct tax depreciation (440) (264) (96)

Taxable profit/(loss) (196) 28 278

Tax refund/(payment) @ 25% 49 (7) (70)
Post-tax profit 26 18 38

Note: Year 3 tax depreciation is calculated =158 - 62 = 96

Calculation of average accounting rate of return

Average post-tax profit (26+18+38)/3 = 27.3

Average investment (1,100 + 300)/2 = 700
Return on investment 27.5/700 * 100 = 3.9%

Calculation of discount rate

Real cost of capital = 8%
Inflation rate = 2⋅75%
Nominal cost of capital = (1⋅08 x 1⋅0275) - 1 ≈ 11%

Calculation of NPV
Year 0 1 2 3
Capital cost (1,100)
Residual value 300
Revenue less production costs 244 292 374
Tax refund/(payment) 49 (7) (70)
Net cash flows (1,100) 293 285 604
Discount factor @ 11% 1 0⋅901 0⋅812 0⋅731
DCFs (1,100) 264 231 442

NPV = (£163,000)

May 2008 32 P9
INVESTMENT 2

Calculation of post-tax profit

Pre-tax profit 73 193 354

Profit/loss before depreciation
1,040 1,160 1,320
(Revenue less production costs)
Deduct tax depreciation (2,900)

Taxable profit/(loss) (1,860) 1,160 1,320

(116) (132)
Tax refund/(payment) @ 10% 186

Post-tax profit 259 77 222

Calculation of average accounting rate of return

Average post-tax profit (259+77+222)/3 = 186

Average investment 2,900/2 = 1,450
Return on investment 186/1,450 * 100 = 12.8%

Calculation of discount rate

Sterling cost of capital = 11%
Sterling weakens by 4⋅5% per annum
Therefore adjusted cost of capital = (1⋅11/1⋅045) – 1 = 6⋅2% ≈ 6%

Calculation of NPV
Year 0 1 2 3

Capital cost (2,900)

Revenue less production costs 1,040 1,160 1,320
Tax refund/(payment) 186 (116) (132)

Net cash flows (2,900) 1,226 1,044 1,188

Discount factor @ 6% 1 0⋅943 0⋅890 0⋅840

DCFs (2,900) 1,156 929 998

NPV = A$183,000

Converted @ spot = £91,500

May 2008 33 P9
Notes:

1 Various shortcut methods are available for calculating average post tax profits for use in
the accounting rate of returns. These methods, if correct gained full credit. For example:

Investment 1
Average post-tax profits = [(-23) + 25 + 108) x 0⋅75]/3 = 27.5

Investment 2
Average post-tax profits = [(73 + 193 + 354) x 0⋅90]/3 = 186.0

2 An alternative approach to the NPV calculations in Investment 2 would calculate forward

exchange rates, A$ to sterling, convert the A$ cash flows to sterling and discount at the
UK discount rate. The figures using this approach would be as follows:

Year 0 1 2 3

Capital expenditure (2,900)

Revenue less production costs 1,040 1,160 1,320
Tax refund/(payment) 186 (116) (132)
Net cash flows (A$) (2,900) 1,226 1,044 1,188

Forward exchange rates 2⋅0 1⋅914 1⋅831 1⋅753

NCF £ (1,450) 642 572 682

DF 11% 1⋅0 0⋅901 0⋅812 0⋅731

DCFs (1,450) 578 464 499

NPV ≈ £91,000

The slight difference in NPV under the two methods is due to rounding of discount rates.

(b)
Recommendation

Summary of figures: Investment 1 Investment 2

Accounting return on investment 3⋅9% 12⋅8%

NPV (to nearest £000) (£163,000) £91,500

Key points

• Investment 1 fails to meet either investment criteria, with a RoI on only 3⋅9% and a
negative NPV. Investment 2 shows a positive NPV, but also fails to meet the RoI criteria.
• However, average profit is a very poor criterion to use in investment appraisal as it fails to
take into account time value of money or incremental cash flows. The size of the initial
investment is also ignored using this measure.
• The calculations assume the entity has other profit generating activities against which the
tax depreciation allowance can be set.
• It is assumed repatriation of profits will not be a problem in Investment 2.
• The discount rates are very rough and ready. Investment 1 is probably more accurate
than Investment 2, which is based on a forecast weakening of sterling. Investment 2 is
more risky than Investment 1, so there must be an argument for increasing the sterling
rate before adjustment.

May 2008 34 P9
• The risks involved in Investment 2 are far greater than Investment 1 as it is in a foreign
country; CM has not invested overseas before. Also, it is likely to be funded by a
combination of debt and equity which further increases the risk.
• A sensitivity analysis could be carried out on Investment 2 in particular.
• Payback or discounted payback could be calculated. Investment 1 does not payback at
all within the three-year time horizon. Investment 2 pays back just before the end of year
three.
• Three years is far too short a time to appraise investments of this type (note – but done to
simplify calculations in an exam environment).
• Non-financial considerations include the availability of labour in the Asian country,
environmental factors, political stability, availability of capital equipment and ability to
maintain it overseas. On the positive side, Investment 2 provides greater diversification
than Investment 1.

Answer to Question Five

Report to: Finance Director, MAT

From: Financial Manager
Date: 23 May 2008
Subject: Evaluation of financial performance and recommended strategies

Introduction

This report is to address the financial performance of MAT with respect to a potential over-
trading situation arising. It further aims to recommend financial strategies to deal with the
situation should it become necessary.

The report is presented in three sections and an appendix:

1 Discussion of the calculations as symptoms of overtrading;

2 Advice on financial strategies;
3 Other information
Appendix – Summary of calculations

1 Discussion of the calculations as symptoms of over-trading

• There is a fall in liquidity, as measured here by the current ratio. The ratio of current
liabilities to current assets is expected to fall dramatically from 2⋅83 to 1⋅55.
• There is a rapid increase in revenue. This is expected to increase by 27⋅8% over the
year. This is substantial but not necessarily excessive given the industry and the entity’s
profile. However, the rise in cost of goods sold is likely to be even greater at 31⋅4%.
Profit margin, as measured by profit before tax, is only forecast to rise by 15%.
• The sales to net-current assets ratio will rise from 5⋅5 to 10 indicating a potential
overtrading situation.
• The increase in inventory to receivables is likely to be modest – a rise to 10 from 9⋅5
times.
• There is expected to be a sharp rise in receivables as measured by days outstanding.
Last year, on average, debtors were 44⋅6 days. The forecast is 60⋅3 days. This indicates
either a change in collection policy or an expectation that sales will be extended to
customers with poorer credit or payment history.

May 2008 35 P9
• Days accounts payable outstanding will also rise, but not as dramatically – from 93⋅9 days
to 99⋅2 days. However, days inventory is expected to fall from 99⋅1 to 91⋅3.
The operating cycle will change as follows:

Last year Forecast

Days inventory 99⋅1 91⋅3
Less: Days accounts payable 93⋅9 99⋅2
5⋅2 (7⋅9)

Days accounts receivable 44⋅6 60⋅3

49⋅8 52⋅4

This is not a dramatic increase. A breakdown of inventory between raw materials, WIP and
finished goods would be useful. Also, it is not clear whether cost of goods sold includes
depreciation.

2 Advice on financial strategies

MAT is demonstrating some signs of overtrading – a substantial rise in revenue, the current ratio
and the ratio of sales to net current assets and days accounts receivable. However, mitigating
factors are that days’ accounts payable and the ratio of inventory to revenue are rising to a far
less extent and the gearing ratio is expected to fall (if bank overdraft is excluded from debt) as is
days’ inventory. The entity is forecasting an increase in its non-current assets but no increase in
long term debt. This suggests these purchases are likely to be financed by overdraft.

Overtrading can have serious consequences for any organisation; liquidity problems can result
in bankruptcy or financial distress. Possible solutions and their consequences are
recommended as follows:

• Reduce the operating cycle by reducing raw materials and/or work in progress and/or
finished goods stock.

• Use more trade credit, although this might result in poor relations with suppliers unless
formally negotiated. MAT already takes more trade credit than it allows its customers so
this might not be an option.

• Reduce credit to customers. This policy seems to be one of the causes of MAT’s
potential problems so needs careful consideration, recognising a change in credit policy
might reduce sales.

• MAT might be using credit as the entity is in a very competitive market, so an increase in
prices might result in a proportionately greater fall in sales with obvious consequences for
profitability.

• Consider invoicing customers in their own currency. This might increase sales but
introduces transaction risk into the entity. However if a number of customers would then
pay in US$, this introduces a matching benefit as MAT pays for its raw materials in US$.

• More aggressive debt collection – again, an increase in bad debts seems to be an

accepted consequence of its new credit policy.

• Increase the entity’s capital base via debt or new equity from the owners/shareholders. A
flotation is unlikely to be an option as the entity is relatively small. The debt in its balance
sheet is due to be repaid in two years’ time, so now might be an opportunity to discuss re-
financing with its lenders.

• MAT needs to revisit its marketing strategy of increasing credit to customers. If this is part
of a long term strategy to build market share in readiness for going public then this needs

May 2008 36 P9
 to be formalised into its corporate objectives and discussed with other stakeholders, such
as its lenders.

3 Additional information

• Breakdown of inventory into raw materials, WIP and finished goods;

• Cash flow forecast by month;

• Details of the non-current assets purchases and depreciation policy;

• Information on level of bad debts incurred and expected.

Appendix - Summary of calculations

Last Year Forecast

Increase in sales 27⋅8%
(5,750 - 4,500)/4,500 x 100
Increase in cost of goods sold 31⋅4%
(2,300 - 1,750)/1,750 x 100
Increase in profit margin 15%
(1,208 - 1,050)/1,050 x 100
Current ratio 1,275 1,625
= 2 ⋅ 83 = 1 ⋅ 55
450 1,050
Quick ratio 1,275 − 475 1,625 − 575
= 1 ⋅ 78 = 1⋅ 0
450 1,050
Sales to net current assets 5⋅5 times 10⋅0 times
4,500/(1,275 - 450) 5,750/(1,625 - 1,050)
Inventory to revenue 9⋅5 times 10 times
(4,500/475) (5,750/575)
Debt Ratio : Debt Equity 22⋅7% 21⋅0%
(850/3,750) x 100 (850/4,050) x 100
Gearing – Debt : Debt + Equity 850 850
= 18 ⋅ 5% = 17 ⋅ 3%
850 + 3,750 850 + 4,050
Days accounts receivable 44⋅6 60⋅3
(550/4,500) x 365 (950/5,750) x 365
Days accounts payable 93⋅9 99⋅2
(450/1,750) x 365 (625/2,300) x 365
Days inventory 99⋅1 91⋅3
(475/1,750) x 365 (575/2,300) x 365
Capital turnover 4,500 5,750
= 97 ⋅ 8% = 117 ⋅ 3%
5,050 − 450 5,950 − 1,050
Revenue: Non-current assets 4,500 5,750
= 1 ⋅ 19 = 1 ⋅ 33
3,775 4,325

May 2008 37 P9