Financial Management - Professional Stage June 2010
MARK PLAN AND EXAMINERS COMMENTARY
The marking plan set out below was that used to mark this question. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.
Question 1
Total Marks: 27
General comments
With an average mark of 71.9%, it is clear that most candidates were well prepared for this standard
question on the investment appraisal section of the syllabus.
(a)
Option 1: Introduce the Diamond and drop the RotoEdge
31 December
2010
2011
2012
2013
2014
2015
Unit sales
12,000
18,000
24,000
18,000
12,000
()
Contribution (72/unit)
864,000 1,296,000 1,728,000
1,296,000
864,000
Redundancy
(144,000)
Fixed costs
Net cash flow
Tax (28%)
Working capital (W1)
Investment
Cap. Allowances (W2)
Net cash flow
df (10%)
PV
NPV
(300,000) (300,000)
(144,000) 564,000
996,000
40,320 (157,920) (278,880)
(144,000)
(300,000)
1,428,000
(399,840)
(300,000)
(300,000)
996,000
564,000
(278,880)
(157,920)
72,000
144,000
(72,000)
(72,000)
72,000
67,200
53,760
43,008
34,406
137,626
401,280
698,880
1,143,168
823,526
687.706
0.909
0.826
0.751
364,764
577,275
858,519
(1,500,000)
84,000
(1,663,680)
1
(1,663,680)
0.683
0.621
562,468
427,065
2014
2,160,000
144,000
72,000
2015
1,440,000
144,000
1,126,411
Omission of the outstanding committed cost of 100,000
Workings:
W1:
31/12
2010
2011
2012
2013
Sales
1,440,000 2,160,000 2,880,000
Working capital
144,000 216,000
288,000
216,000
Incremental effect
(144,000) (72,000) (72,000)
72,000
W2:
WDV
Tax saved (28%)
31.12.2010
Cost
1,500,000
31.12.2010
WDA
300,000
84,000
1,200,000
31.12.2011
WDA
240,000
67,200
960,000
31.12.2012
WDA
192,000
53,760
768,000
31.12.2013
WDA
153,600
43,008
614,400
31.12.2014
WDA
122,880
34,406
31.12.2015
Bal.All
491,520
137,626
The Institute of Chartered Accountants in England and Wales 2010
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Financial Management - Professional Stage June 2010
(b)
Option 2: Introduce the Diamond and retain the RotoEdge
31/12
Unit sales:
RotoEdge
Diamond
2010
()
Contribution:
RotoEdge (42/unit)
Diamond (72/unit)
Redundancy
(60,000)
Fixed costs
Net cash flow
Tax (28%)
Working capital (W1)
Investment
Cap. Allowances
Net cash flow
df (10%)
PV
NPV
Workings W1:
31/12
Sales
Working capital
Incremental effect
2011
2012
2013
2014
2015
4,800
9,600
3,600
16,200
2,400
22,800
18,000
12,000
201,600 151,200
691,200 1,166,400
100,800
1,641,600
1,296,000
864,000
(48,000)
(48,000)
(24,000)
(320,000) (320,000)
(320,000)
(60,000) 524,800
16,800
(161,280)
949,600
(146,944) (265,888)
(300,000)
(300,000)
996,000
564,000
(391,552)
(278,880)
(157,920)
144,000
1,398,400
(67,680)
(67,680)
80,640
72,000
67,200
53,760
43,008
34,406
137,626
(1,620,480) 377,376
669,792
1,130,496
823,526
687,706
(1,500,000)
84,000
0.909
0.826
0.751
0.683
0.621
(1,620,480)
343,035
553,248
849,003
562,468
427,065
2011
2012
2013
1,612,800 2,289,600 2,966,400
161,280 228,960
296,640
216,000
(161,280) (67,680) (67,680)
80,640
2014
2,160,000
144,000
72,000
2015
1,440,000
144,000
1,114,339
2010
The recommendation, therefore, should be that Option 1 be pursued.
In the opening section of the question the majority of candidate responses scored highly, although weaker
scripts were characterised by errors in the following areas:
1. A failure to omit irrelevant costs, which included the costs to which the firm in the two scenarios was
already committed;
2. Accurate calculation of the working capital impact of the investment proposals;
3. Confusion regarding the correct treatment of fixed costs in the second of the two scenarios outlined in
the question.
Total possible marks
Maximum full marks
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Financial Management - Professional Stage June 2010
(c )
1. The firms shareholders may not be diversified, as assumed by the CAPM.
2. The shareholders are not the only stakeholders in the firm, as assumed by the CAPM directors and
employees will struggle to be persuaded that they should be unconcerned if the new project has an
adverse effect on the risk/return profile of the firm.
In the second section of the question, there was some polarisation of performance between those
candidates with a clear knowledge of the relevant area of the learning materials and those with none. In
addition, many candidates made reference to the issue of a beta calculation, but this was a difficulty
associated with the methodology rather than an assumption underpinning its use to calculate a discount
factor for investment appraisal purposes.
Total possible marks
Maximum full marks
(d)
1. Increase the rate of growth of sales (use of marketing)
2. Increase the operating profit margin (increase selling price/decrease variable costs)
3. Reduce the investment in non-current assets (acquire for less than 1.5m)
4. Reduce the investment in working capital (less than 10%)
5. Reduce the firms cost of capital (change capital structure)
6. Extend the life of the project (use of marketing)
2
2
In the final section of the question, the vast majority of candidates were able to list many, if not all, the
value drivers, although the frequent references to the idea that the firm could simply reduce the rate of
corporation tax scored no marks as this is not a variable the firm can directly influence even if the firm can
seek to minimise the amount of tax it pays in absolute terms. Another key characteristic of weaker
candidates was their failure to follow up the identification of value drivers with an explanation of how
improvements in shareholder value might actually be achieved in practice.
Total possible marks
Maximum full marks
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Financial Management - Professional Stage June 2010
Question 2
Total Marks: 27
Performance on this second question was also good, although the average mark of 65.6% indicates that
candidates did not find it as much to their liking as the opening question.
(a)
Forecast Income Statement for the years ending 31 December:
31 March 2011
31 March 2012
Revenue
Operating costs (excluding depreciation)
Depreciation
Operating profit
Finance costs
Profit before tax
Tax (W1)
Profit after tax
Dividends
Retained profit
65,059
51,480
875
12,704
1,200
11,504
3,018
8,486
2,951
5,535
70,264
53,539
875
15,850
1,200
14,650
3,989
10,661
3,128
7,533
W1 Tax:
Profit before tax
Add back depreciation
Less capital allowances
Taxable profits
Tax @ 28%
11,504
875
(1,600)
10,779
3,018
14,650
875
(1,280)
14,245
3,989
Forecast Balance Sheets as at 31 December:
31 March 2011
ASSETS
Non-current assets
35,975
Inventories
9,922
Receivables
9,759
Cash (balancing figure)
TOTAL ASSETS
55,656
EQUITY AND LIABILITIES
Ordinary share capital
Retained earnings
Debentures
Payables
Bank overdraft (balancing figure)
Dividends
TOTAL EQUITY AND LIABILITIES
16,700
18,017
8,000
7,629
2,359
2,951
55,656
31 March 2012
35,100
9,922
10,540
5,751
61,313
16,700
25,550
8,000
7,935
3,128
61,313
Forecast Cash Flow Statements for the years ending 31 December:
31 March 2011
31 March 2012
Profit before tax
11,504
14,650
Depreciation
875
875
Increase in inventories
(902)
Increase in receivables
(723)
(781)
Increase in payables
293
306
Purchase of non-current assets
(8,000)
Tax paid
(3,018)
(3,989)
Dividends paid
(2,784)
(2,951)
Net cash flow
(2,755)
8,110
Cash balance brought forward
396
(2.359)
Cash balance carried forward
(2,359)
5,751
The Institute of Chartered Accountants in England and Wales 2010
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Financial Management - Professional Stage June 2010
In the first section of the question the main errors made by weaker candidates were in the following areas:
1. An inability to correctly calculate the tax figure in the Income Statement very often weaker candidates
simply calculated 28% of the profit before tax rather than taking account of both the depreciation and the
capital allowances in the calculation;
2. A failure to use the cash/overdraft figure as the balancing item in the Balance Sheet it was also
surprising how many candidates chose to put an overdraft in the current assets section of the Balance
Sheet;
3. Incorrect calculation of the payables figure due to misinterpretation of the available information;
4. Failure to include, on many occasions, tax and dividends in the Cash Flow Statement.
It seemed that weaker candidates had failed to prepare themselves adequately for a question on this new
aspect of the syllabus and had placed too much reliance on their knowledge from earlier papers rather
than studying the Financial Management learning materials closely which would have rendered this
question quite straightforward as it mirrored closely the style of question used in the learning materials.
Total possible marks
21
Maximum full marks
21
(b)
1. Management buy-out: a new company acquires either the trade and assets or the shares of the
subsidiary to be sold, with the purchase usually funded by a mix of debt and equity provided by the
managers (equity), venture capital providers (debt and equity) and other financiers (debt)
2. Management buy-in: as above, but with purchase by a group of external managers
3. Spin-off (demerger): shareholders are given shares in the new entity pro rata to their shareholdings in
the parent company there is no change in ownership; with separate legal identities established; used
to avoid the problems of the conglomerate discount; sometimes used as a defence against takeover of
the entire business
4. Sale of shares/assets to a third party.
Most candidates coped well with the demands of the second part of the question, although weaker
candidates too often simply listed a number of divestment options without actually describing the nature of
the options in each case.
Total possible marks
Maximum full marks
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Financial Management - Professional Stage June 2010
Q uestion 3
Total Marks: 26
The average mark of 65.8% seen on this question was much in line with that of WT2. One pleasing aspect
was that there was less polarisation in performance apparent in the responses to the question than has
been evident at previous sittings candidates are clearly more comfortable overall with this area of the
syllabus than has previously been the case.
(a)(i)
1. Costs (direct and implicit)
2. Materiality of the exposure
3. Attitude to risk may lead the firm to decide to leave the upside potential open
4. Portfolio effect
5. If shareholders are fully diversified, their exposure to systematic risk will not be affected, so there will be
no benefits for them from hedging
(a)(ii)
1. 8,000,000/1.1980 = 6,677,796
2. 8,000,000/1.1420 = 7,005,254
Forward contract: Forward rate 1.1608
8,000,000/1.1608 = 6,891,799
OTC Option:
Need to sell so a put option is required at a premium of 1.25 per 100 = 100,000
1. If spot is 1.1980/, exercise the option 8,000,000/1.1750 = 6,808,511, net 6,708,511
2. If spot is 1.1420/, let the option lapse 8,000,000/1.1420 = 7,005,254, net 6,905,254
(a)(iii)
1. Appropriate choice of invoice currency
2. Matching payments and receipts (eg. Creating payables and receivables in same currency)
3. Matching assets and liabilities (eg. Creating overdraft borrowing in respect of a receivable)
4. Leading and lagging payments
5. Maintaining currency accounts
6. Use of a money market hedge
In the opening section of the question most candidates coped well with the identification of reasons why a
firm may choose not to hedge its foreign exchange exposure, although attitude to risk was the most
frequently omitted item by weaker candidates.
The majority of candidates clearly had a firm grasp of the workings of both forward and option contracts
(although there was evidence of continuing confusion amongst weaker candidates of the distinction
between a put option and a call option). Most candidates also had a good knowledge of the operational
techniques available to a firm to hedge its foreign exchange exposure.
Total possible marks
Maximum full marks
The Institute of Chartered Accountants in England and Wales 2010
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Financial Management - Professional Stag
(b)(i)
Futures price $1.6436/ Contract size 62,500 Current spot $1.6520/
So needs to buy 20,000,000/62,500 = 320 contracts
Scenario 1:
Buy 320 contracts @
In 6 months sell 320 contracts @
Gain per
Total gain (320 x 62.500 x 0.0174)
Purchase of 20m in 6 months
Net cost
Scenario 2:
Buy 320 contracts @
In 6 months sell 320 contracts @
Loss per
Total loss (320 x 62,500 x 0.0036)
Purchase of 20m in 6 months
Net cost
1.6436
1.6610
0.0174
$348,000
$33,260,000 (20m x 1.6630)
$32,912,000
1.6436
1.6400
0.0036
($72,000)
$32,840,000 (20m x 1.6420)
$32,912,000
(b)(ii)
1. Hedge inefficiency caused by basis risk
2. The fact that the buyer of the contract is tied into buying the even if the purchase does not proceed
(which appears to be a real possibility) a currency option would appear to be a much better option in this
scenario
Not surprisingly, weaker candidates found the second section of the question more challenging, with
common errors arising in the following areas:
1. Failure to calculate correctly the precise number of futures contracts required in the scenario outlined in
the question;
2. Confusion regarding whether the futures contracts would be bought or sold;
3. Confusion between whether gains or losses would arise on the futures contracts;
4. Failure to recognise that the firm still needs to buy sterling in the spot market at the conclusion of the
transaction.
Each of these failings relates to fundamental knowledge in this area of the syllabus and whilst there was a
welcome improvement in overall performance on this topic, it is clear that the weakest candidates tend not
to have mastered these basics at all and so struggle to pick up marks.
Total possible marks
Maximum full marks
The Institute of Chartered Accountants in England and Wales 2010
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