Sample Mark Scheme

Level 5 Effective Financial Management

Section A – 20 marks
(Short answer questions: 4 x 5 marks each = 20 marks total)

1 (5 marks)
Discuss the potential disadvantages of the use of the weighted average cost of capital (WACC) to measure
the cost of capital.
Q Indicative Content Total
1 Responses should be in the form of a discussion of the disadvantages of the use of WACC to
measure the cost of capital.

Disadvantages/criticisms
Assumption that debt is cheaper than equity: higher proportions of debt will, in fact, lead to
increasingly expensive equity: as equity investors seek greater protection from the increased risks
that arise from high levels of debt
Cost of equity: estimation of the cost of equity can be difficult. Methods such as the Capital Asset
Pricing Model (CAPM) and Dividend Valuation Model (DVM) are not perfect methods for the
calculation of the cost of equity
Time-lag: WACC is based on a business’s current characteristics: an investment decision is based
on future cash flows
High risk: the ‘true’ cost of capital depends on the purpose to which finance is applied: strict
reliance on the WACC could lead to the acceptance of too many high-risk projects and reject too
many low-risk projects
No change in capital structure: mix of debt and equity to finance new project is that same as the
existing capital structure of the firm.
No change in risk: risk associated with new project will be the same as that for existing projects
Other sources of finance: simplification of using debt, equity and preference shares excludes items
such as convertible debt, extendable bonds etc.

Other relevant material should be credited. 5

Mark Allocation Guidance
1 mark for identification of disadvantage up to a maximum of 2 marks
1 mark for discussion of each identified disadvantage up to a maximum of 3 marks

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2 (5 marks)
Explain two factors that contribute to the existence of the ‘agency problem’.
Q Indicative Content Total
2 Responses should be in the form of an explanation of two factors that contribute to the existence
of the agency problem.
Ownership and control: those who own the company (shareholders) appoint agents (managers) to
run the company on their behalf. This can lead to moral hazard: the aims and objectives of the
two groups might not be consistent.

Goals: managers are likely to seek to maximise their own wealth rather than the wealth of
shareholders

Asymmetry of information: managers have access to detailed financial data, whereas shareholders
only receive summary reports (that may have been subject to manipulation by managers

debt finance: From a financial management perspective, another important agency problem can
exist between shareholders and the providers of debt finance. Shareholders (as agents) have a
preference for the use of debt finance for progressively riskier investment projects, since they will
benefit from the success of these investment projects. The providers of debt finance (as principals)
bear the risks that arise from these investments.

Other relevant material should be credited. 5

Mark Allocation Guidance
1 mark for identification of contributing factor up to a maximum of 2 marks
1 mark for explanation of each identified factor up to a maximum of 3 marks

3 (5 marks)
i. Calculate the operating gearing for Product A and Product B. (4 marks)
ii. Recommend which of the two products should be manufactured by Montreal plc. (1 mark)

Q Indicative Content Total

3 i. Operating gearing = Contribution margin % / Net operating income
Where contribution margin % = (Revenues – Variable costs) / Revenue x 100/1

Product A
CMR = (130000 – 40000) / 130000 x 100 / 1 = 69.23% (1)
OG = 69.23% / 20000 x 100 / 1 = 0.3462 (1)

Product B
CMR = (150000 – 50000) / 150000 x 100 / 1 = 66.67% (1)
OG = 66.67% / 30000 x 100 / 1 = 0.2222 (1)

ii) Product A has a higher OG effect that Product B. If all other factors remain the same, Product A
presents a higher financial risk. Therefore, Product B should be selected (1)

Accept alternative formula based on CM (rather than CMR) / Revenue x 100 / 1. 5

Mark Allocation Guidance
i) 1 mark for correct calculation of CMR, up to a maximum of 2 marks for both products
1 mark for correct calculation of OG, up to a maximum of 2 marks for both products

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 ii) 1 mark for correct identification of product with more profitability.
4 (5 marks)
Analyse the role of financial management in each stage of the business planning process.

Q Indicative Content Total

4 Responses should be in the form of an analysis of the role of financial management in each stage
of the business planning process.

Key step Role of financial management

Setting of objectives Remember: the primary objective of a business is the maximisation of
shareholder wealth. This must be reflected by the ‘vision’ and sense of
direction for the business (2)
Identifying options Each of the strategies will have to be considered in terms of both their
financing requirements and their investment implications (1)
Evaluating options and A variety of financial management techniques can be applied to help
making a selection management to select the most suitable option (1)
Developing plans for Financial management techniques can be used to support detailed
activities and processes planning and day-to-day management (1)

Other relevant material should be credited. 5

Mark Allocation Guidance
Award marks as allocated above

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 Section B – 30 marks
(Short answer questions: 3 x 10 marks each = 30 marks total)

5 (10 marks)
a. Calculate the payback period for project A and project B, assuming that all cash flows occur at the end
of the respective year. (2 marks)
b. Calculate the accounting rate of return (ARR) for project A and project B, assuming that the only
difference between cash flow and profit is the depreciation charge. (4 marks)
c. Calculate the net present value (NPV) for project A and project B, using Clutterbuck plc’s cost of capital
as the discount rate. (4 marks)

Q Indicative Content Total

5a Project A
Investment = £250,000
Cumulative cash flow
1 90,000 90,000
2 80,000 170,000
3 75,000 245,000
4 60,000 305,000
5 55,000 360,000

The payback period is somewhere between 3 and 4 years. At the end of year 3, only £245,000 of
the £250,000 initial investment has paid back, but at the end of year 4 £305,000 has paid back.

If we assume that all cash flows arise at the end of each year, we must say that the payback period
is 4 years (1)

Project B
Investment = £260,000
Cumulative cash flow
1 120,000 120,000
2 90,000 210,000
3 80,000 290,000
4 50,000 340,000
5 50,000 390,000

The payback period is somewhere between 2 and 3 years.

If we assume that the cash flow arises evenly throughout the year:
Payback period = 2 years + ((£260,000 - £210,000)/£80,000) = 2.63 years [or 2 years and 8
months]
2.63 years OR for 2 years, 8 months (1) 2
Mark Allocation Guidance
1 mark for each calculation up to a maximum of 2 marks for calculating payback for both products.
5b Project A

Using the formula: ARR = (Average annual profit / Average investment) x 100/1
4
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 Total cash flow for the project = £360,000
Total depreciation for the project = £250,000 - £10,000 = £240,000 [investment cost - scrap value]
Therefore, total profit = £360,000 - £240,000 = £120,000
As the investment has a life of 5 years.
Average annual profit £120,000 / 5 = £24,000 (1)
The average value of the investment will be the average of the initial investment and the scrap
value. This can be calculated as a simple arithmetic mean of these two values:
Average investment = (£250,000 + £10,000) / 2= £130,000
Therefore the ARR = (£24,000/£130 000) x 100 = 18.5% (1)

Project B
Average annual profit = £390,000 – (£260,000 - £25,000) / 5 years = £31,000 (1) years
Average investment = (£260,000 + £25,000) / 2= £142,500 (1)
ARR = (£31,000/£142,500) x 100% = 21.8%
Mark Allocation Guidance
Up to 4 marks, as indicated, for the calculation of ARR.
5c Project A
Year cash flow Discount Factor Present Value
0 (250,000) 1.000 (250,000)
1 90,000 0.862 77,580
2 80,000 0.743 59,440
3 75,000 0.641 48,075
4 60,000 0.552 33,120
5 55,000 0.476 26,180
5 (Scrap)* 10,000 0.476 4,760
NPV (845)

If all DFs are correct (1)

If all PVs are correct (1)

*Note: The scrap value of £10,000 will generate a positive cash flow at the end of the investment
when the equipment is sold.

Project B
Year cash flow DF PV
0 (260,000) 1.000 (260,000)
1 120,000 0.862 103,440
2 90,000 0.743 66,870
3 80,000 0.641 51,280
4 50,000 0.552 27,600
5 50,000 0.476 23,800
5 (Scrap) 25,000 0.476 11,900
NPV 24,890
If all DFs are correct (1)
If all PVs are correct (1) 4
Mark Allocation Guidance
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 Up to 4 marks, as indicated, for the calculation of NPV

6 (10 marks)
a. Calculate financial gearing for Business A and for Business B. (4 marks)
b. As a potential ordinary shareholder, critically discuss the levels of financial gearing in Business A and in
Business B. (6 marks)

Q Indicative Content Total

6a Financial gearing = Debt / (Debt + Equity) x 100 / 1

Business A
2,000,000 + 1,000,000 (1) / (3,000,000 + 6,350,000) (1) x 100/1 =32.09%

Business B
15,000,000 + 1,000,000 (1) / (16,000,000 + 24,700,000) (1) x 100/1 = 39.31% 4
Mark Allocation Guidance
1 mark per correct formula, up to a maximum of 2 marks
1 mark per correct result, up to a maximum of 2 marks
6b The attitude of the shareholders of a business to the level of financial gearing are likely to be
influenced by a number of factors, including control (owners may see debt finance as a way to
expand the business without issuing more shares) (1), flexibility (debt finance can be raised more
quickly than share capital) (1), capacity (excessive financial gearing can eliminate the capacity for
future borrowing) (1), risk and return (risk averse shareholders will only be prepared to take on
more risk where there is an opportunity for higher rates of return). (1)

The use of debt finance gives rise to a number of different risks, including liquidation risk, interest
rate risk and refinancing risk (1). Each of these risks must be balanced with the returns (or lower)
costs that can be achieved by the use of particular forms of debt finance. (1) These include the
lower cost of borrowing at variable interest rates and when using debt with a short term maturity.
(1)

Higher financial gearing makes returns more sensitive to changes in profit: a change in profits for
a business with a high level of financial gearing will lead to a proportionately greater change in the
return on shareholders’ funds. (1)

Other relevant material should be credited.

A basic pass would include:

• Some of the factors that might influence the attitudes of shareholders
• Some of the risks that arise due to the use of debt fiannce

A better answer would include:

• Most of the factors that might influence the attitudes of shareholders
• Most of the risks that arise due to the use of debt finance
• The implications of high levels of financial gearing on ROSF 6
Mark Allocation Guidance
Award a maximum of 6 marks, as per breakdown above.

7 (10 marks)

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 Cash is an important element of working capital. The amount of cash held by a business needs to be
considered with great care:
a. Explain three reasons an organisation might hold cash balances. (3 marks)
b. Explain three potential responses that a business might make to a forecast shortage of cash. (7 marks)

Q Indicative Content Total

7a Transactions motive – balancing of short term cash inflows and outflows for day-to-day operational
needs e.g. settling liabilities (1)
Precautionary motive – reserve amount held to meet unexpected demands for cash (1)
Speculative motive – use cash to take advantage of investment opportunities (1) 3
Mark Allocation Guidance
Award a maximum of 3 marks, as per breakdown above.
7b • Arrange extra finance – temporary shortages could be addressed via bank overdrafts or short
term bridging loans
• Accelerate payments from customers – acceleration of inflows could also have adverse effects
on trade relationships
• Delay supplier payments - decerlartion of outflows could also have adverse effects on trade
relationships
• Delay/suspend capital expenditure – this may have implications for maintenance/renewal of the
non-current asset base
• Seek to reduce operating costs – this might not be possible in the short-term
• Reduce/suspend dividend payments – this may affect investor perception and attitude
• Delay employee payments – this might not be possible due to contractual obligations
• Renegotiate structuring of debt obligations – agreement would have to be obtained from
providers of finance

Other relevant material should be credited.

A basic pass would include:

• Two potential responses
• An explanation of each of the potential responses identified

A better answer would include:

• Three potential responses
• Detailed explanation of each of the potential responses identified
• More appreciation of the implications for the business 7
Mark Allocation Guidance
1-3 marks per response, depending on the level of detail provided, up to a maximum of 7 marks.

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 Section C – 50 marks
(Essay questions: 2 out of 3 x 25 marks each = 50 marks total)

8 (25 marks)
The process of selling shares to the public for the first time is called an initial public offering (IPO).
a. Discuss the typical stages in the IPO process. (6 marks)
b. Critically evaluate the use of IPOs as a method of raising equity finance. (19 marks)

Q Indicative content Total

8a Stage Description
Investment bank Select an investment bank as a professional advisor and underwriter
Due diligence An investigation by the investment bank and the business that produces
the information required to satisfy appropriate regulatory authorities
Pre-marketing Distribution of briefing documents to institutional investors in order to
introduce the company
Underwriting An underwriting syndicate is formed by the investment bank to
underwrite the issue
Initial prospectus An initial prospectus includes an initial price range based on the
investment bank's analysis and the feedback from pre-marketing. Note
that some techniques for taking the business public fix the price in the
due diligence phase, so there is no initial prospectus
Pricing/allocation If the price has already been fixed, only the allocation remains to be
done 6
Mark Allocation Guidance
Award 1 mark per stage fully described up to a maximum of 6 marks.
8b Advantages
• Access: IPOs provide access to a much greater amount of equity finance
• Performance: provide a ‘yardstick’ measure with which to evaluate performance
• Diversification: greater diversification of sources of finance
• Reduced costs: potentially reduces the cost of borrowing
Disadvantages
• Dilution of control: shareholders of a business become more widely dispersed
• Agency problem: direct monitoring and supervision of managers becomes more difficult
• Administrative costs: additional regulatory and administrative costs

Other relevant material should be credited. 19

Level Mark Descriptor
0 No rewardable material
1 1-7 • Demonstrates isolated knowledge and understanding of relevant information; there may be
major gaps or omissions.
• Provides little evidence of application and links between relevant information. Analysis likely to
consist of basic description of information.
• Meaning may be conveyed but in a non-specialist way; response lacks clarity and fails to
provide an adequate answer to the question.
2 8-13 • Demonstrates coherent knowledge and understanding of relevant information with a few
omissions.
• Evidence of application demonstrating some linkages and interrelationships between factors
leading to an analysis being presented.

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 • Demonstrates the use of logical reasoning, clarity, and appropriate specialist technical
language.
3 14-19 • Demonstrates accurate and thorough knowledge and understanding of relevant information;
any gaps or omissions are minor.
• Evidences thorough application leading to a balanced analysis containing linkages and
interrelationships between factors.
• Logical reasoning evidenced throughout response which is clear and uses specialist technical
language consistently.

9 (25 marks)
Capital investments can involve substantial cash flows (both outflows and inflows). Often, the initial
investment that is needed to finance the acquisition of an asset that is needed to undertake a project can be
significant. Inappropriate investments can lead to disaster for the business.
Critically evaluate the following capital investment appraisal techniques:
i. Payback
ii. Accounting rate of return
iii. Net present value

Q Indicative content Total

9 Technique Advantages Disadvantages
Payback • simple and quick • does not accurately allow for the
• will tend to identify and lead to the timing of cash flows within the
acceptance of low-risk projects payback period
• Does not relate to wealth
maximisation
• Ignores the cash flows outside the
payback period
• target payback period is arbitrary
and difficult to establish
Accounting • simple and quick • profit based: profit can be distorted
rate of return • profit-based and is therefore easy by accounting adjustments
for managers to understand. • does not seek to adjust for the
effects of the time value of money.
• target ARR is necessarily arbitrary
and difficult to establish
• does not relate directly to the
concepts of wealth creation or
wealth maximisation
Net present • relates directly to wealth creation • difficult to use and to understand
value and wealth maximisation • does not necessarily lead to the
• reflects and adjusts for the effects identification and acceptance of
of the time value of money. the least risky investment.
• takes full account of the timing of •
the initial investment and of the
cash inflows and outflows that arise
during the project

Other relevant material should be credited. 25

Level Mark Descriptor
0 0 No rewardable material

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 1 1-9 • Demonstrates isolated knowledge and understanding of capital investment appraisal
techniques; there may be major gaps or omissions.
• Provides limited evidence of application and links between capital investment appraisal
techniques. Analysis likely to consist of basic description of information.
• Meaning may be conveyed but in a non-specialist way; response lacks clarity and fails to
provide an adequate answer to the question.
2 10-14 • Demonstrates some knowledge and understanding of capital investment appraisal techniques;
there may be major gaps or omissions.
• Provides superficial evidence of application and links between capital investment appraisal
techniques. Analysis likely to consist of imbalanced description of information.
• Meaning may be conveyed but in a non-specialist way; response lacks clarity but provides
partially an answer to the question.
3 15-18 • Demonstrates coherent knowledge and understanding of capital investment appraisal
techniques with a few omissions.
• Evidence of application demonstrating relevant linkages and interrelationships between
factors leading to an analysis being presented.
• Demonstrates sound use of logical reasoning, clarity, and appropriate specialist technical
language.
4 19-25 • Demonstrates accurate and thorough knowledge and understanding of capital investment
appraisal techniques; any gaps or omissions are minor.
• Evidences developed application leading to a balanced analysis containing linkages and
interrelationships between factors.
• Logical reasoning evidenced throughout response which is clear and uses specialist technical
language consistently.

10 (25 marks)
The range and complexity of the different types of risk and the impact that they could have on business can
seem overwhelming. A financial decision can have major implications for the success or even survival of a
business.
a. Analyse the financial management techniques that could be used to support the management risk in:
i. Financing decisions (3 marks)
ii. Investment decisions (3 marks)

b. Analyse the use of the following financial risk management techniques:

i. Sensitivity analysis (9 marks)
ii. Simulations (10 marks)

Q Indicative content Total

10a Financing decisions Investment decisions
Cost of capital: weighted average cost of Investment appraisal: net present value (NPV)
capital (WACC) (including the capital asset and other discounted cash flow (DCF)
pricing model and the dividend valuation techniques, internal rate of return (IRR), payback
model) period, accounting rate of return (ARR)
Financial gearing: Modigliani and Miller, Portfolio theory: expected values, security
financial gearing investment and risk, capital asset pricing model,
arbitrage pricing
Dividend decisions: Modigliani and Miller, Perfect and efficient markets: efficient markets
traditional school hypothesis, behavioural finance
6

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 Other relevant material should be credited.
Mark Allocation Guidance
Award 1 mark per technique identified and analysed up to a maximum of 6 marks.
10b i. Sensitivity analysis

Advantages
• Reduced exposure to financial risk: if applied appropriately
• Margin of safety: the calculation of a margin of safety for each key factor can help to identify
highly sensitive factors that require more detailed information. The collection, reporting and
evaluation of information can be costly and time-consuming. The more managers can focus on
the critical aspects of a financial decision, the better
• Planning: financial managers can use sensitivity analysis to formulate plans to deal with factors
that are highly sensitive
Disadvantages
• Clarity: sensitivity analysis does not provide clear decision rules. To some extent, financial
managers must still rely on their judgement
• Static: only one factor can be considered at a time whilst the rest of the variables are held
constant

Award one mark per advantage and disadvantage identified, to a maximum of 3 marks.
Award 2 marks per explanation of each advantage and disadvantage identified, to a maximum of
6 marks.
Total: 9 marks

ii. Simulations

Advantages
• Understanding: the process of modelling can help managers to understand it nature and the
key issues in the decision
• Risk measurement: the distribution of outcomes can help to assess the risk of a decision

Disadvantages
• Time consuming: designing and producing a simulation model can be time consuming.
• Complexity: The greater the complexity of a decision, the greater the complexity of identifying
key variables and probabilities
• Mechanical approach: simulations can lead to an over reliance on a quantitative approach to
financial decision making

Award one mark per advantage and disadvantage identified, to a maximum of 4 marks.
Award 2 marks per explanation of each advantage and disadvantage identified, to a maximum of
6 marks.
Total: 10 marks

Other relevant material should be credited. 19

Level Mark Descriptor
0 No rewardable material
1 1-8 • Demonstrates isolated knowledge and understanding of financial risk management techniques;
there may be major gaps or omissions.

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 • Provides limited evidence of application and links between financial risk management
techniques. Analysis likely to consist of basic description of information.
• Meaning may be conveyed but in a non-specialist way; response lacks clarity and fails to
provide an adequate answer to the question.
2 9-14 • Demonstrates good knowledge and understanding of financial risk management techniques
• Provides superficial evidence of application and links between financial risk management
techniques. Analysis likely to consist of imbalanced description of information.
• Meaning may be conveyed but in a non-specialist way; response lacks clarity but provides
partially an answer to the question.
3 15-19 • Demonstrates accurate knowledge and understanding of financial risk management techniques.
• Evidence of application demonstrating relevant linkages and interrelationships between factors
leading to an analysis being presented.
• Logical reasoning evidenced throughout response which is clear and uses specialist technical
language consistently.

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