Financial Pillar

F3 – Financial Strategy
26 May 2011 – Thursday 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

F3 – Financial Strategy
your calculator during this reading time.

You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is all parts and/or sub-
questions).

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

You should show all workings as marks are available for the method you use.

The pre-seen case study material is included in this question paper on pages
2 to 9. The unseen case study material, specific to this examination, is
provided on pages 10 and 11.

Answer the compulsory question in Section A on page 13. This page is

detachable for ease of reference.

Answer TWO of the three questions in Section B on pages 15 to 19.

Maths tables and formulae are provided on pages 21 to 25.

The list of verbs as published in the syllabus is given for reference on page
27.

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 2011

F plc

Pre-seen case study

Introduction
F plc is a food manufacturer based in the United Kingdom. It generates its revenue from three
divisions named the Meals, Snacks and Desserts divisions. Each division specialises in the
production of different types of food and operates from its own factory located on three different
sites in England. F plc’s head office is located in a remote part of England and is about
equidistant from each of the company’s three divisions.

Currently, F plc has a total employment establishment of about 10,000 full-time equivalent
employees, about 97% of whom are employed in its three divisions. It is constantly running with
about 700 full-time vacancies, mostly in the Desserts Division. This vacancy factor in the
Desserts Division impedes its productivity.

The company was founded over 150 years ago by an entrepreneurial farmer who saw the
opportunity to expand his farming business by vertically integrating into food production. Instead
of selling his crops on the open market, he established a mill and produced flour. From this, it
was a natural progression to diversify into producing other crops which were then processed into
different ingredients for food products.
th
The company grew steadily and it became clear at the beginning of the 20 Century that
increased production facilities were needed. It was at this point that the company built its first
factory which at the time was a state of the art manufacturing facility. As demand continued to
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grow during the 20 Century, the company required additional manufacturing facilities and made
a public offering of shares in 1960 to finance this expansion. The public offer was successful and
F Limited was established. The original family’s holding in the company fell to 25% at this point.
Although a second factory was opened with the capital that had been raised, F Limited
continued to manage the company on a centralised basis.

The next phase of development came in the late 1980’s when F Limited became F plc. After
this, F plc had a successful rights issue which raised sufficient capital to enable a third factory to
be built. It was at this point that the divisionalised and de-centralised structure was established.
Prior to this, the company managed its factories directly from its head office. The family
shareholding fell to 20% at this point, with one family member holding 10% of the shares and
family trusts holding the other 10%.

The environment in which F plc trades is dynamic, particularly with regard to the growth of
legislation relating to food hygiene and production methods. F plc now exports many of its
products as well as obtaining ingredients from foreign producers, which means that F plc must
observe legislative requirements and food standard protocols in different countries.

Mission statement
F plc’s mission statement, which was set in the year 2000, is as follows:

“F plc is committed to continually seek ways to increase its return to investors by expanding its
share of both its domestic and overseas markets. It will achieve this by sourcing high quality
ingredients, using efficient processes and maintaining the highest standards of hygiene in its
production methods and paying fair prices for the goods and services it uses.”

May 2011 2 Financial Strategy

Strategic aims
The strategic aims are set in order to enable F plc to meet the obligations contained in its
mission statement. F plc aims to:

(i) increase profitability of each of its divisions through increased market share in both
domestic and overseas markets
(ii) source high quality ingredients to enhance product attractiveness
(iii) ensure that its factories adhere to the highest standards of food hygiene which
guarantee the quality of its products
(iv) strive to be at the forefront in food manufacturing techniques by being innovative and
increasing efficiency of production with least waste.

Corporate Social Responsibility

F plc takes Corporate Social Responsibility (CSR) seriously. The post of Environmental Effects
Manager was created two years ago and a qualified environmental scientist was appointed to it.
The Environmental Effects Manager reports directly to the Director of Operations. The role of
the Environmental Effects Manager is to develop initiatives to reduce environmental impacts,
capture data on the environmental effects of divisional and head office operations and report to
the Board of Directors on the progress towards the achievement of F plc’s CSR targets. An
extract from F plc’s internal CSR report for 2010 is shown in Appendix 1. F plc does not publish
its CSR report externally.

Last year, F plc received criticism in the national press in England and in other countries for
exploiting some of its suppliers in Africa by paying low prices for ingredients. This resulted in an
extensive public relations campaign by F plc to counter these accusations. It established a
programme to channel funds to support farmers in Africa via payments made through African
government agencies. The programme, which is managed through F plc’s head office, received
initial financing from F plc itself and is now widening its remit to draw funding from other sources
including public funding from the European Union.

The Board of Directors

The Board of Directors comprises five executive and five non-executive members all of whom
are British. No member of the Board is from an ethnic minority.

The Chairman is a senior non-executive director and a retired Chief Executive of a major quoted
retail clothing company based in England. He received a knighthood two years ago for services
to industry.

The Chief Executive is 52 years old and was Director of Operations at F plc before taking up his
current post three years ago.

The Finance Director is 49 years old and a qualified CIMA accountant. He has experience in a
variety of manufacturing and retail organisations.

The Director of Operations is 65 years old and is a member of the original family which founded
the business. He has been employed by F plc for all of his working life. He took up his current
post three years ago following the promotion of the previous post holder to the role of Chief
Executive.

The Marketing Director is 43 years old and has held various positions in sales and marketing for
different organisations before being appointed to the Board. He came to the attention of the
Chief Executive when he was instrumental in a successful initiative to market a new shopping
complex in the city in which F plc’s head office is based. At the time, the Marketing Director was
the Chief Marketing Officer for the local government authority in the area.

The Director of Human Resources, the only female member of the Board, is 38 years old and
holds a recognised HR professional qualification. Last year she was presented with a national
award which recognised her achievements in the development of human resource management
practices.

Financial Strategy 3 May 2011

In addition there are four other non-executive directors on the Board. Two of them previously
worked in senior positions alongside the Chairman when he was Chief Executive of the retail
clothing company. One of them was the clothing company’s finance director, but is now retired
and the other was its marketing director but is now the sales and marketing director for a
pharmaceutical company. One of the other non-executive directors is a practising lawyer and the
other is a sports personality of national renown and a personal friend of the Chairman.

The Divisional General Managers, responsible for each of the three divisions, are not members
of F plc’s board. The Divisions are organised along traditional functional lines. Each division is
managed by a Divisional Board which is headed by a Divisional General Manager. Each
Divisional Board comprises the posts of Divisional Operations Manager, Divisional Accountant,
Divisional Marketing Manager and Divisional Human Resources Manager. Each division
undertakes its own marketing and human resource management. The divisional accountants are
responsible for the management accounting functions within their divisions. Each member of the
divisional boards is directly accountable to the Divisional General Manager but have
professional accountability to the relevant functional F plc executive board members.

Financial position and borrowing facilities

Extracts from F plc’s financial statements for the year ended 31 December 2010 are shown in
Appendix 2.

F plc’s long term borrowings are made up of a £160 million bank loan for capital expenditure and
a £74 million revolving credit facility (RCF).

The bank loan is secured on F plc’s assets and is repayable on 1 January 2018.

The RCF allows F plc to borrow, make repayments and then re-borrow over the term of the
agreement. This provides F plc with flexibility because it can continue to obtain loans as long as
it remains at or below £80 million, being the total amount agreed for this facility. The RCF
expires on 31 December 2013.

Planning process
The planning process employed by F plc is one which can be described as adhering to classical
rational principles. This has been the method of planning used for many years and culminates in
the production of a five year forecast. The annual budget cycle feeds in to the strategic plan
which is then updated on an annual basis. All F plc’s revenue is derived through the operations
of the three divisions. The only income generated by F plc’s head office is from investments. The
five year forecast for sales revenue and net operating profit for each division and F plc in total,
after deduction of head office operating costs, is shown in Appendix 3. This shows that F plc is
seeking to increase its sales revenue and net operating profit over the five year plan period.

Competition within the industry

F plc is one of the largest food production companies in England. It had an overall share of
about 6% of its home market in 2010. Its nearest competitors held 5% and 7% market share
respectively in 2010. The products in the industry have varying product life cycles. Competition
is intense and there is a high failure rate for new products. Usually, new products require
significant marketing support particularly if a new brand is being established.

Organisational culture within each division

Different cultures have emerged within each division.

Meals Division:
In the Meals Division, each function operates with little direct interference from the Divisional
Board members. The approach is to allow each function to operate with as little control as
possible being exercised by the Divisional Board.

May 2011 4 Financial Strategy

Snacks Division:
In the Snacks Division, the emphasis of the Divisional Board is on product research and
development and marketing. The Snacks Divisional Board expects its divisional marketing staff
to undertake market research into customer tastes and preferences and then for products which
satisfy these to be developed by its divisional research staff.

Desserts Division:
In the Desserts Division, the finance function is the dominant force. The finance functions in the
other two divisions exert less influence over operations than is the case in the Desserts Division.
It is not unusual for the Divisional Accountant in the Desserts Division to have confrontational
meetings with managers of other functions. Such confrontation is particularly evident in the
monthly meetings between the Divisional Accountant and the Divisional Marketing staff. It is
clear that within the Desserts Division, the Divisional General Manager, a food technologist by
profession, and the Divisional Accountant, formerly an auditor with a local government authority,
maintain strict control over the operation of the division.

Further details relating to the three divisions are as follows:

Meals Division
The Meals division is located in the South of England. It specialises in manufacturing frozen
meals, which are designed to be easy for consumers to quickly heat up and serve. The meals
are sold to supermarkets and other retail outlets. Some are manufactured under F plc’s own
brand and others are manufactured under supermarkets’ own labels. The division is also
increasing its sales to welfare organisations which support elderly and infirm people. These
organisations purchase simple frozen meals in bulk which they then heat up to provide a hot
meal each day to those people in their care. In 2010, the Meals Division earned 14% of its
revenue from outside the United Kingdom.

One of the Meals Division’s most profitable products is a steak pie that is flavoured with special
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gravy that was developed by one of F plc’s founding family members in the early part of the 20
Century. F plc’s competitors cannot copy this gravy because the ingredients have to be
combined in a very precise manner and then cooked in a particular way. The recipe for this
gravy is known only to F plc’s Director of Operations and the manager of the pie factory.
Two of the Meals Division’s products are currently subject to investigation by the Food
Standards Authority of a European country. Please see Appendix 1 under the heading “Food
labelling” for more information on this.

Snacks Division
The Snacks Division, located in the East of England, mainly manufactures confectionery such as
packet savouries and chocolate bars. Its main customers are supermarkets and retail shops. It
has a growing market in continental Europe and in 2010 the division earned 19% of its revenue
from non-United Kingdom sales. Many of its products are F plc’s own brands, although, similarly
with the Meals Division, it supplies products to supermarkets under their own label.

The Snacks Division successfully launched a new premium brand of chocolate bars in the UK in
2010.

Desserts Division
The Desserts Division is located in the North of England where road, rail and air links are not
well developed. This has resulted in high transportation costs for goods into and out of the
factory. Originally, this location was chosen because the lease terms for the factory were very
competitive but in recent times the local taxes placed on the factory have become expensive.
There is some limited room for expansion on the site the factory occupies but the local
government authority has repeatedly rejected the expansion plans when the Division has sought
the necessary planning permission to put its plans into action. This has caused the Divisional
Board to consider whether it should move its entire operation to another part of England where
its expansion plans may be more easily accomplished.

Financial Strategy 5 May 2011

The Division has experienced technical and managerial staff shortages. The workforce of the
Division has an establishment of 4,700 full-time equivalent employees. Despite there being a
ready supply of manual labour for production work, the Desserts division runs with an average
of 385 full-time vacancies at any one time.

The Division’s products range from cold desserts, particularly ice cream, which can be eaten
directly from the packaging, to those which require some preparation by the final purchaser
before the product can be consumed. The Divisional Marketing Department has been
investigating the possibility of negotiating ‘Freezer deals’ by which the Desserts Division would
supply ice cream freezers to independent retailers which sell the Division’s ice cream products.
An independent retailer is a shop or outlet that is not part of a larger chain. This is in order to
investigate the possibility of increasing the Division’s share of the ice cream market sold by
independent retailers.

The Division’s sales increase in the periods which lead up to national and international festive
periods such as Christmas and Chinese New Year. The Division is constantly researching new
markets in an effort to increase its foreign earnings. Revenue from outside the United Kingdom
in 2010 represented 23% of the Division’s total revenue.

Inventory control and IT systems

There have been a number of problems across all three divisions in respect of inventory control.
Poor inventory control has led to high levels of wastage and obsolete inventory being carried.
This has been particularly problematic in respect of perishable ingredients. In the case of the
Desserts Division, the Divisional Accountant has estimated that 5% of the Division’s potential
revenue has been lost as a result of not being able to satisfy customer orders on time, due to
poor inventory control.

F plc operates a standard information management system across all the Divisions and at Head
Office. The Information Technology in use has been unreliable due to technical malfunctions
since the information management system was installed in 2001. Monthly management
accounts, provided by each division to head office are often late, sometimes not being made
available for up to three weeks into the subsequent month.

Internal audit
Until now, F plc’s Internal Audit function, which is based at Head Office, has tended to
concentrate its efforts on reviewing activities in the Meals and Snacks divisions as they each
produce lower revenues and net operating profits in absolute terms compared with the Desserts
division. The Internal Audit function’s approach of applying a “light touch” to the Desserts
Division is also in recognition of the influence exerted by the Divisional Finance function over the
Division’s operational activities.

Strategic development
The Board of Directors is now midway through its strategic planning cycle and is considering
how the company should move forward. There is a proposal to build and operate a factory in
West Africa to reduce air kilometres being flown in supplying the Meals Division with fresh
vegetables. It is intended that the African factory will freeze the vegetables and then transport
them to the Meals Division’s factory in England by refrigerated ship.

May 2011 6 Financial Strategy

 APPENDIX 1

Extracts from F plc’s internal Corporate Social Responsibility report for the year ended 31
December 2010.

This report was produced by the Environmental Effects Manager and presented to the
Board of F plc in February 2011.

Fair trading
In accordance with its mission statement, F plc is committed to paying a fair price for the
ingredients it uses in its products, particularly to farmers in the less developed economies of the
world.

Waste reduction and recycling

F plc set a target for the financial year 2010 that waste of ingredients should be cut by 2%,
measured by weight, from the 2009 levels. The actual ingredient waste was 2.5% lower in 2010
than in 2009 as measured by weight.

A target was also set for F plc to recycle 90% of its used packaging in the year 2010. It was
recorded that 85% of packaging in 2010 was actually recycled.

Food labelling
Legal requirements demand accuracy in food labelling, in respect of ingredients, product
description and cooking instructions in many countries. F plc employs a Compliance Manager to
ensure that relevant labelling laws in each country, with which the company trades, are adhered
to. A target is set for F plc to justify 100% of its claims in food labelling. Two products
manufactured in the Meals Division are currently undergoing investigations by the Food
Standards Authority of a European country following allegations that the labelling is inaccurate.

(Update: Eight elderly people were admitted to hospital in February 2011 with suspected food
poisoning after eating one of the packaged meal products which is under investigation by the
Food Standards Authority.)

Transportation
Following adverse press coverage relating to the high number of kilometres travelled when
importing and exporting goods from and to overseas countries, F plc introduced a target that its
use of air travel should be reduced by 10% in 2010 compared with the amount used in 2009. F
plc fell short of its target by only reducing air kilometres travelled by 3% in 2010 compared with
2009. Road kilometres travelled increased by 5% in 2010 compared with 2009.

Efficiency of energy usage in production

In an effort to reduce carbon emissions from the three divisions and head office, a target was set
that by 2015, F plc will become carbon neutral in terms of its usage of energy. Energy usage in
2010 was at the same level as 2009. It has been proposed that energy efficient lighting should
replace the current energy inefficient lighting at all three factories and at head office in 2011 and
smart meters should be installed in all of F plc’s premises to keep the waste of electricity to a
minimum.

Financial Strategy 7 May 2011

 APPENDIX 2

Extracts from F plc’s income statement and statement of financial position

Income statement for the year ended 31 December 2010

£ million (GBP million)

Revenue 986
Operating costs (938)
Net operating profit 48
Interest income 1
Finance costs (16)
Corporate income tax (10)
PROFIT FOR THE YEAR 23

Statement of financial position as at 31 December 2010

Notes £ million (GBP million)

ASSETS
Non-current assets 465
Current assets
Inventories 90
Trade and other receivables 112
Cash and cash equivalents 20
Total current assets 222
Total assets 687

EQUITY AND LIABILITIES

Equity
Share capital 1 140
Share premium 40
Retained earnings 61
Total equity 241

Non-current liabilities
Long term borrowings 2 234
Current liabilities
Trade and other payables 212
Total liabilities 446
Total equity and liabilities 687

Notes:

1. There are 560 million ordinary shares of £0.25 each in issue.

2. The long term borrowings comprise £160 million loan for capital expenditure which is
repayable on 1 January 2018 and a £74 million revolving credit facility which expires on
31 December 2013.

May 2011 8 Financial Strategy

 APPENDIX 3

Five year forecast of sales revenue and net operating profit for each division and F plc in
total and operating costs for head office

All figures are shown in £ million (GBP million)

2010 2011 2012 2013 2014 2015

(Actual)

Meals Division

Sales revenue 266 287 310 335 362 391

Net operating profit 31 34 40 47 54 63

Snacks Division

Sales revenue 176 194 213 234 258 283

Net operating profit 44 48 53 58 64 71

Desserts Division

Sales revenue 544 571 600 630 661 694

Net operating profit 72 80 90 101 112 125

Head office

Operating costs (99) (107) (112) (118) (124) (130)

F plc total

Sales revenue 986 1,052 1,123 1,199 1,281 1,368

Net operating profit 48 55 71 88 106 129

End of Pre-seen Material

The unseen material begins on page 10

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Financial Strategy 9 May 2011

SECTION A – 50 MARKS
[You are advised to spend no longer than 90 minutes on this question]
ANSWER THIS QUESTION

Question One
Unseen case material
Background

Today’s date is 26 May 2011.

In 2010, the Snacks Division successfully launched a new premium brand of chocolate bars,
MATT SNACKS, in the UK. The Divisional Board of the Snacks Division is now considering
plans put forward by the Divisional Marketing Manager to launch the full range of MATT
SNACKS in France, priced in euro (EUR). The launch is planned for 1 January 2012.

It is well known within the industry that it can be very difficult for a foreign company to break into
the French market for chocolate snacks because there is significant loyalty towards local French
brands and imported Swiss and Belgian brands. Initial market research based on free tasting
sessions has met with an encouraging response but there is still some uncertainty over the
success of the launch. However, the greatest danger to the success of MATT SNACKS in
France is considered to be the risk that a UK competitor might launch a similar range of products
in the same market.

Financial data for the project

To date, British Pounds (GBP) 0.5 million has been spent on initial market research for the
products in the French market.

If the project is approved, an additional GBP 2.0 million will be required for detailed market
research and packaging design. The cost of the launch itself includes an expensive radio and
television advertising campaign in France and is expected to be of the order of GBP 1.0 million.
Both of these costs are tax deductible. In addition, EUR 8.4 million will be spent on a distribution
centre in France. All of these one-off costs are payable on 1 January 2012.

Estimates of net operating cash flows for the project vary considerably according to assumptions
made regarding consumer and competitor reaction to the launch of MATT SNACKS in France.
Forecast cash flow figures for the sales revenue and associated costs for the project for the year
ending 31 December 2012 have been estimated based on two possible outcomes, known as
Scenario A and Scenario B. The forecasts are:

Forecast operating cash flow figures

for the year ending 31 December 2012

Scenario A: Sales revenue EUR 10.0 million

Costs EUR 1.0 million plus GBP 2.0 million

Scenario B: Sales revenue EUR 5.5 million

Costs EUR 1.0 million plus GBP 1.5 million

All operating cash flows shown above are expected to grow by 5% per annum in subsequent
years for the duration of the project.

It can be assumed that if Scenario A occurs in 2012, it will also occur in all subsequent years.
The same is true for Scenario B. It is estimated that there is a 70% probability of occurrence of
Scenario A and a 30% probability of Scenario B.

May 2011 10 Financial Strategy

Other relevant financial information:

• The Snacks Division evaluates projects of this nature at a risk-adjusted after-tax

discount rate of 15% over a 4 year period.

• The proposed new distribution centre to be built in France is expected to have a

residual value of EUR 5.2 million after 4 years.

• Corporate income tax is charged at 35% on taxable profits and is paid at the end of the
year in which the taxable profit arises. Tax depreciation allowances are available on all
capital expenditure associated with the project at a rate of 100%. Balancing charges
will arise on any residual value. There are sufficient profits elsewhere in the group to
be able to take advantage of these tax benefits or any taxable losses that occur.

• Operating cash flows should be assumed to arise at the end of the year to which they
relate.

• The exchange rate is expected to be GBP/EUR 1.2000 (GBP 1 = EUR 1.2000) on

1 January 2012 and British Pounds are expected to strengthen against the euro by 2%
a year in each of the next 4 years.

• The project could be abandoned on 1 January 2013 and the distribution centre sold for
an estimated EUR 7.0 million. If the project were abandoned on 1 January 2013, no
further cash inflows or outflows would arise from then onwards and there would be no
penalties for pulling out of the market.

The requirement for Question One is on page 13 which is detachable

for ease of reference

Financial Strategy 11 May 2011

 This page is blank

May 2011 12 Financial Strategy

Required:

Assume that you are the Management Accountant of the Snacks Division and have been asked
to write a Report addressed to the Divisional Board of the Snacks Division of F plc that will assist
it in deciding whether or not to proceed with the proposed product launch. In your report you are
required to:

(a) Ignoring the abandonment option:

(i) Calculate the NPV for the project as at 1 January 2012 for Scenarios A and B
individually as well as the overall total expected NPV.
(13 marks)

(ii) Calculate the payback period for the project for each of Scenarios A and B.
(4 marks)

(iii) Interpret your results from (a)(i) and (a)(ii).

(6 marks)

(b) Evaluate whether or not the project should be abandoned on 1 January 2013 if Scenario
B occurs.
(8 marks)

(c) Advise how real options and other strategic financial issues might influence the initial
investment decision.
(12 marks)

(d) Recommend, with reasons, whether or not to proceed with the proposed product launch
on 1 January 2012.
(4 marks)

Additional marks available for structure and presentation: (3 marks)

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A
Section B starts on page 15

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Financial Strategy 13 May 2011

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May 2011 14 Financial Strategy

SECTION B
[You are advised to spend no longer than 45 minutes on each question in this section]

ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH

Question Two
HJK is a long established, family owned and run, IT consultancy company. The company has
experienced rapid growth in recent years.
Recent financial history for HJK:
Year ending Profit for the year Investment in projects Dividend
31 December after interest and tax or capital expenditure paid
EUR million EUR million EUR million
2006 6 - 3
2007 7 10 2
2008 10 - 5
2009 11 15 2
2010 16 - 8
In recent years, investment has been funded by cash held generated by the business but HJK
now requires additional funds to finance significant expansion. The Directors have considered
additional bank finance but their preference is for an initial public offering (IPO), that is, an offer
for sale of shares to the public. However, the Directors are concerned about the implications of
an IPO on the financial strategy of the company in the areas of dividend, financing and
investment.

Required:

(a) Evaluate the current dividend policy of HJK.

(6 marks)

(b) (i) Describe the process involved in an IPO.

(3 marks)

(ii) Advise on the potential risks with an IPO and what action can be taken to minimise
such risks.
(4 marks)

(c) Discuss the concerns of the Directors regarding the possible implications of becoming a
listed company on dividend, financing and investment strategies and the
interrelationship between them.
(12 marks)

(Total for Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

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Financial Strategy 15 May 2011

Question Three

AB is a spin-off company from a major South American university. AB works with large
manufacturing companies to find effective ways to reduce carbon emissions. Revenue was
$300 million in the year ended 30 June 2010 and the company is expected to earn its first profit
in the year ending 30 June 2011. Demand for its services is very high in a market which is
developing very rapidly. A proposal to invest in specialist equipment has been appraised and
shows a positive NPV using the company’s weighted average cost of capital.

The specialist equipment will cost $50 million and is estimated to have a useful economic life of
five years with no residual value. The equipment will need to be installed on 1 July 2011.

Three alternative methods of financing the equipment are being considered, each of which
would commence on 1 July 2011. These are as follows:

Alternative 1

• Buy the equipment outright on 1 July 2011, funded by a five year bank borrowing that has
an after-tax cost of debt of 7% per annum.

Alternative 2

• Enter into a finance lease. AB would make a payment of $14.0 million in advance and
then five further annual payments of $9.0 million on 1 July each year, starting in 2012.
The interest rate implicit in the finance lease has been calculated to be approximately
8.4% and the implied interest has been calculated as follows:

Year to 30 June 30 June 30 June 30 June 30 June

2012 2013 2014 2015 2016
Implied interest at 8.4% 3.0 2.5 2.0 1.4 0.7
($ million)

• Tax relief is available on both the accounting depreciation and the interest element of the
finance lease payments.

Alternative 3

• Enter into a lease that is classified as an operating lease for tax purposes. AB would
make payments of $16.5 million annually in arrears for three years, with the first payment
on 1 July 2012. It is possible that on termination of the lease a new operating lease would
be available for two further years for more advanced equipment at an estimated cost of
$15.0 million per annum payable in arrears.

Other information

• AB’s accounting policy is to depreciate specialist equipment on a straight line basis over
its economic useful life.
• Corporate income tax is charged at 25% on taxable profits and is paid at the end of the
year in which the taxable profit arises.
• A tax depreciation allowance is available on a straight line basis over the economic useful
life of an asset.
• Due to the nature of the specialist equipment maintenance costs are expected to be fairly
high at $2 million a year, payable at the end of each year. These will be the responsibility
of AB under the terms of the finance lease and with an outright purchase. However,
maintenance costs will be the responsibility of the lessor under the terms of the operating
lease.

May 2011 16 Financial Strategy

 Required:

(a) Calculate the present value, as at 1 July 2011, of the cash-flows associated with
each of the three alternative financing methods under consideration.
(13 marks)

(b) Recommend, with reasons, which of the three alternative financing methods should
be chosen.
(8 marks)

(c) Discuss how an immediate change in government policy to improve tax depreciation
allowances on equipment used in low carbon emission technology would impact on the
decision. No further calculations are required.
(4 marks)

(Total for Question Three = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

TURN OVER

Financial Strategy 17 May 2011

Question Four

Today’s date is 26 May 2011.

WW is a publishing company that is listed in an Asian country, Country A, which uses the A$ as
its currency. WW operates as three separate divisions according to type of publication as
follows:

• Public Division – magazines and journals that are widely available in retail stores for
purchase by the general public.
• Specialist Division - specialist magazines for particular industry sectors which are only
available for delivery by post.
• In-house Division – company in-house journals for circulation to its own staff members.

WW has been disappointed with the recent performance of the Specialist Division and is
considering selling that division. WW manages the company’s debt centrally and measures the
performance of the divisions on the basis of EBIT (earnings before interest and tax).

XX, a book publishing company, has expressed an interest in purchasing the Specialist Division.
XX is also located in Country A and is confident that it has the expertise required to improve the
performance of the Specialist Division. XX would purchase the net assets employed in the
division (that is, non-current assets plus working capital). All borrowings would remain with WW.

There has been some discussion amongst the Directors of XX as to the most appropriate
method to use to value the Specialist Division.

Director A has suggested that an asset-based valuation should be used.

Director B has proposed that the valuation should be based on the future operating cash
flows of the division, adjusted for tax and discounted by XX’s existing weighted average
cost of capital (WACC).

Director C has suggested that the WACC used in the valuation should be derived from a
proxy company. He has identified YY as a possible proxy for the Specialist Division. YY’s
sole activity is publishing specialist magazines in a similar market to the Specialist Division.

Director D has suggested that the earnings valuation model should be used based on an
estimated cost of equity for the Specialist Division.

Financial data for WW’s Specialist Division

The management of WW have provided XX with the following financial data for the Specialist
Division:
• The net assets employed in the division had a book value of A$ 15.0 million and an
estimated replacement value of A$ 20.0 million on 31 March 2011.
• Operating cash flows adjusted for tax were A$ 2.5 million in the year ended
31 March 2011.
• Operating cash flows are forecast to grow by only 1% per annum in perpetuity if the
division remains within WW.

May 2011 18 Financial Strategy

Financial data for XX and YY

XX YY
Equity beta 1.5 0.8
Gearing ratio (debt/(debt plus equity)) 40% 25%
Pre tax cost of debt 6% 7%
Market capitalisation A$ 150 million A$ 30 million

Additional relevant information for all companies WW, XX and YY:

• Corporate income tax rate is 30%.
• Risk free rate is 5%.
• The premium over the risk free rate by the market is 6%.
• Debt betas are zero.

Required:

(a) Calculate:

(i) XX’s existing cost of equity.

(1 mark)
(ii) XX’s existing weighted average cost of capital (WACC).
(2 marks)

(iii) A suitable WACC for the Specialist Division based on proxy YY, adjusted for XX’s
gearing.
(5 marks)

(b) (i) Calculate a range of values for the Specialist Division based on the different
methods suggested by Directors A, B and C (but not Director D).
(5 marks)

(ii) Discuss the validity of the methods suggested by each of the four Directors A, B,
C and D.
(8 marks)

(iii) Advise XX on an appropriate price for the purchase of the Specialist Division.
(4 marks)

(Total for Question Four = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

(Total for Section B = 50 marks)

End of Question Paper

Maths Tables and Formulae are on Pages 21 – 25

Financial Strategy 19 May 2011

 Maths Tables and Formulae are on Pages 21 – 25

May 2011 20 Financial Strategy

 MATHS TABLES AND FORMULAE

Present value table

-n
Present value of 1.00 unit of currency, that is (1 + r) where r = interest rate; n = number of periods until
payment or receipt.

Periods 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 0.705 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

Financial Strategy 21 May 2011

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 2011 22 Financial Strategy

 FORMULAE

Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div
value:
d
P0 =
k pref
(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value:
d
P0 =
ke
(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where
P 0 is the ex-div value:
d1 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 P 0 is the ex-interest
value:
i [1 − t ]
P0 =
k d net

i
or, without tax: P0 =
kd

(v) Total value of the geared entity, V g (based on MM):

V g = V u + TB

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

n
S = X[1 + r]

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

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

Financial Strategy 23 May 2011

 Cost of capital
(i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current
ex-div price P 0 :
d
k pref =
P0

(ii) Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price P 0 :
i [1 − t ]
k d net =
P0
(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div
price P 0 :
d
ke =
P0

(iv) Cost of ordinary (equity) shares, having a current ex-div price, P 0 , having just paid a dividend, d 0 , with the
dividend growing in perpetuity by a constant g% per annum:

d1 d 0 [1 + g ]
ke = +g or ke = +g
P0 P0
(v) Cost of ordinary (equity) shares, using the CAPM:
k e = R f + [R m – R f ]ß

(vi) Cost of ordinary (equity) share capital in a geared entity :

VD [1− t ]
k eg = k eu + [k eu – k d ] VE

(vii) Weighted average cost of capital, k 0 or WACC

 VE   VD 
WACC = k e
V + V  + k d [1 − t ] V + V 
 E D   E D 

(viii) Adjusted cost of capital (MM formula):

K adj = k eu [1 – tL] or r* = r[1 – T*L]

(ix) Ungear ß:

 VE   VD [1 − t ] 
ßu = ßg
  + ß d V V 
VE + VD [1 − t ]   E + D [1 − t ] 
(x) Regear ß:
VD [1− t ]
ß g = ß u + [ß u – ß d ] VE

(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)

1 + annual discount rate B$ Future spot rate A$/B$ in 12 months' time

=
1 + annual discount rate A$ Spot rate A$/B$
where A$/B$ is the number of B$ to each A$

May 2011 24 Financial Strategy

Other formulae

(i) Expectations theory:

1 + nominal countryB interest rate

Future spot rate A$/B$ = Spot rate A$/B$ x
1 + nominal countryA interest rate

where:
A$/B$ is the number of B$ to each A$, and
A$ is the currency of country A and B$ is the currency of country B

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

1 + countryB inflation rate

Future spot rate A$B$ = Spot rate A$/B$ x
1 + countryA inflation rate

(iii) Link between nominal (money) and real interest rates:

[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]

(iv) Equivalent annual cost:

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:

Theoretica l ex rights price − issue price

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

Financial Strategy 25 May 2011

 This page is blank

May 2011 26 Financial Strategy

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

Level 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

Level 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 or
purpose of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something

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

Level 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 Build up or compile
Discuss Examine in detail by argument
Interpret Translate into intelligible or familiar terms
Prioritise Place in order of priority or sequence for action
Produce Create or bring into existence

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

Financial Strategy 27 May 2011

 Financial Pillar

Strategic Level Paper

F3 – Financial Strategy

May 2011

Thursday Morning Session

May 2011 28 Financial Strategy