Corporate Finance

QCF
Subject Examiner’s Report

Unit Title: Corporate Finance

Unit Code: 6CF

QCF Level: Six

Session: December 2016

Subject Examiner: S Green

Comments on Learning Outcome and Assessment Criteria Performance

Learning Outcomes & Assessment Criteria Comments

Learning Outcome Some strong performance by some students.
1 Understand the role of the Corporate Finance Manager Weaker students failed to explain the role of corporate
and its main links to business objectives including finance in mergers and acquisitions activity
mergers and acquisitions

Learning Outcome Some students were not able to apply knowledge in the
7 Understand the different elements of treasury and context of the characteristics of overtrading
working capital and be able to perform calculations from
a given set of data to determine the effect on an element
of, or on the entire working capital of, a business.

Question 1

(a) Explain the rationale for organisational growth through mergers and/or acquisitions.

(b) Explain the main defences against unwelcome takeover bids. Use examples to support your answers.

Learning Outcome
1 Understand the role of the Corporate Finance Manager and its main links to business objectives including mergers
and acquisitions

Assessment Criterion
1.3 Explain the main justifications for, and dangers of, mergers and takeovers (financial and otherwise).
1. Mark scheme
(a) Two marks per developed point (Maximum: eight marks)
Synergy – combination of activities will improve performance and reduce costs.
Diversification – risk management. Reduce exposure to risks in one sector by developing a presence in another sector.
‘Sharpening’ of focus – deeper penetration of existing market sector.
Increase supply chain power – integration of elements of supply chain. Reduce costs that were previously margins for
supplier. Acquisition of distributor may lead to similar reductions in costs.
Elimination of competition – eliminate existing or potential competitors. Acquire greater market share.

(b) Two marks per developed point (Maximum: six marks)

Staggered board – board members are divided into separate groups, with only one group appointed on rotational
basis. Bidder cannot obtain control immediately after acquisition of a majority of shares.
Poison pill – rights to preferred stock are issued to existing ordinary investors. Rights can be exercised after a hostile
offer or following accumulation of a large block of ordinary shares by a third party. Exercised rights are repurchased by
issuing firm. Bidder is excluded.
Super-majority – high percentage of ordinary shares is needed to approve merger. Increases number of shares
needed to obtain control.
Fair price – super majority provisions are waived if bidder pays all ordinary investors the same price. Prevents two tier
takeovers.
Dual class recapitalisation – distribute a new class of ordinary shares to investors with superior voting rights (but
inferior dividend marketability). Allows investors to exchange new shares for ordinary shares. Allows board to obtain
majority of voting rights without owning majority of ordinary shares.

Total Maximum Marks for Q1 14 marks

2. Comments on learners’ performance

Some students demonstrated an ability to apply knowledge in the context of mergers and acquisitions and in relation
to defences against unwelcome takeover bids.
Weaker students made limited or no attempts to relate their knowledge to the specific issue of mergers and
acquisitions activity.

Examiner’s tips
Take care to apply knowledge, when
required, rather than to merely produce
lists or descriptions.

Question 2

(a) Calculate financial gearing and interest cover ratios for each company.

(b) Critically evaluate the implications of a high level of financial gearing.

Learning Outcome
2 Understand the main sources of debt and equity funding and the significance of financial gearing.

Assessment Criterion
2.4 Explain the significance, advantages and dangers of different levels of financial gearing.

1. Comments on learners’ performance

Some learners demonstrated an ability to critically assess and discuss the advantages and disadvantages of high levels
of financial gearing. Stronger responses were received from students who were able to develop this evaluation in the
context of the wider features of corporate finance.
Weaker responses merely described financial gearing rather than developed a critical evaluation thereof.

2. Mark scheme

(a) One mark per gearing ratio using D/D+E or D/E (but not both).
One mark per interest cover ratio. (Maximum: Six marks)
Cerex Deister Eglor
Gearing ratio (one of)
Debt/Debt + Equity 25% 50% 70%
OR Debt / Equity 33% 100% 233%
Interest cover 3.6 1.7 1.0

(b) Two marks per developed point (Maximum: Eight marks)

Advantages
Enhanced earnings – can allow for disproportionate earnings relative to capital employed.
Tax treatment – most jurisdictions allow interest on debt to be deducted in the calculation of tax adjusted trading
profits

Disadvantages
Disproportionate losses – finance costs may overwhelm the borrower if profits are not sufficient.
Volatility of share price – swings in profitability that might arise may be viewed negatively by the market.
Cyclical businesses – low barriers to entry increase likelihood of fluctuations in profitability. Increase likelihood of
bankruptcy.

Total Maximum Marks for Q2 14 marks

Examiner’s tips
Consider the advantages and
disadvantages of financial gearing, rather
than its nature or features.

Question 3

Critically assess the factors that influence a company’s decision to issue cash dividends, with consideration of the
alternatives.

Learning Outcome
5 Understand the factors that determine a company’s dividend policy.

Assessment Criterion
5.3 Explain the main alternatives to cash dividends.

1. Comments on learners’ performance

Stronger responses reflected an ability to explain the advantages and disadvantages of cash dividends, with suitable
consideration of the alternatives.

Some learners failed to focus their responses on the justifications and benefits of cash dividends: some responses
tended towards mere identification and description.
2. Mark scheme
Two marks per point (Maximum: 14 marks)

Signalling – dividends send a powerful message about a firm’s future performance. Retention of profits may signal
management’s view that growth opportunities exist. These opportunities may result in capital growth.
Management decision making – dividends promote discipline in management decision making. Firms that pay
dividends tend to make more efficient use of capital than those that do not pay dividends. Such firms may generate
greater levels of capital growth.
Tax – dividends are often taxed at higher rates of income tax than those that are applied to capital gains. Use of
dividends may be less efficient than reinvestment of profits in the firm and subsequent capital growth.

Alternatives to cash dividends

Bonuses – ordinary investors are issued with new shares relative to their existing shareholding.
Scrip dividends – similar to bonus issues. Cash reserves are converted to ordinary shares and issued to ordinary
investors relative to their existing shareholding.
Stock splits – ordinary investors are issued with new shares relative to their existing shareholding. The new shares
have a lower nominal value than their existing shares.
Concessions – granting of rights to purchase new shares relative to existing shareholding.

Total Maximum Marks for Q3 14 marks

Examiner’s tips
Consider the broader implications of the
benefits and justifications of cash
dividends and the alternatives thereto.

Question 4

(a) Calculate the accounting rate of return and payback periods of each of the three projects.

(b) Critically evaluate the approach to investment appraisal in part (a).

(c) Explain the additional information that could be used to improve the approach to investment appraisal.

Learning Outcome
3 Be able to evaluate investment decisions using a variety of appraisal techniques

Assessment Criterion
3.1 Explain the principles, benefits and limitations of the following different methods of investment appraisal:
accounting rate of return, payback, net present value (NPV), Profitability Indices, and the internal rate of return (IRR)
and be able to perform calculations in order to assess investment value.

1. Comments on learners’ performance

Learners that chose to address this question demonstrated some knowledge and comprehension of the relevant
capital investment appraisal techniques.

Stronger responses reflected an ability to discuss and critically evaluate the ARR and payback techniques.

2. Mark scheme
(a) Maximum: Four marks

Project 1 Project 2 Project 3

Net cash flow 90,000 100,000 95,000

Payback
0 (240,000) (240,000) (240,000) 1 mark for not ded depn
1 (150,000) (140,000) (145,000)
2 (60,000) (40,000) (50,000)
3 30,000 60,000 45,000

2y8m 2y5m 2y7m 1/2 mark for each OR

Or 2.67y 2.40y 2.53y 1/2 mark for each

ARR 73/240 83/240 78/240

30% 35% 33% 1/2 mark for each

(b) One mark per point (Maximum: Six marks)

Calculate NPV
Calculate IRR
Cost of capital would be needed
Comparison rate would be needed for IRR
NPV takes account of time value of money
NPV relates to wealth maximisation
IRR represents yield from investment opportunities – can be used to rank projects
But IRR does not relate to wealth maximisation

(c) One mark per point (Maximum: Four marks)

Discount factor to enable discounting of cash flows
Cost of capital to identify DF: equity and debt of firm
Sensitivity analysis: reliability of cash flow forecasts
Interpolation to allow calculation of IRR
Profitability indices
Availability of capital finance

Total Maximum Marks for Q4 14 marks

Examiner’s tips
Take care to develop any evaluation to a
sufficient depth. Ensure that advantages
and disadvantages are discussed.

Question 5

(a) Calculate Alpha plc’s cost of capital.

(b) Critically evaluate the use of weighted average cost of capital to calculate a company’s cost of capital.

Learning Outcome
6 Understand the concept of, and know how to calculate, the cost of capital of a business

Assessment Criterion
6.3 Calculate the weighted average cost of capital and discuss its usefulness.
1. Comments on learners’ performance
Learners that chose to respond this question demonstrated some understanding of how to apply the relevant
quantitative techniques. Stronger responses reflected an ability to critically evaluate the use of a WACC in this context.

Weaker responses were either unable to apply the required technique and/or tended towards description rather than
critical evaluation.

2. Mark scheme
(a) One mark per element of WACC, plus one mark for solution (Maximum: Four marks)

Ri = 4.5% + 1.05 x 0.05

= 9.75%

(b) Two marks per point (Maximum: Ten marks)

Advantages
Simplicity – provides a ‘hurdle rate’ against which investment opportunities can be evaluated
Ease of use – provides a single benchmark against which all investment opportunities can be evaluated
Ease of understandability – simple test against which investment opportunities can be compared and evaluated
Enables prompt decision making – stimulates management to evaluate opportunities promptly

Disadvantages
Assumes no change in capital structure – capital mix of investment opportunity is the same as that for the firm.
Assumes no change in risk for new projects – risk of investment in investment opportunity is the same as that for
existing projects
Sub-optimal decision making – can lead to acceptance of ‘bad’ projects and rejection of ‘good’ projects

Examiner’s tips
Learners and tutors are reminded to
develop an understanding of the relevant
quantitative techniques.

Question 6

(a) Calculate liquidity ratios for Sorrinson Ltd for both 2016 and 2015.

(b) Assess Sorrinson Ltd’s liquidity position and explain whether or not it would be advisable for Sorrinson Ltd to
seek to achieve ‘ideal’ liquidity ratios of 2:1 (current ratio) and 1:1 (quick ratio).

Learning Outcome
4 Understand and be able to calculate the main methods for valuing company shares.

Assessment Criterion
4.3 Explain and calculate the main accounting ratios that can be applied to organisations.

1. Comments on learners’ performance

A majority of learners demonstrated an understanding of liquidity ratios.

Weaker responses failed to understand the features and consequences of aggressive and / or conservative liquidity
positions.

Stronger responses reflected an ability to discuss the advantages and limitations of the ‘ideal’ approaches to the
management of liqudity.
2. Mark scheme
(a) One mark per correct solution (Maximum: Four marks)

2016 2015
Current ratio 1265: 2108 1035: 2070
= 0.6 = 0.5

Quick ratio 435: 2108 408: 2070

= 0.21 = 0.2

(b) 0.5 marks per percentage calculated as part of a constituent percentage analysis (Maximum: 3 marks)
Two marks per point (Maximum: Eight marks). Total (Maximum: 11 marks)

2016 (%) 2015 (%)

Inventory 65.6 60.6
Trade receivables 17.0 17.4
Cash 17.4 22.0

Liquidity ratios are low (compared to ‘ideals’) but have improved

Difference between current and quick ratios indicate significance of inventory
Improvement is due to increases in inventory and trade receivables
Desirable ratios depend on business model and industry sector
Large liquidity ratios could be a sign of poor management of working capital

Total Maximum Marks for Q6 15 marks

Question 7

(a) Calculate the cost of equity capital.

(b) Critically evaluate the use of the capital asset pricing model to judge an investment portfolio

Learning Outcome
4 Understand and be able to calculate the main methods for valuing company shares.

Assessment Criterion
4.1 Explain and calculate the share value of a business based on: net asset value (NAV), price earnings (PER), free cash
flow and dividend valuation and discuss the relative merits of each method.

1. Comments on learners’ performance

Stronger learners were able to apply the relevant quantitative technique and, importantly, to critically evaluate its use
in the context of an investment portfolio.
Weaker responses did not situate their critical discussion in the context of investment portfolios.

2. Mark scheme
(a) One mark per element (Maximum: Five marks)

Nominal growth rate = ((1.025) (1.05) -1 2 marks

= 7.625% 1 mark

Ri = (3/100) + 7.625% 1 mark

= 3% + 7.625% 1 mark

(b) Two marks per point (Maximum: Ten marks)

Advantages
 Provides a basis by which performance of active fund managers can be compared against a passive strategy
(investment in risk free assets or an index with the same beta)
CAPM tells managers what they could expect to achieve by investing in a portfolio rather than in an
investment project
Betas are relatively simple to use and understandable
Allow companies to estimate their equity cost of capital

Disadvantages
Only provides an approximate estimate of the cost of equity
CAPM is a single period model – it fails to take account of differing lengths of investment
Assumption that investors hold diversified portfolios – assumes that investors only require returns for the
systematic risk in a portfolio, since unsystematic risk has been diversified away
Assumption that investors can borrow and lend at a risk free rate
Assumption of a perfect capital market

Total Maximum Marks for Q7 15 marks

Examiner’s tips
Take care to engage with the
requirements and to develop any critical
evaluation accordingly.

Question 8

(a) Explain the components of the working capital cycle.

(b) Critically discuss the actions that might be taken to improve a firm’s working capital cycle.

Learning Outcome
7 Understand the different elements of treasury and working capital and be able to perform calculations from a given
set of data to determine the effect on an element of, or on the entire working capital of, a business.

Assessment Criterion
7.1 Explain the main areas of treasury and working capital and calculate the working capital cycle and the cash
conversion or operating cycle.

1. Comments on learners’ performance

Stronger responses reflected an ability to both explain the components of the WCC and, importantly, to critically
discuss the actions that might be taken to improve a WCC position.
Weaker responses failed to develop a critical discussion or did not identify methods by which a weak WCC position
might be developed.

2. Mark scheme
(a) One mark for explanation of WC. Upto four marks for explanation of components (Maximum: Five marks)
WC = Current assets - Current liabilities
Current assets examples; Inventories, trade receivables, cash
Current liabilities examples: Trade payables, short term borrowings

(b) Upto four marks per action (Maximum: Ten marks)

Reduce inventory turnover period – reduce holding and associated costs. Can lead to supply chain difficulties. May
lead to inefficient production – loss of sales and reduction in profitability.
Reduce trade receivables collection period – reduce credit periods offered to customers can help to generate cash.
Can help to reduce irrecoverable receivables. Aggressive management may lead to loss of customer goodwill, erosion
of customer base.
Increase trade payables settlement period – can be used to generate short term financing. Excessive TPSP may result
in loss of supplier goodwill, loss of discount opportunities

Total Maximum Marks for Q8 15 marks

Examiner’s tips
Take care to develop any evaluation
appropriately. Consider advantages and
disadvantages, rather than the listing of
key features.

Question 9

(a) Discuss the potential symptoms of overtrading.

(b) Recommend the actions that might be taken to address each of the symptoms identified in part (a).

Learning Outcome
7 Understand the different elements of treasury and working capital and be able to perform calculations from a given
set of data to determine the effect on an element of, or on the entire working capital of, a business.

Assessment Criterion
7.3 Explain overtrading and identify its symptoms.

1. Comments on learners’ performance

Most students were able to understanding the different elements of working capital. Some weaker students failed to
relate this knowledge to the context of overtrading.

2. Mark scheme
(a) One mark per symptom (Maximum: Five marks)

Reductions in current and quick ratios

Rapid growth in business development and sales.
Reductions in net profit
Shortages of working capital
Unrealistic cash budgets
High levels of finance costs
High levels of financial gearing
High trade payables settlement periods
Slow movements of inventories

(b) Up to four marks per action (Maximum: Ten marks)

Management of trade receivables

Ensure that the company is paid more efficiently
Ensure that cash is available to pay suppliers and salaries to staff.
Setting new payment terms
Offer discounts for prompt payment
Consider automated payments
Invoice discounting or factoring

Management of trade payables

Negotiate improved terms with suppliers
Improve payment scheduling to utilise available credit without loss of supplier goodwill

Management of inventories
Introduce inventory control methods
Consider techniques such as JIT

Financing arrangements
Consider short/long term alternatives to cash investment e.g. leasing, hire purchase

Profitability
Scrutinise appropriations. Consider dividend policies.

Cost reduction
Consider strategies such as bootstrapping, short term reduction in employee remuneration

Total Maximum Marks for Q9 15 marks

Examiner’s tips
Take care to engage with any
requirement and to develop any answer
accordingly. Try to avoid generic
description when there is a need to apply
knowledge.