The Institute of Chartered Accountants in England and Wales

FINANCIAL
MANAGEMENT

For exams in 2020

Question Bank
www.icaew.com
 Financial Management
The Institute of Chartered Accountants in England and Wales

ISBN: 978-1-5097-2782-7
Previous ISBN: 978-1-5097-2137-5

First edition 2007

Thirteenth edition 2019
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system or transmitted in any form or by any means,
graphic, electronic or mechanical including photocopying, recording,
scanning or otherwise, without the prior written permission of the
publisher.
The content of this publication is intended to prepare students for the
ICAEW examinations, and should not be used as professional advice.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Contains public sector information licensed under the Open Government
Licence v3.0
Originally printed in the United Kingdom on paper obtained from
traceable, sustainable sources.

© ICAEW 2019

ii Financial Management: Question Bank ICAEW 2020

Contents
The following questions are exam-standard. They are not the original questions from the exams.
The original questions can be downloaded from the ICAEW website. The marking guides
provided with the answers are illustrative to help students understand how marks may be
allocated in the exam and to identify gaps in their answers.

Study Time Page

manual allocation
Title reference Marks Mins Question Answer

Objectives and investment

appraisal
1 Stoane Gayte Sounds plc
(March 2013) 2, 7 29 43.5 3 123
2 Profitis plc (December 2001) 2 17 25.5 4 126
3 Horton plc (June 2009) 2 35 52.5 5 128
4 ProBuild plc (June 2013) 2, 3 29 43.5 7 132
5 Frome Lee Electronics Ltd
(September 2008) 2, 3, 5 26 39 8 134
6 Nuts and Bolts Ltd (March 2011) 2 24 36 10 137
7 Newmarket plc (Sample paper) 2, 3 35 52.5 11 140
8 Grimpen McColl International Ltd
(September 2012) 2, 3 30 45 12 144
9 Wicklow plc (December 2008) 2, 3, 6 35 52.5 14 147
10 Daniels Ltd (March 2007) 2 25 37.5 16 150
11 Hawke Appliances Ltd
(September 2014) 2, 3, 8 35 52.5 17 153
12 Alliance plc (December 2015) 2, 3 35 52.5 19 157

Finance and capital structure

13 Turners plc (June 2014) 2, 4, 5, 6 35 52.5 22 160
14 Middleham plc (Sample paper) 4, 5 35 52.5 23 163
15 Better Deal plc (March 2010) 5, 7 35 52.5 24 165
16 Puerto plc (December 2013) 5, 6 35 52.5 25 168
17 Abydos plc 2, 6 16 24 26 171
18 Biddaford Lundy plc (March 2012) 4, 6 35 52.5 27 173
19 BBB Sports plc (December 2015) 4, 5, 6, 7 35 52.5 28 177

Business valuations, plans,

dividends and growth
20 Cern Ltd (December 2012) 2, 8 31 46.5 30 181
21 Wexford plc (December 2008) 4, 6, 8 30 45 32 184
22 Loxwood (March 2014, amended) 2, 4, 8 40 60 34 187
23 Sennen plc (June 2014) 2, 3, 7, 8 35 52.5 35 191
24 Tower Brazil plc (September 2014) 4, 6, 7 35 52.5 37 194
25 Brennan plc 2, 8 20 30 38 196

ICAEW 2020 Contents iii

 Study Time Page
manual allocation
Title reference Marks Mins Question Answer

Risk management
26 Fratton plc (June 2011) 9, 10 30 45 40 198
27 Sunwin plc (December 2012) 9 26 39 41 200
28 Padd Shoes Ltd (March 2014) 9, 10 30 45 42 203
29 Lambourn plc (Sample paper) 9, 10 30 45 43 205
30 Bridge Engineering plc
(December 2015) 9 30 45 44 208

March 2016 exam

31 Aranheuston Pharma plc 1, 2, 3 35 52.5 46 212
32 Oliphant Williams plc 4, 6 35 52.5 47 216
33 Tully Carlisle Ltd 9, 10 30 45 49 219

June 2016 exam

34 Zeus plc 2, 4, 8 35 52.5 50 223
35 Ross Travel plc 4, 5 35 52.5 51 226
36 Heaton Risk Management 9, 10 30 45 53 230

September 2016 exam

37 Northern Energy Ltd 9, 10 30 45 55 233
38 Roper Newey plc 2, 5, 6 35 52.5 56 236
39 Darlo Games Ltd 2, 8 35 52.5 57 239

December 2016 exam

40 Ribble plc 2, 3 35 52.5 60 242
41 Bristol Corporate Finance 4, 5, 6 35 52.5 61 245
42 Orion plc 9, 10 30 45 63 249

March 2017 exam

43 Sentry Underwood plc 4, 6, 7 35 52.5 65 252
44 White Rock plc 2, 3, 4 35 52.5 66 256
45 ST Leonard Foods 9, 10 30 45 68 261

June 2017 exam

46 Brighton plc 1, 2, 3 35 52.5 70 264
47 Easton plc 3, 4, 5, 6 35 52.5 71 267
48 Lake Ltd 9, 10 30 45 72 270

iv Financial Management: Question Bank ICAEW 2020

 Study Time Page
manual allocation
Title reference Marks Mins Question Answer

September 2017 exam

49 Merikan Media plc 8 35 52.5 74 273
50 Ramsey Douglas Motors plc 4, 5, 6 35 52.5 75 275
51 Jenson Grosvenor plc 9, 10 30 45 77 278

December 2017 exam

52 Innovative Alarms 1, 2, 3, 4 35 52.5 79 281
53 Peel Kitchens plc 3, 4, 5, 6, 7 35 52.5 81 284
54 Jewel House Investments Ltd 9, 10 30 45 82 288

March 2018 exam

55 Wells Bakers plc 1, 3, 4, 5 35 52.5 85 291
56 Hunt Trading plc 9, 10 30 45 86 294
57 Bishop Homes Ltd 2, 3 35 52.5 88 297

June 2018 exam

58 Helvellyn Corporate Finance 2, 8 35 52.5 90 301
59 Blackstar plc 1, 4, 6, 7 35 52.5 92 304
60 Tarbena plc 9, 10 30 45 94 307

September 2018 exam

61 Thomas Rumsey Group plc 2, 3 35 52.5 96 311
62 Heath Care plc 4, 5, 6 35 52.5 97 315
63 Eddyson Cordless Ltd 9, 10 30 45 99 319

December 2018 exam

64 Physiotec plc 2, 3, 4 35 52.5 101 323
65 North American Cars Ltd 9, 10 30 45 102 326
66 Continental plc 4, 5, 6 35 52.5 104 329

March 2019 exam

67 Palace Parade Furniture plc 4, 6, 8 35 52.5 106 334
68 Edencatt Packaging plc 1, 5, 6 35 52.5 107 338
69 Cool Sports Ltd 9, 10 30 45 109 342

June 2019 exam

70 Optical Answers plc 2, 8 35 52.5 111 346
71 Stable plc 4, 5, 7 35 52.5 112 350
72 Technical Equipment Ltd 10 30 45 114 353

ICAEW 2020 Contents v

 Study Time Page
manual allocation
Title reference Marks Mins Question Answer

September 2019 exam

73 Hodder Specialist Engineering Ltd 2, 3 35 52.5 116 356
74 Jackett Clarke Travel plc 4 35 52.5 117 360
75 Barratt Waters Shine plc 9,10 30 45 119 364

Appendix
Formulae and discount tables

vi Financial Management: Question Bank ICAEW 2020

Question Bank topic finder
Set out below is a guide showing the Financial Management syllabus learning outcomes, topic
areas, and related questions in the Question Bank for each topic area. If you need to concentrate
on certain topic areas, or if you want to attempt all available questions that refer to a particular
topic, you will find this guide useful.

Syllabus Study
learning Manual
Topic area outcome(s) Question number(s) chapter(s)

Adjusted present value 1g 9,13,17,38,47,53,68 6

Business valuation 3i 11,20,22,23,25,34,39,49,67 8
methods
Capital rationing 3g 3,10,12,44,70 2
CAPM 1h 13,14,15,16,19,35,38,41,47,53,55,62,66,71 3
Currency futures 2d 29,36,37,42,48,51,54,60,63,69,73 10
Currency options 2d 26,28,33,36,37,42,45,48,51,54,56,60,63,65, 10
69,73
Debenture issues 1j 17,35,41,50,53,59,71 6
Dividend policy 1i 1,15,24,32,43,53,59,71 7
Economic risk 2f 42,51,63,65,72 10
EMH/behavioural 1d 13,14,16,44,50,53 4
effects
Ethics 1c 19,22,23,24,32,34,39,40,43,46,50,52,55,59, 1,4
61,64, 69,71
Financial statements/ 1k 16,21,41,43 6
financing plans
Forward contracts 2d 26,28,29,33,36,37,42,45,48,51,54,56,60,63, 10
65,69, 72
Forward rate 2c 26,37,45 9
agreements
Gearing 1g 24,53,66 6
Gordon growth model 1f 13,19,62 5
Hedging advice 2a, 2b 28,42,45,48,51,54,56,60,63,65,69,72 9,10
Index options/futures 2c 27,36,54,63,65 9
Interest rate futures 2c 26,27,29,45,54,56,65 9
Interest rate options 2c 27,30,37,45,56 9
Interest rate parity 2c 42,60,69 9
Interest rate swaps 2c 33,37,54 9
Loan covenants 1e 16 4

ICAEW 2020 Question Bank topic finder vii

 Syllabus Study
learning Manual
Topic area outcome(s) Question number(s) chapter(s)

Management buy outs 3i 23,34,41,49,67 8

Money market hedges 2d 26,28,29,33,37,45,48,51,56,63,65,69,72 10
NPV – 3e 7,8 2
assumptions/strategic
factors
NPV calculations – 3b 4,5,6,8,8,64,70 2
inflation
NPV calculations – 3b 1,4,5,6,7,8,9,10,11,12,44,52,57,58,61 2
relevant cash flows
Overseas trading 2f; 3f 8,19,28,48,51,63 2,10
Real options 3e 4,7,40,46,52,57,61,64,70 2
Replacement 3h 2,10,20,52 2
decision/cycle
Rights issues 1j 18,24,41,44,53,59 6
Risk 3d 4,7,8,19,47,64 2,3
Sensitivity analysis 3c 9,11,12,31,40,46,52,57,64,70 3
Share buy back 1i 59 7
Share for share 3i 23 8
exchange
Share options 2e 30,36 9
Shareholder value 3a 22,25,31,39,46,49,58,61,67,70 2,8
analysis (SVA)
Sources of 1f; Ij 16,18,24,32,47,53,59,62,66 5, 6
finance/capital
structure
Stakeholder objectives 1b 31,32,41,43,46,47,53,59,68 1
and conflict
Weighted average cost 1f 13,14,15,16,19,35,38,47,50,53,55,62,66,68, 5
of capital (WACC) 71

viii Financial Management: Question Bank ICAEW 2020

Exam
Your exam will consist of:
3 questions 100 marks
Pass mark 55
Exam length 2.5 hours
The ACA student area of our website includes the latest information, guidance and exclusive
resources to help you progress through the ACA. Find everything you need, from exam
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at icaew.com/exams.

ICAEW 2020 Exam ix

x Financial Management: Question Bank ICAEW 2020
Question Bank
2 Financial Management: Question Bank ICAEW 2020
Objectives and investment appraisal

1 Stoane Gayte Sounds plc

Stoane Gayte Sounds plc (SGS) manufactures audio equipment and has a financial year end of
31 March. Its directors are considering making use of SGS's cash reserves to finance an
investment of £4.9 million in a new range of high specification audio speakers for cars, to be
marketed under the brand name of Inca. However, two of SGS's directors are of the opinion that
this money should be used for an ordinary dividend payment instead, as they feel that this
would help to increase the company's share price.
You work in SGS's finance team and have been asked to advise the SGS board. You have been
given the following information:
Sales
£80,000 of market research work for SGS has been done by Etchingham Tyce Marketing Ltd
(ETM) in the past two months and the payment for this work has yet to be made. The results of
the research suggest that, although it is a very competitive market, Inca speakers would be
popular amongst young drivers for at least three years. ETM's estimated figures for Inca sales
over the next four years, based on a selling price of £190 per unit (at 31 March 20X3 prices), are
shown below:
Units
Year to 31 March 20X4 65,000
Year to 31 March 20X5 110,000
Year to 31 March 20X6 55,000
Year to 31 March 20X7 15,000
As a result of these estimates SGS's directors are concerned about the riskiness of the proposal
and so wish to appraise the investment in Inca speakers over a three-year period only (ie, to
31 March 20X6).
Costs
The estimated variable costs (at 31 March 20X3 prices) of manufacturing one Inca unit are:
£
Raw materials 43
Variable overheads 45
Skilled labour (£9/hour) 18
Because of a lack of skilled labour, SGS will have to transfer all of the skilled production hours
required to manufacture the Inca away from the manufacture of another, lower specification
speaker, the Boom-Boom. Thus a proportion of the Boom-Boom production would have to
cease. Current production details for the Boom-Boom (at 31 March 20X3 prices) are shown
below:
Per unit
£
Selling price 99
Raw materials 28
Variable overheads 35
Skilled labour (£9/hour) 9
SGS's directors estimate that the company's total fixed overheads are unlikely to change as a
result of manufacturing the Inca, but will nonetheless apportion a share of SGS's existing fixed
costs at a rate of £27 per Inca unit (at 31 March 20X3 prices). However this does not include the
depreciation charge (to be spread evenly over the three financial years ending 31 March 20X6)
that will be incurred as a result of the capital expenditure for the Inca (see details below).

ICAEW 2020 Objectives and investment appraisal 3

 Capital expenditure
In order to manufacture the Inca speakers, new machinery costing £4.9 million would be
purchased on 31 March 20X3. SGS's production director estimates that this could be sold on
31 March 20X6 for £980,000 (at 31 March 20X6 prices).
This machinery will attract 18% (reducing balance) capital allowances in the year of expenditure
and in every subsequent year of ownership by the company, except the final year. In the final
year, the difference between the machinery's written down value for tax purposes and its
disposal proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 as a balancing charge, if the disposal proceeds are more than the tax written down value.
Working capital
SGS's directors estimate that a net investment of £750,000 for additional working capital to
support the Inca will be required on 31 March 20X3 and that this will be fully recoverable on
31 March 20X6.
Inflation
Revenues, costs and working capital are all expected to increase in line with the general rate of
inflation, which is estimated at 3% pa.
Taxation
SGS's directors wish to assume that the corporation tax rate will be 17% pa for the foreseeable
future and that tax flows arise in the same year as the cash flows which gave rise to them.
Cost of capital
For investment appraisal purposes SGS uses a money cost of capital of 11% pa.
Other information
 SGS's ordinary dividends have been rising steadily over the past five years and in the
financial year to 31 March 20X2 they totalled £3.4 million.
 Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
Requirements
1.1 Calculate the net present value of the Inca proposal at 31 March 20X3 and, based on this
calculation alone, advise SGS's directors whether they should proceed with it. (17 marks)
1.2 Calculate the internal rate of return of the Inca proposal at 31 March 20X3 and advise SGS's
directors as to the usefulness of this figure. (6 marks)
1.3 Discuss, with reference to relevant theories, the view that SGS should, as an alternative to
the Inca proposal, pay an ordinary dividend in order to increase the company's share price.
(6 marks)
Total: 29 marks

2 Profitis plc
Profitis plc has a continuing need for a machine. At the level of intensity of use by the company,
after four years from new the machine is not capable of efficient working. It has been the
company's practice to replace it every four years. The production manager has pointed out that
in the fourth year the machine needs additional maintenance to keep it working at normal
efficiency. The question has therefore arisen as to whether to replace it after three years instead
of the usual four years.

4 Financial Management: Question Bank ICAEW 2020

 Relevant information is as follows.
(1) The machine costs £80,000 to buy new. If it is retained for four years, it will have a zero
scrap value at the end of the period. If it is retained for three years, it will have an estimated
disposal value of £10,000.
The machine will attract capital allowances. For the purposes of this analysis assume that it
will be excluded from the general pool. This means that it will attract a 18% (reducing
balance) tax allowance in the year of acquisition and in every subsequent year of being
owned by the company, except the last year. In the final year, the difference between the
machine's written down value for tax purposes and its disposal proceeds will be treated by
the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 balancing charge, if the disposal proceeds are more than the tax written down value.
Assume that the machine will be bought and disposed of on the last day of the company's
accounting year.
(2) The company's corporation tax rate is 17%. Tax is payable on the last day of the accounting
year concerned.
(3) During the first year of ownership the supplier takes responsibility for any necessary
maintenance work. In the second and third years maintenance costs average £10,000 a
year. During the fourth year these rise to £20,000. Maintenance charges are payable on the
first day of the company's accounting year and are allowable for tax.
(4) The company's cost of capital is estimated at 15%.
Requirements
2.1 Prepare calculations to show whether it would economically be more desirable to replace
the machine after three years or four years. (13 marks)
2.2 Discuss any other issues that could influence the company's replacement decision. This
should include any weaknesses in the approach taken in 2.1. (4 marks)
Total: 17 marks

3 Horton plc
3.1 The objective of the directors of Horton plc (Horton) is the maximisation of shareholder
wealth. The directors are currently considering Horton's capital investment strategy for
20Y0. Five potential investment projects have been identified, each one having an
expected life of four years. However, at this stage the directors are uncertain of the precise
financial situation the company will be in on 31 December 20X9 when it will actually make
its chosen investments. The company accountant has already undertaken net present value
calculations for each of the five potential investment projects as follows:
Initial Investment (31.12.X9) Net Present Value (31.12.X9)
£ £
Project 1 (2,400,000) 2,676,600
Project 2 (2,250,000) (461,700)
Project 3 (3,000,000) 4,111,500
Project 4 (2,630,000) 2,016,250
Project 5 (3,750,000) (45,250)
Whilst these net present value calculations include the impact of corporation tax, which the
company pays at 17%, they do not include the effect of capital allowances. Project 3 is the
only project that will attract capital allowances and these allowances will apply just to the
initial £3 million investment. The allowances will be at a rate of 18% per annum on a

ICAEW 2020 Objectives and investment appraisal 5

 reducing balance basis, commencing in the year of initial investment, with either a
balancing charge or allowance arising in the final year of the project. The directors are
confident that the company will be able to use all capital allowances in full.
The company's cost of capital is 10%. The cashflows used by the company accountant to
calculate the original net present values of the projects were as follows:
T0 T1 T2 T3 T4
Project 1 (2,400,000) (750,000) 300,000 4,200,000 3,450,000
Project 2 (2,250,000) (750,000) 1,800,000 900,000 450,000
Project 3 (3,000,000) (1,500,000) 3,750,000 3,750,000 3,750,000
Project 4 (2,630,000) 750,000 1,650,000 2,100,000 1,500,000
Project 5 (3,750,000) 1,050,000 1,350,000 1,950,000 250,000
Project 3's T4 cashflow of £3.75 million includes disposal proceeds of £1 million relating to
the assets originally purchased on 31 December 20X9 for £3 million.
To reflect the uncertainty regarding Horton's financial position at the end of 20X9, four
potential scenarios have been identified for consideration:
Scenario 1: Horton will face no capital rationing and the five projects will be independent
and divisible.
Scenario 2: Horton's available capital for investment at T0 will be limited to £4.5 million;
the five projects will be independent and divisible and none of the projects
can be delayed.
Scenario 3: Horton's available capital for investment at T0 will not be limited, but its
available capital for investment at T1 will be limited to £0.3 million; the five
projects will be independent and divisible and none of the projects can be
delayed.
Scenario 4: Horton's available capital for investment at T0 will be limited to £5.25 million,
and whilst the five projects will be independent and none of the projects can
be delayed, they will be indivisible.
One director has indicated that he wishes to discuss the possibility of leasing some of the
assets that would be required as a result of these investment projects in preference to
outright purchase of the assets. He is, however, a little uncertain as to the leasing options
available to the company.
Requirements
(a) Calculate the revised net present value of Project 3 at 31.12.X9 taking account of the
capital allowances attributable to that project. (4 marks)
(b) For each of the four scenarios, prepare calculations which show the proportion of each
project that should be undertaken. (12 marks)
(c) Summarise the different characteristics of finance leases and operating leases and
discuss the potential attractions of lease finance over outright purchase of an asset.
(8 marks)
3.2 The managing director of one of Horton's subsidiary companies has approached Horton's
finance director for advice. On 31 December 20X9 the subsidiary company will be
replacing its three existing company cars with brand new vehicles. The managing director
wishes to know whether to replace these new vehicles every one, two or three years from
now on. He has provided the following background information:
(1) Each new car will cost £11,000.
(2) Resale values for each car (assumed to be received in cash on the last day of the year
to which they relate) are estimated to be £7,000 after one year, £4,200 after two years
and £1,800 after three years.

6 Financial Management: Question Bank ICAEW 2020

 (3) Annual running costs for each car (assumed to be paid on the last day of the year to
which they relate) are estimated at £6,600 in the first year of ownership, £7,600 in the
second year and £9,200 in the third year.
(4) The subsidiary company uses a discount rate of 10% in its appraisal of such
investments.
(5) For the purposes of the advice to be given to the managing director, taxation and
inflation can be ignored.
Requirements
(a) Using appropriate calculations, advise the managing director of the optimal
replacement policy for these new company cars. (5 marks)
(b) Outline the limitations of the method used in answering 3.2(a) above. (6 marks)
Total: 35 marks

4 ProBuild plc
ProBuild plc (ProBuild) runs a network of builders' merchants in northern England. The company
has a small subsidiary, Cabin Ltd (Cabin) that hires out various types of portable cabin used on
building sites. In recent years, Cabin's performance (relative to that of ProBuild's core business)
has been disappointing and the directors of ProBuild have decided that they should focus
resources on their core operations and dispose of Cabin.
Having advertised the business for sale, ProBuild has now been approached by the directors of
Brixham plc (Brixham) with an offer to buy Cabin on 31 December 20X3. Brixham has agreed, in
principle, to pay ProBuild the net present value (as at 31 December 20X3) of the projected
incremental net cash flows of Cabin over the four-year period to 31 December 20X7.
You have been asked by Brixham's directors to calculate an appropriate purchase price using
the following information which has been provided by ProBuild and verified by independent
accountants:
(1) All cash flows can be assumed to occur at the end of the relevant year unless otherwise
stated.
(2) Inflation is expected to average 2% pa for all costs and revenues.
(3) The real discount rates applicable to the appraisal of this investment are:
20X4: 5%
20X5: 6%
20X6: 7%
20X7: 7%
(4) During the past five years, Cabin's annual revenue (at 31 December 20X3 prices) has been
extremely volatile, having peaked at £2 million in one year, whilst falling to a low of
£1.2 million in another year.
(5) During the past five years, Cabin's variable costs have been similarly volatile, being as low
as 25% of annual revenue in one year, whilst having been as high as 30% of annual revenue
in another year. There has been no direct correlation between annual revenue and variable
costs during the past five years.
(6) It has been estimated that under Brixham's ownership, annual fixed costs will be
£0.6 million (at 31 December 20X3 prices), including a share of Brixham's existing head
office costs equal to £0.25 million.

ICAEW 2020 Objectives and investment appraisal 7

 (7) Working capital equal to 8% of Cabin's annual revenue for that year must be in place by the
start of the year concerned and, for the purposes of the calculation of a purchase price, it
can be assumed to be released in full on 31 December 20X7.
(8) Cabin has an existing commitment (which Brixham would have to honour as a condition of
its purchase of Cabin) to make a substantial investment of £1.5 million in new plant and
equipment on 31 December 20X3. This equipment is expected to have a useful working life
of four years, at which time it is estimated that it will be disposed of for a sum of £100,000
(at 31 December 20X7 prices).
This new plant and equipment will attract capital allowances of 18% pa on a reducing balance
basis commencing in the year of purchase and continuing throughout Brixham's ownership of
the equipment. A balancing charge or allowance will arise on disposal of the equipment on
31 December 20X7.
It can be assumed that sufficient profits would be available for Brixham to claim all such tax
allowances in the year they arise. It can also be assumed that the corporation tax rate will be 17%
for the foreseeable future, and that tax payments will occur at the end of the accounting year to
which they relate.
Requirements
4.1 Using money cash flows, calculate the net present values at 31 December 20X3 of the
Cabin business for both the 'worst case' and 'best case' scenarios. (17 marks)
4.2 Distinguish between the terms 'uncertainty' and 'risk' in the context of investment decision-
making and describe how the directors of Brixham might adjust the calculations made in
4.1 from calculations made under conditions of uncertainty to calculations made under
conditions of risk. (6 marks)
4.3 Explain what is meant by the term 'real options' and suggest two real options that might be
relevant to Brixham's purchase of Cabin. (6 marks)
Total: 29 marks

5 Frome Lee Electronics Ltd

Frome Lee Electronics Ltd (Frome Lee) makes small portable radios. Frome Lee's board has
been considering the financial implications of launching a new radio, which it would call 'The
Pink 'Un'. You have recently been appointed on a short-term contract at Frome Lee following the
sudden resignation of the company's chief accountant and have received this memo from the
managing director:

To: A Newman
From: Diana Marshall
As you are aware, our chief accountant, John Smith, left Frome Lee earlier this week following a
disagreement over company policy.
As a result we desperately need financial advice from you. We are considering the purchase of
capital equipment for the manufacture of a new radio, The Pink 'Un. Our marketing team feels
that we would have a competitive advantage with this new radio for three years. Mr Smith had
prepared some estimated figures which we were going to consider at our next meeting on
Monday and he left some of them behind. You will find my summary of them (with some of my
notes) in the Appendix below. We would want to purchase the equipment at the end of our
financial year on 30 September, commence production very soon after and sell the equipment
at the end of September 20Y1.

8 Financial Management: Question Bank ICAEW 2020

 The board would like to consider a complete set of figures and your recommendations over the
weekend so that we can reach a prompt decision on Monday. Apologies for giving you so little
time, but we don't want to miss what could be a valuable investment opportunity for the
company.
Diana Marshall
Friday 5 September

Appendix – summary of information available

Year to 30 September 20X8 20X9 20Y0 20Y1
£'000 £'000 £'000 £'000
Equipment cost (400.000)
Equipment scrap value 60.000
Working capital increment (32.000) (Note 1) (3.000) 40.000
Direct material costs (52.000) (64.000) (70.000)
Other variable costs (12.000) (14.000) (16.000)
Incremental fixed costs (11.000) (11.800) (12.700)
Sales (Note 1) Figures to be calculated
Direct labour costs (Note 2) Figures to be calculated
Notes
1 As you can see, I don't know the estimated sales figures, but we always make sure that we
have sufficient working capital, based on 10% of the annual sales, in place at the beginning
of the relevant year. All working capital will be recovered at the end of September 20Y1.
We need to know the missing figures for (a) annual sales (for 20X9–20Y1) and (b) working
capital (for 20X9) from this information.
2 We always estimate labour costs at 50% of material costs.
3 When discounting, we use a real cost of capital figure of 5% and make adjustments for
inflation when necessary. The figures in the appendix above are all in money terms and I'd
like you to use the following annual rates of general price inflation when working out the
present values of the estimated cash flows:
%
Year to 30 September 20X9 3
Year to 30 September 20Y0 3
Year to 30 September 20Y1 4
I'm not sure how accurate our cost of capital is, but I did read the other day that if a business
uses the wrong cost of capital figure 'it destroys shareholder value'.
Capital allowances
The equipment would attract capital allowances, but would be excluded from the general pool.
Assume that this means that it attracts 18% (reducing balance) tax allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
In the final year, the difference between the equipment's written down value for tax purposes
and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value; or
 balancing charge, if the disposal proceeds are more than the tax written down value.
The corporation tax rate can be assumed to be 17% over the next three years.

ICAEW 2020 Objectives and investment appraisal 9

 Requirements
5.1 Calculate the net present value at 30 September 20X8 of proceeding with production of
The Pink 'Un and advise the board as to whether it should purchase the equipment.
(15 marks)
5.2 Explain your approach to the effects of inflation in your calculation in 5.1 above. (3 marks)
5.3 In response to Diana Marshall's Note (3), discuss the view that a business, by using the
wrong cost of capital figure, 'destroys shareholder value'. (4 marks)
5.4 Explain, in the context of the proposed investment, the nature and importance of follow-on
and abandonment real investment options. (4 marks)
Total: 26 marks

6 Nuts and Bolts Ltd

Nuts and Bolts Ltd (NBL) manufactures parts for motor cars and the majority of its customers are
UK-based. Its financial year end is 31 March. Its management team is considering the purchase
of machinery that would produce a new type of catalytic converter (model number NBL 1114).
However, NBL's management team, mindful of the current weakness of the UK economy, is
uncertain as to the level of demand for NBL 1114. As a result it commissioned a market research
report from Ashford Hume Research and that report showed two alternative overall levels of
demand for NBL 1114 – pessimistic throughout the project's life or optimistic throughout the
project's life. The report concluded that these alternative overall levels of demand were equally
likely to occur.
For each of the overall levels of demand (pessimistic or optimistic), demand for NBL 1114 varies
in the first year of the project as shown here in Table 1:
Table 1
Pessimistic Optimistic
Annual demand Probability Annual demand Probability
(units) (units)
6,000 25% 10,000 25%
10,000 50% 14,000 37.5%
14,000 25% 20,000 37.5%

Demand in each subsequent year of the project's life would remain at the first year's expected
level.
Financial information about the new machinery and NBL 1114 is shown here in Table 2:
Table 2
NBL 1114's period of competitive advantage (1 April 20X1 to 31 March 20X4) 3 years
Maximum annual output of new machinery (units of NBL 1114) 12,800
Cost of new machinery (payable on 31 March 20X1) £480,000
Scrap value of new machinery (at end of three year period, ie, 31 March 20X4) £nil
NBL 1114's contribution per unit (based on a selling price per unit of £65) £33
Additional annual fixed costs incurred (including annual depreciation charge of
£160,000) £300,000
Extra working capital required at 31 March 20X1 (recoverable in full on
31 March 20X4) £50,000
Working capital
The working capital requirement for each year must be in place at the start of the relevant year.

10 Financial Management: Question Bank ICAEW 2020

 Capital allowances
NBL's machinery and equipment attracts capital allowances, but is and will be excluded from the
general pool. The equipment attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
In the final year, the difference between the equipment's written down value for tax purposes
and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value; or
 balancing charge, if the disposal proceeds are more than the tax written down value.
Inflation
All of the above figures are stated at 31 March 20X1 prices. NBL's management is unsure of the
rate of inflation and would like to consider the impact of either 0% or 5% annual inflation.
Other relevant information:
(1) NBL's directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future and the tax will be payable in the same year as the cash flows to which it
relates.
(2) Unless otherwise stated all cash flows occur at the end of the relevant trading year.
(3) NBL uses a real post-tax cost of capital of 10% for appraising its investments.
Requirements
6.1 Assuming that the annual rate of inflation is zero, calculate the expected net present value
of the NBL 1114 project at 31 March 20X1 and advise NBL's management whether it should
purchase the new machinery. (18 marks)
6.2 Assuming that the annual rate of inflation is 5%, explain, with supporting calculations, what
the impact will be on the expected net present value at 31 March 20X1 of this proposed
investment if the effects of inflation on pre-tax contribution and working capital are taken
into account. (6 marks)
Total: 24 marks

7 Newmarket plc
Newmarket plc (Newmarket), a listed company, has recently developed a new lawnmower, the
NL500. Development of the NL500 was supported by market research which was undertaken by
an external agency who agreed that their £10,000 fee would only be payable if the NL500 was
actually launched, with payment due at the end of the NL500's first year on the market.
Newmarket's directors estimate that the market life of the NL500 will be five years but they
would be willing to launch the NL500 only if they were satisfied that the required investment
would generate a net present value of at least £300,000, using a discount factor of 10% pa.
Production and sale of the NL500 would commence on 1 July 20X3 and would require
investment by Newmarket in new production equipment costing £750,000, payable on 30 June
20X3. On 30 June 20X8 it is expected that this equipment could be sold back to the original
vendor for £50,000. Newmarket depreciates plant and equipment in equal annual instalments
over its useful life.
The company's directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future, and it can be assumed that tax payments would occur at the end of the
accounting year to which they relate. The directors are also assuming that the new production
facilities would attract capital allowances of 18% pa on a reducing balance basis commencing in
the year of purchase and continuing throughout the company's ownership of the equipment. A
balancing charge or allowance would arise on disposal of the equipment on 30 June 20X8. It
can be assumed that sufficient profits would be available for Newmarket to claim all such tax
allowances in the year they arise.

ICAEW 2020 Objectives and investment appraisal 11

 Purchase of the new production equipment would be financed by a five-year fixed rate bank
loan which will be drawn down on 30 June 20X3 at an interest rate of 6% pa. Interest on the loan
would be payable annually, with repayment of the capital being made in full on 30 June 20X8.
Newmarket's marketing director has estimated annual demand for the NL500 to be 2,000 units
and on that basis the finance department has estimated the unit cost of the NL500 as follows:
£
Labour (4 hours @ £12 per hour) 48.00
Components 32.00
Loan interest 22.50
Depreciation 70.00
Variable energy costs 5.00
Share of Newmarket's fixed costs 20.00
197.50
If the NL500 is launched, a manager already employed by Newmarket would be moved from his
present position to manage production and sale of the NL500. This existing manager's position
would consequently have to be filled by a new recruit, specifically employed to replace him, on
a five-year contract at a fixed annual salary of £35,000. The launch of the NL500 would have a
negligible impact on both Newmarket's working capital requirements and on its fixed costs.
Newmarket's accounting year end is 30 June and it can be assumed that all cash flows would
occur at the end of the year to which they relate.
Requirements
7.1 Calculate (to the nearest £) the minimum price per unit that Newmarket should charge for
the NL500 if a net present value of at least £300,000 is to be achieved. (15 marks)
7.2 Identify and describe two quantitative techniques that Newmarket could use to assess and
adjust for the various risks to which launching the NL500 would expose the company.
(6 marks)
7.3 Distinguish between systematic risk and non-systematic risk and explain, using examples,
how each of these types of risk might apply to the launch of the NL500. (6 marks)
7.4 Identify and explain, in the context of the proposed investment in the NL500, the nature and
importance of the real options available to Newmarket. (8 marks)
Total: 35 marks

8 Grimpen McColl International Ltd

Grimpen McColl International Ltd (GMI) specialises in the construction of hydroelectric dams. It
has a financial year end of 31 December. GMI is currently negotiating with the government of a
South American country regarding a new dam that the government plans to build on a tributary
of the River Amazon. You work for GMI and have been asked to advise its directors during the
negotiations. The following information has been collected:
Costs
GMI's estimated costs of constructing the dam (all at 31 December 20X2 prices except where
stated otherwise) are shown below:
31 December
20X2 20X3 20X4 20X5
£'000 £'000 £'000 £'000
Specialist machinery (Note 1) 30,000
Working capital (Note 2) 5,000
Materials and labour costs 7,000 8,000 9,000
Overheads (Note 3) 4,000 4,500 5,000
Lost contribution (Note 4) 4,000 4,000 4,000

12 Financial Management: Question Bank ICAEW 2020

 Notes
1 GMI will need to purchase specialist machinery for the construction of the dam. This will
have an estimated resale value at the end of the construction period of £5 million (at
31 December 20X5 prices).
2 The initial working capital required will increase by £1 million pa (in 31 December 20X2
prices), but will be fully recoverable on 31 December 20X5.
3 The overhead costs include a share of GMI head office costs which have been allocated to
this project at a rate of £1.5 million pa.
4 South America would be a new market for GMI and its directors are keen to win this
contract. If GMI were successful then it would be necessary to transfer resources from other
projects – typically service contracts for existing GMI dams in Europe and North America.
The directors estimate that this would result in a loss of contribution in each year of the
construction period.
Inflation rates and cost of capital
GMI's directors propose using the following inflation rates:
Materials, labour and overhead costs 4% pa
Working capital 4% pa
Lost contribution 5% pa
GMI's directors plan to use a money cost of capital of 8% when appraising this investment.
However, one of GMI's directors has commented 'I think that our hurdle rate may be wrong.
Inflation rates may actually be higher than those used in our estimates, which should be adjusted
to take account of this.'
Capital allowances
The specialist equipment attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
In the final year, the difference between the plant and equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 as a balancing charge, if the disposal proceeds are more than the tax written down value.
Contract price
GMI's board is keen that the contract price is not too high and has tendered a price of £95 million.
£10 million would be receivable on 31 December 20X2 when the specialist equipment is
purchased. The second instalment of £85 million (in 31 December 20X5 prices) would be
receivable on completion of the dam.
Taxation
GMI's directors wish to assume that the corporation tax rate will be 17% for the foreseeable
future and that tax flows arise in the same year as the cash flows which gave rise to them.
Maintenance contract
The South American government has also proposed that, were GMI to build the dam, then GMI
should also provide annual maintenance in perpetuity from completion of the dam on
31 December 20X5. GMI's directors estimate that this would cost GMI £3 million pa (in
31 December 20X5 prices) and feel that it would be reasonable to charge a price of £5 million
pa (in 31 December 20X5 prices). Costs and revenues for the maintenance contract are
expected to rise by 3% pa after 31 December 20X5. However, they are concerned about such a

ICAEW 2020 Objectives and investment appraisal 13

 long-term commitment and would like to investigate the price at which GMI could sell this
maintenance contract to another company.
Other information
 Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
 Ignore all foreign currency issues.
Requirements
8.1 Ignoring the maintenance contract, calculate the net present value of the dam project at
31 December 20X2 and advise GMI's directors whether they should proceed with it.
(13 marks)
8.2 Calculate the minimum value of the second instalment of the contract price (receivable on
31 December 20X5) that would be acceptable to the GMI board, assuming that it wishes to
enhance shareholder value. (3 marks)
8.3 With reference to the GMI director's concerns about the rates of inflation being more than
the original estimates, discuss the potential effect of this on the project's cash flows, cost of
capital and net present value. (5 marks)
8.4 Advise the GMI board, showing supporting calculations, of the minimum selling price on
31 December 20X2 that it should set were it to sell the maintenance contract. (4 marks)
8.5 Discuss the types of political risk that GMI may encounter were its proposed investment in
South America to proceed. (5 marks)
Total: 30 marks

9 Wicklow plc
Wicklow plc (Wicklow) is a manufacturer of prestige cast iron cookers, having a long-standing
reputation for selling distinctive high price, high quality cookers to an increasingly global
market. In the face of growing competition from firms offering slightly more modern style
cookers at much lower prices, Wicklow's recent strategy has been to introduce a 'Heritage'
version of some of its major product lines. The aim has been to emphasise the original design
features of the brand and to differentiate itself further from its competitors.
Wicklow is currently considering the introduction of a 'Heritage' version of its existing 'Duo'
product, a standard two-oven cooker. Wicklow has recently spent £375,000 developing the new
version of the product, to be known as the Duo Heritage (DH).
Production of the DH would require Wicklow to invest £2 million in new machinery and
equipment on 31 December 20X8. Based on past experience, the directors are assuming that
this machinery and equipment will have a disposal value on 31 December 20Y2 of £200,000.
Sales of the DH would be expected to commence during the year ending 31 December 20X9.
Based on a unit selling price of £7,000, Wicklow's marketing director has estimated that unit
sales in 20X9 will be either 1,500 (0.65 probability) or 2,000 (0.35 probability). In view of the
uncertainty of unit demand in the first year of production, the marketing director has also
forecast that if 20X9 sales were to be 1,500 units, then 20Y0 sales would be estimated at either
1,800 units (0.7 probability) or 2,000 units (0.3 probability). However, if 20X9 sales were to be
2,000 units, 20Y0 sales would be estimated at either 2,200 units (0.6 probability) or 2,500 units
(0.4 probability). In 20Y1 and 20Y2 unit sales would be 110% of the expected unit sales in 20Y0.
In each year production will equal sales, which can be assumed to occur on the last day of each
year.
As with other similar 'Heritage' product launches, the company invariably experiences a
consequent loss of sales on the original product line. In this particular case, the expectation is
that for every two DHs sold, the sale of one standard Duo oven will be lost. This effect would be

14 Financial Management: Question Bank ICAEW 2020

 expected to continue throughout the four years over which the directors have decided to
appraise this potential project. As a result, it can be assumed that sales of both cookers will not
continue beyond 20Y2.
The unit selling price and cost structure of the standard Duo product are as follows:
£
Selling price 6,500
Materials 3,516
Labour (8 hours) 200
Fixed overheads (on a labour hour basis) 480
Launch of the DH is not expected to impact on the company's total fixed overheads.
The material cost per unit of the DH will be £3,800. Production of each DH will require eight
hours of labour. The reduced levels of production on the Duo product line would mean that part
of this labour requirement will be met from labour transferred from that product, but to the
extent that this would provide insufficient hours, additional labour will be recruited at the
company's standard labour rate of £25 per hour.
Each major product line within Wicklow is currently managed by a dedicated team of managers.
However, should the DH be launched, one additional manager would need to be recruited to
the Duo team. Wicklow has identified this new manager. He is currently employed by the
company and had recently accepted voluntary redundancy but would now be asked to stay on
until 31 December 20Y2. He was due to leave Wicklow on 31 December 20X8 and to receive a
lump sum of £35,000 at that time. He will be paid an annual salary of £40,000 together with a
lump sum bonus of £20,000 payable on 31 December 20Y2.
Working capital to support production of the DH would be expected to run at a rate of 15% of
sales value, although this would be off-set to some extent by reduced working capital
commitments in respect of the standard Duo product which also requires working capital equal
to 15% of sales value. The working capital would need to be in place by the beginning of each
year and can be assumed to be released in full on 31 December 20Y2. The working capital flows
will have no tax effects.
Regarding tax, the directors are assuming that if Wicklow buys the new machinery and
equipment it will attract capital allowances of 18% per annum on a reducing balance basis,
commencing in the year of acquisition, with either a balancing charge or allowance arising at the
end of the equipment's useful life. The company can be assumed to be in a position to claim all
tax allowances in full as soon as they become available and to pay corporation tax at a rate of
17% per annum over the life of the DH project. All tax is payable at the end of the year to which it
relates.
At the present time the company is financed entirely by equity and it has been decided that this
will continue even if the DH is launched, with internal funds being used to finance the
investment. The decision on whether or not to introduce the DH is to be based on the expected
net present value of the relevant cash flows, discounted at the company's cost of equity capital
of 8%.
However, the finance director had argued strongly that if Wicklow did decide to introduce the
DH, then the company should partly finance the project with a four-year loan of £2 million (at an
interest rate of 5% per annum), which would be well within Wicklow's current debt capacity.
Requirements
9.1 Calculate the expected net present value at 31 December 20X8 of the introduction of the
DH product and advise the directors whether or not Wicklow should proceed with its
introduction. (18 marks)

ICAEW 2020 Objectives and investment appraisal 15

 9.2 Calculate the sensitivity of the decision to invest in DH to changes in:
(a) The DH selling price (for the purpose of this calculation, assume working capital does
not change)
(b) The cost of equity (7 marks)
9.3 Calculate the adjusted present value of the introduction of the DH product if Wicklow had
decided to inject debt on the basis proposed by the finance director. (4 marks)
9.4 Making reference to relevant theories, explain the weaknesses of the adjusted present value
methodology used in 9.3 above.
(6 marks)
Total: 35 marks
Note: Ignore inflation.

10 Daniels Ltd
Daniels Ltd (Daniels) is a large civil engineering company and it has a financial year end of
31 May. Much of Daniels' work involves long-term contracts for the railway industry. You work for
Daniels and have been asked for advice by the board on the following problems:
Problem 1
Daniels is considering a major investment involving five possible projects in the West of England
and South Wales which have been put out to tender. Daniels' board of directors has prepared
the following estimated cash flows (and resultant net present values at 31 May 20X7) for the five
projects:
Investment Year to Year to Year to
Project Location on 31/5/X7 31/5/X8 31/5/X9 31/5/Y0 NPV
£'000 £'000 £'000 £'000 £'000
B Bristol (4,150) (1,290) 530 7,270 577
C Cardiff (3,870) (1,310) 3,130 1,550 (1,309)
G Gloucester (6,400) 1,770 2,160 3,160 (632)
S Swansea (5,000) (2,610) 6,450 6,520 2,856
T Tiverton (4,600) 1,290 2,870 3,620 1,664
You can assume that the net present values shown in the table above are accurate.
Due to financial constraints, the company, if successful with its tenders, would be unable to take
on all five projects. The board is prepared to release £8 million for initial investment (on 31 May
20X7) into one or more of the projects, but might increase this figure to £9 million if there are
grounds for doing so. An alternative scenario which has been considered would be to make
available sufficient funds to start all five projects in May 20X7, but this would limit the capital
available in the year to 31 May 20X8 to a maximum of only £500,000.
Problem 2
Daniels runs a fleet of vans to support its operations. Currently it replaces those vans every three
years, but the board is not sure whether this is in the company's best interests. Vans cost, on
average, £12,400 each. Daniels' transport manager has prepared the following schedule of
costs and resale values for the vans:
Maintenance and
running costs Resale value
£ £
In first year of van's life 4,300 After one year 9,800
In second year of van's life 4,800 After two years 7,000
In third year of van's life 5,100 After three years 5,000

16 Financial Management: Question Bank ICAEW 2020

 Problem 3
About a year ago (March 20X6) Daniels completed construction of a factory for Kithill Ltd (Kithill).
This cost Daniels £720,000 to construct and Kithill is paying £190,000 a year for eight years.
Daniels will, therefore, ultimately make a profit of £800,000, which gives a return on the
investment of over 100%. When Kithill sent its first annual instalment last week, it indicated that
rather than make annual payments it would prefer to settle the outstanding balance by making a
one-off payment of £925,000 in a year's time (March 20X8). One of Daniels' directors is keen on
this proposal stating 'I know that this is less than we would receive over the full eight years, but
my calculations show that the internal rate of return would be much better.'
General information
(1) Daniels uses a cost of capital of 10% when appraising possible investments.
(2) You should assume that all cash flows take place at the end of the year in question.
(3) All projects are independent.
Requirements
10.1 For Problem 1, assuming that all of the projects are divisible and:
(a) Assuming that Daniels has no capital rationing, advise its directors as to which projects
should be accepted. (2 marks)
(b) Assuming that the directors are prepared to spend a maximum of £8 million on
31 May 20X7, advise them as to which projects should be accepted. (3 marks)
(c) Assuming that the directors are prepared to make available sufficient funds to start all
five projects on 31 May 20X7, but only £500,000 on 31 May 20X8, advise them as to
which projects should be accepted. (5 marks)
10.2 For Problem 1, assuming that none of the projects are divisible and that the directors are
prepared to spend a maximum of £9 million on 31 May 20X7, advise them as to which
projects should be accepted. (4 marks)
10.3 For Problem 2, advise the directors as to the optimal replacement period for Daniels' vans
and comment on the limitations of the approach used. (6 marks)
10.4 For Problem 3, advise the directors as to whether they should accept Kithill's proposal.
(5 marks)
Total: 25 marks
Note: Ignore taxation.

11 Hawke Appliances Ltd

11.1 Hawke Appliances Ltd (Hawke) is a UK-based manufacturer of household appliances. It has
a financial year end of 31 December. You work for Hawke and have been asked to advise
the company's board on the viability of a proposed new product.
The company is considering the development of a new vacuum cleaner, the JH143. This will
be more expensive than Hawke's other vacuum cleaners but it contains a number of
innovative design features that Hawke's board believes will be attractive in an increasingly
competitive market. Because of these market conditions, Hawke's board wishes to evaluate
the JH143 over a three-year time horizon.

ICAEW 2020 Objectives and investment appraisal 17

 Selling price, materials and unskilled labour
You have obtained the following information on the budgeted price and costs per unit for
the JH143 (in 31 December 20X4 prices):
£
Selling price 155
Materials 53
Unskilled labour 28
Fixed costs are not expected to increase as a result of producing the JH143.
Skilled labour
Each JH143 will require one hour of skilled labour that is in short supply. Hawke will need to
transfer some of its skilled labour away from making another older vacuum cleaner (the
JH114), which requires half the skilled labour time per unit of the JH143. The current selling
price of the JH114 is £96 and its materials and unskilled labour costs total £74 per unit (in
31 December 20X4 prices). Hawke's skilled labour is paid £8.80 per hour (in 31 December 20X4
prices).
Inflation
Revenues and costs are expected to inflate at a rate of 4% pa.
Sales volumes
Hawke commissioned market research at a cost of £55,000 for the JH143 project, half of
which remains unpaid and is due for settlement on 31 December 20X4. An extract from the
results of that market research is shown here:
20X5 20X6 20X7
Estimated annual sales of the JH143 (units) 50,000 95,000 45,000
Machinery
Specialised new production machinery will be required in order to make the new vacuum
cleaner. This machinery will cost £4.5 million to buy on 31 December 20X4 and will have an
estimated scrap value of £1 million on 31 December 20X7 (in 31 December 20X7 prices). If
production of the existing JH114 is reduced then some of Hawke's older machinery could
be sold on 31 December 20X4. This machinery had a tax written down value of £80,000 on
1 January 20X4 and Hawke estimates that it could be sold for £220,000.
The machinery will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the machinery's written down value for tax
purposes and its disposal proceeds will be treated by the company either:
 as a balancing allowance, if the disposal proceeds are less than the tax written down
value; or
 as a balancing charge, if the disposal proceeds are more than the tax written down
value.
Corporation tax
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Working capital
Hawke will invest in working capital at a rate of 10% of the JH143's annual sales revenue, to
be in place at the start of each year. It expects to recover the working capital in full on
31 December 20X7.
Cost of capital
Hawke uses a money cost of capital of 12% pa for investment appraisal purposes.

18 Financial Management: Question Bank ICAEW 2020

 Requirements
(a) Using money cash flows, calculate the net present value on 31 December 20X4 of the
proposed development of the JH143 and advise the company's board whether it
should proceed with the investment. (16 marks)
(b) Ignoring the effects on working capital, calculate the sensitivity of your advice in part
(a) to:
 changes in the selling price of the JH143 (3 marks)
 changes in the volume of sales of the JH143 (4 marks)
11.2 Hawke's board is also investigating the possibility of buying another company, Durram
Electricals Ltd (Durram) which is a successful retailer of electrical goods. The board has
obtained the following information about Durram:
Earnings and cash flows for the year ended 31 August 20X4 £700,000
Expected growth of earnings and cash flows 5% pa
Book value of equity at 31 August 20X4 £3,600,000
Average industry P/E ratio 11
Cost of capital 12% pa
Hawke's board has no experience of buying another company and you have been invited to
the next board meeting to answer these questions:
(a) What range of values is reasonable for Durram on 31 August 20X4?
(b) Why do many acquisitions not benefit the bidding firm?
(c) Would it be better to pay for Durram in cash or with Hawke's shares?
Requirement
Prepare calculations and notes that will enable you to answer these questions at the next
board meeting. (12 marks)
Total: 35 marks

12 Alliance plc
You should assume that the current date is 31 December 20X5.
Alliance plc (Alliance) is a manufacturer of electronic devices. At a recent board meeting two
agenda items were discussed as follows:
(1) The possible development of an automatic watering system (Autowater) for indoor potted
plants in private houses and business premises. The sales director commented that there
are similar more expensive products on the market and it is likely that competitors will
develop their technology and bring down their prices in future. Therefore, it would be
prudent to assume a life cycle of four years for the Autowater.
(2) For other projects that have already been appraised using NPV analysis, the 20X6 capital
expenditure budget (excluding Autowater) should not exceed £350 million. The
£350 million will be allocated to projects, excluding Autowater, on the basis of maximising
shareholder wealth.
The chairman of Alliance closed the meeting with the following statement:
"We will continue to see excellent opportunities to invest in profitable projects across
our business and we have no difficulty in raising finance. However we will be
disciplined in our approach to committing to capital expenditure. I would now like the
finance director to evaluate the Autowater project and to determine in which other
projects the £350 million 20X6 capital expenditure budget is going to be invested."

ICAEW 2020 Objectives and investment appraisal 19

 The following information is available regarding the Autowater project:
 The selling price will be £800 per unit for the year to 31 December 20X6 and will then
increase by 5% pa. Contribution is 40% of the selling price.
 The number of units sold in the year to 31 December 20X6 is expected to be 9,000 per
month. For the year to 31 December 20X7 the number of units sold will increase by 15%.
Because of increased competition in the market it is anticipated that in the two years to
31 December 20X9 the number of units sold will decline by 10% pa.
 Incremental fixed production costs are expected to be £4 million pa and will increase after
31 December 20X6 by the general level of inflation.
 Alliance will rent a factory at an annual rent of £1.5 million, payable in advance on
31 December. The rent is not subject to inflationary increases.
 Investment in working capital will be £2 million on 31 December 20X5 and will increase or
decrease at the start of each year in line with sales volumes and the unit selling price.
Working capital will be fully recoverable on 31 December 20X9.
 On 31 December 20X5 the project will require an investment in machinery and equipment
of £60 million, which is expected to have a realisable value of £5 million (in 31 December
20X9 prices) at the end of the project. The machinery and equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent
year of ownership by the company, except the final year.
In the final year, the difference between the machinery and equipment's written down value
for tax purposes and its disposal proceeds will be treated by the company either:
(1) as a balancing allowance, if the disposal proceeds are less than the tax written down
value; or
(2) as a balancing charge, if the disposal proceeds are more than the tax written down
value.
 Assume that the rate of corporation tax will be 17% pa for the foreseeable future and that
tax flows arise in the same year as the cash flows that gave rise to them.
 An appropriate real cost of capital for the Autowater project is 7% pa and the level of
general inflation is expected to be 3% pa.
The following information relates to the 20X6 capital expenditure budget of £350 million and
excludes the Autowater project.
The indivisible projects available for investment of the £350 million are:

Project Initial expenditure £ million NPV £ million

A 100 180
B 50 90
C 40 100
D 140 150
E 100 140
Requirements
12.1 Using money cash flows, calculate the net present value of the Autowater project on
31 December 20X5 and advise the board whether it should accept the project. (16 marks)
12.2 Ignoring the effects on working capital, calculate the sensitivity of the Autowater project to
changes in sales revenue and indicate whether there is a sufficient margin of safety for the
project to go ahead. (4 marks)

20 Financial Management: Question Bank ICAEW 2020

 12.3 Discuss the disadvantages of sensitivity analysis and explain how simulation might be a
better way to assess the risk of the project. (6 marks)
12.4 With regard to the 20X6 capital expenditure budget of £350 million:
(a) Discuss the differences between hard and soft capital rationing and comment on the
form of capital rationing that is being employed by Alliance. (5 marks)
(b) Determine the combination of projects that will maximise shareholder wealth.
(4 marks)
Total: 35 marks

ICAEW 2020 Objectives and investment appraisal 21

 Finance and capital structure

13 Turners plc
Turners plc (Turners) is a listed company in the food retailing sector and has large stores in all
the major cities in the UK. Turners' board is considering diversifying by opening holiday travel
shops in all of its stores.
At a recent board meeting the directors were discussing how the holiday travel shops project
('the project') should be appraised. The sales director insisted that Turners' current weighted
average cost of capital (WACC) should be used to appraise the project as the majority of its
operations will still be in food retailing. The finance director disagreed because the existing cost
of equity does not take into account the systematic risk of the new project. The finance director
also said that the company's overall WACC, which reflects all of the company's activities, would
change as a result of the project's acceptance. The board were also concerned about the
market's reaction to their diversification plans. A further board meeting was scheduled at which
Turners' advisors would be asked to make a presentation on the project.
You work for Turners' advisors and have been asked to prepare information for the presentation.
You have established the following:
Turners intends to raise the capital required for the project in such a way as to leave its existing
debt:equity ratio (by market values) unchanged following the diversification.
Extracts from Turners' most recent management accounts are shown below:
Balance sheet at 31 May 20X4
£m
Ordinary share capital (10p shares) 233
Retained earnings 5,030
5,263
6% Redeemable debentures at nominal value (redeemable 20X8) 1,900
Long term bank loans (interest rate 4%) 635
7,798

On 31 May 20X4 Turners' ordinary shares had a market value of 276p (ex-div) and an equity beta
of 0.60. For the year ended 31 May 20X4 the dividend yield was 4.2% and the earnings per
share were 25p. The return on the market is expected to be 8% pa and the risk-free rate 2% pa.
Turners' debentures had a market value of £108 (ex-interest) per £100 nominal value on 31 May 20X4
and they are redeemable at par on 31 May 20X8.
Companies operating solely in the holiday travel industry have an average equity beta of 1.40
and an average debt: equity ratio (by market values) of 3:5. It has been estimated that if the
project goes ahead the overall equity beta of Turners will be made up of 90% food retailing and
10% holiday travel shops.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
13.1 Ignoring the project, calculate the current WACC of Turners using:
(a) The CAPM (8 marks)
(b) The Gordon growth model (6 marks)
13.2 Using the CAPM, calculate the cost of equity that should be included in a WACC suitable for
appraising the project and explain your reasoning. (6 marks)

22 Financial Management: Question Bank ICAEW 2020

 13.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
Turners assuming that the project goes ahead and comment upon the implications of a
permanent change in the overall WACC. (6 marks)
13.4 Discuss whether Turners should diversify its operations and how the stock market might
react to the proposed project. (5 marks)
13.5 Identify the appropriate project appraisal methodology that should be used when a
project's financing results in a major increase in a company's market gearing ratio and,
using the data relating to Turners, calculate the project discount rate that should be used in
these circumstances. (4 marks)
Total: 35 marks

14 Middleham plc
Middleham plc (Middleham) is a company involved in the production of printing inks used in a
wide range of applications in the food packaging industry. The directors of Middleham are
currently considering a £2 million investment in new production facilities. At the present time,
the company's finance director is seeking to establish an appropriate cost of capital figure for
use in the appraisal of the proposed investment. Extracts from Middleham's most recent
financial statements for the year ended 31 March 20X3 are shown below:
£'000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800
£'000
Profit before taxation 3,000
Taxation (510)
Preference share dividends (70)
Ordinary share dividends (1,088)

The market prices for the company's shares and debentures on 31 March 20X3 were:
(1) Ordinary shares: £1.42 each (cum-div)
(2) 5% irredeemable preference shares: £0.20 each (ex-div)
(3) 7% debentures: £105.00 (per £100 nominal)
The ordinary dividend for the year ended 31 March 20X3 is due to be paid shortly. This is the
first dividend paid since the year ended 31 March 20W9, when the dividend payout ratio was
40% and the earnings per share were £0.35. Middleham's directors expect future dividends to
grow at the annual growth rate implied by the dividends paid in 20W9 and 20X3. The number of
ordinary shares in issue has not changed since March 20W9.
The annual debenture interest has recently been paid. The 7% debentures are redeemable at
par in 10 years' time.
Shares in the industrial sector in which Middleham operates typically have an equity beta of 1.3
with a debt to equity ratio of 1:1. The risk free rate is 6% pa and the return from the market
portfolio is 14% pa.
The company's finance director has proposed that, if the investment is undertaken, then an issue
of redeemable debentures is used to finance it. However, Middleham's Chief Executive has
expressed concerns about the possible use of redeemable debentures. His view is that
increasing the number of debentures issued by the company will increase the company's

ICAEW 2020 Finance and capital structure 23

 gearing dramatically and the increased financial risk associated with this could easily lead to a
fall in the company's share price and, therefore, its market value.
The directors wish to assume a rate of corporation tax of 17% for the foreseeable future.
Requirements
14.1 Calculate (using the dividend growth model) a weighted average cost of capital that could
be used to appraise Middleham's proposed investment. (13 marks)
14.2 Explain the underlying assumptions and any other relevant factors that may mean it is
inappropriate to use the cost of capital figure calculated in requirement 14.1 in the
appraisal of Middleham's proposed investment. (5 marks)
14.3 (a) Estimate Middleham's cost of equity using the capital asset pricing model.
(b) Explain two key assumptions that would underpin the use of this cost of equity in the
calculation of the weighted average cost of capital. (7 marks)
14.4 Making reference to relevant theories, comment on the views expressed by Middleham's
chief executive. (5 marks)
14.5 Explain, with reference to the efficient market hypothesis, when news of the proposed
investment in the new production facilities would be reflected in Middleham's share price
on the London Stock Exchange. (5 marks)
Total: 35 marks

15 Better Deal plc

Better Deal plc (Better Deal) is a UK supermarket chain which has a financial year end of
28 February. An extract from its balance sheet at 28 February 20Y0 is shown below:
£m
Ordinary shares (50p each) 82.5
Retained earnings 391.5
474.0
8% debentures (at nominal value; redeemable at par in 20Y4) 340.0
814.0

Additional information about Better Deal:

Current market value of one ordinary share (ex div) £2.65
Current market value of one 8% debenture (ex int) £98
Dividends paid on 28 February 20Y0 £29.5m
Dividends paid on 28 February 20X6 £25.2m
Equity beta 1.1
Market return 11.4% pa
Risk free rate 5.2% pa
Notes
1 There have been no changes in the number of issued shares over the period 20X6–20Y0.
Better Deal's annual dividend payments have risen steadily since 20X6.
2 Better Deal's management is considering diversifying its product range and opening petrol
outlets at a number of its stores. The finance for this capital investment would be raised in
such a way as not to alter the current gearing ratio of Better Deal (measured by market
values). The debt element of the finance raised will come from a new issue at par of 9%
irredeemable debentures.

24 Financial Management: Question Bank ICAEW 2020

 3 Better Deal's finance team has undertaken research into the company's competitors in the
UK petroleum market and has calculated that the equity beta for this market is 1.5 and
companies in that market have, on average, long term funds in the ratio of 64:31 for
equity:debt by market value.
4 You should assume that the corporation tax rate is 17% pa and is payable in the same year
as profits are earned.
Requirements
15.1 Calculate Better Deal's current weighted average cost of capital based on:
(a) The dividend growth model
(b) The CAPM model (10 marks)
15.2 Calculate the cost of capital that Better Deal should use when appraising the proposed
investment in petrol outlets and explain the reasoning for your approach. (11 marks)
15.3 Compare and contrast multiple factor models with the CAPM model as a means of dealing
with risk. (8 marks)
15.4 Making reference to relevant theories, advise Better Deal's management as to what extent
the company's dividend policy will affect the market value of its shares. (6 marks)
Total: 35 marks

16 Puerto plc
You should assume that it is now 1 December 20X3.
Puerto plc (Puerto) is listed on the UK stock market and operates in the vehicle leasing industry.
During a period of expansion from 20W3 to 20W7 the company funded growth by way of
convertible loans obtained from an investment bank, SM Capital (SMC). As a result of the global
economic downturn Puerto has experienced a number of trading difficulties, and the company
ceased to pay dividends to its ordinary shareholders in 20W8. Since 20W9 Puerto has embarked
on a significant restructuring of its business. Although in the current year to 30 November 20X3
the company has sustained losses, industry conditions have stabilised giving both the board of
Puerto and SMC confidence in the company's future. This confidence is also shared by the UK
stock market as Puerto's share price has been increasing over the last six months to 10p per
ordinary share on 30 November 20X3.
Extracts from Puerto's most recent management accounts are shown below:
Income statement for the year ended 30 November 20X3
£'000
Operating profit 2,280
Interest (2,460)
Profit/(loss) before tax (180)
Taxation 0
Profit/(loss) after tax (180)

The board of Puerto is now considering a further restructuring that includes the purchase on
1 December 20X3 of another vehicle leasing business that in the last financial year achieved a
pre-tax operating profit of £3 million. The purchase price for this business is £24 million. The
board is confident it will be able to raise the additional borrowings required for this purchase on
1 December 20X3, particularly as SMC, as part of the restructuring, has agreed to exercise its
option to convert its convertible loans into equity on that date in order to participate in Puerto's
future growth potential. The board and SMC believe that Puerto's share price will increase
immediately on 1 December 20X3 by 35% as a result of the restructuring.

ICAEW 2020 Finance and capital structure 25

 Additional information:
 The SMC convertible loans amount to £68 million and the rate of interest on these loans is
3% pa. The market value of these loans, on 30 November 20X3, is equal to their nominal value
of £68 million.
 SMC has the option to convert its loans into thirty ordinary shares for every £4 of loan.
 Puerto also has non-convertible secured bank loans amounting to £6 million that carry an
interest rate of 7% pa.
 On 30 November 20X3 Puerto had 492 million ordinary shares in issue.
 £24 million of new secured borrowings at an interest rate of 6% pa will be raised from Risky
Bank plc (Risky) to finance the purchase of the vehicle leasing business. A covenant
attached to this loan requires that the gearing (debt/equity by market values) immediately
after the restructuring is not more than the industry average of 25%.
 Corporation tax is 17% pa on current year profits.
 Puerto has an equity beta of 2.13 which reflects Puerto's gearing on 30 November 20X3.
 The risk free rate is 2.8% pa.
 An appropriate market risk premium is 5% pa.
Requirements
16.1 Prepare Puerto's forecast income statement for the year ended 30 November 20X4
assuming that the restructuring goes ahead and that both the existing and newly-acquired
leasing businesses earn similar operating profits to those in the year to 30 November 20X3.
(3 marks)
16.2 Calculate Puerto's gearing ratio (debt/equity) by market values on 30 November 20X3 and
on 1 December 20X3 immediately after the restructuring. (5 marks)
16.3 Using your answer to 16.1 and 16.2, comment on the financial health of Puerto both before
and after the restructuring and whether the covenant imposed by Risky would be met if
Puerto's share price remains at 10p on 1 December 20X3. (5 marks)
16.4 Calculate (using the capital asset pricing model) the weighted average cost of capital of
Puerto on 30 November 20X3 and on 1 December 20X3 immediately after the
restructuring. (10 marks)
16.5 Discuss, with reference to relevant theories, whether the change in Puerto's capital structure
following the restructuring on 1 December 20X3 will bring about a permanent change in its
weighted average cost of capital. (6 marks)
16.6 Advise the board of Puerto on the likely reaction of the various stakeholders in the company
to the restructuring. (6 marks)
Total: 35 marks

17 Abydos plc
Abydos plc is considering a large strategic investment in a significantly different line of business
to its existing operations. The scale of the new venture is such that a significant injection of
£12.5 million of new capital will be required.
The current gearing of Abydos is 80% equity and 20% debt by market value.
The new project will require outlays immediately as follows:
£'000
Plant and equipment (purchased on first day of financial year) 10,000
Working capital 1,500
Equity issue costs (not tax allowable) 700
Debt issue costs (not tax allowable) 300
12,500

26 Financial Management: Question Bank ICAEW 2020

 Other details are as follows:
 Estimates of relevant cash flows and other financial information associated with the possible
new investment. These are shown below.
Year 1 Year 2 Year 3 Year 4
£'000 £'000 £'000 £'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
 The directors have examined similar quoted companies operating in the same sector as the
new investment and have determined that a suitable equity beta is 1.4, using average
industry gearing of 60% equity, 40% debt by market values.
 The risk free rate is 5% and the market return 12%.
 £5 million of debt (an 8% fixed rate debenture) will be raised to fund part of the investment.
The remainder will be equity.
 Capital allowances are at 18% per year on a reducing balance basis.
 Tax is payable at 17% in the year that the taxable cash flow arises.
 The after tax realisable value of the investment (including any balancing allowance/charge
on the equipment) as a continuing operation is estimated to be £4 million (including
working capital) at the end of Year 4.
 Working capital may be assumed to be constant during the four years.
The board of directors of Abydos plc is discussing how the company should appraise the new
investment. There is a difference of opinion between two directors.
The sales director believes that net present value at the current weighted average cost of capital
should be used as positive NPV investments should be quickly reflected in increases in the
company's share price.
The finance director states that NPV is not good enough as it is only valid in potentially restrictive
conditions, and should be replaced by APV (adjusted present value).
Requirements
17.1 Calculate the expected APV of the proposed investment. (10 marks)
17.2 Discuss briefly the validity of the views of the two directors. Use your calculations in 17.1 to
illustrate and support the discussion. (6 marks)
Total: 16 marks

18 Biddaford Lundy plc

Biddaford Lundy plc (BL) is a large UK engineering company. Its ordinary shares are quoted on
the London Stock Exchange.
BL's board is concerned that the company's gearing level is too high and that this is having a
detrimental impact on its market capitalisation. As a result the board is considering a
restructuring of BL's long term funds, details of which are shown here as at 29 February 20X2:
Total par value Market value
£m
Ordinary share capital (50p) 67.5 £2.65/share ex-div
7% Preference share capital (£1) 60.0 £1.44/share ex-div
4% Redeemable debentures (£100) 45.0 £90% ex-int
The debentures are redeemable in 20X7. BL's earnings for the year to 29 February 20X2 were
£32.4 million and are expected to remain at this level for the foreseeable future. Retained
earnings at 29 February 20X2 were £73.2 million.

ICAEW 2020 Finance and capital structure 27

 The board is considering a 1 for 9 rights issue of ordinary shares and this additional funding would
be used to redeem 60% of BL's redeemable debentures at par. However, some of BL's directors
are concerned that this issue of extra ordinary shares will cause the company's ordinary share price
and its earnings per share (EPS) to fall by an excessive amount, to the detriment of BL's
shareholders. Accordingly, they are arguing that the rights issue should be designed so that the
EPS is not diluted by more than 5%.
The directors wish to assume that the corporation tax rate will be 17% for the foreseeable future
and that tax will be payable in the same year as the cash flows to which it relates.
Requirements
18.1 Calculate BL's gearing ratio using both book and market values and discuss, with reference
to relevant theories, why BL's board might have concerns over the level of gearing and its
impact on BL's market capitalisation. (9 marks)
18.2 Assuming that a 1 for 9 rights issue goes ahead, calculate the theoretical ex-rights price of a
BL ordinary share and the value of a right. (4 marks)
18.3 Discuss the directors' view that the rights issue will cause the share price and the EPS to fall
by an excessive amount, to the detriment of BL's ordinary shareholders. Your discussion
should be supported by relevant calculations. (10 marks)
18.4 Calculate and comment on the rights issue price that would cause a 5% dilution in the
current EPS figure. (6 marks)
18.5 Discuss the factors to be considered when making a rights issue. (6 marks)
Total: 35 marks

19 BBB Sports plc

BBB Sports plc (BBB) operates gyms and health clubs in the UK and it is considering diversifying
by setting up a division called 'Climbhigh' which would operate indoor climbing walls in several
cities in other countries. Some of these countries have unstable governments and/or are
countries where health and safety laws are not as strict as those in the UK. The chairman of BBB
is anxious that any climbing walls that they operate overseas should be of the highest standard
and meet the national guidelines in the UK, which are available from the Association of British
Climbing Walls (ABC).
The finance director of BBB, who is an ICAEW Chartered Accountant, has available the following
information regarding the Climbhigh project:
• The finance for Climbhigh can be raised in the UK in such a way as to leave the existing
debt:equity ratio (by market values) of BBB unchanged after the diversification.
• An appropriate equity beta for a company that operates climbing walls is 1.90 at a
debt:equity ratio (by market values) of 4:6.
• An email has been received from a contractor in one of the other countries. The contractor
intends to tender for the contract to build one of the climbing walls. Part of the email stated:
"The ABC guidelines are very strict and we can build a cheaper, but safe, wall by just
ignoring them. We do things differently here and can save you a lot of money by cutting
corners!"
• If the Climbhigh project goes ahead, the overall equity beta of BBB will be made up of 80%
existing operations and 20% Climbhigh.

28 Financial Management: Question Bank ICAEW 2020

 The following information relates to BBB without the Climbhigh project.
Extracts from the most recent management accounts:
Balance sheet at 30 November 20X5
£m
Ordinary share capital (20p shares) 365
Retained earnings 4,788
5,153
5% Redeemable debentures at nominal value 2,200
7,353

On 30 November 20X5 BBB's ordinary shares each had a market value of 360p (cum-div) and an
equity beta of 1.10. For the year ended 30 November 20X5, the dividend declared was 10p per
ordinary share and the earnings yield (earnings per share divided by ex-div share price) was 7%.
BBB's debentures had a market value at 30 November 20X5 of £99 (cum-interest) per £100
nominal value and are redeemable at par on 30 November 20X9.
The market return is expected to be 7% pa and the risk free rate 2% pa.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
19.1 Ignoring the Climbhigh project, calculate the WACC of BBB at 30 November 20X5 using:
(a) The CAPM (8 marks)
(b) The Gordon growth model (6 marks)
19.2 Using the CAPM, calculate a WACC that is suitable for appraising the Climbhigh project
and explain the rationale for using this as the discount rate for the project. (6 marks)
19.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
BBB assuming that the Climbhigh project goes ahead and comment upon the implications
for the value of BBB of any change from the WACC that you have calculated in 19.1(a)
above. (6 marks)
19.4 Advise BBB on how political risk could potentially affect the value of the Climbhigh project
and how it might limit its effects where such risk exists. (6 marks)
19.5 Explain the ethical issues for the finance director in relation to the email received from the
contractor who wishes to tender for building one of the climbing walls, and briefly outline
the action that he should take. (3 marks)
Total: 35 marks

ICAEW 2020 Finance and capital structure 29

 Business valuations, plans, dividends and growth

20 Cern Ltd
20.1 Cern Ltd (Cern) is an unquoted company that manufactures a range of products used in the
construction industry. Extracts from the most recent management accounts of Cern are set
out below:
Income statement for the year ended 30 September 20X2
£
Profit before interest and tax 1,080,000
Interest (180,000)
Profit before tax 900,000
Tax (17%) (153,000)
Profit after tax 747,000

Dividends declared and paid:

Preference dividend 43,200
Ordinary dividend 180,000

Balance sheet at 30 September 20X2

Non-current assets £ £
Intangibles 900,000
Freehold land and property 1,800,000
Plant and equipment 3,600,000
Investments 900,000
7,200,000
Current assets
Inventory 540,000
Receivables 1,080,000
Cash 180,000
1,800,000
Current liabilities (1,080,000)
720,000
7,920,000
Equity and non-current liabilities
Ordinary share capital (£1 shares) 3,600,000
6% Preference shares (£1 shares) 720,000
Retained earnings 1,800,000
6,120,000
10% Debentures 1,800,000
7,920,000
The following information is also available:
(1) In the two previous financial years the profit before interest and tax was:
• year ended 30 September 20X1: £440,000.
• year ended 30 September 20X0: £1,800,000.
(2) The current market value of the preference shares has been estimated at £0.90 per
preference share.
(3) The current market value of the debentures has been estimated at £110 per £100 of
debentures.
(4) The current rental value of the freehold land and property is £270,000 pa and this
represents a 6% return.

30 Financial Management: Question Bank ICAEW 2020

 (5) The current market value of the investments is £1,350,000.
(6) The most recent P/E ratios of two comparable quoted companies operating in the
same sector as Cern are 9.6 and 7.0, and their most recent dividend yields are 4% and
3.4% respectively.
(7) Cern's directors assume that for the foreseeable future the corporation tax rate will be
17%.
The directors have recently received an approach from Fenton Holdings plc (Fenton), a
conglomerate company, whose directors have expressed an interest in making an offer to
buy the whole of Cern. Fenton's directors have confirmed that if an acquisition goes ahead,
they will purchase the debentures at their market value and Fenton's bank has agreed to
buy the preference shares at their market value. Cern's directors have sought your advice as
an external consultant.
Requirements
(a) Using the available information, calculate the minimum price per ordinary share that
the shareholders of Cern should be willing to accept from Fenton using each of the
following methods of valuation:
 Net assets
 Dividend yield
 P/E ratio (13 marks)
(b) Comment on the values you have calculated and any issues you think should be
brought to the attention of Cern's directors. (4 marks)
(c) Identify the motives that might lie behind Fenton's possible acquisition of Cern.
(4 marks)
20.2 Cern has an annual cost of capital of 10%. One of its most successful products is Hadtone, a
mortar colouring agent. Hadtone is made using a single processing machine which mixes
the raw ingredients and dispenses the completed product into five-litre cartons.
A five-litre carton of Hadtone sells for £12.00 and estimated maximum annual demand at
this price is 300,000 cartons. At this level of demand, Cern can justify the operation of only
one processing machine, which Cern currently replaces every three years, although the
processing machine has a productive life of four years.
In the first year of its life the processing machine has a productive capacity in line with the
maximum annual demand for the product, but each year thereafter this productive capacity
falls at a rate of 15,000 units pa. Annual maintenance costs in the first year of operating the
processing machine are estimated at £12,000. Thereafter, the directors expect the annual
maintenance costs to increase by £2,000 pa regardless of the actual number of five-litre
cartons produced. Cern incurs variable costs, excluding depreciation and maintenance
costs, of £8.00 in producing each five-litre carton. Cern provides for depreciation on all its
non-current assets using the straight-line method.
If Cern were to dispose of the processing machine after one year, the directors estimate
sale proceeds of £320,000, but these would fall by £120,000 pa in each of the following two
years. Once the machine has reached the end of its four-year productive life its residual
value will be £10,000.
Following a recent increase in the cost of a processing machine to £480,000, Cern's
directors are reconsidering their current replacement policy with a view to maximising the
present value of the company's cash-flows. It can be assumed that all revenues and costs
are received or paid in cash at the end of the year to which they relate, with the exception of
the initial price of the processing machine which is paid in full at the time of purchase.

ICAEW 2020 Business valuations, plans, dividends and growth 31

 Requirement
Assuming that the processing machine is used to maximum capacity, and showing all your
supporting calculations, advise Cern's directors how often they should replace the
processing machine. (10 marks)
Total: 31 marks
Note: Ignore inflation and taxation when answering 20.2.

21 Wexford plc
Wexford plc (Wexford) is a listed manufacturer of dairy products. In recent years the company
has experienced only modest levels of growth, but following the recent retirement of the chief
executive, his replacement is keen to expand Wexford's operations.
It is currently December 20X8 and the board of directors has recently agreed to support a
proposal by the new chief executive that the company purchase new manufacturing equipment
to enable it to expand its range of yoghurt-based products. The new equipment will cost
£25 million and the company is seeking to raise new finance to fund the expenditure in full.
However, the board of directors is undecided as to how the new finance is to be raised. The
directors are considering either a 1 for 5 rights issue at a price of 250p per share or a floating
rate loan of £25 million at an initial interest rate of 8% per annum. The company's bank has
agreed to provide the £25 million loan. The loan would be for a term of five years, with interest
paid annually in arrears and with the capital being repaid in full at maturity. The loan would be
secured against the company's freehold land and buildings.
You are employed by Wexford as a company accountant and have been able to obtain the
following additional information:
 As a result of the investment in the new machinery, the directors aim to increase the
company's revenue by 15% per annum for the foreseeable future.
 It is expected that direct costs, other than depreciation, will, on average, increase by 18% during
the year ending 30 November 20X9 due to the 'learning curve' effects associated with the new
machinery.
 Indirect costs are expected to increase by £10 million in the year to 30 November 20X9.
 The ratios of receivables to sales and payables to direct costs (excluding depreciation) will
remain the same as in the year to 30 November 20X8.
 Depreciation on assets existing at 30 November 20X8 is forecast to be £18 million in the
year ending 30 November 20X9.
 Depreciation on the new machinery will be 20% per annum on a straight line basis
commencing in the year of purchase.
 Capital allowances can be assumed to be equal to the depreciation charged in a particular
year.
 The company's inventory levels are expected to increase by £10 million as a result of the
increased levels of business.
 Tax is payable at a rate of 17% per annum in the year in which the liability arises.
 Dividends are payable the year following their declaration and the board of directors has
confirmed to the bank its intention to maintain the company's current dividend payout ratio
for the foreseeable future.

32 Financial Management: Question Bank ICAEW 2020

 A summary of Wexford's most recent draft financial statements is shown below:
Income statement for the year ended 30 November 20X8
£'000
Revenue 270,000
Direct costs (Note) 171,000
Indirect costs 40,000
Operating profit 59,000
Interest 5,000
Profit before tax 54,000
Taxation 9,180
Profit after tax 44,820

Note: Includes depreciation of £19 million.

The company has declared a dividend that will cost £22,680,000.
Balance sheet at 30 November 20X8
£'000 £'000
Non-current assets (carrying amount) 152,590
Current assets
Inventory 35,000
Trade receivables 49,000
Cash at bank 10,500
94,500
247,090
Capital and reserves
£1 Ordinary shares 50,000
Retained earnings 81,410
131,410
Non-current liabilities
10% Debentures (repayable 20Y5) 50,000
Current liabilities
Trade payables 43,000
Dividends payable 22,680
65,680
247,090

Requirements
21.1 For each of the financing alternatives being considered, prepare a forecast income
statement for the year ending 30 November 20X9 and a forecast Balance sheet at
30 November 20X9. (16 marks)
Note: Transaction costs on the issuing of new capital and returns on surplus cash invested
in the short term can both be ignored.
21.2 Write a report (including appropriate calculations) to Wexford's board of directors that fully
evaluates the two potential methods of financing the company's expansion plans.
(14 marks)
Total: 30 marks

ICAEW 2020 Business valuations, plans, dividends and growth 33

22 Loxwood
Loxwood is a firm of ICAEW Chartered Accountants. You work in its Business Valuations Unit
(BVU) which advises clients wishing either (a) to sell their own business or (b) to purchase a new
business. You are currently advising three of Loxwood's clients:
Client One
Walton plc (Walton) is considering making takeover bids for two of its competitors, Hampton plc
(Hampton) and Richmond Ltd (Richmond). Loxwood has been asked to advise Walton as to what
value it should place on these target companies. You have obtained the following financial data:
Walton Hampton Richmond
Profit before interest and tax
(year ended 28 February 20X4) £36.2m £5.5m £4.8m
Depreciation charge (year ended 28 February
20X4) £6.5m £2.9m £0.9m
Average annual growth in profit after tax
(years ended 28 February 20X0-20X4) 5% 7.5% 9%
Average dividend pay-out ratio
(years ended 28 February 20X0-20X4) 30% 35% 45%
P/E ratio (at 28 February 20X4) 16.5 15.2 Not available
Cost of equity (estimated) 5.0% 9% 10.5%

Statement of financial position

Extracts at 28 February 20X4
Walton Hampton Richmond
£m £m £m
Non-current assets (Note 1) 177.0 32.7 22.4
Current assets (Note 1) 146.5 22.8 33.3
Current liabilities (96.5) (11.3) (13.7)
Non-current liabilities (Note 2) (70.0) (22.5) (19.3)
157.0 21.7 22.7
Ordinary share capital (£1 shares) 62.0 17.6 9.8
Retained earnings 95.0 4.1 12.9
157.0 21.7 22.7

Notes
1 These assets have been professionally valued on 28 February 20X4 as follows:
Hampton Richmond
£m £m
Non-current assets 45.2 24.1
Current assets 25.1 35.2

2 The non-current liabilities are all debentures, redeemable within the next six years, with
coupon rates as follows: Walton 7%, Hampton, 7%; Richmond, 8%. The debentures are
currently trading at: Walton £125, Hampton £110, Richmond £80.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Client Two
Jackie Wight has run a very successful fashion business, Regent Spark Ltd, for many years and is
now considering selling it and taking early retirement. She has read a recent article in the
financial press and is concerned that she won't get a fair price for her company. As a result she
has contacted Loxwood for guidance. The following is an extract from the article:
'Angel Ventures (AV) recently bid for biometrics company Praed Bio (PB), offering PB's
shareholders £5.20 a share. Maida Money (MM), a hedge fund that owns PB shares, disliked

34 Financial Management: Question Bank ICAEW 2020

 the deal and sought a court's opinion on fair value. MM wanted £10.25 a share. AV
countered with £5.10. In court, the judge, using shareholder value analysis (SVA), settled on
£5.80 but said there were problems in estimating future cash flows and in calculating the
value of the cash flows after the competitive advantage period (the residual value).'
Client Three
Doug Williams owns 60 acres of agricultural land in south west England and is considering
accepting an offer from So Lah Energy Ltd (SLE) to install solar panels on his land. SLE would pay
Doug £1,000 per acre pa (in 28 February 20X4 prices) at the end of each of the next 10 years for
the use of his land, after which time it would revert back to agricultural use. To take account of the
general rate of inflation, SLE will increase this payment by 3% pa (compound). One of Doug's
neighbours, Bill Etheridge, is very unhappy at the prospect of this solar farm and is prepared to
buy Doug's land from him for £500,000 in order to stop it being built. The land has a market value
of £120,000 in agricultural use on 28 February 20X4 and this is expected to rise in line with the
general rate of inflation, ie, 3% pa. Doug could invest Bill's money in a bank account bearing
interest at 4% pa, but he is unsure whether he should accept Bill's offer.
Requirements
22.1 For Client One, prepare a report for Walton's board advising it of a range of suitable prices
for both Hampton and Richmond using asset, dividend, earnings and EBITDA multiple
based valuations. Your report should include your workings supported by a clear
commentary as to the strengths and weaknesses of each of the valuation methods used.
(25 marks)
22.2 For Client Two, explain how SVA works and why future cash flows and the residual value are
such problems. (7 marks)
22.3 For Client Three, ignoring tax, advise Doug Williams as to whether he should accept Bill's
offer. You should support your answer with workings and any assumptions that you make
should be clearly stated. (5 marks)
22.4 Loxwood is planning a new marketing campaign for its BVU. Outline the key ethical issues
that Loxwood should consider when planning this campaign. (3 marks)
Total: 40 marks

23 Sennen plc
You should assume that the current date is 31 May 20X4.
Sennen plc (Sennen) is a UK listed company in the chemical industry. Morgan plc (Morgan) is a
UK listed company that has a policy of expanding by way of acquisition. As a result of financing
its acquisitions with borrowings, Morgan's gearing is high compared to its competitors.
Morgan has identified Sennen as a potential takeover target and intends to make an offer for all
of the ordinary shares of the company. The finance director of Morgan wishes to value Sennen's
ordinary shares including any synergistic benefits that may arise following the acquisition. He is
also considering the advantages and disadvantages of the different methods that can be used to
pay for the ordinary shares. The intended offer for Sennen is not public knowledge.

ICAEW 2020 Business valuations, plans, dividends and growth 35

 The Finance Director of Morgan has asked North West Corporate Finance (NWCF) to give him
advice regarding the intended offer for the ordinary shares of Sennen. You work for NWCF and
a partner in the firm has asked you to prepare a report for a meeting that he is due to attend with
the board of Morgan. You have established the following data relating to Sennen:
Sales revenue for the year ended 31 May 20X4 £20 million
Competitive advantage period 3 years
Estimated sales revenue growth for the next three years 5% pa
Estimated sales revenue growth thereafter in perpetuity 2% pa
Operating profit margin 15%
Additional working capital investment at the start of each year 1% of that year's sales revenue
Additional non-current asset investment at the end of each year 2% of that year's sales revenue
After tax synergies at the end of each year 2.5% of that year's sales revenue
Number of ordinary shares in issue 17,000,000
Current share price 160p
Appropriate weighted average cost of capital 7% pa
Price earnings (p/e) multiple used to value recent takeovers in
the chemical industry 17
You may assume that replacement non-current asset expenditure equals depreciation in each
year.
On 31 May 20X4 Sennen had short-term investments with a market value of £2 million currently
yielding 3% pa and irredeemable debt with a market value of £10 million. The current gross yield
on Sennen's debt is 5% pa.
Assume that corporation tax will be 17% of operating profits for the foreseeable future and that
there are no other tax issues that need to be considered.
The management team of Sennen, which includes a member of the ICAEW, has been preparing
a business plan to present to potential financial backers of a management buyout (MBO) that
they intend to launch for the ordinary shares of the company. The intended MBO is not public
knowledge.
Requirements
23.1 Prepare a report for the partner in NWCF which includes:
(a) The estimated value of the ordinary shares of Sennen calculated using Shareholder
Value Analysis (SVA) and an explanation of the strengths and weaknesses of this
valuation method. (13 marks)
(b) The sensitivity of the total value of Sennen (debt plus the value of equity calculated in
(a) above) to a change in the after tax synergies. (3 marks)
(c) The value of the ordinary shares of Sennen using the p/e method and an explanation of
the strengths and weaknesses of this valuation method. (5 marks)
(d) A discussion of whether Morgan should offer the shareholders of Sennen a premium
over its current share price given the valuations calculated in parts (a) and (c). (3 marks)
(e) Advice on the suitability of each of the following methods that Morgan could use to
pay for the ordinary shares of Sennen:
 Cash
 A share for share exchange
 A loan stock for share exchange
 Part cash and part share for share exchange (8 marks)
23.2 Identify and briefly discuss the ethical issues faced by the MBO team should Morgan make
an offer for the ordinary shares of Sennen. (3 marks)
Total: 35 marks

36 Financial Management: Question Bank ICAEW 2020

24 Tower Brazil plc
You are an ICAEW Chartered Accountant and work in the finance team at Tower Brazil plc
(Tower). The company manufactures wallpaper and paint for major UK homeware retailers and
has been trading since 2001. It has a financial year end of 31 August. Extracts from its most
recent management accounts are shown below.
Income statement for the year ended 31 August 20X4
£'000
Profit before interest 9,356
Debenture interest (2,338)
Profit before tax 7,018
Tax at 17% (1,193)
Profit after tax 5,825
Dividends – preference shares (480)
Dividends – ordinary shares (4,509)
Retained profits 836

Balance sheet at 31 August 20X4

£'000
£1 ordinary share capital 16,500
Retained earnings 26,420
42,920
6% £1 preference shares 8,000
5% debentures at nominal value (redeemable 20X6) 46,750
97,670

The market values of Tower's long-term finance on 31 August 20X4 are shown below:
£1 ordinary share capital £4.20/share
6% £1 preference shares £0.80/share
5% debentures £110%

Extracts from the minutes of Tower's board meeting, 1 September 20X4

AB (Production Director) once again raised the issue of Tower's 'gearing problem' and said that
gearing was now over 50%. DB (Marketing Director) and WR (Sales Director) concurred. All
three felt that gearing should be reduced as a matter of urgency, otherwise, according to AB, it's
very risky and the company's share price (and cost of capital) will be adversely affected which
will make new projects difficult to justify.
It was agreed to investigate the implications of using a rights issue to address the gearing
problem. The rights issue would enable ordinary shareholders to significantly increase their
investment and so reward them for their loyalty. It was proposed that a one for two rights issue
would be made, but concerns were raised that this would reduce the company's earnings per
share figure by more than 10%.
WR raised the point that dividends have increased 3% pa on average over the past five years. He
suggested that rather than raising more capital the company could change its dividend policy.
As a result it would retain more of its profits for re-investment. He thought this would not be
popular with shareholders, but that, if they did react badly to the change then Tower could
always pay a one-off special dividend to make up for any shortfall.

As a result of these discussions the board decided to explore the implications of making a 1 for
2 rights issue which would raise sufficient funds to purchase and cancel 60% of Tower's
debentures by market value.

ICAEW 2020 Business valuations, plans, dividends and growth 37

 In advance of the next board meeting, you have been asked by your manager, Luke Cleeve, to
prepare calculations and advice for Tower's directors. Luke pointed out to you that you should
'be careful with this information as it's potentially price sensitive and not in the public domain.'
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
24.1 Calculate Tower's theoretical ex-rights share price if a 1 for 2 rights issue were made on
1 September 20X4. (3 marks)
24.2 (a) Calculate Tower's earnings per share figure for the year ended 31 August 20X4 and for
the year ended 31 August 20X5 after the proposed rights issue (assuming no change
in profit before interest).
(b) Calculate and comment on the terms of the rights issue required if the earnings per
share figure is not to worsen by more than 10% for the year ended 31 August 20X5.
(11 marks)
24.3 Calculate Tower's gearing (debt/debt + equity) at 31 August 20X4 using both book and
market values and advise its board as to whether it has a 'gearing problem' and how its
gearing level could affect its share price. Where relevant, make reference to theories
regarding the impact of capital structure on share price. (9 marks)
24.4 Advise Tower's board as to whether the suggested change in dividend policy would have a
negative impact on the company's share price. Where relevant, make reference to theories
regarding the impact of dividend policy on share price. (9 marks)
24.5 Explain the ethical implications for an ICAEW Chartered Accountant of having access to
'price-sensitive information'. (3 marks)
Total: 35 marks

25 Brennan plc
Brennan plc is a family run business, which obtained a stock market listing around three years
ago. The board is comprised of 75% of members of the founding family. Brennan plc has a
current stock market capitalisation of £250 million and the board owns 45% of the issued shares.
The net book value of assets held by Brennan plc is £300 million.
Brennan currently enjoys competitive advantage through being a low cost producer and the
board feels that this competitive advantage is likely to continue for the next six years. The
following information relating to Brennan and the period of competitive advantage is available.
Current sales revenue £200 million
Estimated sales growth 6%
Operating profit margin after depreciation 15%
Additional working capital investment 7% of sales increase
Additional non-current asset investment 12% of sales increase
Following the end of the period of competitive advantage, cash flows are expected to remain
constant for the foreseeable future.
Brennan plc currently has no long-term debt and holds short-term investments worth
£2.5 million. The corporation tax rate is expected to be 17% for the foreseeable future.
Brennan plc has an equity beta of 0.75, the risk free rate of interest is 3% and the return on the
market portfolio is 11%.
Brennan plc has a policy of paying out 10% of its post-tax earnings as dividends.

38 Financial Management: Question Bank ICAEW 2020

 Requirements
25.1 Calculate the value of Brennan plc using SVA methodology and comment on the results.
(13 marks)
25.2 Discuss the reasons why Brennan plc has a market capitalisation lower than its net book
value of assets. (7 marks)
Total: 20 marks

ICAEW 2020 Business valuations, plans, dividends and growth 39

 Risk management

26 Fratton plc
26.1 Fratton plc (Fratton) trades extensively in Europe. The firm is due to receive €2,960,000 in
three months' time. The following information is available:
(1) The spot exchange rate is currently €1.1845 – 1.1856/£.
(2) The three-month forward rate of exchange is currently at a 0.79 – 0.59 cent premium.
(3) The prices of three-month sterling traded option contracts (premiums in cents per £
are payable up front, with a standard contract size of £10,000) are as follows:
Exercise price Calls Puts
€1.18 2.40 1.20
(4) Annual interest rates at the present time are as follows:
Deposit Borrowing
UK 1.15% 2.40%
Eurozone 0.75% 1.60%
Requirements
(a) Calculate the net sterling receipt that Fratton can expect in three months' time if it
hedges its foreign exchange exposure using:
 the forward market
 the money market
 the options market, assuming the spot exchange rate in three months is:
– €1.1185 – 1.1200/£
– €1.1985 – 1.2000/£ (14 marks)
(b) Discuss the advantages and disadvantages of using futures contracts as opposed to
forward contracts when hedging foreign currency exposure. (7 marks)
26.2 In addition, in three months' time Fratton will be drawing down a three-month £2.5 million
loan facility which is granted each year by its bank to see the firm through its peak
borrowing period. The following information is available:
(1) The quotation for a '3–6' forward rate agreement is currently 2.60 – 1.35.
(2) The spot rate of interest today is 2.40% pa and the relevant three-month sterling
interest rate futures contract (standard contract size £500,000) is currently trading at
97.20.
Requirements
(a) Explain how Fratton could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months' time, the
spot rate of interest is 3% pa. (4 marks)
(b) Explain how Fratton could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months' time, the spot rate of interest is
3% pa and the price of the interest rate futures contract has fallen to 97. (5 marks)
Total: 30 marks

40 Financial Management: Question Bank ICAEW 2020

27 Sunwin plc
27.1 The finance director of Sunwin plc (Sunwin) is a trustee of the firm's employee pension fund.
The vast majority of the fund's assets are currently invested in a portfolio of FTSE 100
shares. It is 1 December 20X2 and the trustees are concerned that FTSE 100 share prices
will fall over the next month and they wish to hedge against this possibility by using FTSE
index options. The current market value of the pension fund's portfolio of shares is
£5.6 million. The FTSE 100 index stands at 5,000 on 1 December 20X2 and the directors
wish to protect the current value of the portfolio. The trustees have obtained the following
information as at 1 December 20X2:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)

4,900 4,950 5,000 5,050 5,100

Call Put Call Put Call Put Call Put Call Put

December 139 34 104 48 74 70 49 99 34 134

January 214 94 184 114 154 134 124 159 104 189
February 275 135 245 155 220 180 190 200 165 225

Requirements
Demonstrate how FTSE 100 index options can be used by the trustees to hedge the pension
fund's exposure to falling share prices and show the outcome if, on 31 December 20X2, the
portfolio's value:
(a) Rises to £6.608 million and the FTSE index rises to 5,900
(b) Falls to £4.592 million and the FTSE index falls to 4,100 (8 marks)
27.2 It is 1 December 20X2 and Sunwin's board of directors has recently agreed to purchase
machinery from a UK supplier on 28 February 20X3. The firm's cash flow forecasts reveal
that the firm will need to borrow £4 million on 28 February 20X3 for a period of nine months.
The directors are concerned that short-term sterling interest rates may rise between now
and the end of February and are considering the use of either sterling short-term interest
rate futures or traded interest rate options on futures to hedge against the firm's exposure
to interest rate rises.
The spot rate of interest on 1 December is 3% pa and March three-month sterling interest
rate futures with a contract size of £500,000 are trading at 96. Information regarding traded
interest options on futures on 1 December 20X2 is as follows:

Calls Puts

Strike Price March June September March June September

96.25 0.20 0.23 0.25 0.18 0.96 1.66

96.50 0.09 0.10 0.11 0.32 1.19 1.89
96.75 0.05 0.06 0.07 0.53 1.43 2.14

Premiums are in annual % terms.

Requirements
(a) Demonstrate how sterling short-term interest rate futures can be used by Sunwin to
hedge against interest rate rises, and show the effective loan rate achieved and the
hedge efficiency if, on 28 February 20X3, the spot rate of interest is 4.5% pa and the
March interest rate futures price has fallen to 95. (6 marks)

ICAEW 2020 Risk management 41

 (b) Demonstrate how traded interest rate options on futures can be used by Sunwin to
hedge against the interest rate rising above 3.75% pa and show the effective loan rate
achieved if, on 28 February 20X3:
(1) The spot price is 4.4% pa and the futures price is 95.31.
(2) The spot price is 2.1% pa and the futures price is 97.75. (9 marks)
(c) Identify three factors that will affect the time value of an option. (3 marks)
Total: 26 marks

28 Padd Shoes Ltd

You should assume that the current date is 31 March 20X4.
You work in the finance team at Padd Shoes Ltd (Padd), a footwear manufacturer and retailer
based in the UK. You have been given two tasks to deal with:
Task 1
Padd's chief executive has been contacted by the managing director of a large Indian retailer,
DS, who feels that Padd's footwear would sell well in India because, in her words, "Padd's styles
are attractive to our consumers, UK brands are generally highly regarded here in India and our
country has a growing middle class with enhanced spending power".
It has been agreed that, to test the market, Padd will send a large consignment of footwear to
DS for sale in its shops across India. The price for this consignment is 200 million Indian rupees
(INR), which will be payable by DS on 30 June 20X4.
Padd's board is aware that the Indian rupee has weakened against sterling by almost 2% in the
past six months and so it wishes to explore whether to hedge this sale to DS. In addition,
because Padd has not traded outside of the UK before, its board has some more general
concerns about trading abroad.
You have been asked to prepare advice for the board and have obtained the following
information at the close of business on 31 March 20X4:
Spot rate (INR/£) 94.0625 – 95.4930
Sterling interest rate (lending) 3.2% pa
Sterling interest rate (borrowing) 4.0% pa
INR interest rate (lending) 4.2% pa
INR interest rate (borrowing) 4.8% pa
Three-month OTC currency call option on INR – exercise price INR 94.7500/£
Three-month OTC currency put option on INR – exercise price INR 95.5500/£
Three-month forward rate discount (INR/£) 0.0195 – 0.2265
Cost of relevant OTC currency option £8,000
Cost of forward contract £4,500
Task 2
On 1 April 20X3 Padd borrowed £8.5 million over a four-year period at LIBOR + 1% pa to
finance an expansion of its production capacity and the refurbishment of a number of its larger
stores. Padd's board is now investigating whether it should hedge against adverse interest rate
movements over the next 12 months. Its bank has offered either (a) an option at 4% pa plus a
premium of 0.75% of the sum borrowed or (b) a Forward Rate Agreement (FRA) at 4.5% pa.

42 Financial Management: Question Bank ICAEW 2020

 Requirements
28.1 Calculate Padd's sterling receipt from the sale to DS if it:
(a) Does not hedge the receipt and the Indian rupee weakens by 1% by 30 June 20X4
(b) Uses an OTC currency option
(c) Uses a forward contract
(d) Uses a money market hedge (10 marks)
28.2 With reference to your calculations in 28.1 above, advise Padd's board whether it is worth
hedging the DS receipt. (8 marks)
28.3 Advise Padd's board as to the risks, other than currency risk, that should be considered if
the company is to continue to trade abroad in future. (5 marks)
28.4 By preparing suitable interest payment calculations, recommend to Padd's board whether it
is worth hedging against interest rate movements over the next 12 months if LIBOR is either
(a) 3% pa or (b) 6% pa. (7 marks)
Total: 30 marks

29 Lambourn plc
Throughout both parts of this question you should assume that today's date is 30 June 20X2.
29.1 Lambourn plc (Lambourn) is a UK company that trades in a range of pharmaceutical
products. It buys and sells these products in the UK and also in the USA, where it trades with
three companies – Biotron Inc., Hope Inc. and USMed Inc.
In the past, the relatively low level of trading with US companies has meant that Lambourn
has not hedged its foreign currency exposure. However, due to increases in the level of
trade conducted in the USA, Lambourn's finance director is now considering the use of a
variety of hedging instruments.
Receipts and payments in respect of the following exports and imports (designated in the
currencies shown) are due in six months' time:
Receipts due from exports to:
Biotron Inc. $600,000
Hope Inc. £400,000
USMed Inc. $200,000
Payments due on imports from:
Biotron Inc. $1,100,000
Hope Inc. £900,000
USMed Inc. $1,250,000
Exchange rates at the present time are as follows:
Spot $1.6666 – 1.6720/£
3-month forward premium 0.90c – 0.98c
6-month forward premium 2.49c – 2.65c
Sterling currency options (standard contract size £10,000) are currently priced as follows
(with premiums, payable up front, quoted in cents per £):
Calls Puts
Strike Price September December September December
$1.63 3.67 4.59 0.06 1.69
$1.65 2.35 3.07 1.63 3.43
$1.67 1.82 2.65 2.04 5.55

ICAEW 2020 Risk management 43

 Sterling currency futures (standard contract size £62,500) are currently priced as follows:
September $1.6555/£
December $1.6496/£
Annual borrowing and deposit interest rates at the present time are as follows:
Sterling 3.00% – 1.70%
Dollar 1.50% – 0.50%
Requirements
Assuming the spot rate in six months' time will be $1.6400 – 1.6454/£, calculate Lambourn's
net foreign currency exposure, and the outcome achieved, using:
(a) A forward market hedge
(b) Exchange-traded currency options (hedging to the nearest whole number of contracts)
so as to guarantee no worse an exchange rate than the current spot rate
(c) Currency futures contracts (hedging to the nearest whole number of contracts) and
assuming the relevant futures contract is trading at $1.6400 in six months' time
(d) A money market hedge (17 marks)
29.2 In six months' time (ie, in December 20X2), Lambourn will need to borrow £1.5 million for a
period of six months at a fixed rate of interest. The company's finance director is keen to
ensure that the interest rate on the loan does not exceed 3.75% pa. The spot rate of interest
is currently 3% pa. The finance director intends to use three-month sterling traded interest
rate options on futures to hedge the company's interest rate exposure.
The current schedule of prices (premiums are in annual % terms) for these contracts
(standard contract size £500,000) is as follows:
Calls Puts
Strike Price Sept Dec Mar Sept Dec Mar
96.25 0.20 0.23 0.25 0.19 0.96 1.66
96.50 0.09 0.10 0.11 0.32 1.19 1.89
96.75 0.05 0.06 0.07 0.53 1.43 2.14
Requirements
(a) Calculate the outcome of the hedge and the effective annual rate of interest achieved if
prices in December 20X2, when Lambourn negotiates the six-month fixed rate loan
with its bank, are either:
 a spot interest rate of 4.4% pa and a futures price of 95.31; or
 a spot interest rate of 2.1% pa and a futures price of 97.75. (10 marks)
(b) Explain why a hedge using futures contracts may be less than 100% efficient. (3 marks)
Total: 30 marks

30 Bridge Engineering plc

You should assume that the current date is 31 December 20X5.
David Mann (David) is the finance director of Bridge Engineering plc (BE). David has
approached your firm to give a presentation to the board of BE on the characteristics and use of
options in the following two situations:
(1) BE has been expanding in recent years by acquisition. David would like to know how his
company might use traded options to protect itself against a fall in the value of the small
shareholdings that it holds in potential acquisitions. One such potential acquisition is Stickle
plc (Stickle) in which BE has a holding on 31 December 20X5.

44 Financial Management: Question Bank ICAEW 2020

 The following information is available:
On 31 December 20X5 the share price of Stickle is 287 pence (ex div) and traded options
on its shares are available as follows (all figures in pence):
Calls Puts
Exercise price January March January March
280 8.5 16 1.5 10.5
290 2.5 11 5.5 16
(2) BE currently uses forward rate agreements (FRAs) and interest rate futures to hedge its
interest rate risk. David is now considering the use of traded interest rate options. BE needs
to take out a loan of £20 million on 31 July 20X6 for a period of seven months and David
has agreed with BE's bank that the loan will have an interest rate of LIBOR + 4% pa.
LIBOR on 31 December 20X5 is 0.62% pa and David wishes to hedge against any increase
in this rate between 31 December 20X5 and 31 July 20X6.
The following information is available:
At 31 December 20X5 the following traded interest rate options on three month interest
rate futures with a contract size of £500,000 are available (option premiums are in annual %
terms):
Calls Puts
Exercise price March June September March June September
99.13 0.05 0.09 0.13 0.26 0.31 0.35
99.38 0.02 0.03 0.05 0.48 0.50 0.52
99.63 0.01 0.02 0.03 0.71 0.73 0.74
Assume that the options in (1) and (2) above expire at the end of the relevant month and that
premiums are payable on 31 December 20X5. The interest implications of paying the premium
on 31 December 20X5 can be ignored.
You have been asked to prepare briefing notes for the presentation on options to be given to
the board of BE.
Requirements
Prepare the briefing notes for the presentation that include:
30.1 A calculation of the intrinsic value and time value of each of the options on Stickle's shares
at 31 December 20X5. (4 marks)
30.2 A brief explanation of the three factors that affect the time value of the options on Stickle's
shares. (3 marks)
30.3 A brief explanation of the two factors that affect the intrinsic value of the options on Stickle's
shares. (2 marks)
30.4 A demonstration, using options, of how BE can protect itself against a fall in the Stickle
share price in the period up to 31 March 20X6 when it will decide whether to make an offer
for the whole of Stickle. Assume Stickle's share price will be 250p on 31 March 20X6.
(4 marks)
30.5 A demonstration of how traded interest rate options on interest rate futures can be used by
BE to hedge against LIBOR rising above 0.62% pa, showing the effective interest rate on the
loan, if on 31 July 20X6:
(a) LIBOR is 0.80% pa and the futures price is 99.15
(b) LIBOR is 0.40% pa and the futures price is 99.66 (10 marks)
30.6 An explanation of the comparative advantages and disadvantages of using traded interest
rate options, rather than FRAs and interest rate futures, to hedge BE's interest rate risk.
(7 marks)
Total: 30 marks

ICAEW 2020 Risk management 45

 March 2016 exam questions

31 Aranheuston Pharma plc

Aranheuston Pharma plc (AP) is a large listed UK pharmaceuticals company and its financial year
end is 31 March. Its directors have decided to invest in new products on a regular basis in order
to keep pace with the global trading environment. In order to help grow the company more
quickly, AP's directors are also investigating the possible takeover of a competitor.
Considerable development time is required for the production of new pharmaceutical products
and so net cash inflows from sales often lag well behind the development costs required.
Forecast life-cycle data for a new product (AP525) that is under consideration are provided
below:
Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£'000 £'000 £'000 £'000
Depreciation (Note 1) (350) (350) (350) –
Rent (Note 2) – (80) (80) (80)
Fixed costs (Notes 3 & 5) – (290) (290) (290)
Interest (Note 4) – (60) (60) (60)
Sales (Note 5) – 0 2,600 700
Variable costs (Note 5) – 0 (1,180) (220)
Profit/(loss) (350) (780) 640 50
Total working capital required (Note 5) 0 260 70 0

Notes
1 New equipment required for the production of AP525 will cost £1,150,000 on 31 March
20X6 and will be sold on 31 March 20X9 for an agreed price of £100,000 (in 31 March 20X9
prices).
AP depreciates its equipment on a straight-line basis. A full year's depreciation is charged
in the year of purchase and none in the year of sale.
If this new equipment is purchased, existing equipment, which originally cost £120,000
many years ago and has a tax written down value of zero, will be sold on 31 March 20X6 for
£70,000.
The new equipment will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down
value; or
 balancing charge, if the disposal proceeds are more than the tax written down value.
2 The new equipment will take up extra space, which will have to be rented for three years.
The rent would be at a fixed annual amount of £80,000, payable in advance, with the first
payment due on 31 March 20X6.
3 £130,000 of these fixed costs per annum are existing head office costs that will be allocated
to the project.

46 Financial Management: Question Bank ICAEW 2020

 4 The purchase of the new equipment would be funded from an issue of debt and this
represents the interest cost on that debt.
5 Unless otherwise stated, all of the above figures are in 31 March 20X6 prices. The following
inflation rates are expected for the years ended 31 March 20X7–20X9:
 Sales: 2% pa
 Variable and fixed costs and working capital: 3% pa
Other information
Corporation tax will be payable at the rate of 17% pa for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
An appropriate money cost of capital for the project is 8% pa.
Requirements
31.1 Using money cash flows, calculate the net present value of the AP525 product at 31 March 20X6
and advise AP's directors whether the company should proceed with it. (18 marks)
31.2 Calculate the sensitivity of your advice in 31.1 to changes in the variable costs of the AP525
product and comment on your result. (5 marks)
31.3 For the purposes of the possible takeover of a competitor, outline the Shareholder Value
Analysis (SVA) approach to company valuation for AP's directors, identifying its advantages
and disadvantages. (6 marks)
31.4 Agency theory highlights the potential conflicts that may occur between a company's
shareholders and its directors.
(a) Explain how these conflicts might arise in AP in relation to the potential takeover of a
competitor.
(b) Assuming that the AP525 product goes ahead, explain how these conflicts might arise
in AP in relation to:
 debt levels
 short-term versus long-term performance appraisal (6 marks)
Total: 35 marks

32 Oliphant Williams plc

You should assume that the current date is 1 March 20X6.
Oliphant Williams plc (OW) is a large UK design company that has traded since 1994. Its capital
structure at 29 February 20X6 is shown below:
Total market
Par Value Market Value value
£m (ex-div/ex-int) £m
Ordinary share capital 96 £1.70/share 326.4
Preference share capital 28 £1.80/share 50.4
3.5% debentures (redeemable at par in 20X9) 160 £105% 168.0
Notes
1 OW's retained earnings at 29 February 20X6 were £43.8 million.
2 OW's earnings for the year to 29 February 20X6 were £21.12 million. Earnings are not
expected to change significantly in the next two years.
3 OW's ordinary dividend for the year to 29 February 20X6 was £0.09 per share.

ICAEW 2020 March 2016 exam questions 47

 You are an ICAEW Chartered Accountant and the managing director of OW. The following
comments were made at OW's most recent board meeting:
Finance director
"The company's level of debt is too high and its balance sheet needs restructuring. Why don't
we raise more equity and pay off some of the debt? This would reduce gearing and have a
positive impact on the price of ordinary shares. A reasonably priced rights issue is probably the
best way forward and should not dilute OW's earnings per share excessively."
Marketing director
"Our dividend is similar, in terms of the payout ratio, to previous years, but I think that this policy
of paying high dividends is an unnecessary drain on our resources. I think that our shareholders
would react positively if we reduce the dividend in future."
Production director
"Whilst we don't expect our earnings to change much in the next two years, surely it would be
better for our share price if we predict some growth when we communicate with our
shareholders?"
In response to the finance director's concerns, OW's board is considering the redemption of
one half of its debentures. The debentures would be redeemed at an agreed price of £110.40%.
The redemption would be funded by a 2 for 5 rights issue.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
32.1 Calculate OW's gearing ratio (debt / debt + equity) at 29 February 20X6, using both book
and market values. (3 marks)
32.2 Discuss, with reference to relevant theories and your calculations in 32.1 above, the finance
director's view that a reduction in OW's gearing would have a positive impact on the
company's share price. (6 marks)
32.3 Assuming that the debenture redemption and rights issue goes ahead on 1 March 20X6 as
outlined above, calculate the theoretical ex-rights price of one OW ordinary share. Show
the financial impact of the proposed rights issue on an OW shareholder who owns 10,000
ordinary shares and who:
(a) Takes up all of the rights
(b) Sells all of the rights
(c) Does nothing (9 marks)
32.4 Calculate, and comment upon, the actual price of an ordinary OW share after the rights
issue is made, assuming that OW's current P/E (price/earnings) ratio remains unchanged.
(7 marks)
32.5 Making reference to relevant theories, discuss whether the marketing director is correct that
a reduction in OW's ordinary dividend would affect the price of its ordinary shares.
(7 marks)
32.6 Comment on the ethical implications of the production director's suggestion for you as an
ICAEW Chartered Accountant. (3 marks)
Total: 35 marks

48 Financial Management: Question Bank ICAEW 2020

33 Tully Carlisle Ltd
You should assume that the current date is 29 February 20X6.
33.1 Tully Carlisle Ltd (TC) is a UK construction firm. Most of its suppliers are UK-based. However,
since 20X4 it has been purchasing steel girders from a Russian company, GSL.
At a recent board meeting one of TC's directors commented:
"With our GSL purchases, we've never hedged against adverse exchange rate movements.
I think that we should as we're now buying a lot of steel from GSL. The orders are made
three months ahead of delivery and payment. A lot could happen to the exchange rate in
those three months."
TC's next order from GSL, at a price of R145.6 million (R = roubles, the Russian currency) will
be paid for in three months' time on 31 May 20X6. You are a member of TC's finance team
and have been asked to advise the board of the implications of hedging this purchase. You
have collected the following information:
Spot exchange rate at 31 December 20X4 (R/£) 79.45 – 91.34
Spot exchange rate at 31 December 20X5 (R/£) 76.51 – 87.95
Spot exchange rate at 29 February 20X6 (R/£) 78.81 – 90.62
Three-month forward contract discount (R/£) 0.55 – 0.63
Forward contract arrangement fee (per one million roubles converted) £40
Three-month over the counter (OTC) put option on roubles, exercise price
(R/£) 91.83
Three-month OTC call option on roubles, exercise price (R/£) 79.85
Relevant OTC option premium (per one million roubles converted) £90
Sterling interest rate (borrowing) 3.6% pa
Rouble interest rate (borrowing) 6.6% pa
Sterling interest rate (lending) 2.9% pa
Rouble interest rate (lending) 5.6% pa
Requirements
(a) Calculate the sterling cost of TC's payment to GSL on 31 May 20X6 if it uses the
following to hedge its exchange rate risk:
 A forward contract
 A money market hedge
 An OTC currency option (8 marks)
(b) With reference to your calculations in (a) above and the spot exchange rates provided,
advise TC's board whether to hedge the payment to GSL. (9 marks)
(c) Explain, with relevant workings, why the three-month forward rate is expressed at a
discount to the spot rate on 29 February 20X6. (5 marks)
33.2 TC borrowed £18.5 million last year at a fixed rate of 5.2% pa and this loan is repayable in
March 20X9. Anticipating a fall in interest rates, TC's board has asked its finance team to
investigate the possibility of arranging an interest rate swap. TC's bank has offered the
company a variable rate loan at LIBOR plus 1.2% pa.
Saunders Southgate Media (SSM), a company with a similar sized loan to TC (at a variable
rate of LIBOR plus 1.6% pa), is keen to swap its loan for one at a fixed rate. SSM has been
offered a fixed rate of 6.4% pa by its bank. LIBOR is currently 3.5% pa.
Requirement
Prepare workings for TC's board that show how an interest rate swap that is equally
beneficial to both companies could be set up. The variable leg of the swap should be set at
LIBOR. Your workings should include a calculation of the total annual interest payable by
each company once the swap has been made. (8 marks)
Total: 30 marks

ICAEW 2020 March 2016 exam questions 49

 June 2016 exam questions

34 Zeus plc
You should assume that the current date is 30 June 20X6.
Zeus plc (Zeus) is a large clothing retailer. Over the past five years it has built up an internet
based division, Venus, which specialises in selling to 16–24 year old female customers.
At a recent board meeting the Chief Executive Officer (CEO) of Zeus stated that:
"Venus has been successful, but we have not been able to get the value out of it that we initially
expected and the management time involved in running Venus is damaging the financial
performance of the group as a whole. Because internet-based companies have very high values
compared to non-internet companies with similar earnings, I feel that there could be more value
in Venus if it operated outside of our group. I think that we should divest ourselves of Venus and
appoint a financial advisor to assist us in the process. I wonder whether an Initial Public Offering
(IPO), where the shares are brought to the stock market for the first time, is a possibility."
The board agreed with the CEO and voted in favour of the divestment of Venus. Starr
Accountants (SA), a firm of ICAEW Chartered Accountants, has been appointed to give advice to
Zeus regarding the value of Venus and the potential IPO. In their valuation SA would like to use
net present value analysis and also a multiple of earnings. In addition to general corporate
finance work, SA also has a team that specialises in giving investment advice to clients who buy
shares in IPOs.
Extracts from Venus's most recent management accounts are shown below:
Balance sheet value of net assets at 30 June 20X6: £39 million.
Income statement for the year ended 30 June 20X6
£m
Sales 140.0
Cost of sales (56.0)
Gross profit 84.0
Selling and administration costs (72.0)
Operating profit 12.0
Taxation 17% (2.0)
Profit after tax 10.0

Note: Selling and administration costs include depreciation of £2 million.

Additional information relating to Venus:
(1) An analyst has estimated that, for the four years to 30 June 20Y0, the volume of sales will
grow by 18% pa and selling prices will increase by 2% pa. Because of volume discounts, the
gross profit percentage will increase to 66%.
(2) Selling and administration costs, excluding depreciation, are estimated to increase by
5% pa for the four years to 30 June 20Y0.
(3) Venus will require an additional investment in working capital on 1 July 20X6 of £26 million.
This will increase at the start of each subsequent year in line with sales volume growth and
selling price increases. Working capital will be fully recoverable on 30 June 20Y0.

50 Financial Management: Question Bank ICAEW 2020

 (4) On 30 June 20X6 Venus will need to invest in a new warehouse management system that
will cost £10 million and will not have any scrap value on 30 June 20Y0. The warehouse
management system will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year.
At 30 June 20Y0, the difference between the warehouse management system's written
down value for tax purposes and its disposal proceeds will be treated by the company
either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 balancing charge, if the disposal proceeds are more than the tax written down value.
(5) SA intends to include in the net present value analysis a continuing value at the end of four
years that will represent the value of the net cash flows after tax beyond the fourth year.
This will be calculated by treating the after-tax operating cash flows for the year ended
30 June 20Y0 as a growing perpetuity with a growth rate of 1% pa.
(6) An appropriate money discount rate to reflect the risk of Venus is 10% pa.
(7) SA would like to assume that the rate of corporation tax will be 17% for the foreseeable
future and that tax flows arise in the same year as the cash flows that gave rise to them.
(8) The average price earnings (P/E) ratio of companies similar to Venus is 55.
(9) Unless otherwise stated assume that all cash flows arise at the end of the year to which they
relate.
Requirements
34.1 Using money cash flows, calculate the value of Venus on 30 June 20X6 using net present
value analysis. (15 marks)
34.2 Calculate the value of Venus on 30 June 20X6 using a multiple of current earnings.
(2 marks)
34.3 Summarise the advantages and disadvantages of the two valuation methods used in parts
34.1 and 34.2 and identify any concerns you have in respect of using them to value Venus.
(5 marks)
34.4 In relation to the potential IPO, explain the difference between an offer for sale and an offer
for subscription (also known as a direct offer). (2 marks)
34.5 Outline the advantages and disadvantages of underwriting and advise the board of Zeus as
to whether the potential IPO should be underwritten. (4 marks)
34.6 Explain two methods, other than an IPO, by which Zeus could divest itself of Venus.
(4 marks)
34.7 Identify any ethical issues that SA may have in relation to the potential Venus IPO and state
how they might be resolved. (3 marks)
Total: 35 marks

35 Ross Travel plc

Ross Travel plc (Ross) provides public transport services in the UK. Ross is planning to set up a
new division called 'Happytours' and to expand into a different sector of the transportation
industry by operating holiday and sightseeing tours. The Chief Executive Officer (CEO) of Ross
believes that the expansion will cost £500 million and that the finance can be raised in such a
way as to leave the existing debt:equity ratio, by market values, of the company unchanged after
the expansion.

ICAEW 2020 June 2016 exam questions 51

 The CEO of Ross would like the finance director of the company to advise him of how the
company's current weighted average cost of capital (WACC) can be adjusted to take into
account the risk of expanding into the new sector. The debt proportion of the new finance will
be raised in the form of redeemable debentures. However, the CEO would also like to know the
advantages and disadvantages of Ross issuing convertible debentures.
The finance director has established the following:
 The debt proportion of the £500 million finance to be raised on 1 June 20X6 will be in the
form of new 4% coupon debentures, which will be redeemed on 31 May 20Y1 at par. The
redemption yield of the new debentures will be equal to the redemption yield of Ross's
existing debentures.
 An appropriate equity beta for a company that operates in the holiday and sightseeing tour
sector is 1.3 at a debt:equity ratio, by market values, of 1:1.
 The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
 The corporation tax rate will be 17% for the foreseeable future.
The following information relates to Ross without the Happytours project.
Extracts from Ross's most recent management accounts are as follows:
Balance sheet at 31 May 20X6
£m
Ordinary share capital (5p shares) 32
Retained earnings 3,072
3,104
6% Redeemable debentures at nominal value 608
3,712

On 31 May 20X6 Ross's ordinary shares each had a market value of 576p (cum-div) and an
equity beta of 0.65. For the year ended 31 May 20X6, the dividend declared was 11p per
ordinary share and the earnings yield (earnings per share divided by the ex-div share price) was
6%.
Ross's 6% coupon debentures had a market value on 31 May 20X6 of £111 (cum-interest) per
£100 nominal value and are redeemable at par on 31 May 20Y0.
Requirements
35.1 Ignoring the Happytours project, calculate the WACC of Ross at 31 May 20X6 using:
(a) The Gordon growth model (12 marks)
(b) The CAPM (2 marks)
35.2 Explain the limitations of the Gordon growth model. (3 marks)
35.3 Using the CAPM, calculate a WACC that is suitable for appraising the Happytours project
and explain your rationale. (6 marks)
35.4 Assuming that £75 million is raised from the new 4% coupon debentures issued on 1 June 20X6,
calculate the issue price per £100 nominal value and the total nominal value that will have
to be issued. Comment on the issue terms for these new debentures. (7 marks)
35.5 Explain what is meant by a convertible debenture and outline the advantages and
disadvantages for Ross in raising finance using this type of debt. (5 marks)
Total: 35 marks

52 Financial Management: Question Bank ICAEW 2020

36 Heaton Risk Management
You should assume that the current date is 31 May 20X6.
36.1 Heaton Risk Management (HRM) is an authorised financial advisor and provides investment
and risk management advice. You work for HRM and currently you are advising two clients,
Orchid Cars Ltd (Orchid) and Sheldon Investments (Sheldon).
Orchid is a UK company that manufactures sports cars. Orchid's main market is the UK but it
also exports cars to the USA.
Currently Orchid uses forward contracts to hedge its foreign exchange rate risk. However,
Orchid's managing director has recently been considering using foreign currency futures
and over-the-counter foreign currency options. You have been asked to make a comparison
of the results of hedging using the three different techniques.
Orchid is due to receive $2,500,000 on 30 September 20X6.
The following data is available to you at the close of business on 31 May 20X6:
Exchange rates:
Spot exchange rate ($/£) 1.5398 – 1.5402
Four-month forward premium ($/£) 0.0015 – 0.0010
September currency futures price (standard contract size £62,500): $1.5379/£
Four-month over-the-counter currency options:
Call options to buy £ have an exercise price of $1.5300/£. The premium is £0.03 per $ to be
converted and is payable on 31 May 20X6.
Put options to sell £ have an exercise price of $1.5200/£. The premium is £0.01 per $ to be
converted and is payable on 31 May 20X6.
Orchid has surplus cash funds on which it receives interest at 3.60% pa.
Requirements
(a) Assuming that the spot exchange rate on 30 September 20X6 will be $/£1.5315 –
1.5325 and that the sterling currency futures price will be $1.5320/£, calculate Orchid's
net sterling receipt if it uses the following to hedge its foreign exchange rate risk:
 A forward contract
 Currency futures contracts
 An over-the-counter currency option (11 marks)
(b) Discuss the relative advantages and disadvantages of each hedging technique and
advise Orchid on which would be most beneficial for hedging its foreign exchange rate
risk. (9 marks)
36.2 Sheldon holds a portfolio of FTSE 100 shares and the current market value on 31 May 20X6
is £9,657,000. The managers at Sheldon are worried that over the next three months the
FTSE 100 will fall in value due to economic uncertainty in Europe and Asia. The managers at
Sheldon do not want to sell the company's portfolio and wish to protect its current value
against a potential fall in the FTSE 100.
The FTSE 100 index is 6,525 on 31 May 20X6 and you have the following information
available to you regarding traded index option premiums:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)
6,450 6,525 6,600
Calls Puts Calls Puts Calls Puts
July 155 51 87 85 70 135
August 215 120 171 159 120 213
Option contracts expire at the end of the month.

ICAEW 2020 June 2016 exam questions 53

 Requirements
Demonstrate how FTSE 100 index options can be used by Sheldon to hedge its portfolio of
shares against a fall in the FTSE 100 and show the outcome if, on 31 August 20X6, the
portfolio's value:
(a) Rises to £10,471,000 and the FTSE 100 index rises to 7,075
(b) Falls to £8,695,000 and the FTSE 100 index falls to 5,875 (7 marks)

36.3 Sheldon's managers would like an explanation regarding the time value of the FTSE 100
index options.
Requirement
Explain the three factors that will affect the time value of the FTSE 100 index options in
36.2 above. (3 marks)
Total: 30 marks

54 Financial Management: Question Bank ICAEW 2020

 September 2016 exam questions

37 Northern Energy Ltd

You should assume that the current date is 30 September 20X6.
Northern Energy Ltd (Northern) is a UK electricity generator. On 31 March 20X7 it has
contracted to borrow £9.5 million for a year at an interest rate of LIBOR + 2% pa. The loan will be
used to finance the construction of a new rail terminal at one of its power stations. Northern's
board is now worried that interest rates may well increase over the next six months and would
like to investigate how it might hedge against any adverse movements. Northern's bank has
offered the company either a Forward Rate Agreement (FRA) at 7.25% pa or an option at 6.5%
pa plus a premium of 1% of the sum borrowed. The board would also like to consider the
possibility of an interest rate swap.
Northern's three power stations are coal-fired and the company has for many years imported
coal from China and India, with payment made to suppliers at the time of the order. Northern's
board is concerned that in recent months the Indian and Chinese exchange rates have become
more volatile. As a result Northern's board is considering buying coal from the USA.
Earlier this month Northern's purchasing team started discussions with ACT Inc (ACT), an
American coal mining company. ACT has informed Northern that, because of the logistical
issues involved, the first consignment of coal would arrive in three months' time on
31 December 20X6. Northern has agreed to pay for the coal one month later on 31 January 20X7.
Northern's board is keen to establish whether it is worth hedging its dollar exchange rate risk.
ACT has quoted Northern a price of $4.8 million for this first consignment. You work in
Northern's finance team and have been asked to prepare workings to help Northern's board to
decide on a hedging strategy. You have collected the following data at the close of business on
30 September 20X6:
Spot rate ($/£) 1.5150 – 1.5260

Relevant currency futures contract price (standard contract size $1.5095/£

£62,500)

OTC currency option Four-month put option on dollars ($/£) 1.5110

Four-month call option on dollars ($/£) 1.5020
Premium (per $ converted) £0.011

Forward contract Four month forward premium ($/£) 0.0112 – 0.0094

Arrangement fee (per $ converted) £0.004

Interest rates US dollar interest rate (lending) 3.6% pa

US dollar interest rate (borrowing) 4.5% pa
Sterling interest rate (lending) 5.4% pa
Sterling interest rate (borrowing) 6.9% pa

ICAEW 2020 September 2016 exam questions 55

 Requirements
37.1 Assuming that on 31 March 20X7 LIBOR will be:
(a) 5% pa
(b) 7% pa
prepare suitable interest payment calculations for each eventuality and recommend to
Northern's board whether it should hedge against interest rate movements using a FRA, an
option or an interest rate swap. (9 marks)
37.2 Calculate Northern's sterling cost of the ACT consignment if it uses the following to hedge
its exchange rate risk:
(a) Currency futures contracts
(b) An OTC currency option
(c) A forward contract
(d) A money market hedge
You should assume that on 31 January 20X7 the spot exchange rate will be $1.4895 –
1.4956/£ and that the sterling currency futures price will be $1.4945/£. (13 marks)
37.3 With reference to your calculations in 37.2 above, explain to Northern's board the
implications of hedging or not hedging the payment to ACT. (8 marks)
Total: 30 marks

38 Roper Newey plc

Roper Newey plc (Roper) is a UK engineering company that operates in the oil industry
providing support services on oil rigs and at oil terminals. It started trading nearly 20 years ago
and it has a financial year end of 31 August.
For a number of years Roper has used a weighted average cost of capital (WACC) figure of 7% pa
as its hurdle rate when appraising large-scale investments. At Roper's most recent board
meeting it was decided to investigate the possibility of the company diversifying into the UK
fracking industry. Fracking involves extracting oil and gas from beneath the ground via the high
pressure injection of water and sand. It is a very controversial industry in the UK, not least
because of concerns about its impact on the natural environment.
Roper's board is considering supplying services to the fracking industry. The finance for this
investment would be raised in such a way so as not to alter Roper's current gearing ratio
(measured by market values). The debt element of the finance will come from a new issue of 6%
irredeemable debentures at par.
Roper's directors are aware that many American companies have been very successful
financially when investing in fracking, but are concerned that such a diversification by Roper in
the UK would be excessively risky. As a result Becky Challoner, Roper's finance director, has
agreed to present relevant figures and advice at the next board meeting. Becky has asked you,
as a member of Roper's finance team, to work with her on this.
Details of Roper's capital structure at 31 August 20X6 are shown below:
Total nominal value Market value
£m
Ordinary share capital (£1 shares) 15.5 £5.20/share (ex-div)
Preference share capital (£1 shares) 9.0 £1.08/share (ex-div)
4% redeemable debentures (Note 1) 6.5 £107% (cum-int)
5% irredeemable debentures 10.0 £101% (cum-int)

56 Financial Management: Question Bank ICAEW 2020

 Roper's most recent dividend payments and the interest payments due in the near future are
shown below:
Ordinary dividends (Note 2) £3,797,500 Paid in August 20X6
Preference dividends (Note 2) £540,000 Paid in August 20X6
4% redeemable debentures interest £260,000 To be paid in September 20X6
5% irredeemable debentures interest £500,000 To be paid in September 20X6
Notes
1 These are redeemable at par on 31 August 20X9.
2 Ordinary and preference dividends are paid once a year. Ordinary dividend payments have
increased at a steady annual rate since August 20X2 at which time the ordinary dividend
per share was £0.201. There have been no issues of ordinary shares since August 20X2.
Additional information at 31 August 20X6
Roper equity beta 1.2
Risk free rate (pa) 1.9%
Market return (pa) 9.5%
Fracking industry – market data at 31 August 20X6
Average equity beta 1.9
Ratio of long–term funds (equity:debt) by market values 90:25
Assume that corporation tax will be payable at the rate of 17% for the foreseeable future and tax
will be payable in the same year as the cash flows to which it relates.
Requirements
38.1 Ignoring the investment in fracking services, calculate Roper's WACC at 31 August 20X6
using:
(a) The dividend growth model and
(b) The CAPM (13 marks)
38.2 Ignoring the investment in fracking services, advise Roper's board, giving reasons, whether
it should continue using 7% as its hurdle rate when appraising large-scale investments.
(3 marks)
38.3 Explain the underlying logic for using the CAPM when calculating a company's WACC.
(5 marks)
38.4 Calculate the WACC that Roper should use when appraising its proposed investment in
fracking and explain the reasoning behind your approach. (10 marks)
38.5 With reference to the information provided, explain the circumstances in which it would be
appropriate to use the adjusted present value approach to investment appraisal. (4 marks)
Total: 35 marks

39 Darlo Games Ltd

Darlo Games Ltd (Darlo) is a UK company which was formed in 20W5 by Michelle Cartmel and
Rob Orton. Darlo produces games for use on computers and mobile devices such as phones. Its
financial year end is 31 August. Michelle and Rob own 70% of Darlo's issued share capital and are
part of its executive management team. The remainder of Darlo's share capital is owned by
Michelle and Rob's friends and family. Darlo has been particularly successful in the past three years
as two of its games introduced in late 20X3 have generated very high levels of sales. A game has a
typical lifespan of three to five years.

ICAEW 2020 September 2016 exam questions 57

 NSL plc (NSL) is a listed software development company based in the UK and is actively seeking
to invest in other companies. You are an ICAEW Chartered Accountant and work in Darlo's
finance team. You have received an email from your manager, Jackie Tann, an extract from
which is shown below:

From: Jackie Tann

Date: 1 September 20X6
A member of the board has told me, in confidence, that NSL is considering buying shares in
Darlo. I'm not sure at this stage if they want to buy all of them or just a minority holding. We
need some guidance on what a reasonable share price might be. I've extracted the key figures
from our most recent management accounts in the document attached to this email. I've also
provided you with some working assumptions.
Could you please prepare a range of prices for the Darlo board to consider? Also I'm keen to
know if we could value Darlo using Shareholder Value Analysis (SVA).

Email attachment:
Income statement for the year ended 31 August 20X6
£'000
Revenue 9,390

Profit before interest and tax 2,849

Interest (30)
Profit before taxation 2,819
Corporation tax at 17% (479)
Profit after taxation 2,340
Dividends paid (740)
Retained profit 1,600

Balance sheet at 31 August 20X6

£'000
Freehold land and buildings (original cost £2.8 million) 2,400
Equipment (original cost £4.5 million) 3,200
5,600
Working capital 148
5,748
4% debentures (redeemable in 20Y3) at nominal value (750)
4,998

Ordinary shares of £1 each 500

Retained earnings 4,498
4,998

Working assumptions
(1) Darlo's fixed assets were revalued at 31 August 20X6 as follows:
£'000
Freehold land and buildings 3,150
Equipment 3,370
These revalued amounts have not been recognised in the balance sheet at 31 August 20X6.
(2) The average price/earnings ratio for listed businesses in Darlo's industrial sector is 10 and
the average dividend yield is 8%.
(3) A discount rate of 12% pa appropriately reflects the risk of Darlo's cash flows.

58 Financial Management: Question Bank ICAEW 2020

 (4) Darlo's pre-tax net cash inflows (after interest) for the next three years are estimated to
be:
£'000
Year to 31 August 20X7 2,900
Year to 31 August 20X8 3,000
Year to 31 August 20X9 3,100
Projecting forward from 31 August 20X9 and taking a prudent view, our estimated net cash
inflows (after interest, capital asset replacement and all necessary tax adjustments) will be
£2 million pa.
(5) On 31 August 20X6 Darlo's equipment had a tax written down value of £920,000. Assume
that we will scrap it (ie, dispose of it for zero income) on 31 August 20X9. The equipment
attracts 18% (reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year. In the final year, the
difference between the equipment's written down value for tax purposes and its disposal
proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value;
or
 balancing charge, if the disposal proceeds are more than the tax written down value.
(6) Corporation tax will be payable at the rate of 17% for the foreseeable future and that tax will
be payable in the same year as the cash flows to which it relates.
Requirements
39.1 Prepare a report for Darlo's board which:
(a) Calculates the value of one share in Darlo based on each of these methods:
 Net asset basis (historic cost)
 Net asset basis (revalued)
 Price/earnings ratio
 Dividend yield
 Present value of future cash flows (14 marks)
(b) Explains, with reference to your calculations and the information provided, the
advantages and disadvantages of using each of the five valuation methods in
(a) above. (10 marks)
39.2 Explain how the SVA approach works and whether the information provided by Jackie Tann
is sufficient to value Darlo using SVA (calculations are not required). (8 marks)
39.3 Explain the ethical issues that you should consider as an ICAEW Chartered Accountant
arising from Jackie Tann's email. (3 marks)
Total: 35 marks

ICAEW 2020 September 2016 exam questions 59

 December 2016 exam questions

40 Ribble plc
You should assume that the current date is 31 December 20X6.
Ribble plc (Ribble), a UK company, manufactures hoverboards and other products. Hoverboards
are a form of self-balancing scooter powered by rechargeable batteries. In the last two years
total UK sales of hoverboards have increased rapidly but major concerns have arisen over their
safety and, even though they are still in high demand, some retailers have stopped selling them.
At a recent directors' meeting of Ribble the chief executive officer (CEO), who is an ICAEW
Chartered Accountant, presented a research and development report (that had cost £100,000)
on a new and safer hoverboard; the Ribbleboard. The CEO stated that he believed the new
Ribbleboard could be successfully marketed for a period of four years and would replace the
company's existing hoverboard, the Ribflyer. The directors decided that a project appraisal
should be undertaken to ascertain whether the Ribbleboard should be marketed. Some
directors felt that as there is a continuing demand for the Ribflyer, even though there are
concerns about its safety, it should still be manufactured and sold rather than taking the risk of
marketing the Ribbleboard. There was also concern that a rival company was known to be developing
a new safer hoverboard and it is likely to launch it onto the market on 31 December 20X7.
The following information is available regarding the Ribbleboard project:
• The selling price will be £299 per unit in the year to 31 December 20X7 and will remain
fixed in each subsequent year of the product's life. The contribution for the year to
31 December 20X7 is expected to be 45% of the selling price. The variable cost of
producing the Ribbleboard is expected to increase by 5% pa in the three years to
31 December 20Y0.
• The number of units sold in the year to 31 December 20X7 is expected to be 8,000 per
month. For the year to 31 December 20X8 the number of units sold is expected to increase
by 20%. For the remaining two years to 31 December 20Y0, the number of units sold is
expected to decline by 15% pa.
• The new specialist equipment required to manufacture the Ribbleboard requires more
space than Ribble currently has available. Therefore, Ribble will use factory space that it
currently owns and rents out for storage to another company for a fixed rent of £1 million pa
payable in advance on 31 December. The space will be re-let for £1 million pa at the end of
the project on 31 December 20Y0.
• If the project goes ahead, two managers who had already accepted voluntary redundancy
would be asked to remain employed until 31 December 20Y0 and manage the project at a
salary of £60,000 pa each. These managers were due to leave on 31 December 20X6 and
receive lump sum payments of £50,000 each at that time. They will now receive lump sum
payments of £60,000 each on 31 December 20Y0 when their services will no longer be
required. The managers were also due to receive consultancy fees of £25,000 pa each for
the two years ended 31 December 20X7 and 20X8. These consultancy fees would not be
paid to them if they remained employed to manage the project. All of the above salaries,
lump sums and fees are stated in money terms.
• It is estimated that for every 10 Ribbleboards sold there will be a loss of sales of one unit of
the Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a contribution
of 25%, in each of the four years to 31 December 20Y0.

60 Financial Management: Question Bank ICAEW 2020

 • The project will incur fixed overhead costs of £500,000 in the year to 31 December 20X7 of
which 40% is centrally allocated overheads. The fixed overhead costs will increase after
31 December 20X7 by 3% pa.
• Investment in working capital will be £1 million on 1 January 20X7 and will increase or
decrease at the start of each year in line with sales volumes. Working capital will be fully
recoverable on 31 December 20Y0.
• On 31 December 20X6 the project will require an investment in machinery and equipment
of £24 million, which is expected to have a realisable value of £4 million (in 31 December 20Y0
prices) at the end of the project. The machinery and equipment will attract 18% (reducing
balance) capital allowances in the year of expenditure and in every subsequent year of
ownership by the company, except the final year.
In the final year, the difference between the machinery and equipment's written down value
for tax purposes and its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down
value; or
– balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that give rise to them.
• An appropriate money cost of capital for the Ribbleboard project is 10% pa.
Requirements
40.1 Using money cash flows calculate the net present value of the Ribbleboard project at
31 December 20X6 and advise Ribble's directors whether it should be accepted.
(20 marks)
40.2 Advise Ribble's directors as to the sensitivity of the NPV of the Ribbleboard project to:
(a) Changes in sales revenue (ignoring the effects on working capital) (4 marks)
(b) Changes in the realisable value of the machinery and equipment (3 marks)
40.3 Identify and discuss two real options available to Ribble in relation to the Ribbleboard
project. (5 marks)
40.4 Discuss the ethical issues that the CEO should consider regarding the suggestion by some
directors that only the Ribflyer hoverboard should continue to be manufactured. (3 marks)
Total: 35 marks

41 Bristol Corporate Finance

You should assume that the current date is 31 December 20X6.
You work for Bristol Corporate Finance (BCF). Two of the clients for whom you are responsible
are Middleton plc (Middleton) and the management team of Oldham Ltd (Oldham).
41.1 Middleton
Middleton is a listed company and is seeking to raise £70 million to invest in new projects
during 20X7. Currently Middleton is financed only by equity. However, at a recent board
meeting the finance director stated that, since other companies in Middleton's industry
sector have average gearing ratios (measured as debt/equity by market value) of 30% (with
a maximum of 40%) and an average interest cover of six times (with a minimum of five
times), perhaps the company should access the debt markets. The finance director
presented the board with two alternative sources of finance to raise the £70 million.

ICAEW 2020 December 2016 exam questions 61

 Equity issue: The £70 million would be raised by a 1 for 2 rights issue, priced at a discount
on the current market value of Middleton's shares.
Debt issue: The £70 million would be raised by an issue of 7% coupon debentures,
redeemable at par on 31 December 20Y6. The yield to redemption of the debentures
would be equal to the yield to redemption of the debentures of Wood plc (Wood), another
listed company in Middleton's market sector. Wood has a similar risk profile to Middleton
and has recently issued its debentures. Wood's debentures have a coupon of 7%, will be
redeemed in four years at par and their current cum-interest market price is £110 per £100
nominal value.
There were concerns expressed by a number of board members regarding the debt issue
since it has been the long-standing policy of the company not to borrow. Their concerns
were how Middleton's shareholders and the stock market would react and that the
company's cost of capital would increase as a result of borrowing, leading to a fall in the
company's value.
An extract from Middleton's most recent management accounts is shown below:
Income statement for the year ended 31 December 20X6
£m
Operating profit 25.00
Taxation at 17% (4.25)
Profit after tax 20.75

Additional information:
• Middleton has an equity beta of 1.1
• The risk free rate is expected to be 3% pa
• The market return is expected to be 8% pa
• Middleton's current share price is £5 per share ex-div
• Middleton has 40 million ordinary shares in issue
Requirements
(a) Calculate, using the CAPM, Middleton's cost of capital on 31 December 20X6.
(1 mark)
(b) Assuming a 1 for 2 rights issue is made on 1 January 20X7:
• Calculate the discount the rights price represents on Middleton's current share
price.
• Calculate the theoretical ex-rights price per share.
• Discuss whether the actual share price is likely to be equal to the theoretical ex-
rights price. (5 marks)
(c) Alternatively, assuming debt is issued on 1 January 20X7:
• Calculate the issue price and total nominal value of the debentures that will have
to be issued to give a yield to redemption equal to that of Wood's debentures.
• Discuss the validity of the use of the yield to redemption of Wood's debentures in
the above calculation. (7 marks)
(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using
the gearing and interest cover information provided by the finance director) and advise
Middleton's board on which source of finance should be used. (12 marks)

62 Financial Management: Question Bank ICAEW 2020

 41.2 The management team of Oldham
You have been asked to make a presentation to the management team of Oldham, an
unlisted company, who are considering a management buyout (MBO) of the company. Your
presentation will cover certain aspects of the MBO process and the contents of the financial
information section of the business plan that will need to be prepared for potential
financiers.
Requirements
Prepare notes for your presentation which include:
(a) An outline of the sources and forms of finance that the management team is likely to
need. (3 marks)
(b) The possible exit routes for the financiers that contribute to the funding of the MBO.
(2 marks)
(c) The content of the financial information section of the business plan. (5 marks)
Total : 35 marks

42 Orion plc
You should assume that the current date is 30 November 20X6.
Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to the
USA and receives payment in dollars. Orion imports raw materials from a number of countries
located in Europe and makes payments to suppliers in euros.
At a recent board meeting of Orion concern was expressed about several aspects of the
company's foreign exchange rate risk (forex) hedging strategy. Below is an extract from the
minutes of the meeting:
Managing director: "We have always hedged our forex and we should continue to do so.
But I am worried that because we import our raw materials and export our finished
products, we are subject to economic risk."
Production director: "We use derivative instruments to hedge forex and I think they are too
complicated. How do the banks calculate forward rates for example? Also can someone
explain to me what economic risk is?"
It was decided that at the next board meeting the finance director should make a presentation
to the board on the subject of forex. The finance director has asked you to prepare some
information for his presentation including an example of how receipts are hedged using
different hedging techniques.
You have the following information available to you at the close of business on 30 November 20X6:
Orion currently has substantial sterling funds on deposit.
Receipts due from USA customers on 31 March 20X7 are $5,000,000.
Exchange rates:
Spot rate ($/£) 1.4336 – 1.4340
Four month forward discount ($/£) 0.0086 – 0.0090
March currency futures price (standard contract size £62,500) $1.4410/£
Over-the-counter (OTC) currency option
A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is
£0.03 per $ and is payable on 30 November 20X6.

ICAEW 2020 December 2016 exam questions 63

 Annual borrowing and depositing interest rates (%)
Dollar 5.20 – 4.80
Sterling 3.30 – 3.00
Requirements
Provide the following information for the finance director of Orion:
42.1 A calculation of Orion's sterling receipt using:
(a) A forward contract
(b) Currency futures
(c) An OTC currency option
assuming that the spot price on 31 March 20X7 is $/£ 1.4484 – 1.4490 and the March
futures price is $1.4487/£. (11 marks)
42.2 An explanation of the advantages and disadvantages of the three hedging techniques used
in 42.1 above and, using your results from 42.1 above, advice on which hedging technique
Orion should use. (8 marks)
42.3 A demonstration, with reference to theories and relevant workings, of why the forward rate
is at a discount to the spot rate at 30 November 20X6. (5 marks)
42.4 An explanation of what economic risk is, a discussion of how it affects Orion and an outline
of how economic risk can be mitigated. (6 marks)
Total: 30 marks

64 Financial Management: Question Bank ICAEW 2020

 March 2017 exam questions

43 Sentry Underwood plc

You should assume that the current date is 28 February 20X7.
Sentry Underwood plc (Sentry) is a large, listed UK drinks manufacturer. Sentry's recent
profitability has deteriorated because of increased competition and a volatile consumer market.
As a result, Sentry's board is considering a major change in the company's trading strategy
which will cost £20 million to implement. The board has decided that this investment will be
funded either via a rights issue or an issue of debentures. Jenna Helier is Sentry's finance
director and she is an ICAEW Chartered Accountant. Sentry's other directors have asked her to
provide information to help them decide on the source of funding for the new investment.
Extracts from Sentry's most recent management accounts are shown below:
Income statement for the year to 28 February 20X7
£'000
Sales 78,500
Variable costs (56,520)
Fixed costs (13,850)
Profit before interest 8,130
Debenture interest (1,421)
Profit before tax 6,709
Taxation at 17% (1,141)
Profit after tax 5,568
Dividends proposed (3,000)
Retained profit 2,568

Balance sheet at 28 February 20X7

£'000
Ordinary share capital (£1 shares) 12,500
Retained profits 11,286
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
44,086

The market values of Sentry's ordinary shares and debentures on 28 February 20X7 are:
Ordinary shares £3.44 (cum div)
7% debentures £111% (cum int)
The £20 million required would be raised on 1 March 20X7 by either:
(1) A rights issue at £2.50 per ordinary share; or
(2) An issue of 8% debentures at par, redeemable in 20Y3.
You have been asked by the directors to assume the following for the year to 28 February 20X8:
 Sales will increase by 20%
 The contribution to sales ratio will remain unchanged
 Fixed costs will increase by £2 million pa
 The current level of dividends per share will be maintained
 Corporation tax will remain at 17%

ICAEW 2020 March 2017 exam questions 65

 At last week's board meeting the following comments were made by two of Sentry's other
directors:
Matthew Girvan: "We could decrease the amount of new capital that we have to raise by
reducing the annual dividend. Our payout ratio has been excessive for a
number of years now. Why not halve it?"
Roger Smyth: "We need to be very careful with this issue of shares or debentures. There's a
danger that our earnings per share (EPS) figure will be diluted, which could
cause a fall in our share price. To avoid any problem with our share price, I
suggest it would be better to tell our shareholders that we expect sales to
increase by 30%–35% next year, rather than the 20% we are forecasting."
Requirements
43.1 For both the rights issue and the debenture issue, prepare forecast income statements for
Sentry for the year to 28 February 20X8. (6 marks)
43.2 For both the rights issue and the debenture issue, calculate Sentry's forecast:
 EPS figure for the year to 28 February 20X8; and
 gearing ratio (book value of long-term borrowings/long-term funds) as at
28 February 20X8. (6 marks)
43.3 For the rights issue only, calculate the increase in annual sales required for the year to
28 February 20X8 in order that Sentry's EPS figure remains the same as in the current year.
(6 marks)
43.4 Making reference to your calculations in 43.1, 43.2 and 43.3 above, discuss the implications
for Sentry's shareholders of the company using a rights issue or a debenture issue to fund
its proposed £20 million investment. (8 marks)
43.5 Discuss Matthew Girvan's proposal that dividends should be cut, making reference to
relevant theories. (6 marks)
43.6 Discuss the ethical issues for Jenna Helier that would be caused by Roger Smyth's
suggestion. (3 marks)
Total: 35 marks

44 White Rock plc

White Rock plc (White), a UK listed company, manufactures a range of cosmetics at three
factories: lipsticks (London), mascara (Newcastle) and foundation products (Manchester).
White's financial year end is 31 March.
At its most recent board meeting the following matters were discussed:
(1) Closure of the London factory
(2) Investment priorities at the Manchester factory
(3) The impact of (1) and (2) above on White's share price
44.1 Closure of the London factory
The cosmetics industry is very competitive and products can quickly become unfashionable.
Falling demand for White's lipsticks and the high costs of operating in London have meant
that the company's directors have decided to close the London factory. Instead, White will
manufacture a smaller range of lipsticks at its Newcastle factory which currently only makes
mascara, but does have spare capacity. Manufacture of this smaller range of lipsticks would
commence in Newcastle as soon as the London factory is closed. White's directors are
unsure whether to close the London factory on 31 March 20X7 or on 31 March 20X9, when
its lease expires.

66 Financial Management: Question Bank ICAEW 2020

 You work in White's finance team and have been asked to provide information to aid the
directors' decision on the date of the factory closure. Information to support your task is
shown below:
Sales and contribution
London Newcastle
factory factory
Estimated lipstick sales (all at 31 March 20X7 prices)
Year to 31 March 20X8 £7.2m £1.3m
Year to 31 March 20X9 £5.5m £1.5m

Contribution to sales ratio 60% 65%

Leases
The London factory lease costs £1.8 million pa and expires on 31 March 20X9. The annual
lease cost is fixed and is payable on 1 April. If the factory is closed on 31 March 20X7 then
White would pay a tax allowable cancellation charge of £3 million on that date to cancel the
lease. The Newcastle factory lease costs a fixed £0.8 million pa which is payable on 1 April.
Other fixed costs
London Newcastle
factory factory
Factory-wide fixed costs pa (at 31 March 20X7 prices) £1.4m £1.2m
Allocated head office costs pa (at 31 March 20X7 prices) £1.6m £1.3m
Working capital
The London factory has a working capital balance on 31 March 20X7 of £0.8 million. White's
policy is that at the start of each financial year, there should be working capital in place that
is equivalent to 10% of the estimated sales for that year.
Tax allowable London factory closure payments
Closure payments if closure is on 31 March 20X7 £1.6m
Closure payments if closure is on 31 March 20X9 (at 31 March 20X9 prices) £2.3m
London factory machinery
Machinery tax written down value at 1 April 20X6 £3.1m
Resale value of machinery at 31 March 20X7 £1.7m
Resale value of machinery at 31 March 20X9 (at 31 March 20X9 prices) £0.6m
The factory machinery attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the machinery's written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down
value; or
• balancing charge, if the disposal proceeds are more than the tax written down value.
Inflation rates (applicable to all sales and costs unless otherwise indicated)
Year to 31 March 20X8 2%
Year to 31 March 20X9 3%
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.

ICAEW 2020 March 2017 exam questions 67

 White uses a money cost of capital of 11% for investment appraisal purposes.
Requirements
(a) Calculate the relevant money cash flows associated with closing the London factory on:
(1) 31 March 20X7
(2) 31 March 20X9
and use these to calculate the net present value at 31 March 20X7 of each of these
possible closure dates.
In both of these calculations you should ignore any opportunity cash flows associated
with the alternative closure date. (21 marks)
(b) Advise White's directors as to the preferred closure date of the London factory.
(1 mark)
44.2 Investment priorities at the Manchester factory
The Manchester factory has a capital expenditure budget of £15 million for the financial
year to 31 March 20X8. White's board needs to choose which of the available projects
would maximise shareholder wealth. Details of the four projects available are shown below:
Project 1 2 3 4
£'000 £'000 £'000 £'000
Investment required 6,000 4,500 4,700 3,850
Net Present Value 621 563 869 622
Requirement
Prepare calculations showing the combination of projects that will maximise White's
shareholders' wealth if the four projects are assumed to be either (1) divisible or (2)
indivisible. (6 marks)
44.3 White's managing director has stated that once the London closure date and the
Manchester investment plans are announced to the stock market, White's share price will
adjust to reflect this information accurately. However, the finance director has pointed out
that there are behavioural factors that may mean that this is not the case.
Requirement
Explain the key principles underlying the Efficient Market Hypothesis and how behavioural
factors question the validity of that hypothesis. (7 marks)
Total: 35 marks

45 ST Leonard Foods
You should assume that the current date is 31 March 20X7.
ST Leonard Foods (STL) is a UK frozen food company. It buys raw vegetables and fish from its
suppliers and, following processing and freezing, sells them to its customers.
You work in STL's finance team and have been asked to prepare calculations that will help STL's
management decide on the best strategy with regard to these two issues:
Issue 1 – foreign exchange rate hedging
Earlier this year STL's management signed a contract worth €1,750,000 with one of its Spanish
suppliers and the goods arrived at STL last week. In addition, it has agreed to sell €600,000
worth of frozen goods to a new customer, a French hypermarket, and these goods will be
despatched to France in 10 days' time.

68 Financial Management: Question Bank ICAEW 2020

 Both of these contracts are due to be settled in three months' time on 30 June 20X7. STL's
management is keen to explore whether it is worth hedging against movements in the value of
the euro between now and then. Four possible strategies are under consideration by the board:
 Do not hedge
 Use an over-the-counter (OTC) currency option
 Use a money market hedge
 Use a forward contract
The following data has been collected at the close of business on 31 March 20X7:
Spot rate (€/£) 1.2652 – 1.2744
Euro interest rate (lending) 2.2% pa
Euro interest rate (borrowing) 3.4% pa
Sterling interest rate (lending) 4.2% pa
Sterling interest rate (borrowing) 4.6% pa
Three-month OTC call option on € – exercise price 1.2540/£
Three-month OTC put option on € – exercise price 1.2650/£
Three month forward contract premium (€/£) 0.0058 – 0.0042
Cost of relevant OTC option £0.70 per €100 converted
Arrangement fee for forward contract £5,500
Issue 2 – interest rate hedging
STL has recently signed a contract with its bank to borrow £4.2 million on 1 July 20X7 to help
fund the construction of a new factory. The loan is for three years at an interest rate of LIBOR +
1% pa. STL's management is concerned that interest rates will rise before 1 July and wishes to
explore whether it should hedge its borrowing cost. Its bank has offered STL a Forward Rate
Agreement (FRA) at 5.8% pa, or an option at 5.2% pa plus a premium of 0.5% of the sum
borrowed.
Requirements
45.1 For Issue 1, show the net sterling payment for the four possible strategies under
consideration, assuming that on 30 June 20X7 the spot exchange rate will be:
(a) €1.1875 – 1.1960/£
(b) €1.2745 – 1.2860/£ (11 marks)
45.2 For Issue 1, with reference to your calculations in 45.1 above, advise STL's board whether it
should hedge against movements in the value of the euro. (8 marks)
45.3 For Issue 2, assuming that on 1 July 20X7 LIBOR will be:
(a) 4% pa
(b) 6% pa
calculate the annual interest rate payment if STL chooses an FRA, an option or no hedging
instrument and advise STL's management as to its best strategy. (7 marks)
45.4 Explain briefly how FRAs differ from interest rate futures. (4 marks)
Total: 30 marks

ICAEW 2020 March 2017 exam questions 69

 June 2017 exam questions

46 Brighton plc
Brighton plc (Brighton) manufactures and sells various types of lock. After undertaking market
research that cost £50,000, Brighton is considering manufacturing and selling a new type of lock
for bikes. For the purposes of the initial project appraisal it can be assumed that the locks would
be manufactured in the UK. However, the board of Brighton are considering manufacturing
them overseas where labour costs and associated safety standards for employees are much
lower than in the UK. The bike lock market is highly competitive with companies entering and
leaving the market on a regular basis.
The decision on whether to introduce the new lock will be based on net present value analysis.
At a recent board meeting one of Brighton's directors quoted from a recent financial newspaper
article that he had read:
"Shareholder wealth maximisation is the generally accepted corporate objective. Net
present value analysis is the most logical way to achieve this when used in conjunction with
Shareholder Value Analysis."
The director felt that Brighton should be concerned with more than just the shareholders since
there are other stakeholders who also contribute to the business. However, some of the other
directors felt that if shareholder wealth is maximised they had fulfilled their obligations and that
the company should not be concerned about these other stakeholders.
The following data relates to the new bike lock
• The bike lock's product life-cycle is estimated to be four years and the sales volume is
expected to be 5,500 units per month in the year to 30 June 20X8. The sales volume is
expected to increase by 5% in the year to 30 June 20X9 and then decrease at the rate of
10% pa (compound) in the two years to 30 June 20Y1.
• The selling price will be £100 per lock in the year to 30 June 20X8 and will increase at
2% pa for the three years to 30 June 20Y1. The contribution per unit is expected to be 45%
of the selling price.
• Fixed production overhead costs are estimated to be £0.2 million in the year to
30 June 20X8. 50% of these fixed production overheads are centrally allocated. The fixed
production overheads are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Selling and administration costs are estimated to be £0.5 million in the year to 30 June
20X8 and are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Warehousing and office space that Brighton currently owns and lets to third parties for an
annual fixed rent of £0.4 million pa, payable in advance on 30 June, will be used for the
bike lock project. The rent will not increase with inflation. At the end of the project the
warehousing and office space will be re-let to third parties.
• An investment in working capital of £1 million will be required on 1 July 20X7. This will
increase at the start of each subsequent year in line with sales volume growth and selling
price increases. Working capital will be fully recoverable on 30 June 20Y1.
• An investment in plant and machinery costing £8 million will be required on 30 June 20X7
and this will not have any scrap value on 30 June 20Y1. The plant and machinery will attract
18% (reducing balance) capital allowances in the year of expenditure and in every
subsequent year of ownership by the company, except the final year.

70 Financial Management: Question Bank ICAEW 2020

 At 30 June 20Y1, the difference between the plant and machinery's written down value for
tax purposes and its disposal proceeds will be treated by the company either as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down value;
or
(2) balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that gave rise to them.
• A suitable real cost of capital to appraise the project is 7% pa and the general level of
inflation is expected to be 2.5% pa.
Requirements
46.1 Using money cash flows, calculate the net present value of the bike lock project on 30 June 20X7
and advise Brighton as to whether it should proceed with the project. (15 marks)
46.2 Ignoring the effects on working capital, calculate and comment upon the sensitivity of the
project to changes in sales revenue. (4 marks)
46.3 Outline what is meant by Shareholder Value Analysis and identify how it might be
specifically applied to the bike lock project. (6 marks)
46.4 Identify and explain two real options associated with the proposed bike lock project.
(4 marks)
46.5 Giving two examples, illustrate how conflicts may arise between the shareholders and the
other stakeholders in Brighton. (3 marks)
46.6 Outline the main elements of an ethical employment policy that Brighton could adopt if it
were to manufacture the bike locks overseas. (3 marks)
Total: 35 marks
Note: Ignore any issues relating to foreign exchange throughout this question.

47 Easton plc
Easton plc (Easton) is a listed company and a specialist retailer of pet-related products and
operates stores throughout the UK. The company is considering diversifying by opening
veterinary practices ('the project'), which will operate from dedicated space in all of its stores.
At a board meeting of Easton it was agreed to appraise the project using net present value
analysis. However, considerable debate took place regarding the discount factor to use and
whether the company should be diversifying at all. At the meeting the finance director said:
"I will have to calculate a weighted average cost of capital (WACC) that reflects the
systematic risk of the project. I also intend to raise the capital required for the project in
such a way as to leave our existing debt:equity ratio (by market values) unchanged
following the diversification".
Various comments made by the other attendees at the meeting were as follows:
"Why can't we just use our current WACC?"
"I have read that the shareholders of listed companies should diversify away unsystematic
risk. But I am confused as to what systematic and unsystematic risks are."
"I think that we should stick to what we know and not attempt to diversify. I am worried
about the stock market's reaction to this diversification."
"What happens if we can't maintain our existing capital structure? How do we then appraise
the project?"

ICAEW 2020 June 2017 exam questions 71

 Extracts from Easton's most recent management accounts are shown below:
Balance sheet at 31 May 20X7
£m
Ordinary share capital (1p shares) 5
Retained earnings 1,098
1,103
4% Redeemable debentures at nominal value (redeemable 20Y5) 200
1,303

On 31 May 20X7 Easton's ordinary shares had a market value of 252p each (cum-div). The
company declared a dividend of 10p per ordinary share during the year to 31 May 20X7 and it is
expected to be paid shortly. The equity beta of Easton is 0.45. The return on the market is
expected to be 9% pa and the risk free rate 2% pa.
On 31 May 20X7 Easton's 4% redeemable debentures had a market value of £109 (cum-interest)
per £100 nominal value. The debentures are due to be redeemed at par on 31 May 20Y5.
A listed company operating solely in the veterinary practices market had an equity beta of 0.80
and a debt:equity ratio by market values of 3:7 on 31 May 20X7. It has been estimated by the
finance director that if the project goes ahead the overall equity beta of Easton will be made up
of 75% pet-related products and 25% veterinary practices.
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
47.1 Ignoring the project, calculate the current WACC of Easton on 31 May 20X7 using the
CAPM. (8 marks)
47.2 Using the CAPM, calculate a cost of equity that reflects the systematic risk of the project and
explain your reasoning. (6 marks)
47.3 Assuming that the project goes ahead, estimate, using the CAPM, the overall WACC of
Easton and comment upon the implications of any permanent change in the overall WACC.
(6 marks)
47.4 Explain what is meant by systematic and unsystematic risk and give two examples of each
for Easton. (6 marks)
47.5 Discuss whether Easton should diversify its operations and how its shareholders and the
stock market might react to the proposed project. (4 marks)
47.6 Identify and describe the appropriate project appraisal methodology that should be used if,
as a result of financing the project, the current capital structure of Easton is not maintained.
Using the data relating to Easton, calculate the project discount rate that should be used in
these circumstances. (5 marks)
Total: 35 marks

48 Lake Ltd
Lake Ltd (Lake) is a UK company that has recently started exporting leather goods to the USA.
Lake is fully aware of its exposure to foreign exchange rate risk ('forex risk') and the need to
hedge it. However, Lake is concerned that there may be other overseas trading risks that it
should be protecting itself against.
You work for Lake and have been asked to advise the board on how to hedge the forex risk
associated with its US trading activities. You have the following information available to you at
the close of business on 30 June 20X7:

72 Financial Management: Question Bank ICAEW 2020

 Lake is due to receive payments from its US customers in three months' time totalling
$1,300,000. Lake currently has an overdraft.
Exchange rates
Spot rate ($/£) 1.3086 – 1.3092
Three-month forward contract discount ($/£) 0.0014 – 0.0018
September currency futures price (standard contract size £62,500): $1.3105/£
Annual borrowing and depositing interest rates
Sterling 3.20% – 3.10%
Dollar 3.70% – 3.60%
Three-month over-the-counter currency options
Call options to buy £ have an exercise price of $/£1.3200 and premium of £0.02 per $
converted.
Put options to sell £ have an exercise price of $/£1.3100 and a premium of £0.03 per $
converted.
Requirements
48.1 Assuming that the spot exchange rate on 30 September 20X7 will be $/£1.3210 – 1.3250
and that the sterling currency futures price will be $1.3230/£, calculate Lake's sterling
receipt if it uses the following to hedge its forex risk:
• A forward contract
• A money market hedge
• Currency futures contracts
• An over-the-counter currency option (14 marks)
48.2 Describe the relative advantages and disadvantages of each of the hedging techniques in
48.1 above and advise Lake on which would be most beneficial for hedging its forex risk.
(10 marks)
48.3 Identify and explain two overseas trading risks (other than forex risk) that Lake is exposed to
and discuss how they might be mitigated. (6 marks)
Total: 30 marks

ICAEW 2020 June 2017 exam questions 73

 September 2017 exam questions

49 Merikan Media plc

Merikan Media plc (Merikan) is a large listed media group based in the UK. It currently owns a
controlling interest in 35 companies worldwide. Merikan's board is considering altering its UK
investment portfolio via:
(1) the purchase of all of the shares in a commercial radio company; and
(2) the disposal of all of its shares in a newspaper company.
You work in Merikan's finance team and have been asked to prepare valuations and supporting
notes for the board. Details of the two proposed transactions are shown below.
49.1 Purchase of all of the shares in a commercial radio company
Coastal Radio Ltd (Coastal) was formed nearly 15 years ago, and has been a very successful
radio station. Its listener numbers have increased steadily, as have advertising revenue and
annual profits. Extracts from Coastal's most recent management accounts (together with
supporting notes) are shown here:
Income statement Balance sheet
for the year ended 31 August 20X7 at 31 August 20X7
£'000 £'000
Sales 28,400 Non-current assets 36,310
Operating costs (15,600) Current assets 4,316
Depreciation (3,500) 40,626
Amortisation (1,200)
Profit before interest 8,100 £1 ordinary shares 3,500
Debenture interest (400) Retained earnings 27,206
Profit before tax 7,700 5% debentures 8,000
Taxation (at 17%) (1,309) Current liabilities 1,920
Profit after taxation 6,391 40,626
Dividends paid (1,750)
Retained profit 4,641

Notes
1 Coastal's non-current assets originally cost £52.8 million. They were valued at
£37.8 million on 31 August 20X7 and its current assets were valued at £4.2 million on
the same date. Neither of these valuations is reflected in the balance sheet at
31 August 20X7.
2 Coastal's debentures were trading at £110% on 31 August 20X7.
3 Average figures for listed UK commercial radio companies:
P/E ratio 8.5
Dividend yield 5%
Enterprise value multiple 6.5
Requirements
(a) Calculate the value of one Coastal share based on each of the following methods:
 Price earnings ratio
 Dividend yield
 Enterprise value
 Net assets basis (historic cost)
 Net assets basis (revalued) (12 marks)

74 Financial Management: Question Bank ICAEW 2020

 (b) Justify and advise the board of the price range within which it should make an offer for
Coastal's shares. Refer to your calculations in part (a) above. (8 marks)
49.2 Disposal of all of its shares in a newspaper company
Merikan has owned all of the share capital of Albion Newspaper Group Ltd (Albion) since
2005. Recently Albion's directors have informed Merikan's board that they are willing to
make a management buy-out (MBO) of Albion. Accordingly, Merikan's board wishes to
value Albion using the shareholder value analysis method (SVA). Merikan's board estimates
that Albion has a three-year competitive advantage over its competitors (to 31 August 20Y0)
and the following data regarding Albion's value drivers and additional financial information
has been collected:
Sales for the current year (to 31 August 20X7) £70.0 million
Annual depreciation
(equal to annual replacement non-current asset expenditure) £1.5 million
Par value of 6% debentures in issue (current market value £95%) £10.0 million
Short-term investments held £0.7 million
Corporation tax rate 17%
Current WACC 8%

Beyond
Year to 31 August (budgeted) 20X8 20X9 20Y0 20Y0
Sales growth 5% 3% 2% 0%
Operating profit margin 8% 9% 9% 9%
Incremental non-current asset investment
(as a % of sales increase) 6% 5% 2% 0%
Incremental working capital investment
(as a % of sales increase) 5% 5% 4% 0%
Requirements
(a) Calculate the value of Albion's equity using SVA. (12 marks)
(b) Outline the methods by which Albion's directors might raise the funds necessary for
the proposed MBO of the company. (3 marks)
Total: 35 marks

50 Ramsey Douglas Motors plc

You should assume that the current date is 31 August 20X7.
Ramsey Douglas Motors plc (Ramsey) is a UK-listed, UK-based motor car manufacturer which
was formed nearly 40 years ago. Ramsey's financial year end is 31 August.
Details of Ramsey's long term-finance at 31 August 20X7 and its total dividend and interest
payments for the year to 31 August 20X7 are shown in the following table:

ICAEW 2020 September 2017 exam questions 75

 Table
Market value Nominal value Dividends Interest paid
at at paid in year to in year to
31/8/X7 31/8/X7 31/8/X7 31/8/X7
£'000 £'000 £'000 £'000
£1 ordinary shares (Note 1) 65,600 32,000 5,440
£0.50 preference shares 10,800 2,000 640
£100 irredeemable
debentures 6,000 5,000 275
£100 redeemable
debentures (Note 2) 4,200 4,000 240
Notes
1 Ordinary share dividends have been growing at 3% pa for the past four years.
2 The redeemable debentures are redeemable at par on 31 August 20Y0.
3 All dividends and interest for the year to 31 August 20X7 have been paid in full.

You are Ramsey's finance director and an ICAEW Chartered Accountant. At its 22 August 20X7
meeting, the board considered two proposed new investments. You were asked to prepare
workings and recommendations in advance of the next meeting regarding those two
investments, details of which are shown below:
Investment 1
Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making use of
robotic techniques. Half of this investment would be funded from Ramsey's retained earnings and
the balance via a bank loan at an agreed rate of 7.5% pa. A report was presented by the
production director at the 22 August board meeting. It concluded that this new system would
generate efficiencies that would increase manufacturing profit by 6–8% pa. At the same meeting,
one of Ramsey's other directors, Michael Bateman, said that "because the company should be
striving for a higher share price, any press releases regarding the new system should state that
profits are expected to increase by at least 15% pa."
Investment 2
Ramsey's board is considering a major change in strategy by investing in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and
navigating without human input. The finance for this investment would be raised in such a way
so as not to alter Ramsey's current gearing ratio (measured as debt:equity by market values).
The debt element of the finance will come from a new issue of 9% irredeemable debentures at
par.
Ramsey's directors want to establish a cost of capital that could be used to appraise the
investment in driverless cars. They are aware that such a diversification would be very risky and is
likely to increase Ramsey's equity beta which is currently 1.25.
The following data, collected at 31 August 20X7, should be used when preparing your workings
for the next board meeting:
Driverless cars industry sector
Equity beta 2.10
Ratio of long-term funds (debt:equity) by market values 16:72
Expected risk free rate 2.25% pa
Expected return on the market 9.15% pa
The board also discussed the possible negative impact of this risky investment on Ramsey's
share price. One director, Laura Young, commented "It's okay. Markets are efficient. Even if it
does fall, the share price will soon adjust to its normal level."

76 Financial Management: Question Bank ICAEW 2020

 Other information
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
Requirements
50.1 Using the information in the table, calculate Ramsey's WACC at 31 August 20X7. (10 marks)
50.2 Calculate, and briefly comment upon, the impact on the market value of Ramsey's
redeemable debentures of a rise in their gross redemption yield to 5% pa. (3 marks)
50.3 Advise, with reasons, whether Ramsey should use the WACC figure calculated in part 50.1
above when appraising Investment 1. (5 marks)
50.4 Explain the ethical implications for you, as an ICAEW Chartered Accountant, arising from
Michael Bateman's suggestion regarding the press releases for Investment 1. (3 marks)
50.5 Calculate an appropriate WACC that Ramsey could use when appraising Investment 2 and
explain the reasoning behind your approach. (10 marks)
50.6 Evaluate briefly Laura Young's comments regarding Investment 2's effect on Ramsey's share
price. (4 marks)
Total: 35 marks

51 Jenson Grosvenor plc

You should assume that the current date is 31 August 20X7.
Jenson Grosvenor plc (Jenson) is a UK-based manufacturer of industrial pumps. The majority of
the raw materials and component parts used in the manufacture of Jenson's pumps are
imported from EU countries and are invoiced in euros.
You work in Jenson's finance team and have been asked to provide guidance on two issues to
be discussed at the next board meeting.
Issue 1 – AZS Oil contract
Jenson's directors recently signed a contract with a Canadian oil company, AZS Oil (AZS). This
contract is for the supply of a large consignment of specialised oil pumps for use by AZS at its
oilfields in northern Canada. The contract is valued at 5.2 million Canadian dollars (C$). The
pumps will be dispatched on 31 October 20X7 and Jenson will receive the C$5.2 million from
AZS on 30 November 20X7.
You have been given the following information at the close of business on 31 August 20X7:
Spot rate (C$/£) 1.6305 – 1.6385
Three-month forward contract discount (C$/£) 0.0045 – 0.0085
Arrangement fee for forward contract £0.35 per C$100 converted
Canadian dollar interest rate (lending) 4.4% pa
Sterling interest rate (lending) 2.8% pa
Canadian dollar interest rate (borrowing) 5.2% pa
Sterling interest rate (borrowing) 3.6% pa
Three-month OTC call option on C$ – exercise price 1.6090/£
Three-month OTC put option on C$ – exercise price 1.6245/£
Cost of relevant OTC option £0.75 per C$100 converted
In relation to the AZS contract, you are aware that at the next board meeting Jenson's directors
will discuss (a) the implications of an increase in the value of sterling and (b) the foreign
exchange hedging techniques that Jenson might employ.

ICAEW 2020 September 2017 exam questions 77

 Issue 2 – Shareholding in Callella plc
Jenson owns 50,000 shares in Callella plc (Callella). The company has never used any hedging
techniques to protect it from a fall in the value of this investment and the board now wishes to
remedy that. As a first step, the directors will consider how traded options work at the next
board meeting.
The market price of one Callella share at 31 August 20X7 is 365p. Traded options on Callella
shares at the same date are available as follows (all figures are in pence):
Calls Puts
Exercise price September October September October
355 11.0 21.0 2.0 13.5
370 3.5 14.0 9.0 20.5
Requirements
51.1 For Issue 1, calculate Jenson's sterling receipt from the AZS contract if it:
(a) Uses an OTC currency option
(b) Uses a forward contract
(c) Uses a money market hedge
(d) Does not hedge the Canadian dollar receipt and sterling strengthens by 5% by
30 November 20X7 (9 marks)
51.2 With reference to your calculations in part 51.1, advise Jenson's board whether or not it
should hedge its Canadian dollar receipt from the AZS contract. (7 marks)
51.3 Explain why Jenson's imports and exports might expose the company to economic risk.
(3 marks)
51.4 Explain the advantages and disadvantages of using currency futures rather than a forward
contract to manage foreign exchange risk. (4 marks)
51.5 For Issue 2, calculate the intrinsic value and the time value of each of the options on
Callella's shares at 31 August 20X7. (4 marks)
51.6 For Issue 2, explain briefly the three factors that affect the time value of the options on
Callella's shares. (3 marks)
Total: 30 marks

78 Financial Management: Question Bank ICAEW 2020

 December 2017 exam questions

52 Innovative Alarms
Assume that the current date is 31 December 20X7.
Innovative Alarms (Innovative) is a division of a major quoted company and manufactures and
sells a single alarm system to private houses and commercial premises. The financial
management department of Innovative is considering two separate issues:
Issue One: Whether to launch onto the market a new type of alarm system, the Defender, which
when triggered will not only ring a bell but also play a realistic recording of dogs barking.
Issue Two: How often the division's fleet of delivery vans should be replaced.
You are asked to provide advice on both of these issues and report to the head of the financial
management department.
52.1 Issue One: The Defender Project
The Defender is to be evaluated over a planning horizon of three years from 31 December
20X7. It has been agreed that on 31 December 20Y0 the rights to manufacture the
Defender will be sold to a team made up of the current management of Innovative ('the
team') as by that date the Defender is expected to be Innovative's only product. The
finance director of Innovative, who is an ICAEW Chartered Accountant, will be a member of
the team and is responsible for calculating the value of the rights to manufacture the
Defender.
The following information is available regarding the Defender project:
 The selling price will be £399 per unit in the year to 31 December 20X8 and the
contribution per unit is expected to be 40% of the selling price. The selling price and
variable costs per unit are expected to increase by 3% pa in the two years to 31
December 20Y0.
 The number of units sold in the year to 31 December 20X8 is estimated to be 30,000
and is expected to increase by 6% pa in the two years to 31 December 20Y0.
 On 31 December 20X7 the project will require an investment in working capital of
£2 million, which will increase at the start of each subsequent year in line with sales
volume growth and sales price increases. Working capital will be fully recoverable on
31 December 20Y0.
 Incremental fixed costs for the year ended 31 December 20X8 are expected to be
£0.5 million and are expected to increase by 5% pa in the two years to 31 December 20Y0.
 The Defender will require two hours of skilled labour per unit. Skilled labour is
expected to be in short supply over the next three years. Innovative will need to
transfer skilled labour from its existing product, which requires half the skilled labour
time per unit of the Defender. The existing product has a selling price of £175 and an
expected material and skilled labour cost of £150 in the year to 31 December 20X8.
The selling price and variable costs are expected to increase by 3% pa in the two years
to 31 December 20Y0, the end of the existing product's life cycle. Innovative's skilled
labour is paid at the rate of £15 per hour (in 31 December 20X8 prices). Any working
capital adjustments associated with the existing product can be ignored.

ICAEW 2020 December 2017 exam questions 79

 New equipment will be required to manufacture the Defender, which will cost £8
million on 31 December 20X7 and will have an estimated scrap value of £2 million on
31 December 20Y0 (in 31 December 20Y0 prices). The new equipment will attract 18%
(reducing balance) capital allowances in the year of expenditure, except in the final
year.
At 31 December 20Y0, the difference between the equipment's written down value for
tax purposes and its disposal proceeds will be treated by the company as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down
value; or
(2) balancing charge, if the disposal proceeds are more than the tax written down
value.
 Assume that the rate of corporation tax will be 17% for the foreseeable future and that
tax flows arise in the same year as the cash flows that gave rise to them.
 The finance director calculated the value of the rights to manufacture the Defender as
three times the net contribution after tax for the year to 31 December 20Y0.
 A suitable money cost of capital to appraise the project is 10% pa.
Requirements
(a) Using money cash flows, calculate the net present value of the Defender project on
31 December 20X7 and advise whether Innovative should proceed with the project.
(16 marks)
(b) Outline the disadvantages of sensitivity analysis for the head of the financial
management department and how simulation might be a better way to assess the risk
of the Defender project. (4 marks)
(c) Describe two real options that are available at the end of the project on 31 December 20Y0
as an alternative to selling the rights to manufacture the Defender. (4 marks)
(d) Identify and discuss the ethical issues in relation to the sale of the rights to manufacture
the Defender. (3 marks)
52.2 Issue Two: Replacing the fleet of delivery vans
Innovative would like to decide upon a policy for replacing its fleet of delivery vans, since
no formal policy exists at the present time. A new delivery van costs £30,000. The following
information is available:
Interval between Trade-in Maintenance cost
replacement (years) value (paid at the end of the year)
£ £
1 22,500 500
2 17,000 2,500
3 12,000 3,500
A suitable cost of capital for evaluating the replacement policy is 15% pa.
Requirement
Calculate the optimal replacement policy for the delivery vans and advise the head of the
financial management department of the limitations of the approach used.
Note: Ignore inflation and taxation when determining the optimal replacement policy.
(8 marks)
Total: 35 marks

80 Financial Management: Question Bank ICAEW 2020

53 Peel Kitchens plc
Assume that the current date is 1 December 20X7.
Peel Kitchens plc (Peel) is a quoted wholesaler of kitchen cabinets and worktops and has a
financial year end of 30 November.
The board of Peel is considering diversifying into the supply of domestic appliances and would
need to raise finance of £200 million during 20X8 should the diversification go ahead. The
finance director of Peel, Debbie Harris (Debbie), needs to calculate the weighted average cost
of capital (WACC) that will be used to appraise the potential diversification. She is also
considering whether the finance required should be raised by debt in the form of 6%
debentures issued at par or by equity in the form of an issue of 100 million ordinary shares.
Debbie is particularly concerned about how the financial markets and the company's
shareholders might react to the impact the additional £200 million finance may have on the
company's capital structure.
The board of Peel is also contemplating its dividend policy beyond 20X7. Extracts from Peel's
management accounts are produced below:
Year ended 30 November
20X3 20X4 20X5 20X6 20X7
£m £m £m £m £m
Profits before interest and tax 81.03 78.86 87.54 85.37 94.04
Interest (33.32) (33.32) (33.32) (33.32) (33.32)
47.71 45.54 54.22 52.05 60.72
Taxation (8.11) (7.74) (9.22) (8.85) (10.32)
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividends 19.80 18.90 22.50 21.60 25.20
Special dividend – – – – 9.00
Total dividends 19.80 18.90 22.50 21.60 34.20

Capital at 30 November 20X7 £m

Ordinary shares (50p nominal value) 90.00
Retained earnings 256.50
346.50
7% Debentures at nominal value
(redeemable at par on 30 November 20Y2) 476.00
822.50

The number of shares in issue has not changed during the period from 1 December 20X2 to
30 November 20X7.
Additional information:
 The cum-div share price on 1 December 20X7 is £2.92 per ordinary share. The special
dividend was paid in June 20X7.
 The 7% debentures have a cum-interest market value of £111 per £100 nominal value.
 Peel has an equity beta of 1.3.
 A company that supplies domestic appliances has an equity beta of 1.1 and a debt:equity
ratio of 40:60 by market values.
 The risk free rate is expected to be 3% pa.
 The market risk premium is expected to be 6% pa.
 Assume that the rate of corporation tax will be 17% for the foreseeable future.

ICAEW 2020 December 2017 exam questions 81

  An analyst has calculated the gearing ratios (measured as debt/equity by market values)
and interest cover for companies that operate in Peel's market sector as follows:

Maximum Minimum Average

Gearing ratio 135% 80% 100%

Interest cover 3 2 2.4

Debbie has asked you to provide her with certain information so that she can prepare a
report for the board of Peel.
Requirements
53.1 Calculate Peel's WACC on 1 December 20X7 using:
(a) The dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information provided)
(b) The CAPM (10 marks)
53.2 Explain and evaluate whether either of the WACC figures calculated in 53.1 above would
be appropriate for appraising Peel's diversification into supplying domestic appliances.
(5 marks)
53.3 Determine whether the £200 million finance required should be raised from either debt or
equity sources. You should discuss the likely reaction of both shareholders and the financial
markets, and make reference to the gearing and interest cover data provided and give
advice to Debbie on which source of finance should be used. (12 marks)
53.4 Assuming that Peel raises the £200 million finance required wholly from debt, identify the
most appropriate project appraisal methodology that could be used to appraise the
diversification. Also determine the project discount rate that should be used in these
circumstances. (3 marks)
53.5 Discuss whether Peel's dividend policy over the last five years is appropriate for a listed
company. (5 marks)
Total: 35 marks

54 Jewel House Investments Ltd

Assume that the current date is 30 November 20X7.
Jewel House Investments Ltd (Jewel) is an investment company based in the UK. You work for
Jewel and at a recent meeting with the company's finance director it was agreed that you would
work on three specific tasks:
Task One: Hedging foreign exchange rate risk for receipts from foreign investors.
Task Two: Hedging a portfolio of investments.
Task Three: Arranging an interest rate swap for a loan that the company has recently taken out.
54.1 Task One: Jewel is due to receive an investment of $8 million from a client in the USA on
31 March 20X8. It was agreed with the client that Jewel would hedge the foreign exchange
rate risk associated with the $ receipt and invest the sterling equivalent of the $8 million on
behalf of the client.
You have the following information available to you on 30 November 20X7:
Exchange rates:
Spot rate ($/£) 1.2490 – 1.2492
Four-month forward contract discount ($/£) 0.0031 – 0.0034

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 Over-the-counter (OTC) currency option
A put option to sell $ is available with an exercise price of $1.2400. The premium is £0.02
per $ and is payable on 30 November 20X7.
Jewel has funds on deposit which earns interest of 3% pa.
Requirements
(a) Calculate the amount of sterling to be invested on behalf of the US client using:
 a forward contract
 an OTC currency option
assuming that the spot price on 31 March 20X8 is $/£ 1.2697 – 1.2700. (6 marks)
(b) Using your results from 54.1 (a) above, explain the advantages and disadvantages of
the two hedging techniques used and advise which hedging technique would be the
more beneficial for Jewel's client. (4 marks)
(c) Outline whether currency futures would have been more advantageous than using a
forward contract to hedge the foreign exchange rate risk associated with the $8 million
receipt. (2 marks)
54.2 Task Two: One of Jewel's investments is a portfolio of UK FTSE 100 shares, which is worth
£100 million on 30 November 20X7. The finance director of Jewel is concerned about a
potential fall in value of the portfolio over the next four months.
You have the following information available to you on 30 November 20X7:
 The FTSE 100 index is 7,261
 The price for a March 20X8 FTSE 100 index future is 7,195
 The face value of a FTSE 100 index futures contract is £10 per index point
Requirements
(a) Calculate the outcome of hedging Jewel's £100 million portfolio using March 20X8
FTSE 100 index futures. Assume that on 31 March 20X8 both the FTSE 100 index and
the FTSE 100 index futures price are 7,010 and that the portfolio value changes exactly
in line with the change in the FTSE 100 index. (6 marks)
(b) Explain why the hedge in 54.2 (a) above will not be 100% efficient. (2 marks)
54.3 Task Three: Jewel recently bought new premises and borrowed £50 million for a period of
10 years. The loan is at a floating rate of LIBOR + 4% pa. LIBOR is currently 0.36% pa. The
finance director of Jewel believes that interest rates are going to rise and he would like to
protect the company against interest rate risk.
The finance director of Jewel identified Nevis plc (Nevis), which is a company that would like
to swap £50 million of its 5% pa fixed rate loans to a floating rate. Jewel and Nevis agreed
to enter into an interest rate swap with any benefits from the swap being shared equally
between the two companies. Jewel can borrow at a fixed rate of 6.5% pa and Nevis can
borrow at a floating rate of LIBOR + 3.5% pa.

ICAEW 2020 December 2017 exam questions 83

 Requirements
(a) Demonstrate how the interest rate swap between Jewel and Nevis would be
implemented, with the floating rate leg of the swap set at LIBOR. (4 marks)
(b) Calculate:
 the initial difference in annual interest rates for Jewel if it enters into the interest
rate swap with Nevis.
 the amount to which LIBOR would have to rise for the cost of Jewel's floating rate
borrowing to equal the fixed rate achieved through the interest rate swap.
(2 marks)
(c) Identify four advantages for Jewel of entering into an interest rate swap with Nevis.
(4 marks)
Total: 30 marks

84 Financial Management: Question Bank ICAEW 2020

 March 2018 exam questions

55 Wells Bakers plc

Assume that the current date is 31 March 20X8.
Wells Bakers plc (Wells) is a UK bakery firm that has been trading since 1983. It manufactures
and sells its own branded products to UK supermarkets and its financial year end is 31 March.
Wells' board is considering a change in the company's strategy with the opening of a number of
retail bakery outlets across the UK. This would be a major investment for the company. The
£17 million required for this investment would be raised in such a way as not to alter the
company's existing gearing ratio (equity:debt by market values). Wells' bank, London &
Edinburgh plc (L&E), is aware of the company's plans and has stated that it is prepared to
provide the debt element of the £17 million at an interest rate of 8.5% pa, with repayment due in
10 years' time.
Wells has always used a discount rate of 7% when assessing potential investments. The following
comments made by directors regarding the planned £17 million investment were recorded in
the minutes of the board meeting held on 27 February 20X8:
Phil Turner: "Let's carry on using 7% as the discount rate. We're being prudent here, as
7% represents the most costly source of finance that we have, ie, preference
shares. At least that's a fixed cost, unlike the ordinary shares."
Alana Clarke: "I don't think we can ignore the ordinary shares. Can't we average out the
costs of the various types of capital and use that?"
Alison Hughes: "We should use 8.5% as our discount rate as that's what L&E would charge us
for funding the retail expansion."
The board wants to determine the appropriate discount rate to use when assessing the
investment in retail bakery outlets. You work in Wells' finance team and are an ICAEW Chartered
Accountant. You have been asked to provide workings for the board to consider when it meets
next month. You have collected the following data as at 31 March 20X8:
Balance sheet extract Nominal value Market value
(£'000)
£1 ordinary shares (Note 1) 6,600 £3.46/share cum-div
7% £1 preference shares 1,000 £1.35/share ex-div
6% Irredeemable debentures 1,200 £106% ex-int
4% Redeemable debentures (Note 2) 1,800 £100% cum-int
Notes
(1) Wells will pay its ordinary dividend (£1.716 million) for the year to 31 March 20X8 in early
April 20X8. Its annual dividend has been growing steadily every year since April 20X5, at
which time the dividend totalled £1.570 million.
(2) The 4% debentures are redeemable at par in 20Y1.
CAPM data
Wells' equity beta 1.25
Expected risk-free return 2.4% pa
Expected return on the market portfolio 10.8% pa
Average equity beta for bakery retailers 1.80
Ratio of long-term funds (equity:debt by market values) for bakery retailers 77:23

ICAEW 2020 March 2018 exam questions 85

 Two days ago, Alison Hughes sent you an email about Wells' proposed investment. An extract
from her email is shown below:

Email extract
.....................The board has managed to
keep our expansion plans very quiet so
far. Do be very careful who you share
this information with as the proposals
are likely to have an impact on the Wells
share price.....................

Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
55.1 Ignoring the investment in retail bakery outlets, calculate Wells' weighted average cost of
capital (WACC) at 31 March 20X8 using:
(a) The dividend growth model and (14 marks)
(b) The CAPM (2 marks)
55.2 Discuss the points raised by the three directors at the 27 February 20X8 board meeting.
(6 marks)
55.3 Calculate an appropriate WACC that Wells could use when appraising the £17 million
investment in retail bakery outlets and explain the reasoning behind your approach.
(10 marks)
55.4 Identify and explain the ethical implications of Alison Hughes' email for you, as an ICAEW
Chartered Accountant. (3 marks)
Total: 35 marks

56 Hunt Trading plc

Assume that the current date is 31 March 20X8.
Hunt Trading plc (Hunt) is a UK supplier of timber products. It imports timber in large quantities
and manufactures a range of products for sale to builders' merchants and garden centres in the
UK. You work in Hunt's finance team and have been asked to provide advice on two issues.
56.1 Issue one: interest rate risk
The company has been very successful recently with demand for its products growing
steadily. At its March meeting, Hunt's board identified a need for £4.5 million of short term
finance to fund additional machinery and increasing levels of working capital. A £4.5 million
bank loan would be required for a six-month period from 1 June 20X8 until 30 November
20X8. The board is concerned that the current cost of borrowing, 6.4% pa, will increase
before 1 June and would like to investigate how it might hedge this risk using either traded
sterling interest rate futures or over-the-counter (OTC) interest rate options.
You have collected the following information on 31 March 20X8:
Traded sterling interest rate futures OTC interest rate options
June 3-month futures price = 93.2 Strike rate = 7.3% pa plus
a premium of 0.2% of the sum borrowed
Standard contact size = £500,000

86 Financial Management: Question Bank ICAEW 2020

 Requirements
(a) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses traded
sterling interest rate futures to hedge its interest rate risk and if by 1 June 20X8:
 interest rates increase to 7.5% pa and the futures price moves to 92.2
 interest rates increase to 8.0% pa and the futures price moves to 91.8
 interest rates decrease to 5.5% pa and the futures price moves to 94.1 (8 marks)
(b) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses OTC
interest rate options to hedge its interest rate risk and if by 1 June 20X8:
 interest rates increase to 7.5% pa
 interest rates increase to 8.0% pa
 interest rates decrease to 5.5% pa (3 marks)
(c) Based on your calculations in (a) and (b) above, advise Hunt's board as to the preferred
method of hedging its interest rate risk. (2 marks)
56.2 Issue two: foreign exchange rate risk
The majority of Hunt's timber suppliers are based in Scotland and Wales. However, Hunt's
board is concerned that those suppliers' delivery lead times are lengthening as they
struggle to keep pace with increasing demand. The board has a contract with a Finnish
supplier for a very large consignment of timber costing €1.7 million. This is due to arrive at
Hunt's factory on 31 May 20X8, with payment due on 30 June 20X8. There is concern
amongst board members that sterling might weaken against the euro before the end of
June and they would like to explore the implications of hedging the foreign exchange risk
of the Finnish purchase.
You have been asked to advise Hunt's board and have collected the following information
at the close of business on 31 March 20X8:
Spot rate (€/£) 1.1764 – 1.1808
Three-month forward contract discount (€/£) 0.0059 – 0.0081
Arrangement fee for forward contract £4,600
Sterling interest rate (lending) 5.8% pa
Sterling interest rate (borrowing) 6.6% pa
Euro interest rate (lending) 8.0% pa
Euro interest rate (borrowing) 9.2% pa
Requirements
(a) Calculate Hunt's sterling payment if it:
 does not hedge the euro payment and sterling weakens by 5% by 30 June 20X8
 uses a forward contract
 uses a money market hedge (7 marks)
(b) With reference to your calculations in (a) above, advise Hunt's board whether it should
hedge its euro payment. (7 marks)
(c) Identify the differences between traded currency options and OTC currency options.
(3 marks)
Total: 30 marks

ICAEW 2020 March 2018 exam questions 87

57 Bishop Homes Ltd
Bishop Homes Ltd (Bishop) is a UK property company that started trading in 20W8. It has a
financial year-end of 31 March. Bishop builds low-cost houses for sale and for rent. It currently
owns and collects rent from 12,500 rental properties.
Bishop has the opportunity to invest in a new development of 500 identical low-energy houses
on one of its vacant sites called Garthwick. Once the land has been cleared then Bishop will
employ Piper Hardwick plc (Piper), a UK house-building firm, to construct the houses over a two
year period. You work in Bishop's finance department and have been asked to provide
information on the viability of the Garthwick development for Bishop's board. You have been
provided with the following details:
Land clearance
This will cost £1.4 million, payable on 31 March 20X8.
Construction cost
The total contract price for the 500 houses is £57 million, which will be payable to Piper in three
equal annual instalments starting on 31 March 20X8. Only the construction costs relating to the
houses for sale are an allowable expense for tax purposes. Those construction costs are
allowable for tax in the year of sale (see building schedule below).
Building schedule
Of the 500 houses built, 150 will be sold and 350 will be rented. Houses built for sale are sold in
the year of construction whereas houses built for rent are not rented out until the year after
construction.
Year to 31 March
20X9 20Y0 20Y1
Houses constructed in year 250 250 0
Houses sold in year 75 75 0
Houses rented in year 0 175 350
Houses for rent
The rent per property will be £5,940 pa. Bishop estimates that bad debts amount to 1.5% of
rental income.
Houses for sale
The selling price of a house will be £340,000.
New staff
Bishop will need to employ two new full-time employees to manage the additional rented
houses in the year to 31 March 20Y0 and then two more employees will be employed in the year
to 31 March 20Y1. The average salary per employee will be £23,000 pa.
Other costs
In addition to the new employees, it is estimated that the new houses for rent will lead to an
increase in general costs equal to 3% of their rental income before bad debts.
New machinery
Bishop will need to purchase specialist equipment to check the low-energy specifications of the
new houses. This will be purchased on 31 March 20X9 at a cost of £1.2 million. Because this
equipment has a high rate of obsolescence, Bishop estimates that it will be sold on 31 March 20Y1
for £100,000.

88 Financial Management: Question Bank ICAEW 2020

 The equipment attracts 18% (reducing balance) capital allowances in the year of expenditure
and in every subsequent year of ownership by the company, except the final year. In the final
year, the difference between the equipment's written down value for tax purposes and its
disposal proceeds will be treated by the company either as a:
 balancing allowance, if the disposal proceeds are less than the tax written down value; or
 balancing charge, if the disposal proceeds are more than the tax written down value.
Assumptions to be used in calculations
 Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
 All income will be liable to corporation tax.
 Unless indicated otherwise, all costs will be allowable for corporation tax.
 Inflation can be ignored throughout.
 A suitable cost of capital is 6%.
 All cash flows occur at the end of the relevant financial year.
Investment appraisal
Bishop appraises its capital investments using the net present value approach. For new
developments Bishop discounts its future income and costs over a 20-year period.
6% annuity factors
Year 3 = 2.673
Year 17 = 10.477
Year 20 = 11.470
Requirements
57.1 Calculate the net present value of the Garthwick development at 31 March 20X8 and advise
Bishop's board whether the company should proceed with it. (18 marks)
57.2 Calculate the sensitivity of the decision in 57.1 above to changes in the selling price per
house sold and hence the minimum selling price per house sold that Bishop should accept
for the Garthwick development to proceed. (4 marks)
57.3 Determine the impact on your advice in 57.1 above if Piper offers to accept a revised
contract price of £54 million payable in full on 31 March 20X8. (5 marks)
57.4 Compare the strengths and weaknesses of sensitivity analysis with those of simulation.
(4 marks)
57.5 Explain what is meant by the term ‘real options' and identify two real options that could
apply to the Garthwick development. (4 marks)
Total: 35 marks

ICAEW 2020 March 2018 exam questions 89

 June 2018 exam questions

58 Helvellyn Corporate Finance

You work for Helvellyn Corporate Finance (HCF) and you are currently working on two tasks:
Task 1: Evans Stores Ltd (Evans) is an independent food retailer. Evans is considering an initial
public offering (IPO) of its ordinary shares on 30 June 20X8 and you have been asked to advise
on a value for these shares.
Task 2: Huzzey plc (Huzzey) is a quoted conglomerate that is considering divesting itself of one
of its divisions. You have been asked to value the division.
58.1 Task 1: Valuation of Evans's ordinary shares
Extracts from Evans's most recent management accounts are as follows:
Income statement
for the year ended Balance sheet
31 May 20X8 as at 31 May 20X8
£'000 £'000
Sales 280,000 Non-current assets 53,000
Operating costs (270,000) Current assets 31,000
Depreciation (6,000) 84,000
Amortisation (500)
Profit before interest 3,500 Share capital (£1 ordinary shares) 3,000
Interest (950) Retained earnings 12,000
Profit before tax 2,550 15,000
Taxation (at 17%) (434) Long term loans 41,000
Profit after tax 2,116 Current liabilities 28,000
84,000

Additional information:
(1) Evans's current assets include cash balances and short-term investments, which total
£7 million.
(2) The market value of Evans's non-current assets at 31 May 20X8 was estimated to be
£59 million.
(3) Average multiples for a sample of listed companies in the same market sector as Evans
at 31 May 20X8 are:
 Enterprise value 6.5
 Price earnings (P/E) ratio 12.1
Requirements
(a) Calculate the value of one Evans ordinary share at 31 May 20X8 based on each of the
following methods:
 Enterprise value
 P/E ratio
 Net assets basis (historic)
 Net assets basis (re-valued) (8 marks)
(b) Recommend and justify to the board of Evans an issue price per share on 30 June 20X8
for the company's ordinary shares. Refer to the range of values calculated in part (a)
above. (4 marks)

90 Financial Management: Question Bank ICAEW 2020

 (c) Discuss whether Shareholder Value Analysis (SVA) might be a useful additional
method, to those in part (a) above, of valuing Evans's ordinary shares. (3 marks)
58.2 Task 2: Divestment of the Huzzey division
Assume that the current date is 30 June 20X8.
At a recent board meeting of Huzzey it was decided that the company should divest itself of
its paint-manufacturing subsidiary, Supercover Ltd (Supercover). The board discussed the
following three proposed ways of carrying out the divestment:
 Proposal 1 – To reduce Supercover's operations over a period of three years and then
close it down.
 Proposal 2 – To sell Supercover to another company.
 Proposal 3 – To sell Supercover to a team made up of its current management.
It was decided at the board meeting that one of the criteria for choosing the best method of
divestment would be the present value of the cash flows associated with each proposal.
A suitable discount rate to assess the present value of the cash flows of all three proposals is
10%.
You should assume that corporation tax will be payable at the rate of 17% for the
foreseeable future and tax will be payable in the same year as the cash flows to which it
relates.
Financial information for each proposal is as follows:
Proposal 1:
 Sales revenue for the year to 30 June 20X8 was £25 million. For the three years to
30 June 20Y1 sales volumes are expected to decrease by 10% pa compound. Selling
prices will not change and contribution is expected to be 60% of the selling price.
 The amount invested in working capital on 30 June 20X8 was £2 million. This amount
will reduce at the end of each year in line with the reduction in sales volumes. On
30 June 20Y1 all remaining working capital will be recovered in full.
 On 30 June 20X8 Supercover's plant and equipment has a tax written down value of
£3 million.
 On 30 June 20Y1 Supercover's plant and equipment will be sold for an estimated
£9 million (at 30 June 20Y1 prices).
 The plant and equipment attracts 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company,
except the final year. In the final year, the difference between the plant and
equipment's written down value for tax purposes and its disposal proceeds will be
treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down
value; or
– balancing charge, if the disposal proceeds are more than the tax written down
value.
 Redundancy payments on 30 June 20Y1 will amount to £0.50 million (at 30 June 20Y1
prices). This amount is fully allowable for tax.
Proposal 2:
All the shares in Supercover will be sold for £38 million before taxation on 30 June 20X8.
Assume that this amount is fully taxable.

ICAEW 2020 June 2018 exam questions 91

 Proposal 3:
The management team will buy the shares of Supercover for £41 million. The £41 million
will be received in three instalments as follows:
 On 30 June 20X8 £15 million
 On 30 June 20X9 £13 million
 On 30 June 20Y0 £13 million
Assume that all these instalments are fully taxable in the year that they are received.
Requirements
(a) Calculate the present value at 30 June 20X8 of each of the three proposed ways in
which Huzzey could divest itself of Supercover. (10 marks)
(b) Identify one advantage and one disadvantage for each of the three divestment
proposals. (6 marks)
(c) Advise the board of Huzzey as to which of the three divestment proposals should be
chosen. (4 marks)
Total: 35 marks

59 Blackstar plc
Assume that the current date is 30 June 20X8.
Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a listed
client, Blackstar plc (Blackstar), on the following two issues:
Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of its
existing operations.
Issue 2: Blackstar is concerned about its existing dividend policy.
59.1 Issue 1: Raising additional funds of £150 million
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar's
market sector have average gearing ratios (measured as debt/equity by market values) of
25%, with a maximum of 35%, and an average interest cover of eight times, with a minimum
of six. The finance director of Blackstar is considering raising the £150 million by either a
rights issue or by the company now borrowing and issuing debentures.
The details of the alternative sources of finance are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount
on the current market value of Blackstar's ordinary shares.
Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 20Y5. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar's
market sector. One such company is Blue plc (Blue). Details for Blue's debentures are as
follows:
 Coupon 5%
 The current market price on 30 June 20X8 is £109 cum interest
 Redemption at par on 30 June 20Y3
Further information regarding Blackstar:
 The forecast pre-tax operating profit for the year ending 30 June 20X8 is £50 million
 The corporation tax rate is 17%
 The current share price at 30 June 20X8 is £7.50 ex-div
 The number of ordinary shares in issue is 60 million

92 Financial Management: Question Bank ICAEW 2020

 Requirements
(a) Assuming a 2 for 3 rights issue is made on 1 July 20X8:
 Calculate the discount the rights price represents on Blackstar's current share price.
 Calculate the theoretical ex-rights price per share.
 Discuss whether the actual share price is likely to be equal to the theoretical
ex-rights price. (5 marks)
(b) Alternatively, assuming debt is issued on 1 July 20X8:
 Calculate the issue price per debenture and total nominal value of the debentures
that will have to be issued to give a yield to redemption equal to that of Blue's
debentures.
 Discuss the validity of using the yield to redemption of Blue's debentures in the
above calculation. (7 marks)
(c) Advise Blackstar's finance director of the advantages and disadvantages of raising the
£150 million by debt or equity or a combination of the two.
You should also discuss the likely reaction of Blackstar's shareholders and the stock
market (you should refer to the gearing and interest cover information provided).
(12 marks)
59.2 Issue 2: Blackstar's dividend policy
Blackstar is reviewing its dividend policy, which has been to maintain a constant payout
ratio of 30% of profits after tax. The following views were expressed by two directors at the
most recent board meeting:
Director A: "We should have a constant dividend growth policy with some growth
irrespective of whether profits after tax rise or fall. If we have surplus cash after reinvestment
we can leave it in the bank."
Director B: "I agree with Director A, but instead of leaving surplus cash in the bank we can
pay a special dividend or repurchase some shares."
Requirements
(a) Describe what is meant by:
 a special dividend
 a share repurchase (4 marks)
(b) Discuss whether Blackstar's current dividend policy is appropriate for a listed company
and critically evaluate the alternatives suggested by Directors A and B. (4 marks)
59.3 Mitchells is also advising Goldwing plc, which is considering making a takeover bid for
Blackstar.
Requirement
Identify the ethical issues for Mitchells regarding giving advice to both Goldwing plc and
Blackstar. Also advise Mitchells on what safeguards might be put in place. (3 marks)
Total: 35 marks

ICAEW 2020 June 2018 exam questions 93

60 Tarbena plc
Assume that the current date is 30 June 20X8.
Tarbena plc (Tarbena) is a UK company that has a subsidiary company in Germany and also has
customers and suppliers in the USA.
At a recent board meeting of Tarbena there was a discussion about the company's exposure to
foreign exchange rate risk (forex). In particular the following points were discussed:
 How the company's dollar receipts and payments are hedged
 The role that interest rate parity and purchasing power parity play in relation to forex
 The likely effect on the company's share price if it shows exchange rate losses when
translating the German subsidiary's financial statements into sterling
It was decided at the meeting that the finance director would make a presentation to the board
and he has asked you to prepare some notes for his presentation, including numerical examples
where appropriate.
You have the following information available to you at the close of business on 30 June 20X8:
Receipts and payments
Receipts due from customers on 30 September 20X8 are $6,000,000.
Payments due to suppliers on 30 September 20X8 are $10,000,000.
Exchange rates
Spot rate ($/£) 1.3078 – 1.3080
Three month forward discount ($/£) 0.0088 – 0.0092
September currency futures price
Standard contract size £62,500 $1.3096/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3190. The premium is
£0.03 per $ and is payable on 30 June 20X8.
September call options to buy $ are available with an exercise price of $1.3170. The premium is
£0.04 per $ and is payable on 30 June 20X8.
Annual borrowing and depositing interest rates (%)
Dollar 6.00 – 5.80
Sterling 3.28 – 2.98
Tarbena currently has an overdraft.
Requirements
Prepare notes for the finance director of Tarbena, which should include:
60.1 A calculation of Tarbena's net sterling payment if it uses the following to hedge its forex:
(a) A forward contract
(b) Currency futures
(c) An OTC currency option
assuming that the spot rate on 30 September 20X8 will be $/£1.3167 – 1.3175 and the
September futures price will be $/£1.3171. (12 marks)

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 60.2 A discussion of the advantages and disadvantages of the three hedging techniques used in
60.1 above and, using your results from 60.1 above, advice on which hedging technique is
the most advantageous for Tarbena. (7 marks)
60.3 An explanation of interest rate parity together with calculations which show why the forward
rate is at a discount to the spot rate on 30 June 20X8. (5 marks)
60.4 An explanation, without calculations, of purchasing power parity. (3 marks)
60.5 The likely effect on Tarbena's share price if there are exchange rate losses when translating
the German subsidiary's financial statements into sterling. (3 marks)
Total: 30 marks

ICAEW 2020 June 2018 exam questions 95

 September 2018 exam questions
61 Thomas Rumsey Group plc
Note: Assume that the current date is 31 August 20X8.
The Thomas Rumsey Group plc (Rumsey) is a UK company which was founded in 20W1 and has
a financial year end of 31 August. Rumsey manufactures computer hardware and also supplies
information technology (IT) support services. Since its formation the group has expanded via
organic growth and the acquisition of other companies.
Snowdog Printers Ltd (Snowdog) is a UK company that manufactures computer printers. Rumsey
has owned 100% of Snowdog's ordinary shares since 20W9.
Snowdog's sales and profits have fallen in each of the last two years. Rumsey's board met in July
20X8 and decided to wind down Snowdog's operations and that Snowdog will cease trading in
three years' time, on 31 August 20Y1.
Following the July 20X8 meeting, Snowdog's directors informed the Rumsey board that they
would like to investigate a management buy-out (MBO) of 100% of Snowdog's share capital. You
are an ICAEW Chartered Accountant and you work in Rumsey's finance team. You have been
asked to provide guidance on the MBO for Rumsey's board.
The Snowdog MBO was discussed at the Rumsey board meeting on 15 August 20X8. Three key
issues discussed at that meeting are summarised below:
 It was agreed that the buy-out price for Snowdog would be its economic value to Rumsey,
assuming that it remained in the group until 31 August 20Y1. The economic value would be
the expected net present value of Snowdog's projected cash flows over the next three
years, discounted at Rumsey's WACC. The forecast data for this calculation is shown below.
 One of Rumsey's directors asked "Couldn't we add a premium to the MBO price? The cash
flows are only estimates after all. I'm sure that we could inflate the cash inflows or alter the
WACC figure in our favour. Snowdog's directors would be unaware of this and they seem
very keen to buy the company."
 Another director asked whether Shareholder Value Analysis (SVA) could be used as an
alternative to the expected NPV to calculate the value of Snowdog.
Forecast data
(1) Sales in the year to 31 August 20Y0 will be dependent on the level of sales in the year to
31 August 20X9 as shown in the table below:

y/e August 20X9 y/e 31 August 20Y0

Sales (£m) Probability Sales (£m) Probability
5.0 0.6
7.0 0.7
4.0 0.4
4.0 0.4
4.5 0.3
3.0 0.6
Sales in the year to 31 August 20Y1 will be £2.5 million. The expected value of annual sales
is to be used in the NPV calculation.
(2) Variable costs will be 30% of sales.
(3) Fixed costs (including depreciation of £600,000 pa) will be £1.7 million pa.
(4) Closure costs on 31 August 20Y1 will be £600,000.

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 (5) All of the figures in (1)–(4) above are in 31 August 20X8 prices. The inflation rate for sales
and costs is 2% pa.
(6) The tax written down value at 31 August 20X8 of Snowdog's plant and machinery is £3.3
million. It is estimated that this will have a scrap value of £1.5 million (in 31 August 20Y1
prices) on 31 August 20Y1. The plant and machinery attracts 18% (reducing balance) capital
allowances in the year of expenditure and in every subsequent year of ownership by the
company, except the final year. In the final year, the difference between the equipment's
written down value for tax purposes and its disposal proceeds will be treated by the
company either as:
 a balancing allowance, if the disposal proceeds are less than the tax written down
value, or
 a balancing charge, if the disposal proceeds are more than the tax written down value.
(7) Snowdog's working capital on 31 August 20X8 totalled £1.8 million. It is planned to reduce
this by £0.2 million on 31 August 20X9 and £0.3 million on 31 August 20Y0. The
outstanding balance will be released on 31 August 20Y1. All working capital figures are
given in money terms.
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Rumsey's money WACC is 11% pa.
Requirements
61.1 Calculate the expected NPV of Snowdog's money cash flows at 31 August 20X8. (18 marks)
61.2 Calculate the effect on this expected NPV if the scrap value of Snowdog's plant and
machinery on 31 August 20Y1 is £1 million. (4 marks)
61.3 Comment on the ethical implications for you as an ICAEW Chartered Accountant of the
Rumsey director's suggestion regarding the MBO premium. (3 marks)
61.4 Explain what is meant by the term 'real options' and identify for Rumsey's board two real
options that could apply to Snowdog as alternatives to the MBO. (5 marks)
61.5 Outline the Shareholder Value Analysis (SVA) approach to company valuation, identifying its
advantages and disadvantages. (5 marks)
Total: 35 marks

62 Heath Care plc

Note: Assume that the current date is 1 September 20X8.
Heath Care plc (Heath) is a listed UK company that sells baby products. The company was
founded in almost thirty years ago and it has a financial year end of 31 August.
All of Heath's customers are based in the UK. They order goods online and these are then
delivered by a national courier company from Heath's central warehouse. Despite not having any
physical shops, Heath was initially very successful. However, in the past two years the market for
baby products has become much more competitive and the company's market share has fallen
as a result. This has led to a 15% decline in the price of its ordinary shares.

ICAEW 2020 September 2018 exam questions 97

 You work in Heath's finance team and have been asked to provide guidance for the company's
board following its most recent meeting. At that meeting the following suggestions were made
by two of Heath's directors:
Janine Barrowland – "We could establish a number of Heath shops across the UK. This
would give more visibility to our brand. I estimate it would cost us £10 million for 10 shops.
I can see from the management accounts that we've not got sufficient cash to make that sort
of investment, but I see no reason why we shouldn't borrow the £10 million. Interest rates
are still very low and we could probably borrow it from our bank at a maximum cost of 4%
pa. Our WACC wouldn't alter by much, which would make any investment decision very
straightforward."
Chris Sinnott – "Why not invest in a completely different type of business? We know that
people in the UK are living longer and I know of an established care home business that is
for sale and it may well be a good investment for us.
There's a steady net cash inflow and we'd own a number of valuable properties. Yes, it's
risky, but diversification like this would be good for our investors as we'd be making positive
use of the portfolio effect."
An extract from Heath's balance sheet at 31 August 20X8 is shown below:
£'000
Ordinary share capital (£1 shares) 6,300
Retained earnings (Note 1) 2,520
9% Preference share capital (£1 shares) 750
4% Redeemable debentures (Note 2) 680
5% Irredeemable debentures 1,240
11,490
Notes
1 Earnings for the year to 31 August 20X8 were £1,050,000 and an ordinary dividend of
£630,000 for the year to 31 August 20X8 has been proposed.
2 These debentures are redeemable at par on 1 September 20Y1.
The market prices of Heath's long-term finance on 1 September 20X8 are:
Ordinary shares £3.45/share (cum div)
Preference shares £1.62/share (cum div)
Redeemable debentures £103% (cum interest)
Irredeemable debentures £94% (ex interest)
Additional information
Heath's equity beta 1.4
Expected risk free rate 3.35% pa
Expected return on the market 8.25% pa
You should assume that corporation tax will be payable at the rate of 17% for the
foreseeable future and tax will be payable in the same year as the cash flows to which it
relates.
Note: In the earnings retention model g = rb.
Requirements
62.1 Calculate Heath's WACC on 1 September 20X8 using:
(a) Gordon's growth model (earnings retention model) (17 marks)
(b) CAPM (3 marks)
62.2 Compare and contrast Gordon's growth model with the CAPM as alternative means of
calculating the cost of equity. (5 marks)

98 Financial Management: Question Bank ICAEW 2020

 62.3 Advise Heath's directors whether they should use the existing WACC figure calculated in
part 62.1 above when appraising the investment suggested by Janine Barrowland. Your
advice should include specific reference to the use of the APV technique and the
circumstances under which it is applicable. (6 marks)
62.4 From the point of view of a shareholder, explain the portfolio effect and discuss the validity
of Chris Sinnott's proposal that Heath should purchase a care home business. (4 marks)
Total: 35 marks

63 Eddyson Cordless Ltd

Note: Assume that the current date is 1 September 20X8.
Eddyson Cordless Ltd (Eddyson) is a UK-based company that designs and manufactures battery-
powered home and garden appliances. It was formed in 20X0 and an analysis of its sales and
purchases, by value, over the past 12 months shows the following:
UK Eurozone
Sales 96% 4%
Purchases of raw materials 74% 26%
Recently, a very large US electrical wholesale company, Timba Inc (Timba), placed an order with
Eddyson worth $2.3 million. The goods will be exported to the US next week and Timba will pay
for them on 30 November 20X8.
Eddyson's board is considering whether it is worth hedging the foreign exchange rate risk
associated with the sale to Timba. Four possible strategies have been proposed:
 Do not hedge
 Use a forward contract
 Use a money market hedge
 Use sterling traded currency options
You work in Eddyson's finance team and have been asked to provide calculations and guidance
for the board. You have collected the following information at the close of business on
1 September 20X8:
Spot exchange rate ($/£) 1.3655 – 1.3775
Three-month forward contract premium ($/£) 0.0060 – 0.0044
Arrangement fee for forward contract £0.30 per $100 converted
Sterling interest rate (borrowing) 5.6% pa
Sterling interest rate (lending) 4.6% pa
US dollar interest rate (borrowing) 4.0% pa
US dollar interest rate (lending) 3.2% pa
Sterling traded currency options (standard contract size £10,000) are priced as follows on
1 September 20X8 (premiums are quoted in cents per £):
September 20X8 November 20X8
contracts contracts
Exercise price ($/£) Calls Puts Calls Puts
1.38 1.08 2.36 1.99 3.70

ICAEW 2020 September 2018 exam questions 99

 Requirements
63.1 Calculate Eddyson's net sterling receipt for each of the four proposed strategies under
consideration, assuming that on 30 November 20X8 the spot exchange rate will be:
(a) $/£ 1.3240 – 1.3350
(b) $/£ 1.3935 – 1.4050
Note: Interest on option premiums should be ignored. (16 marks)
63.2 With reference to your calculations in 63.1 above, advise Eddyson's board whether it should
hedge against movements in the value of the US dollar. (6 marks)
63.3 Explain, with relevant workings, why the three-month forward rate is expressed at a
premium to the spot rate on 1 September 20X8. (5 marks)
63.4 Briefly discuss whether any future sales to Timba might expose Eddyson to economic risk.
(3 marks)
Total: 30 marks

100 Financial Management: Question Bank ICAEW 2020

 December 2018 exam questions
64 Physiotec plc
Assume that the current date is 31 December 20X8.
Physiotec plc (Physiotec) is listed on the London Stock Exchange (LSE) and is a major supplier to
physiotherapy clinics. One of the products that Physiotec supplies is elastic therapeutic tape
(ETT). This is used to treat pain sustained in athletic injuries. Physiotec has incurred £0.5 million
of research and development costs relating to a new type of ETT. The research has been
successful and Physiotec intends to market the new type of ETT called Supertape. Physiotec is
aware that in one year's time, on 31 December 20X9, another supplier is likely to launch a
product similar to Supertape onto the market.
The finance director of Physiotec, who is an ICAEW Chartered Accountant, intends to appraise
the Supertape project using expected net present value. Because the ETT market is very
competitive he intends to evaluate the project over a three-year time horizon.
A marketing analyst has provided the following estimates of sales of packs of Supertape, with
associated probabilities, for the year to 31 December 20X9.
Number of packs sold Probability
4 million 50%
2 million 30%
1 million 20%
Sales volumes for the two years to 31 December 20Y1 are forecast to be at the expected volume
of sales in the year to 31 December 20X9, adjusted for growth of 5% pa.
The sales director of Physiotec suggested to the finance director that a public announcement is
made to the LSE about the Supertape project, in order to increase the company's share price.
He believes that the announcement should state that sales of Supertape are going to be 4
million packs pa. The sales director feels that this is reasonable considering the probability
distribution provided by the marketing analyst.
Additional information relating to the Supertape project:
 Each pack of Supertape will be sold for £5 in the year to 31 December 20X9. The
contribution is expected to be 60% of the selling price. The selling price and variable costs
per pack are expected to increase by 3% pa in the two years to 31 December 20Y1.
 A marketing campaign will cost £0.8 million, payable on 31 December 20X8.
 Selling and administration expenses for the year to 31 December 20X9 are estimated to be
£2 million and are expected to increase by 4% pa in the two years to 31 December 20Y1.
 Fixed production costs for the year to 31 December 20X9 are estimated to be £0.75 million
and are expected to remain constant in the two years to 31 December 20Y1.
 Physiotec will use existing factory space to manufacture Supertape. This factory space is
currently let to a third party at a fixed annual rent, which is payable in advance on
31 December, of £1 million pa. The rent will not increase with inflation. At the end of the
project the factory space will be re-let to third parties.
 On 31 December 20X8 the project requires an investment in working capital of £3 million,
which will increase at the start of each year in line with sales volume growth and sales price
increases. Working capital will be fully recoverable on 31 December 20Y1.

ICAEW 2020 December 2018 exam questions 101

  On 31 December 20X8 the project will require an investment in plant and equipment of £4
million. It is estimated that on 31 December 20Y1 the plant and equipment will have a value
of £0.5 million (in 31 December 20Y1 prices).
 The plant and equipment will attract 18% (reducing balance) capital allowances in the year
of expenditure and in every subsequent year of ownership by the company, except in the
final year.
At 31 December 20Y1, the difference between the equipment's written down value for tax
purposes and its disposal proceeds will be treated by the company as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down value,
or
(2) balancing charge, if the disposal proceeds are more than the tax written down value.
 Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax
flows arise in the same year as the cash flows that gave rise to them.
 A suitable real cost of capital to appraise the Supertape project is 7% pa and the general
level of inflation is expected to be 2.4% pa.
Requirements
64.1 Using money cash flows, calculate the expected net present value of the Supertape project
on 31 December 20X8 and advise Physiotec's board whether it should proceed with the
project. (19 marks)
64.2 Ignoring the effects on working capital, calculate the sensitivity of the Supertape project to
changes in sales volume and discuss this sensitivity with reference to the estimates provided
by the marketing analyst. (5 marks)
64.3 Describe two advantages and two disadvantages of using expected values when
appraising the Supertape project. (4 marks)
64.4 Describe two real options that are available to Physiotec in relation to the Supertape
project. (4 marks)
64.5 Identify the ethical and legal issues for the finance director of Physiotec regarding the
suggestion made by the company's sales director about the public announcement of the
Supertape project to the LSE. (3 marks)
Total: 35 marks

65 North American Cars Ltd

Assume that the current date is 30 November 20X8.
North American Cars Ltd (NAC) is a UK based company that imports classic North American cars
into the UK. NAC sells the cars in both the UK and the Eurozone. There are three issues that the
board of NAC is currently considering.
You are the finance director of NAC and have been asked to report to the board on these three
issues.
65.1 Issue 1
NAC is buying a new warehouse to store the cars and has arranged to borrow £800,000 for
one year from 30 April 20X9 at an interest rate of LIBOR + 3%. The board of NAC is
concerned that LIBOR might increase over the next five months from its current level of 1%
pa. However, one member of the board is of the opinion that LIBOR will fall.
A bank has offered NAC a forward rate agreement (FRA) at 4.5% pa or an interest rate
option at 4% pa plus a premium of 1% of the sum borrowed.

102 Financial Management: Question Bank ICAEW 2020

 Requirements
(a) Calculate the interest cost of the £800,000 loan using the FRA and the option assuming
that LIBOR on 30 April 20X9 will be:
 either 1.25% pa
 or 0.60% pa. (6 marks)
(b) Recommend to the board of NAC whether it should hedge interest rate movements
using the FRA or the interest rate option. (3 marks)
65.2 Issue 2
On 31 March 20X9 NAC is due to pay $1,250,000 to its US suppliers for a shipment of fifty
cars. The board of NAC would like to establish the most appropriate hedging strategy to
protect the company against foreign exchange rate (forex) risk.
The following data is available at the close of business on 30 November 20X8:
Spot exchange rate ($/£) 1.3965 – 1.3970
4-month forward contract discount ($/£) 0.0052 – 0.0058
Annual borrowing and depositing interest rates:
Dollar 4.80% – 4.40%
Sterling 3.75% – 3.25%
4-month over-the-counter (OTC) currency options:
 Call options to buy $ have an exercise price of $/£1.4025 and a premium of £0.006 per
$ converted.
 Put options to sell $ have an exercise price of $/£1.4028 and a premium of £0.002 per
$ converted.
Option premiums are payable on 30 November 20X8. NAC currently has an overdraft.
Requirements
(a) Calculate NAC's sterling cost of the $1,250,000 payment using:
 a forward contract
 a money market hedge
 an OTC currency option
Assume that the spot exchange rate will be $/£1.3980 – 1.3990 on 31 March 20X9.
(9 marks)
(b) Discuss the relative advantages and disadvantages of each of the hedging techniques
in 65.2(a) above and advise NAC's board on which technique would be the most
beneficial for hedging its forex risk. (8 marks)
65.3 Issue 3
The board is concerned about NAC's exposure to economic risk as it imports cars from the
USA and sells some of them to customers in the Eurozone.
Requirement
Explain how economic risk affects NAC. (4 marks)
Total 30 marks

ICAEW 2020 December 2018 exam questions 103

66 Continental plc
Assume that the current date is 30 November 20X8.
Continental plc (Continental) is a major international hotel operator. At a recent board meeting it
was decided that the company should diversify by opening gymnasiums and health spas in or
near to all of its hotels at a cost of £1,000 million. The following are extracts from the board
minutes relating to this diversification:
 The board discussed which discount rate to use to appraise the diversification. Some
directors felt that the company's existing weighted average cost of capital (WACC) should
be used. Others felt that the rate should reflect the systematic risk of the diversification.
 The board discussed how the finance would be raised for this diversification as
Continental's current gearing (measured as debt/equity by market values) is close to the
hotel market average. Some directors felt that gearing is irrelevant and wanted all the
finance to be raised from debt. Others were less sure and expressed concern that the
company's credit rating would fall, affecting Continental's cost of debt and the market value
of its debentures. They preferred a mix of equity and debt or even all equity finance.
 Several board members felt that the £296 million proposed special dividend for the year to
30 November 20X8 should be cancelled and used to partly fund the diversification.
The finance director of Continental was asked to prepare a report on the above issues for
presentation at the next board meeting.
An extract from Continental's most recent management accounts is shown below:
Balance sheet at 30 November 20X8
£m
Ordinary share capital (£1 shares) 190
Retained earnings 6,000
6,190
4% Redeemable debentures at nominal value 1,500
7,690

On 30 November 20X8 Continental's ordinary shares each had a market value of £46 (ex-div).
Continental's debentures are redeemable at par (£100) in four years' time and the current price
of the debentures is £94 (ex-interest).
Profits and dividends for the years to 30 November:
20X4 20X5 20X6 20X7 20X8
£m £m £m £m £m
Profits after tax 372 391 1,222 414 433

Ordinary dividends 105 93 110 137 141

Proposed special dividend – – – – 296
Total dividends 105 93 110 137 437

Other information and assumptions:

 The number of Continental's ordinary shares in issue has not changed in the last five years.
 Continental's equity beta on 30 November 20X8 is 0.74.

104 Financial Management: Question Bank ICAEW 2020

  Other companies operating in similar areas to Continental and its proposed diversification:
Total Total
equity debt
Equity by market by market
Company name Main activity beta value value
£m £m
Fitgroup plc Operating gymnasiums and
health spas 0.56 434 150
Bowlright plc Operating bowling alleys
and gymnasiums 0.85 75 23
The Local plc Operating bars and hotels 0.62 1,221 797

 The risk-free rate is expected to be 3% pa.

 The market return is expected to be 9% pa.
 Corporation tax is at the rate of 17% for the foreseeable future.
 An analyst estimated the following:
(1) If Continental were to fund the £1,000 million diversification entirely by borrowing, the
market value of its existing debentures would fall by 5%.
(2) If Continental were to fund the £1,000 million diversification entirely by equity, the
market value of its existing debentures would rise by 5%.
(3) The price of the company's ordinary shares would stay the same whether the project is
funded entirely by debt or entirely by equity.
Requirements
66.1 Calculate on 30 November 20X8:
(a) Continental's WACC using the dividend valuation model (dividend growth should be
estimated using the earliest and latest dividend information provided).
(b) Continental's cost of equity using the CAPM. (11 marks)
66.2 Using the CAPM and assuming that the current gearing of Continental remains unchanged
after the diversification, calculate a cost of equity that reflects the systematic risk of the
diversification and also explain your reasoning. (8 marks)
66.3 Assuming the £1,000 million finance required is raised on 1 December 20X8, calculate
Continental's gearing (measured as debt/equity by market values) if it comes entirely from:
(a) debt or
(b) equity (4 marks)
66.4 Discuss whether the £1,000 million finance required for the diversification should be raised
from debt, equity or a combination of debt and equity sources. You should make reference
to:
 relevant theories
 Continental's current gearing
 your calculations in 66.3 above
 other relevant practical issues. (12 marks)
Total: 35 marks

ICAEW 2020 December 2018 exam questions 105

 March 2019 exam questions
67 Palace Parade Furniture plc
Assume that the current date is 28 February 20X9.
Palace Parade Furniture plc (PPF) is a UK-based furniture manufacturer. It has been trading since
1992. PPF makes domestic furniture, such as chairs and beds, which is sold to retailers across
Europe. This market is very competitive and PPF's board is considering diversifying its product
range. One means of diversification would be the purchase of the majority of the shares in
Turner Pring Ltd (TP), a UK-based kitchen manufacturer.
TP has traded since 1998 and makes a wide range of kitchen units which are sold to specialist UK
retailers. TP's two founders, Violet Turner and Arthur Pring, own 65% of the company's shares.
PPF's board has been informed that Violet and Arthur wish to sell all of their shares. The senior
managers of TP have expressed an interest in a management buy- out (MBO), but Violet and
Arthur would also consider offers from other parties.
You work in PPF's finance team. You have been asked by PPF's board to prepare a range of
valuations for Violet and Arthur's shares, supported by guidance on the methods by which PPF
could pay for those shares.
Extracts from TP's most recent management accounts are shown below:
Income statement for the year to 28 February 20X9
£’000
Sales 64,200
Profit before interest 7,200
Interest (1,800)
Profit after interest 5,400
Corporation tax at 17% (918)
Profit after tax 4,482
Dividends (2,890)
Retained profits 1,592

Balance sheet as at 28 February 20X9

£'000 £'000
Land and buildings 15,600
Plant and machinery 19,200
Vehicles 1,400
36,200
Current assets 8,110
44,310
Ordinary share capital (£1 shares) 8,500
Retained earnings 8,580
17,080
7.5% Redeemable debentures 24,000
Current liabilities 3,230
44,310

106 Financial Management: Question Bank ICAEW 2020

 Other information
1. Four UK listed companies in the same industry sector as TP have the following P/E ratios
and dividend yields:
Allex plc Tagg plc Gresty plc Joanz plc
P/E ratio 8.1 10.7 9.5 9.3
Dividend yield 7.0% 8.3% 8.0% 7.5%

2. TP's profit before interest figures for the five trading years to 28 February 20X9 were:
20X5 20X6 20X7 20X8 20X9
£'000 £'000 £'000 £'000 £'000
3,600 11,800 3,800 4,800 7,200
PPF wishes to use this information to derive an average earnings figure for use in a P/E
valuation of TP.
3. TP has paid a constant dividend per share since 20X4. TP's last issue of ordinary shares was
in 20X3.
4. TP's debentures are redeemable in 20Y0.
5. TP's non-current assets are independently valued at:
£'000
Land and buildings 23,200
Plant and machinery 20,800
Vehicles 1,150
These values are not reflected in TP's balance sheet at 28 February 20X9.
6. You should assume that the corporation tax rate has been and will remain at 17%.
Requirements
67.1 Prepare a report for PPF's board that
(a) Calculates the value of one share in TP at 28 February 20X9 using the P/E, dividend
yield and asset-based valuation methods (13 marks)
(b) Comments on the strengths and weaknesses of the three valuation methods used and
(10 marks)
(c) Outlines two methods by which PPF could pay for Violet and Arthur's shares. (4 marks)
67.2 Identify how the shareholder value analysis (SVA) approach to company valuation differs
from the valuation methods used in part 67.1 above. (4 marks)
67.3 Explain how an MBO works and the means by which the managers could finance it.
(4 marks)
Total: 35 mark

68 Edencatt Packaging plc

Assume that the current date is 28 February 20X9.
Edencatt Packaging plc (EP) is a UK listed manufacturer. It has a financial year-end of
28 February. The company started trading in 1996, making a limited range of bespoke plastic
shopping bags for small retailers. Since then EP has expanded via organic growth and the
acquisition of other companies. It now supplies plastic bags and bottles to manufacturers across
Europe, mainly in the food, chemicals and agricultural sectors.

ICAEW 2020 March 2019 exam questions 107

 There is public concern with the environmental impact of plastic products. In response, EP's
board is investigating the possible purchase of the entire share capital of Marshgreen Ltd
(Marshgreen), a manufacturer of glass bottles and paper bags and wrapping. It would cost EP
£13 million to purchase Marshgreen.
Minutes taken at EP's most recent board meeting included the following comment made by
Josie Hatton, EP's production director:
"If we are to proceed with our appraisal of the investment in Marshgreen then we should
make sure that we use an accurate hurdle rate in our NPV calculations. We've been using a
cost of capital figure of 8% for at least three years now. The danger here is that by using a
hurdle rate that's too high or too low we will be destroying shareholder wealth. Surely our
objective is to maximise shareholder wealth?"
You work in EP's finance team and have been asked to advise the board on a suitable cost of
capital for appraising the possible Marshgreen investment.
Extracts from EP's most recent management accounts are shown below:
Income statement for the year ended 28 February 20X9
£'000
Profit before interest and tax 7,330
Interest (290)
7,040
Corporation tax at 17% (1,197)
5,843
Preference dividend (160)
5,683
Ordinary dividend (4,455)
Retained profit 1,228

Balance sheet as at 28 February 20X9

Non-current assets 19,600
Net current assets 1,300
20,900
Ordinary shares (£1 par) 5,500
Retained earnings 8,200
13,700
8% Preference shares (£1 par) 2,000
5% Redeemable debentures (see note) 2,200
6% Irredeemable debentures 3,000
20,900

Note: The 5% debentures are redeemable at par on 28 February 20Y2.

Other information:
Market values of EP's long-term funds at 28 February 20X9
Ordinary shares £9.06 cum div
Preference shares £1.24 ex div
5% Redeemable debentures £97% ex int
6% Irredeemable debentures £97% cum int
EP's ordinary dividend has been increasing at a steady rate over the past five years. In 20X4 the
ordinary dividend per share was £0.735. There have been no changes to the number of ordinary
shares in issue since 2014.

108 Financial Management: Question Bank ICAEW 2020

 CAPM data
EP's equity beta 1.20
Expected risk-free return 3.6% pa
Expected return on the market portfolio 9.8%
pa Average equity beta for Marshgreen's sector 1.65
Ratio of long-term funds (equity:debt by market values) for Marshgreen's sector 88:12
If EP were to purchase Marshgreen's shares it would raise the necessary funds via the issue of
both ordinary shares and 8% redeemable debentures. The funds would be raised in such a way
as to preserve EP's existing gearing ratio (equity:debt by market values).
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
68.1 Calculate EP's weighted average cost of capital (WACC) at 28 February 20X9 using
(a) The dividend growth model and (16 marks)
(b) The CAPM (2 marks)
68.2 Determine an appropriate WACC that EP could use when appraising the £13 million
investment in Marshgreen and explain the reasoning behind your approach. (10 marks)
68.3 Explain how the APV technique works and the circumstances under which it is applicable.
(4 marks)
68.4 Comment on Josie Hatton's view that maximisation of shareholder wealth should be the
objective of EP's board. (3 marks)
Total: 35 marks

69 Cool Sports Ltd

Assume that the current date is 1 March 20X9.
Cool Sports Ltd (CS) is a UK retailer of sportswear. It purchases its goods in bulk to take
advantage of quantity discounts. These goods are held in three main warehouses and from there
they are distributed to CS's chain of large retail outlets across the UK. Currently 70% of CS's
purchases are imported from southern Europe with the remainder coming from India. You are an
ICAEW Chartered Accountant and you work in CS's finance team.
CS's board is considering the following two issues:
1. Whether to hedge against exchange rate movements in the Indian currency (rupees).
2. Whether to establish a production facility overseas which would enable CS to take
advantage of lower labour costs and less rigorous health and safety regulations.
To date CS has not hedged against the exchange rate risk of any of its Indian imports. However,
with the possibility of an increased level of purchases from India, you have been asked to
investigate the implications of hedging that risk.
CS has recently signed the contract for a large consignment of goods from its main Indian
supplier, BDC. The goods will arrive on 30 April 20X9. The agreed price is 145 million Indian
rupees (R) and CS will pay that sum to BDC on 31 May 20X9.

ICAEW 2020 March 2019 exam questions 109

 You have collected the following data at the close of business on 1 March 20X9:
Spot rate (R/£) 91.07 – 91.89
Three-month forward contract discount (R/£) 0.62 – 0.78
Forward contract arrangement fee (per one million rupees converted) £95
Three-month OTC call option on rupees, exercise price (R/£) 94.25
Three-month OTC put option on rupees, exercise price (R/£) 95.50
OTC option premium (per one million rupees converted) £250
Relevant currency futures contract price (standard contract size £62,500) R/£ 92.12
Sterling interest rate (lending) 2.8% pa
Sterling interest rate (borrowing) 3.8% pa
Rupee interest rate (lending) 6.0% pa
Rupee interest rate (borrowing) 6.8% pa
Requirements
69.1 Calculate for CS's board the sterling cost of the BDC consignment if it uses the following
hedging instruments to hedge its exchange rate risk:
 A forward contract
 An OTC currency option
 Currency futures contracts
 A money market hedge
You should assume that on 31 May 20X9 the sterling currency futures price will be R/£ 92.88
and the spot exchange rate will be R/£ 92.45 – 93.32. (13 marks)
69.2 Advise CS's board whether it should hedge its Indian rupee payment to BDC. You should
refer to your calculations in part 69.1 above and the sterling cost of not hedging. (9 marks)
69.3 Explain the principle of interest rate parity (IRP). Given the information provided above,
calculate the forward rate of exchange on 31 May 20X9 using IRP, commenting on your
result. You should use the average current spot and borrowing/lending rates for the
purposes of this calculation. (5 marks)
69.4 Outline the main elements of an ethical employment policy that CS could adopt if it were to
establish a production facility overseas. (3 marks)
Total: 30 marks

110 Financial Management: Question Bank ICAEW 2020

 June 2019 exam questions
70 Optical Answers plc
Assume that the current date is 30 June 20X9.
Optical Answers plc (OA) manufactures a range of eyewear and eyewear accessories. The
finance director of OA is undertaking the following two tasks.
70.1 Task One – Handyspecs project
The project involves the launch of a range of compact folding reading glasses called
“Handyspecs”. A market research consultant has produced a report, costing £250,000,
which estimated that the product life cycle will be three years. The report also identified a
rival firm which is contemplating launching a similar product range on the market sometime
in the next 12 months.
The following information is available regarding Handyspecs.
 The selling price will be £18.50 per unit for the year to 30 June 20Y0 and will then
increase by 3% pa. Contribution is expected to be 70% of the selling price.
 Demand is estimated to be 10,000 units per month in the year to 30 June 20Y0 and
then decline by 10% pa in the two years to 30 June 20Y2.
 Selling and administration costs are estimated to be £100,000 for the year to
30 June 20Y0 and are expected to increase by the general level of inflation in the
two years to 30 June 20Y2.
 Fixed costs, 50% of which are centrally allocated, are estimated to be £80,000 in the
year to 30 June 20Y0. These fixed costs are expected to increase by the general level
of inflation in the two years to 30 June 20Y2.
 OA will rent factory space to manufacture Handyspecs at a cost of £50,000 pa, payable
in advance on 30 June. The rent is not subject to inflationary increases.
 Investment in working capital will be £250,000 on 30 June 20X9 and will increase or
decrease at the start of each year in line with sales volume and sales price changes.
Working capital will be fully recoverable on 30 June 20Y2.
 On 30 June 20X9 investment in plant and equipment costing £2 million will be
required. This will have an estimated scrap value of £200,000 on 30 June 20Y2 (in
30 June 20Y2 prices).
 The plant and equipment attracts 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company,
except the final year. In the final year, the difference between the plant and
equipment's written down value for tax purposes and its disposal proceeds will be
treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down
value, or
– balancing charge, if the disposal proceeds are more than the tax written down
value.
 Assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
 A suitable real discount rate to assess the net present value of the project is 7%. The
general level of inflation is expected to be 2.5% pa.

ICAEW 2020 June 2019 exam questions 111

 Requirements
(a) Using money cash flows, calculate the net present value of the Handyspecs project at
30 June 20X9 and advise OA's board as to whether it should proceed with the project.
(15 marks)
(b) Ignoring the effects on working capital, calculate and comment upon the sensitivity of
the project's NPV to changes in sales volume. (4 marks)
(c) Identify and explain two real options associated with the proposed Handyspecs
project. (4 marks)
(d) Outline how shareholder value analysis (SVA) could be used to evaluate the
Handyspecs project. (3 marks)
70.2 Task two – Capital budget
OA has other projects that it has already appraised using NPV analysis. The company has no
difficulty in raising funds from the capital markets. However, the capital expenditure budget
(excluding the Handyspecs project) has been set at a maximum of £10 million for the year
to 30 June 20X9. The £10 million will be allocated to projects, excluding Handyspecs, on
the basis of maximising shareholder wealth.
The indivisible projects available for investment of the £10 million are as follows:
Project Initial expenditure NPV
£m £m
A 2.0 0.5
B 4.0 1.5
C 3.0 1.0
D 2.0 (0.5)
E 6.5 2.5
Requirements
(a) Determine the combination of projects that will maximise shareholder wealth.
(4 marks)
(b) State the difference between hard and soft capital rationing and identify the type of
capital rationing that is being employed by OA. Also discuss whether the type of
rationing being employed by OA is appropriate for maximising shareholder wealth.
(5 marks)
Total: 35 marks

71 Stable plc
Assume that the current date is 31 May 20X9.
Stable plc (Stable) operates department stores and has an accounting year ending 31 May.
Because of a decline in sales and profits, Stable is seeking to diversify and has identified another
quoted company, Exito plc (Exito), as a likely takeover target. Stable's finance department has
estimated that Exito could be purchased for £300 million. The £300 million purchase price
represents the present value of Exito's free cash flows discounted using an appropriate risk
adjusted WACC. The finance to purchase Exito would be raised in such a way as to leave
Stable's existing gearing (measured as debt:equity by market values) unchanged after the
acquisition.
The CEO of Stable would like the finance director (who is an ICAEW Chartered Accountant) to
address the following points raised at a recent board meeting:
 The board would like an explanation of how the WACC used to establish the purchase price
of Exito was calculated and why this differs from Stable's current WACC.

112 Financial Management: Question Bank ICAEW 2020

  The board would like to know at what price the debt proportion of the £300 million finance
required for the Exito purchase should be issued.
 The sales director suggested that since Stable is going to make a bid for Exito, it would be
financially advantageous for board members to buy shares in Exito before the bid is
publicly announced.
 The production director asked whether it would be a good idea to partly finance the
acquisition of Exito by Stable not paying dividends in the next financial year.
The finance director of Stable has the following information available to him to address the
above points raised at the board meeting:
 Stable has in issue £40 million nominal of ordinary shares, each with a par value of 10p and
a market value of 405p(ex div) on 31 May 20X9. The number of ordinary shares has not
changed in the last five years.
 On 31 May 20X9 Stable has in issue £395 million nominal of 5% redeemable debentures
with a market price of £109 (cum interest) per £100 nominal value. The debentures are
redeemable in four years' time at par.
 Stable has an equity beta of 0.5.
 Exito as an equity beta of 1.2 and a debt:equity ratio, by market values, of 40:60.
 The debt proportion of the £300 million finance to be raised on 1 June 20X9 will be in the
form of new 3% coupon debentures redeemable on 31 May 2024 at par. The redemption
yield of the new debentures will be equal to the redemption yield of Stable's existing 5%
debentures.
 The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
 The corporation tax rate will be 17% for the foreseeable future.
 Stable's dividends during the past four years ending 31 May were as follows:
Type of dividend 20X6 20X7 20X8 20X9
£m £m £m £m
Ordinary 43 45 46 48
Special 4 1 – –
Total 47 46 46 48

Requirements
71.1 Ignoring the acquisition of Exito, calculate the cost of equity of Stable at 31 May 20X9
using:
 the dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information provided) (3 marks)
 the CAPM. (1 mark)
71.2 Ignoring the acquisition of Exito and using the CAPM, calculate the current WACC of Stable
at 31 May 20X9. (6 marks)
71.3 Using the CAPM, calculate the risk adjusted WACC that Stable will have used to find the
present value of Exito's free cash flows. Explain why this is different to Stable's current
WACC that you have calculated in 71.2 above. (8 marks)
71.4 Assuming that £80 million is raised from the new 3% coupon debentures issued on
1 June 20X9, calculate the issue price per £100 nominal value and the total nominal value
that will have to be issued to give a redemption yield equal to that of Stable's current 5%
debentures. Also comment upon whether it is appropriate to use the redemption yield on
the current debentures to establish the new issue's price. (6 marks)

ICAEW 2020 June 2019 exam questions 113

 71.5 Making reference to relevant theories and practical considerations, evaluate whether it
would be appropriate for Stable to not pay a dividend next year to part fund the acquisition
of Exito. (8 marks)
71.6 Discuss the ethical and legal implications for the finance director and the advice he should
give to the board regarding the suggestion made by the sales director. (3 marks)
Total: 35 marks

72 Technical Equipment Ltd

Assume that the current date is 30 June 20X9.
Technical Equipment Ltd (TE) is based in the UK. TE has recently secured a contract to import
products from a major manufacturer of outdoor equipment based in the Eurozone and payment
will be made to them in euro. TE intends to sell the equipment to customers in the UK and the
USA.
TE's board has no experience of hedging foreign exchange rate (forex) risk and has asked a firm
of consultants to provide advice. The advice will cover hedging instruments and economic risk.
You work for the consultants and have the following information available to you at the close of
business on 30 June 20X9:
TE has estimated that it will receive $6 million in three months' time from its American
customers.
TE currently has funds on deposit.
Exchange rates
Spot rate ($/£) 1.3155 – 1.3159
Three month forward discount ($/£) 0.0037 – 0.0055
September currency futures
Standard contract size £62,500. Price $1.3200/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3210. The premium is
£0.04 per $ and is payable on 30 June 20X9.
September call options to buy $ are available with an exercise price of $1.3190. The premium is
£0.05 per $ and is payable on 30 June 20X9.
Annual borrowing and depositing interest rates (%)
Dollar 6.20 – 5.90
Sterling 4.80 – 4.40

114 Financial Management: Question Bank ICAEW 2020

 Requirements
72.1 Calculate TE's sterling receipt if it uses the following to hedge its forex risk:
(a) A forward contract
(b) A money market hedge
(c) Currency futures
(d) An OTC currency option
Assume that the spot rate on 30 September 20X9 will be $/£ 1.3192 – 1.3220 and the
September futures price will be $/£ 1.3206. (15 marks)
72.2 Identify the advantages and disadvantages of the four hedging techniques used in 72.1
above and advise TE's board as to which hedging technique it should use to hedge its forex
risk. (9 marks)
72.3 Briefly explain to TE's board what economic risk is, how it affects TE and how it can be
reduced. (6 marks)
Total: 30 marks

ICAEW 2020 June 2019 exam questions 115

 September 2019 exam questions
73 Hodder Specialist Engineering Ltd
Hodder Specialist Engineering Ltd (Hodder) is a UK company with a financial year end of
31 October. Hodder provides a powder-coating service for its UK-based customers that require
a protective finish on their products. Powder coating is applied as a free-flowing, dry powder
producing thicker coatings than conventional liquid coatings such as paint. At present, all of
Hodder's customers operate in the consumer goods sector of the UK market.
Diamond Cars Ltd (DC) is a UK manufacturer of sports vehicles. DC's board has approached
Hodder and asked it to provide a powder coating service for DC's vehicles over a three-year
period.
The majority of Hodder's board members want to accept the contract as DC is a well-established
and very profitable company. However, two of Hodder's directors feel that this diversification
carries excessive risk. At Hodder's most recent board meeting they proposed that the company
would be better served by expanding its existing operations overseas, citing India and China as
two mass markets for consumer goods.
You work in Hodder's finance team and have been asked to advise Hodder's board on the DC
proposal and overseas expansion.
You have been given these estimates with regard to the DC proposal:
Year to 31 October 20X9 20Y0 20Y1 20Y2
£'000 £'000 £'000 £'000
Purchase of new machinery (Note 1) (1,200)
Trade-in value of new machinery (Note 2) 140
Depreciation of new machinery (265) (265) (265) (265)
Interest costs (Note 3) (54) (54) (54) (54)
Additional fixed costs (Note 4) (35) (35) (35)
Additional direct labour and materials (Note 4) (162) (162) (162)
Additional working capital (Note 4) (50) (5) (5) 60
Notes
1 The new machinery would be purchased on 31 October 20X9. Hodder charges a full years'
depreciation in the year of acquisition and disposal.
The machinery attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the machinery's written down value for tax
purposes and its disposal proceeds will be treated by the company either as:
– a balancing allowance, if the disposal proceeds are less than the tax written down
value, or
– a balancing charge, if the disposal proceeds are more than the tax written down value.
2 The trade-in value of the new machinery on 31 October 20Y2 is expressed in
31 October 20Y2 prices.
3 This represents the interest cost on a loan to part-finance the purchase of the new
machinery.
4 The figures for fixed costs, direct labour, materials and working capital are stated in
31 October 20X9 prices. The inflation rate applicable to these flows is 2% pa. The
outstanding working capital balance will be released on 31 October 20Y2.

116 Financial Management: Question Bank ICAEW 2020

 Other information
DC has offered Hodder the choice of two contract prices:
 £550,000 pa on 31 October in each of the three years 20Y0–20Y2; or
 a lump sum of £1.9 million receivable on 31 October 20Y2.
These amounts are expressed in money terms.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant financial
year.
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Hodder's money weighted average cost of capital is 9% pa.
Requirements
73.1 Using the NPV of money cash flows at 31 October 20X9, advise Hodder's board whether it
should accept the DC proposal if the agreed price is:
(a) £550,000 pa receivable on 31 October in each of the years 20Y0–20Y2 or
(b) £1.9 million receivable on 31 October 20Y2. (22 marks)
73.2 Compare the strengths and weaknesses of sensitivity analysis and simulation as methods of
assessing the risk of the DC proposal. (5 marks)
73.3 Explain what is meant by the term 'real options' and identify one real option that could
apply to the DC proposal. (3 marks)
73.4 Outline the potential risks that Hodder could face were it to expand its operations into
China and India. (5 marks)
Total: 35 marks

74 Jackett Clarke Travel plc

Assume that the current date is 30 September 2019
Jackett Clarke Travel plc (Jackett) is a UK-listed company, founded in 19W9. Jackett is a travel
agency and tour operator. It arranges flights and package holidays to destinations across
Europe and North America. You are an ICAEW Chartered Accountant and are a member of
Jackett's finance team. Extracts from Jackett's management accounts for the financial year to
30 September 20X9 are shown below:
Income Statement for the year to 30 September 20X9
£'000
Sales 43,500
Variable costs (23,925)
Fixed costs (9,500)
Profit before interest and tax 10,075
Interest (805)
Profit before tax 9,270
Taxation (17%) (1,576)
Profit after tax 7,694
Dividends paid (2,400)
Retained profit 5,294

ICAEW 2020 September 2019 exam questions 117

 Balance Sheet at 30 September 20X9
£'000
£1 ordinary shares 16,000
Retained earnings 8,750
24,750
7% Debentures (redeemable in 20Y1) 11,500
36,250

Jackett's board is keen to explore the implications of expanding the company's operations into
South East Asia and Australia. The demand for package holidays to these areas has grown
steadily in the past five years and this is expected to continue, but at a slower rate, for at least
another five years. The board commissioned market research and the key financial implications
noted in the research report are shown below:
Table
Initial cost of investment £7 million
Impact on sales and variable costs 20% increase pa
Impact on fixed costs Increase by £1.5 million pa
Other information
Jackett's board plans to maintain the dividend per share payout for at least another 12 months.
Corporation tax will be payable at the rate of 17% for the foreseeable future.
The board has decided that, were this investment to proceed, it would commence on
1 October 20X9 when the £7 million required for the initial investment would be raised via:
 a 1 for 4 rights issue of ordinary shares; or
 an issue of 5% debentures (redeemable in 20Y8) at par.
The current market values of Jackett's shares and debentures are:
Ordinary shares £2.58 (ex-div)
7% debentures £105% (ex-int)
Emails
You have recently received emails from Jackett's sales director, Michael Ayres and a colleague
in the finance team, Ann Baker. An extract from each email is shown below:
Michael Ayres:
"I'm an amateur investor and have been tracking the Jackett share price for about four
years. Past patterns suggest that it will decrease by about 25% in the next quarter, so we
need to make sure that we don't overprice any rights issue."
Ann Baker:
"I'm worried that Jackett's share price will fall if debt is used to finance the expansion.
Please let me know what the board decide so I can sell my Jackett shares if necessary
before the market finds out."
Requirements
74.1 For both the 1 for 4 rights issue and the 5% debenture issue, prepare forecast income
statements for Jackett for the year to 30 September 20Y0. (9 marks)
74.2 For both the 1 for 4 rights issue and the 5% debenture issue, calculate Jackett's:
 Earnings per share for the year to 30 September 20Y0.
 Gearing ratio (long-term borrowings/total long-term funds at book value) as at
30 September 20Y0. (5 marks)

118 Financial Management: Question Bank ICAEW 2020

 74.3 Discuss the implications for Jackett's shareholders of the company choosing equity or debt
to raise the £7 million required for the investment. You should make reference to your
calculations in 74.1 and 74.2 above. (7 marks)
74.4 Assuming that Jackett chooses the rights issue, calculate the theoretical ex-rights price of
one ordinary share and explain why this may be different to the actual ex-rights price.
(6 marks)
74.5 Discuss Michael Ayres' views on the Jackett share price making reference to relevant theory
on efficient markets. (5 marks)
74.6 Identify the legal and ethical issues arising for you as an ICAEW Chartered Accountant as a
result of Ann Baker's email request. (3 marks)
Total: 35 marks

75 Barratt Waters Shine plc

Assume that the current date is 31 August 20X9.
Barratt Waters Shine plc (Barratt) is a UK-listed manufacturer of pharmaceuticals. It has traded
since 19W4 and it sells its products worldwide. You are a member of Barratt's finance team and
are currently working on three tasks.
75.1 Task 1
Barratt has agreed to sell a large consignment of pharmaceuticals to DMBJ, an Argentine
wholesaler. The agreed price is 22.4 million Argentine pesos (AP). The consignment will
leave the UK on 31 October 20X9 and DMBJ will pay for the goods on 30 November 20X9.
Barratt's board has to decide whether to hedge this transaction and you have been asked
to provide advice. You have collected the following data at the close of business on
31 August 20X9:
Spot rate (AP/£) 46.22 – 46.85
AP interest rate (lending) 4.4% pa
AP interest rate (borrowing) 6.0% pa
Sterling interest rate (lending) 3.6% pa
Sterling interest rate (borrowing) 4.8% pa
Three-month forward contract discount (AP/£) 0.10 – 0.13
Forward contract arrangement fee
(per one million pesos converted) £260
Three-month OTC call option on pesos
– exercise price (AP/£) 44.30
Three-month OTC put option on pesos
– exercise price (AP/£) 46.05
Relevant OTC option premium
(per one million pesos converted) £740
Requirements
(a) Calculate Barratt's sterling receipt for the DMBJ consignment if it uses the following to
hedge its foreign exchange rate risk:
 A forward contract
 A money market hedge
 An OTC currency option (8 marks)
(b) With reference to your calculations in 75.1(a), advise Barratt's board whether it should
hedge against movements in the value of the Argentine peso. (6 marks)

ICAEW 2020 September 2019 exam questions 119

 (c) Identify the key differences between forwards and futures as a means of hedging
foreign exchange rate risk. (3 marks)
75.2 Task 2
Barratt has built up a portfolio of UK FTSE100 shares over a number of years. The portfolio
is worth £8,350,000 on 31 August 20X9. The company's board is considering using
FTSE100 index futures to hedge against a fall in the value of the portfolio over the next
four months.
You have the following information available to you on 31 August 20X9:
 The FTSE100 index is 7,130
 The price for December 20X9 FTSE100 index futures is 7,115
 The face value of a FTSE100 index futures contract is £10 per index point
Requirements
(a) Calculate the outcome of hedging the portfolio using December 20X9 FTSE100 index
futures. Assume that on 31 December 20X9 both the FTSE100 index and the FTSE100
index futures price will be 7,055 and that the portfolio value changes exactly in line
with the change in the FTSE100 index. (6 marks)
(b) Explain why the hedge will not be 100% efficient. (2 marks)
75.3 Task 3
Barratt is expanding its manufacturing and warehousing capacity and needs a bank loan to
finance this. Construction work will start in January 20Y0 and Barratt's bank has agreed to
lend the company £12.5 million for a five-year period, commencing on 1 March 20Y0. The
bank will charge interest at LIBOR + 1.5% pa. The board wishes to explore whether it would
be worth taking out an interest rate option to hedge against increases in LIBOR. Barratt's
bank has offered it an option at 5.3% pa plus a premium of 1% of the sum borrowed.
Requirement
Calculate the annual interest payment if Barratt takes out the interest rate option and advise
the board whether it should hedge against increases in LIBOR.
For your calculations, assume that on 1 March 20Y0 LIBOR will be:
(a) 3.5% pa; or
(b) 5.5% pa (5 marks)
Total: 30 marks

120 Financial Management: Question Bank ICAEW 2020

Answer Bank
122 Financial Management: Answer Bank ICAEW 2020
Objectives and investment appraisal

1 Stoane Gayte Sounds plc (March 2013)

Marking guide

Marks
1.1 Machinery 1
Tax saving 2
Tax on income 1
Working capital investment 2
Discounting and NPV 1
Recommendation 1
No market research costs 1
No fixed costs 1
Selling price 1
Raw materials 1
Variable overheads 1
Loss of contribution 3
Labour costs ignored 1
17
1.2 NPV 1
IRR 1
Advice on usefulness 4
6
1.3 Relevant discussion
6
29

1.1
March 20X3 March 20X4 March 20X5 March 20X6
£'000 £'000 £'000 £'000
Machinery (4,900.000) 980.000
Tax saving (W1) 149.940 122.951 100.820 292.690
Income (W2) 2,008.500 3,500.970 1,803.000
Tax on income (W2) (341.445) (595.165) (306.510)
Working capital investment (W3) (750.000) (22.500) (23.175) 795.675
Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855
11% factor 1.000 0.901 0.812 0.731
PV (5,500.060) 1,592.523 2,422.561 2,605.909
NPV 1,120.933

As the NPV is positive SGS should proceed with the investment as this will enhance
shareholder wealth.
No market research costs.
No fixed costs.

ICAEW 2020 Objectives and investment appraisal 123

 WORKINGS
(1)
March 20X3 March 20X4 March 20X5 March 20X6
£'000 £'000 £'000 £'000
Cost/WDV 4,900.000 4,018.000 3,294.760 2,701.703
WDA (18%) (882.000) (723.240) (593.057) (1,721.703)
WDV/disposal 4,018.000 3,294.760 2,701.703 980.000

Tax saved (17%  WDA) 149.940 122.951 100.820 292.690

(2)
March
20X3
Contribution/unit £
Selling price 190
Less: Raw materials (43)
Variable overheads (45)
Loss of Boom-Boom contribution ([£99 – £28 – £35]  2) (72)
Contribution/unit 30

Labour costs ignored

Contribution adjusted for inflation
March March March
20X4 20X5 20X6
Contribution/unit (real terms) £30.00 £30.00 £30.00
  
Sales volume (units) 65,000 110,000 55,000
= = =
Total contribution £1,950,000 £3,300,000 £1,650,000
 
Inflation adjustment 1.03 (1.03)2 (1.03)3
= = =
Total contribution (money terms) £2,008,500 £3,500,970 £1,803,000
Corporation tax on contribution (@ 17%) £341,445 £595,165 £306,510

(3) Working capital investment

March March March March
20X3 20X4 20X5 20X6
Working capital £750,000 1.03
£772,500 1.03
£795,675
Increment (£750,000) (£22,500) (£23,175) £795,675

1.2 IRR calculation

Rework total cash flows at (say) 15%:
Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855
15% factor 1.000 0.870 0.756 0.658
PV (5,500.060) 1,537.730 2,255.488 2,345.675
NPV 638.833
IRR = 15% + [4%  (638,833/(1,120.933 – 638.833))] = 20.3%
The IRR is approximately 20.3%, which exceeds SGS's cost of capital (11%) and so the
investment will enhance shareholder wealth. If, however, the IRR had been less than the
cost of capital then shareholder wealth would decline.

124 Financial Management: Answer Bank ICAEW 2020

 IRR and NPV normally give the same result as to whether investment should take place or
not. As a percentage return, IRR may be easier to understand for managers and employees.
However, IRR does not calculate the change in absolute shareholder wealth. As a
consequence, it may provide the wrong result when alternative projects are being ranked.
Also non-conventional cash flows can create more than one IRR.
1.3 The traditional school of thought regarding dividends states:
Shareholders would prefer dividends today rather than dividends or capital gains in the
future.
This is because cash now is more certain than cash in the future.
However, this implies that future payments would be discounted at a higher rate to take
account of the uncertainty, but does risk really increase over time?
Risk is however related to the activities and operations of the business, and so the discount
rates applied to dividends should reflect this.
Modigliani and Miller (MM)
MM argued that share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities and any loss in dividend
income will be offset by gains in share price.
Shareholders can create home-made dividends and do not have to rely on the company's
dividend policy; if cash is needed, they can sell some shares instead.
Taxes, share transaction costs and share issue costs will have an effect.
Other issues
Informational content – dividends mean that management is confident of the future. The
signalling view.
Clientele effect – investors have a preferred habitat. That is, they seek a company with a
particular dividend policy that suits them. If shares are unpopular because of inconsistent
policy, then the share price will suffer.
Agency – separation of ownership from management of a firm can lead to sub-optimal
decisions being made. Agency costs are borne by shareholders. Managers may often make
investments that do not increase shareholder wealth, and dividends worsen as a result.
Dividend commitments can reduce agency costs. A high dividend payout and low
retentions leads to greater scrutiny of the firm's investment decisions by outsiders (due to
the need for external funds).
Tax – some shareholders may prefer income to capital gains.
Overall
Evidence seems to support MM – valuation not closely related to levels of dividends.
Clientele effect seems to operate.
Dividends do not affect the value of shares, provided the shareholders know the dividend
policy of the company. It is important to establish a consistent policy and stick to it.
Lack of consistency means that shareholders will leave, and as a result the share price is
likely to fall.

ICAEW 2020 Objectives and investment appraisal 125

 Examiner's comments:
This question was generally done very well and had the highest average mark on the paper.
This was a three-part question that tested the candidates' understanding of the investment
decisions and valuations element of the syllabus. In addition it tested candidates' understanding
of IRR and dividend theory.
In the scenario a company was considering whether or not to proceed with the development of
a new range of audio speakers for cars. Part one, for 17 marks was a fairly traditional NPV
calculation and required candidates to deal with lost contribution, inflation, working capital and
capital allowances. Part two, for six marks asked candidates to calculate the IRR of the proposed
investment and explain the usefulness of this figure to the company's directors. In the third part,
also for six marks, candidates had to discuss whether the company should use company funds to
pay a dividend instead of investing in the audio speakers project.
In the first requirement, the majority of candidates scored high marks. The most common errors
were made with regard to the lost contribution and the non-relevance of skilled labour costs.
Also a fair number of candidates were unable to deal correctly with (a) the working capital
requirements and/or (b) the correct discount rate.
Most answers to the second part were disappointing. Too few candidates were able to calculate
the project's IRR correctly, even allowing for errors made in the NPV calculation in part one. Also
it was clear that far too few candidates understood the meaning of the IRR figure and its
usefulness to management.
The third part was answered far better and most candidates demonstrated a good
understanding of the theory underpinning dividend policy and thus scored high marks.

2 Profitis plc (December 2001)

Marking guide

Marks
2.1 Calculations:
Time 0 1
Time 1 1
Time 2 1.5
Time 3 2.5
Time 4 1
PV 2
Equivalent annual cost 3
Conclusion 1
13
2.2 1½ marks per point max 4
17

126 Financial Management: Answer Bank ICAEW 2020

 2.1 Derivation of the equivalent annual cost: Net present value
3 years 4 years
Time PV @ 15% PV @ 15%
£ £ £ £
0 Cost (80,000) (80,000)
Capital allowance (w) 2,448 2,448
(77,552) (77,552) (77,552) (77,552)
1 Capital allowance 2,007 2,007
Maintenance (10,000) (10,000)
(7,993) (6,954) (7,993) (6,954)
2 Capital allowance 1,646 1,646
Maintenance (10,000) (10,000)
Tax on maintenance 1,700 1,700
(6,654) (5,030) (6,654) (5,030)
3 Capital allowance 5,799 1,350
Maintenance – (20,000)
Tax on maintenance 1,700 1,700
Proceeds 10,000 –
17,499 11,514 (16,950) (11,153)
4 Capital allowance – 6,149
Tax on maintenance – 3,400
9,549 5,462
Present value (78,022) (95,227)
Annuity factor 2.283 2.855
Equivalent annual cost £34,175 £33,354

Therefore a four-year life is marginally more economic.

WORKING
Time @ 17%
£ £
0 Cost 80,000
Writing-down allowance (18%) (14,400) 2,448
65,600
1 Writing-down allowance (18%) (11,808) 2,007
53,792
2 Writing-down allowance (18%) (9,683) 1,646
44,109
3 Proceeds (10,000)
34,109 5,799
or

2 Written-down value 44,109

3 Writing-down allowance (18%) (7,940) 1,350
36,169
4 Proceeds Nil
36,169 6,149

2.2 Discussion of other issues

Relevant issues include the following.
(a) The analysis in 2.1 ignores price changes of all descriptions. A change in the price of a
new machine, for example, could easily alter the conclusion. The same would be true
for all of the input factors.

ICAEW 2020 Objectives and investment appraisal 127

 (b) The approach taken assumes that replacement will take place with an identical
machine. The machine may be technologically superseded. The company may
conclude that it no longer has a need for such a machine. In practice it seems unlikely
that many such assets are replaced with identical models on a continuing basis.
(c) The timing of the cash outflows on new machines could be an issue in practice, ie,
making payments every fourth year may cause less of a cash flow problem than every
third year.

3 Horton plc (June 2009)

Marking guide

Marks
3.1 (a) Calculation of capital allowances 3
Calculation of NPV 1
4
(b) Scenario 1 1
Scenario 2 4
Scenario 3 5
Scenario 4 2
12
(c) Characteristics of finance leases 3
Characteristics of operating leases 3
Reasons why leasing might be a preferred source of finance:
1 mark per valid point max 2 8
3.2 (a) Calculations for:
1 year cycle 1
2 year cycle 1
3 year cycle 1
Annual equivalent cost, 0.5 marks per cycle 1.5
Conclusion 0.5
5
(b) 1.5 marks per valid issue discussed max 6
35

3.1 (a) Project 3

Capital Allowances
Cost 3,000,000
20X9 WDA 540,000 @ 17% = 91,800
2,460,000
20Y0 WDA 442,800 @ 17% = 75,276
2,017,200
20Y1 WDA 363,096 @ 17% = 61,726
1,654,104
20Y2 WDA 297,739 @ 17% = 50,616
1,356,365
Proceeds 1,000,000
Bal. All. 356,365 @ 17% = 60,582

128 Financial Management: Answer Bank ICAEW 2020

 Year 0 1 2 3 4
(2,908,200) (1,424,724) 3,811,726 3,800,616 3,810,582
1 0.909 0.826 0.751 0.683
PV (2,908,200) (1,295,074) 3,148,486 2,854,263 2,602,628
NPV £4,402,103
(b) Scenario 1:
With no capital rationing, all projects yielding a positive NPV should be accepted.
Therefore, accept 100% of Projects 1, 3 and 4.
Scenario 2:
With capital rationing of £4.5 million at T0 and divisible projects, the NPV per £
invested needs to be calculated for each project:
Project 1: 2,676,600/2,400,000 = £1.12 (Rank 2)
Project 2: (461,700)/2,250,000 = Negative
Project 3: 4,402,103/3,000,000 = £1.47 (Rank 1)
Project 4: 2,016,250/2,630,000 = £0.77 (Rank 3)
Project 5: (45,250)/3,750,000 = Negative
So with £4.5 million to invest, accept 100% of Project 3 (£3m) and 62.5% of Project 1
(£1.5m).
Scenario 3:
Under this scenario, Project 2 will never be accepted as it yields a negative NPV and
consumes funds in the year of capital rationing. However, Project 4 will always be
accepted as it yields a positive NPV and generates funds in the year of capital
rationing.
Of the remaining projects:
Project 1: 2,676,600/750,000 = £3.57 (Rank 1)
Project 3: 4,402,103/1,500,000 = £2.93 (Rank 2)
Project 5: Negative NPV
However, although Project 5 has a negative NPV of £45,250 it does release £1,050,000
at T1. The question that needs to be asked, therefore, is whether the negative NPV is
outweighed by the return on these released funds if Project 5 is undertaken.
Without Project 5, capital available = £300,000 + £750,000 (from Project 4) which
means Horton can accept 100% of Projects 1 and 4, and 20% of Project 3 to yield an
overall NPV of £5,573,271 (£2,676,600 + £2,016,250 + (0.2  £4,402,103)).
If Project 5 is undertaken, capital available = £300,000 + £750,000 (from Project 4) +
£1,050,000 (from Project 5) which means Horton can accept 100% of Projects 1, 4, 5
and 90% of Project 3 (£1.35m) to yield an overall NPV of £8,609,493. So this latter
solution maximises shareholder wealth.
Scenario 4:
With indivisible projects, the potential portfolios of investments possible with capital of
£5.25 million are as follows: Project 1 or Project 3 or Project 4 or Projects 1 and 4.
The NPVs generated by these four possibilities are:
Project 1: 2,676,600
Project 3: 4,402,103
Project 4: 2,016,250
Projects 1 and 4: 4,692,850

ICAEW 2020 Objectives and investment appraisal 129

 Therefore, the projects that should be undertaken are Projects 1 and 4.
Note: 99.9% of candidates attempting this question proceeded on the basis set out
above, which takes account of the revised NPV for Project 3 calculated in part 3.1(a) –
£4,402,103 – but which retains the original Project 3 cash outlays as (£3m) in T0 and
(£1.5m) in T1, thereby reflecting the practical reality that Horton would have to spend
these sums before receiving the benefit of the capital allowances calculated in part
3.1(a).
However, it should be noted that full credit was given to any candidate who used the
revised Project 3 cash outlays of £2,908,200in T0 and £1,424,724 in T1.
Taking this approach would have the following impact on the calculations:
In Scenario 1, no impact.
In Scenario 2, Project 3 would now yield an NPV per £ invested of £1.51 (still Rank 1)
and 66.3% of Project 1 could now be undertaken (up from 62.5%).
In Scenario 3, Project 3 would now yield an NPV per £ invested of £3.09 (still Rank 2);
without Project 5, 21.1% of Project 3 could now be undertaken (up from 20%); and this
would now yield an overall NPV of £5,621,694; with Project 5, 94.8% of Project 3 could
now be undertaken and this would now yield an overall NPV of £8,820,794.
(c) The differences between finance leases and operating leases can be summarised as
follows:
A finance lease transfers substantially all the risks and rewards of ownership of an asset
to the lessee (ie, the lessor does not retain these risks and rewards). One lease will exist
for the whole or major part of the useful life of the asset – with ownership possibly
passing to the lessee at the end of the term, possibly at a 'bargain price' or a
peppercorn rent is paid during a secondary lease period. The lessor does not usually
deal directly in the type of asset leased. The lease cannot usually be cancelled and if it
is the lessee usually has to pay a penalty that equates to liability for all outstanding
payments due under the lease agreement. The substance of the transaction is the
purchase of the asset by the lessee, financed by a loan from the lessor.
With an operating lease the lease period will be less than the useful life of the asset
and the lessor will depend on the subsequent leasing or eventual sale to cover his
outlay and generate a profit. The lessor may very well carry on a trade in the particular
type of asset leased. The lessor is normally responsible for repairs and maintenance.
The lease can sometimes be cancelled at short notice. The substance of the transaction
is the short-term rental of the asset by the lessee.
The reasons why leasing might be a preferred source of finance are as follows:
(1) Tax: The tax effects of owning an asset compared to using one under a lease are
different and can lead to a preference for leasing as a source of finance.
(2) Capital rationing: Firms, in particular small firms, who may encounter difficulties
raising conventional loan finance, are effectively able to use the asset acquired as
security to overcome such potential funding problems.
(3) Cash flow: Leasing means avoiding the large cash outlay at the outset. Lease
payments will be predictable which aids business planning.
(4) Cost of capital: The implicit cost of borrowing in the lease can be lower than that
in a conventional bank loan.
(5) Flexibility: Examples such as ease of arrangement; lower payments in early stages;
combining other elements into overall package – service, insurance, secondary
lease terms.

130 Financial Management: Answer Bank ICAEW 2020

 3.2 (a) Calculation of NPVs of each potential replacement cycle:
1-year cycle:
(11,000) + {7,000  0.909} + {(6,600)  0.909} = £(10,636)
2-year cycle:
(11,000) + {4,200  0.826} + {(6,600)  0.909} + {(7,600)  0.826} = £(19,808)
3-year cycle:
(11,000) + {1,800  0.751} + {(6,600)  0.909} + {(7,600)  0.826} + {(9,200)  0.751}
= £(28,834)
The annual equivalent costs are:
1-year cycle: (10,636)/0.909 = £(11,701)
2-year cycle: (19,808)/1.736 = £(11,410)
3-year cycle: (28,834)/2.487 = £(11,594)
Therefore the advice to the managing director should be to replace the new company
cars after two years.
(b) Weaknesses of the method:
 The analysis in part 3.1(a) ignores price changes of all descriptions. A change in
the price of a new car, for example, could easily alter the conclusion. The same
would be true for all of the input factors.
 The approach taken assumes that replacement will take place with an identical car.
The car may be replaced with an improved model. Horton may conclude that it no
longer has a need for such a car. In practice it seems unlikely that cars are
replaced with identical models on a continuing basis.
 The timing of the cash outflows on new cars could be an issue in practice, ie,
making payments every fourth year may cause less of a cash flow problem than
every third year.
 The effects of taxation have been ignored in this analysis.

Examiner's comments:
Candidates generally coped well with the calculation of capital allowances in the opening
section of part 3.1 and it was a rare script that failed to pick up full marks (where this did happen,
it was most commonly due only to arithmetical slips of the pen). With the four capital rationing
scenarios most candidates were able to identify the correct projects to pursue in scenario 1.
However, in scenario 2 there were weaker candidates who simply failed to use the ranking
methodology based on NPV per £ invested. Weaker candidates also found scenario 3 rather
challenging, overlooking the need to consider Project 5 in spite of its negative NPV in view of
the cash released in the second period. Most candidates coped well with scenario 4. Most
candidates picked up high marks on the technical knowledge part of the lease discussion, but
scored less strongly on the whole in discussing the relative merits of leasing over outright
purchase. Another notable feature was that some candidates tended to answer the question
with their 'financial reporting' hat on rather than their 'financial management' hat – the
examination is a test of candidates' knowledge of the financial management learning materials.
Most candidates found little to trouble them in the standard replacement analysis question in
part 3.2.

ICAEW 2020 Objectives and investment appraisal 131

4 ProBuild plc (June 2013)
Marking guide

Marks
4.1 Best case scenario:
Plant and equipment 2
Capital allowance 2
Operating cash flow 2
Tax 1
Working capital 2
Discount factor and NPV 2
Worst case scenario:
Capital allowance 2
Operating cash flow 1
Tax 2
NPV 1
17
4.2 Discussion of uncertainty and risk 6

4.3 Discussion of real options 6

29

4.1 Best case scenario

20X3 20X4 20X5 20X6 20X7
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 1,173,000 1,196,460 1,220,389 1,244,797
Tax (17%) (199,410) (203,398) (207,466) (211,615)
Working Capital (W3) (163,200) (3,264) (3,329) (3,396) 173,189
(1,617,300) 1,007,964 1,020,596 1,034,835 1,404,662
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,617,300) 941,136 881,387 818,658 1,018,380
NPV £2,042,260

Worst case scenario

20X3 20X4 20X5 20X6 20X7
Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 499,800 509,796 519,992 530,392
Tax (17%) (84,966) (86,665) (88,399) (90,167)
Working Capital (W3) (97,920) (1,958) (1,998) (2,038) 103,914
(1,552,020) 450,514 451,996 454,863 742,430
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,552,020) 420,645 390,344 359,842 538,262
NPV £157,073

132 Financial Management: Answer Bank ICAEW 2020

 WORKINGS
(1) Capital Allowances (£)
20X3 Cost 1,500,000
WDA 18% 270,000  17% = 45,900
1,230,000
20X4 WDA 18% 221,400  17% = 37,638
1,008,600
20X5 WDA 18% 181,548  17% = 30,863
827,052
20X6 WDA 18% 148,869  17% = 25,308
678,183
20X7 Disposal 100,000
578,183  17% = 98,291

(2) Operating Cash Flows

Best Case Scenario: 2,000,000 – (500,000 + 350,000) = 1,150,000
20X4: 1,173,000 (1,150,000  1.02)
20X5: 1,196,460 (1,150,000  1.022)
20X6: 1,220,389 (1,150,000  1.023)
20X7: 1,244,797 (1,150,000  1.024)

Worst Case Scenario: 1,200,000 – (360,000 + 350,000) = 490,000

20X4: 499,800 (490,000  1.02)
(490,000  1.02 )
2
20X5: 509,796
(490,000  1.02 )
3
20X6: 519,992
(490,000  1.02 )
4
20X7: 530,392
(3) Working Capital
Best Case Scenario:
20X3: (2,000,000  1.02  0.08) = (163,200)
20X4: (2,000,000  1.022  0.08) – 163,200 = (3,264)
20X5: (2,000,000  1.023  0.08) – 166,464 = (3,329)
20X6: (2,000,000  1.024  0.08) – 169,793 = (3,396)
20X7: 173,189

Worst Case Scenario:

20X3: (1,200,000  1.02  0.08) = 97,920
20X4: (1,200,000  1.022  0.08) – 97,920 = (1,958)
20X5: (1,200,000  1.023  0.08) – 99,878 = (1,998)
20X6: (1,200,000  1.024  0.08) – 101,876 = (2,038)
20X7: 103,914
(4) Discount Factor
20X4: 1/(1 + 0.05) (1.02) = 0.9337
2
20X5: 1/(1 + 0.05) (1 + 0.06) (1.02 ) = 0.8636
3
20X6: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07) (1.02 ) = 0.7911
2 4
20X7: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07) (1.02 ) = 0.7250
4.2 Decisions are usually said to be subject to uncertainty if the possible outcomes of a decision
are known but the probabilities attaching to each possible outcome are unknown.
Decisions are usually said to be subject to risk if, although there are several possible
outcomes of a decision, these outcomes as well as the respective probabilities attaching to
each of these possible outcomes are known.

ICAEW 2020 Objectives and investment appraisal 133

 The calculations undertaken in part 4.1 have been made under conditions of uncertainty as
the directors do not have details of the probabilities attaching to the two scenarios. So they
need to establish such probabilities and then calculate expected values for each variable
(the arithmetic mean of possible outcomes weighted by the probability of each outcome).
4.3 The concept of 'real options' relates to the strategic implications attaching to undertaking a
particular project – the value of such 'real options' would not ordinarily be included in a
traditional NPV calculation.
Two obvious 'real options' applicable to Brixham's acquisition of Cabin are as follows:
(1) Follow-on option: For example, the opportunity to add further acquisitions in due
course to gain the benefits of increased economies of scale/market share.
(2) Growth option: For example, the opportunity to broaden the range of services on offer
in due course.

Examiner's comments:
The first question on the paper was a standard investment appraisal question, supplemented by
tests of technical knowledge and its practical application. For the most part, candidates scored
strongly on the first part of the question, the majority clearly being well-drilled in the quantitative
techniques involved in this part of the question. Equally apparent was that the majority of
candidates were ill-equipped in terms of simple technical knowledge to pick up full or even high
marks in the second and third parts of the question, with many scripts scoring zero or at most
very low marks on both parts.
In the first part of the question, probably the most common error was inaccurate calculation of
the inflation-adjusted discount factors. However, there were many instances of full marks.
The second part of the question was a straightforward test of knowledge of elements from the
learning materials, but many candidates were completely unacquainted with them and
consequently there was much waffling and little accuracy and substance to many of the
candidates' responses. In the final part of the question, many candidates were completely
unaware of what a 'real option' was in an investment decision-making context, with many
candidates incorrectly interpreting 'real' as meaning after taking account of the effects of
inflation, thereby betraying their lack of study of the learning materials. The last part of the
question was of a different character to the second part in that it was not merely looking for
technical knowledge, but also the application of that knowledge to the scenario in the question
and weaker candidates too often simply presented theory rather than practical application.

5 Frome Lee Electronics Ltd (September 2008)

Marking guide

Marks
5.1 Net present value 15
5.2 Inflation 4 max 3
5.3 Diana Marshall note 5 max 4
5.4 Real investment options 6 max 4
26

134 Financial Management: Answer Bank ICAEW 2020

 5.1
T0 T1 T2 T3
£'000 £'000 £'000 £'000
Plant (400.000) 60.000
Tax saved (W1) 12.240 10.037 8.230 27.293
Working capital (W2) (32.000) (5.000) (3.000) 40.000
Sales (W2) 320.000 370.000 400.000
Materials (52.000) (64.000) (70.000)
Labour (26.000) (32.000) (35.000)
Other variable costs (12.000) (14.000) (16.000)
Fixed overheads (11.000) (11.800) (12.700)
Tax on profit (W3) (37.230) (42.194) (45.271)
Total Cash Flows (419.760) 186.807 211.236 348.322
Discount factor (W4) 1.000 0.925 0.855 0.783
PV (419.760) 172.796 180.607 272.736
NPV 206.379

Comments:
The NPV is positive and so Frome should proceed with the investment as shareholder value is
enhanced.
WORKINGS
(1)
Cost 400.000 328.000 268.960 220.547
WDA @ 18% (72.000) (59.040) (48.413) (160.547)
WDV 328.000 268.960 220.547 60.000

Tax saved @ 17% 12.240 10.037 8.230 27.293

(2)
Working capital increment 32,000 5,000 3,000 (40,000)
Working capital total 32,000 37,000 40,000
Sales (WC total  10) 320,000 370,000 400,000

(3)
Sales (W2) 320,000 370,000 400,000
Total costs (101,000) (121,800) (133,700)
Taxable profits 219,000 248,200 266,300

Tax payable @ 17% (37,230) (42.194) (45.271)

(4)
Discount factor (1/1.05/1.03) 0.925
(1/1.05/1.03/1.05/1.03) 0.855
(1/1.05/1.03/1.05/1.03/1.05/1.04) 0.783

5.2 Inflation has to be taken properly into account so that the correct NPV is calculated. Inflation
will have a negative effect on the real value of money and an investor will need to be
compensated for that loss of value. As a result it is important to match real cash flows with
real interest/discount rate. This method can be problematic and so it is preferable, if
possible, to match money (nominal) cash flows, ie, actual cash flows, with an inflated
discount rate. This discount rate is calculated as follows: (1 + m) = (1 + r)  (1 + i), where
m = money rate, r = real rate and i = inflation rate.

ICAEW 2020 Objectives and investment appraisal 135

 5.3 The cost of capital is the cost of funds that a company raises and uses, and the return that
investors expect to be paid (commensurate with the risk exposure) for putting funds into the
company and therefore is the minimum return that a company must make on its own
investments, to earn the cash flows out of which investors can be paid their return.
If a company calculates its cost of capital at too high a figure then it is likely to reject
investment opportunities that it should be taking on (ie, would provide a positive NPV).
In contrast if it sets the cost of capital at too low a level then it is likely to take on investment
opportunities that it shouldn't be taking on (ie, those with negative NPVs).
Both of these outcomes would be detrimental to shareholder value.
5.4 Follow-on
Launching the Pink 'Un would give Frome an opportunity to launch further models at a later
date. By investing in this first model, Frome effectively has the right to 'follow-on'. It is a call
option.
Abandonment
Frome has budgeted to sell the capital equipment for £60,000 in September 20Y1. It may
be that the three year project does not go as well as hoped and the company might then
wish to abandon it and sell the assets earlier than anticipated. This would be a put option.
These two real options could be taken account of by Frome's management and would
affect their decision regarding the project, which is otherwise only appraised by calculating
its NPV.

Examiner's comments:
This question scored the highest average mark for the paper and was done very well.
The first part was relatively straightforward and most candidates scored high marks. The main
errors were candidates inflating the cash flows (unnecessarily) or getting the discount factor to t2
and t3 incorrect.
The second part was done reasonably well, but too few candidates were able to adequately
explain the reasons for their approach to inflation.
Most candidates failed to explain the meaning of the cost of capital in part 5.3. Otherwise it was
done well.
Part four was generally done well and those candidates who scored well here explained the real
options in the context of the question.

136 Financial Management: Answer Bank ICAEW 2020

6 Nuts and Bolts Ltd (March 2011)
Marking guide

Marks
6.1 Calculation of expected sales 2.5
Initial investment 1
Tax savings 3
Contribution 1
Fixed costs 1.5
Tax on extra profit 1.5
Working capital 2
Discount factor 1
Optimistic contribution 1
Optimistic tax on extra profit 1.5
Average NPV 1
Conclusion 1

18
6.2 Calculation of money cost of capital 1
Calculation of difference in contribution 2
Calculation of difference in working capital 3
6
24

6.1
Pessimistic Optimistic
Annual Annual
sales (units) p EV sales sales (units) p EV sales
6,000 25% 1,500 10,000 25.0 % 2,500
10,000 50% 5,000 12,800 37.5% 4,800
12,800 25% 3,200 12,800 37.5% 4,800
9,700 12,100

Expected sales 9,700 units Expected sales 12,100 units

EITHER
Pessimistic
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c (W1) 14,688 12,044 9,876 44,992
Contribution (W2) 320,100 320,100 320,100
Fixed costs (W3) (140,000) (140,000) (140,000)
Tax on extra profit (W4) (30,617) (30,617) (30,617)
Working capital (50,000) 50,000
Total cash flows (515,312) 161,527 159,359 244,475
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 146,828 131,631 183,601
NPV (53,252)

ICAEW 2020 Objectives and investment appraisal 137

 Optimistic
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (W5) 399,300 399,300 399,300
Fixed costs (140,000) (140,000) (140,000)
Tax on extra profit (W6) (44,081) (44,081) (44,081)
Working capital (50,000) 50,000
Total cash flows (515,312) 227,263 225,095 310,4211
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 206,582 185,928 232,968
NPV 110,166

 53,252 +110,166
Average NPV = £28,457
2
OR
Overall expected sales = (9,700+12,100)/2=10,900 units
t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (@£33) 359,700 359,700 359,700
Fixed costs (140,000) (140,000) (140,000)
Tax on extra profit (W7) (37,349) (37,349) (37,349)
Working capital (50,000) 50,000
Total cash flows (515,312) 194,395 192,227 277,343
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 176,705 158,780 208,285
NPV 28,458

Positive NPV and shareholder wealth increased; therefore, proceed.

WORKINGS
(1)
t0 t1 t+ t3
£ £ £ £
Cost/WDV 480,000 393,600 322,752 264,657
WDA @ 18% (86,400) (70,848) (58,095) (264,657)
WDV 393,600 322,752 264,657 0
Tax @ 17% 14,688 12,044 9,876 44,992

(2) Annual contribution £33/unit  9,700 units = £320,100

(3) Annual fixed costs £300,000 – £160,000 = £140,000
(4) Annual tax on extra profit (£320,100 – £140,000)  17% = £30,617
(5) Annual contribution £33/unit  12,100 units = £399,300
(6) Annual tax on extra profit (£399,300 – £140,000)  17% = £44,081
(7) Annual tax on extra profit (£359,700 – £140,000)  17% = £37,349

138 Financial Management: Answer Bank ICAEW 2020

 6.2 If inflation is taken into account then money (inflated) cash flows will be matched against
NBL's money cost of capital, which is 15.5% (1.10  1.05).
(1) Contribution – there will be no effect on the NPV of the investment as both the cash
inflows (annual contribution) and the cost of capital will have been inflated by 5% per
annum, which will produce the same present value (allowing for small rounding
differences) in each relevant year.
t1 t2 t3 Total
'Real' cash flow (W2) £320,100 £320,100 £320,100
'Real' discount factor (10%) (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value £291,000 £264,545 £240,496 £796,041

t1 t2 t3 Total
'Money' cash flow (inflated) £336,105 £352,910 £370,556
'Money' discount factor (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value £291,000 £264,545 £240,496 £796,041
NPV difference 0

(2) Working capital – the NPV will be affected by the impact of inflation on the working
capital investment as there will be incremental increases to the working capital in the
three years of the project and there will be an inflated working capital figure at the end
of the project.
t0 t1 t2 t3 Total
'Real' cash flow [see (a)] (50,000) 0 0 50,000 0
'Real' discount
factor (10%) 1.000 (1/1.10) (1/1.102) (1/1.103)
'Real' Present Value (50,000) 0 0 37,566 (12,434)
t0 t1 t2 t3 Total
'Money' cash flow (50,000) (2,500) (2,625) 55,125 0
'Money' discount
factor (15.5%) 1.000 (1/1.155) (1/1.1552) (1/1.1553)
'Money' Present Value (50,000) (2,164) (1,968) 35,777 (18,355)
NPV difference (5,921)

So the total impact of 5% annual inflation on contribution and working capital will be an
NPV figure that is £5,921 lower.

Examiner's comments:
This question had the highest average mark on the paper and most candidates scored high
marks.
This question tested the investment decisions element of the syllabus. The scenario was that of a
manufacturer wishing to introduce a new product to the market and therefore needing to make
a major capital investment.
In the first part, for 18 marks candidates were presented with a lot of information, as in a typical
NPV setting, and were required to calculate the NPV of the proposal. The question was unusual
in that candidates had to calculate the level of customer demand by using expected values. In
addition, this demand was constrained by the fact that the new equipment had a maximum level
of output. Despite this intricacy, candidates could secure a good mark here if they followed the
key elements of an NPV calculation. In the second part, for six marks required candidates to
explain the implications for their NPV calculation in the first part if the contribution and working
capital figures were adjusted to take account of a 5% annual inflation rate.

ICAEW 2020 Objectives and investment appraisal 139

 In the first part most errors related to the expected values calculation with only a small minority
of candidates getting it right. Many candidates ignored the production constraint completely.
Despite these errors the majority of candidates scored high marks.
In the second part, the contribution figure was generally inflated accurately, but too many
candidates only adjusted the final working capital figure, without taking account of the
incremental annual changes. Also, too many candidates failed to make use of a money (inflated)
discount rate, which suggests a real lack of understanding of the impact of inflation on cash
flows.

7 Newmarket plc (Sample paper)

Marking guide

Marks
7.1 Discount factor 1
Equipment cost 1
Incremental unit costs 2
Incremental salary 1
Market research fee 1
Tax 2
Writing down allowance 2
Sale proceeds 1
Price calculation – revenue 1
Price calculation – tax on revenue 1
Price calculation – equation 1
Price calculation – selling price 1
15
7.2 1 mark per point max 6
7.3 1 mark per point max 6
7.4 Existence of real options 1
Follow on options 2
Abandonment options 2
Timing option 2
Growth option 2
max 8
35

140 Financial Management: Answer Bank ICAEW 2020

 7.1 The schedule of relevant cash-flows and present values (in £) would be as follows:
Year Item CF 10% df PV
0 Equipment purchase (750,000) 1.000 (750,000)
1–5 Incremental unit costs (W1) (170,000) 3.791 (644,470)
1–5 Tax re: unit costs 28,900 3.791 109,560
1–5 Incremental salary (35,000) 3.791 (132,685)
1–5 Tax re: incremental salary 5,950 3.791 22,556
1 Market research fee (10,000) 0.909 (9,090)
1 Tax re: market research fee 1,700 0.909 1,545
0 WDA (W2) 22,950 1.000 22,950
1 WDA 18,819 0.909 17,106
2 WDA 15,432 0.826 12,747
3 WDA 12,654 0.751 9,503
4 WDA 10,376 0.683 7,087
5 WDA 38,769 0.621 24,076
5 Sale proceeds 50,000 0.621 31,050
(1,278,065)

Alternative presentation (also in £)

0 1 2 3 4 5
Cost (750,000) 50,000
Fee (10,000)
Inc. Costs (170,000) (170,000) (170,000) (170,000) (170,000)
Salary (35,000) (35,000) (35,000) (35,000) (35,000)
Tax 36,550 34,850 34,850 34,850 34,850
WDA 22,950 18,819 15,432 12,654 10,376 38,769
Net (727,050) (159,631) (154,718) (157,496) (159,774) (81,381)
10% 1 0.909 0.826 0.751 0.683 0.621
PV (727,050) (145,105) (127,797) (118,279) (109,126) (50,538)

Total PV = (1,277,895) difference due to rounding discount factors.

If we set price equal to P:

1–5 Revenue 2,000P 3.791 7,582P
1–5 Tax re: revenue (340)P 3.791 (1,289)P
6,293P
Therefore: 6,293P – 1,278,065 = 300,000
6,293P = 1,578,065
P = £250.77
To the nearest £, Newmarket would need to charge a minimum unit price of £251.
WORKINGS
(1) Incremental unit costs
Incremental unit cost: £
Labour (4 hours @ £12 per hour) 48.00 incremental
Components 32.00 incremental
Loan interest 0.00 dealt with via df
Depreciation 0.00 not a cash-flow
Energy costs 5.00 incremental
Share of Newmarket's fixed costs 0.00 not incremental
85.00
£85.00  2,000 = £170,000

ICAEW 2020 Objectives and investment appraisal 141

 (2) Writing Down Allowances
Tax effect @
Year end 17% Year
£ £
30 June 20X2 Purchase 750,000
WDA @ 18% (135,000) 22,950 0
615,000
30 June 20X3 WDA @ 18% (110,700) 18,819 1
504,300
30 June 20X4 WDA @ 18% (90,774) 15,432 2
413,526
30 June 20X5 WDA @ 18% (74,435) 12,654 3
339,091
30 June 20X6 WDA @ 18% (61,036) 10,376 4
278,055
30 June 20X7 Sale proceeds 50,000
Balancing allowance 228,055 38,769 5
7.2 1 Sensitivity analysis:
 A way of incorporating alternative forecasts into project evaluation
 Involves taking each uncertain forecast and calculating the change in the variable
necessary for the NPV of the project to fall to zero
 Formula: Sensitivity = NPV of project/PV of cash-flows subject to uncertainty  100
2 Simulation (scenario analysis):
 Allows the effect of more than one variable changing simultaneously to be
assessed
 Monte Carlo simulation, for example, makes use of random numbers and
probability statistics to evaluate projects armed with a more detailed insight into
the nature of risks and returns
(Reference to expected values would also be rewarded with up to three marks.)
7.3 Systematic risk:
Also known as market risk.
It is that element of risk which cannot be eliminated by diversification.
It affects all markets within the economy systematically.
Examples in this (or any such scenario) would be changes in macroeconomic variables, for
example, changes in interest rates, inflation rates, capital allowances or other tax rate
changes.
Non-systematic (unsystematic) risk:
Also known as unique or specific risk.
It is that element of risk that can be eliminated by diversification.
It is related to factors that affect the return on individual investments in unique ways.
Examples in this scenario would be a decrease in demand for the product below
projections, unexpected actions of competitors or an increase in component costs.

142 Financial Management: Answer Bank ICAEW 2020

 7.4 NPV only considers the cash flows associated with the NL500 project. It is possible that the
project is worth more than the target NPV of £300,000 because of the existence of real
options associated with the project.
Follow on options
Launching the NL500 gives an opportunity to launch a second (and third and so on) version
of the lawnmower that could be very profitable (or not). The right to invest in later versions
is a call option.
Abandonment option
If the NL500 is a failure then management can terminate the project early and sell the
equipment, giving them a put option.
Timing option
It may be possible to delay the introduction of the NL500, particularly if the demand
estimates are uncertain, effectively a call option. The longer the possible delay the more
valuable the option. Newmarket would need to protect its position, eg, from a competitor
establishing a strong market position, by using patents.
Growth option
If the NL500 is more successful than envisaged, Newmarket have the (call) option to expand
production facilities ie, the opposite of the abandonment option.

Examiner's comments:
Rather surprisingly, this was the lowest scoring question on the paper, which is not something
we normally associate with the investment appraisal question, albeit on a paper with a relatively
high pass rate of 88%. The final stage of the first part of the question proved beyond many
candidates, who up until that point had generally coped well with the standard demands of the
question. Parts two and three proved relatively straightforward for well-prepared candidates,
but the failure of many weak candidates to complement their learning of technique with the
acquisition of basic knowledge led to many of them often sacrificing all 12 of the marks available
on these parts of the question.
Overall, the performance in the first part of the question was strong, although where errors were
made the most common ones related to the inclusion and timing of the fee payment, the
inclusion of irrelevant costs and an inability to use the net present value calculation to accurately
address the final stage of the question.
For the most part, well-prepared candidates scored full marks in the second part, but there were
still a surprising number of scripts that missed the opportunity to score strongly, often veering off
course into other areas of the syllabus, notably derivatives, which were not relevant to the precise
requirements of the question.
Although the third part covers an element of the syllabus that is tested relatively infrequently, the
majority of candidates coped well with it, although there were still a significant number of
weaker scripts that displayed a complete misunderstanding of the terms and that were,
consequently, unable to apply them meaningfully to the scenario in the question.

ICAEW 2020 Objectives and investment appraisal 143

8 Grimpen McColl International Ltd (September 2012)
Marking guide

Marks
8.1 Equipment cost and residual value 0.5
Tax saving 2
Income 0.5
Materials and labour 1
Overheads 2
Lost contribution 1
Tax on extra profit 2
Working capital 2
Discount factor 1
Conclusion 1
13
8.2 Calculation of decrease 2
Minimum value of second instalment 1
3
8.3 1 mark per point max 5

8.4 Annual surplus from year 4 1

Tax 1
Perpetuity factor 1
Discount to PV 1
4
8.5 1 mark per point max 5
30

8.1
20X2 20X3 20X4 20X5
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Machinery (30,000) 5,000
Tax saving (W1) 918 753 617 1,962
Income 10,000 85,000
Materials and labour (W2) (7,280) (8,653) (10,124)
Overheads (W3) (2,600) (3,245) (3,937)
Lost contribution (W4) (4,200) (4,410) (4,631)
Tax on extra profit (W5) (1,700) 2,394 2,772 (11,272)
Working capital (W6) (5,000) (1,240) (1,331) 7,571
Total Cash Flows (25,782) (12,173) (14,250) 69,569
8% factor 1.000 0.926 0.857 0.794
PV (25,782) (11,272) (12,212) 55,238
NPV 5,972

As the NPV is positive GMI should proceed with the investment as this will enhance
shareholder wealth.

144 Financial Management: Answer Bank ICAEW 2020

 WORKINGS
(1)
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Cost of machinery 30,000 24,600 20,172 16,541
WDA @ 18% (5,400) (4,428) (3,631) (11,541)
WDV/sale 24,600 20,172 16,541 5,000
Tax saving @ 17% 918 753 617 1,962

(2)
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Materials and labour (7,000) (8,000) (9,000)
Inflation @ 4% pa  1.04  1.042  1.043
(7,280) (8,653) (10,124)

(3)
Overheads (excluding Head office costs) (2,500) (3,000) (3,500)
Inflation @ 4% pa  1.04  1.042  1.043
(2,600) (3,245) (3,937)

(4)
£'000 £'000 £'000
Lost contribution (4,000) (4,000) (4,000)
Inflation @ 5% pa  1.05  1.052  1.053
(4,200) (4,410) (4,631)

(5)
Income 10,000 85,000
Materials and labour (7,280) (8,653) (10,124)
Overheads (2,600) (3,245) (3,937)
Lost contribution (4,200) (4,410) (4,631)
Profit/(loss) 10,000 (14,080) (16,308) 66,308
Tax @ 17% on profit/(loss) (1,700) 2,394 2,772 (11,272)

(6)
Year 0 Year 1 Year 2 Year 3
£'000 £'000 £'000 £'000
Total investment (money terms) 5,000
£6,000  1.04 (year 1) 6,240
£7,000  1.04 (year 2)
2 7,571 0
(Increase)/decrease in WC (5,000) (1,240) (1,331) 7,571

8.2 For NPV to fall to zero then the second instalment will need to fall by:
£
£5,972,000/0.794/0.83 = (9,061,940)
Estimated second instalment = 85,000,000
Minimum value of the second instalment 75,938,060

8.3 GMI's money cost of capital already takes into account GMI's estimated inflation rate. So if
the cash flows are inflated at the same rate then the correct NPV will be calculated.
If the South American inflation rates are higher than predicted then inflate further the
money cost of capital and the estimated cash flows. NPV will not be affected.
However, for the WDA, equipment resale and the second instalment, the NPV will fall as the
money discount rate rises. These are in money terms already.

ICAEW 2020 Objectives and investment appraisal 145

 8.4
£'000
Annual income from 20X6 (Year 4) 5,000
Annual costs from 20X6 (3,000)
Annual surplus from 20X6 2,000
Less tax @ 17% (340)
1,660
Perpetuity factor (1.08/1.03) 4.85%
PV of future cash flows at Year 3 [end 20X5] (£1,660/4.85%) 34,227
Discount to PV (from Year 3 [end 20X5])  0.794
PV of future cash flows (minimum selling price of the maintenance contract) 27,176

8.5 Political risk is the risk that political action will affect the position and value of a company.
Candidates' discussion should be based on the following possible risks:
 Quotas/tariffs/barriers imposed by the overseas government
 Nationalisation of assets by the overseas government
 Stability of the overseas government
 Political and business ethics
 Economic stability/inflation
 Remittance restrictions
 Special taxes
 Regulations on overseas investors

Examiner's comments:
This question was a good discriminator between those students who have learned the
calculations and underlying theory by rote and those who really understand the topic.
In general, in the first part, a fairly standard NPV calculation, most candidates scored high marks.
The most common errors were made with regard to working capital investment and the
corporation tax flows.
The second part was done reasonably, but a surprising number of candidates forgot to take
taxation into account in their calculations.
The discursive nature of the third part caught out many candidates – they failed to adequately
explain the impact of using an erroneous inflation rate and therefore to demonstrate that they
fully understood this part of the syllabus. A common error made by candidates was to forget that
revenue from the project was fixed.
The final part was done poorly and too few candidates were able to adequately deal with the
discounting techniques required.

146 Financial Management: Answer Bank ICAEW 2020

9 Wicklow plc (December 2008)
Marking guide

Marks
9.1 Capital allowances 3
Revenue 3
Material costs 2
Lost contribution 3
Labour 2
Working capital 4
Tax 1
NPV calculation 1
max 18

9.2 Calculation of selling price sensitivity 4

Calculation of cost of equity sensitivity 3
7
9.3 PV of tax shield 2
APV calculation 2
4
9.4 2 marks per valid point
max 6
35

9.1
20X8 20X9 20Y0 20Y1 20Y2
Investment (2,000,000) 200,000
Capital allowances (W1) 61,200 50,184 41,151 33,744 119,721
DH revenue (W2) 11,725,000 14,147,000 15,561,000 15,561,000
DH material costs (W3) (6,365,000) (7,679,800) (8,447,400) (8,447,400)
Duo lost contribution
(W4) (2,500,592) (3,016,824) (3,318,208) (3,318,208)
Additional labour (W5) (167,500) (202,100) (222,300) (222,300)
New manager 35,000 (40,000) (40,000) (40,000) (60,000)
Working capital (W6) (941,700) (194,625) (113,625) 1,249,950
Taxation (17%) (5,950) (450,824) (545,407) (600,626) (597,226)
NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537
df (8%) 1 0.926 0.857 0.794 0.735
DCF (2,851,450) 1,904,451 2,219,969 2,355,171 3,296,870

NPV £6,925,011
The recommendation to the directors should, therefore, be to proceed with the 'Heritage'
version of the Duo cooker.

ICAEW 2020 Objectives and investment appraisal 147

 WORKINGS
(1) Capital Allowances
£ £
20X8
Cost 2,000,000
WDA (18%) 360,000  17% = 61,200
20X9 1,640,000
WDA (18%) 295,200
20Y0 1,344,800  17% = 50,184
WDA (18%) 242,064
20Y1 1,102,736  17% = 41,151
WDA (18%) 198,492
20Y2 904,244  17% = 33,744
Proceeds 200,000
Bal. Allowance  17% = 119,721
704,244

(2) DH Revenue
20X9: 1,500 (0.65) + 2,000 (0.35) = 1,675  £7,000 = £11,725,000
20Y0: 1,800 (0.65  0.7) + 2,000 (0.65  0.3) + 2,200 (0.35  0.6) + 2,500 (0.35  0.4) =
2,021  £7,000 = £14,147,000
20Y1 and 20Y2: 110%  2,021 = 2,223  £7,000 = £15,561,000 p.a.
(3) DH Material Costs
Unit sales  £3,800
20X9: 1,675 units = £6,365,000
20Y0: 2,021 units = £7,679,800
20Y1 and 20Y2: 2,223 units = £8,447,400 p.a.
(4) Duo Lost Contribution
The effective lost contribution on each Duo = £6,500 – £3,516 = £2,984 as the labour
cost and fixed overheads will still be incurred.
20X9: 838  £2,984 = £2,500,592
20Y0: 1,011  £2,984 = £3,016,824
20Y1 and 20Y2: 1,112  £2,984 = £3,318,208 p.a.
(5) Additional Labour Costs
The standard Duo product will simply provide half of the labour required to
manufacture the 'Heritage' version of the product.
20X9: 1,675 units  8 = 13,400/2 = 6,700  £25 = £167,500
20Y0: 2,021 units  8 = 16,168/2 = 8,084  £25 = £202,100
20Y1 and 20Y2: 2,223 units  8 = 17,784/2 = 8,892  £25 = £222,300 p.a.
(6) Working Capital
Next year's
sales value 15%
DH:
20X8 11,725,000 (1,758,750)
20X9 14,147,000 (2,122,050)
20Y0 15,561,000 (2,334,150)
20Y1 15,561,000 (2,334,150)
20Y2 0 0

148 Financial Management: Answer Bank ICAEW 2020

 Next year's
sales value 15%
Duo:
20X8 (5,447,000) 817,050
20X9 (6,571,500) 985,725
20Y0 (7,228,000) 1,084,200
20Y1 (7,228,000) 1,084,200
20Y2 0 0
Net effect:
20X8 (941,700)
20X9 (194,625)
20Y0 (113,625)
20Y1 0
20Y2 1,249,950

9.2 (a) To calculate the sensitivity of changes in sales price, it is assumed sales quantity is fixed
and then the relevant cash flows from part 9.1 are considered.
20X9 20Y0 20Y1 20Y2
DH revenue 11,725,000 14,147,000 15,561,000 15,561,000
Tax on revenue (1,993,250) (2,404,990) (2,645,370) (2,645,370)
Cash flow 9,731,750 11,742,010 12,915,630 12,915,630
df (8%) 0.926 0.857 0.794 0.735
Present value 9,011,601 10,062,903 10,255,010 9,492,988

Total present value = £38,822,502

Sensitivity = 6,925,011/38,822,502= 17.8%
This means selling price can fall by 17.8% to £5,754 before the decision to invest would
change.
(b) To calculate the sensitivity to the cost of equity, an IRR is required, using the net cash
flows from part 9.1.
NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537
df (15%) 1 0.870 0.756 0.658 0.572
DCF (2,851,450) 1,789,279 1,958,339 1,951,766 2,565,727

NPV = £5,413,661
IRR for this project = 8 + (6,925,011/(6,925,011 – 5,413,661))(15 – 8) = 40.1%
The cost of equity would need to increase to 40.1% (an increase of almost 400% from
its current level) before the investment decision would change.
9.3 The NPV calculated in 10.1 at £6,925,011 is for an ungeared firm.
The PV of the tax shield (interest = £2m  0.05 = £0.1m) is calculated as follows:
Time £ per annum df @ 5% PV (£)
1–4 0.1m  0.17 = 0.017m 3.546 60,282
Therefore the adjusted present value = £6,925,011 + £60,282 = £6,985,293.
9.4 The APV technique is based upon the assumptions of Modigliani and Miller with tax.
That means that issues which may affect the attractiveness of debt finance are not reflected
in the technique:
 Direct and indirect costs of bankruptcy
 Agency costs and covenants
 Tax exhaustion
 Perfect market assumptions eg, risk-free debt

ICAEW 2020 Objectives and investment appraisal 149

 To the extent that any of these assumptions do not hold true, the APV methodology will not
take account of all the potential implications of increased debt within a firm's capital
structure.
There is also a question mark over the appropriate rate at which to discount the tax shield.

Examiner's comments:
Most candidates found the first part of the question to their liking. The initial calculation of
expected values proved largely unproblematic, but common errors among weaker candidates
were incorrect calculation of the lost contribution from the existing product and an inability to
calculate accurately the net working capital impact of the project. In this latter regard, a surprising
number of candidates correctly calculated the impact of the new product, but then failed to
deduct the off-setting impact of the existing product. It was also apparent that a significant number
of candidates appear to believe that it is an effective time-saving tactic not to bother with the
calculation of discount factors and/or the actual discounting of cash flows and simply to say that if
the resultant NPV was positive their recommendation would be to accept the project (or vice
versa). Given that marks were explicitly available for both the discount factors and the discounting
process itself, this was a potentially costly omission.
Section 3 and 4, proved to be effective discriminators between stronger and weaker candidates.
Many weaker candidates were unable to make any meaningful attempt, some simply believing
that what was required was to discount the net cash flows calculated in the first section at a
discount factor of 5%. Common errors among candidates who were able to adopt the correct
approach were to use an incorrect annuity factor in the calculation or to use the post-tax cost of
debt, but for well prepared candidates this proved to be easy marks.
Section 4 polarised performance, although unlike in the third section it was the majority rather
than the minority of candidates who struggled. The question required candidates to think
laterally across the syllabus to establish the link to underlying theory. However, many candidates
resorted simply to listing all they knew about the limitations of issues such as WACC and CAPM.
Performance overall was relatively strong on this question with the majority of candidates
scoring well in the first section, although the adjusted present value sections of the question
served to polarise performance.

10 Daniels Ltd (March 2007)

Marking guide

Marks
10.1 (a) Reasoning: 1 Figures: 1 2
(b) Method and figures: 2 Ranking: 1 3
(c) Method: 1 Calculations: 2 Conclusions and reasoning: 2 5
10
10.2 Reasoning: 2 Conclusion: 1 NPV: 1 4
10.3 Calculations: 4 Limitations: 2 6
10.4 PV calculations: 3 Conclusion and reasoning: 2 5
25

150 Financial Management: Answer Bank ICAEW 2020

 10.1 (a) No capital rationing, so choose all projects with a positive NPV, ie:
NPV
£'000
Bristol 577
Swansea 2,856
Tiverton 1,664
Total 5,097

(b) Capital rationing of £8 million on 31/5/X7 (t0). Rank according to NPV/£ invested:
Bristol Cardiff Gloucester Swansea Tiverton
£'000 £'000 £'000 £'000 £'000
NPV (£'000) 577 (1,309) (632) 2,856 1,664
Investment t0 4,150 3,870 6,400 5,000 4,600
NPV/£ 0.139 n/a n/a 0.571 0.362
Rank 3 1 2

Therefore choose all of Swansea (£5m investment) and 65.2% (£3,000/£4,600) of

Tiverton:
NPV
£'000
Swansea (100%) 2,856
Tiverton (65.2%) 1,085
Total 3,941

(c) No capital rationing at t0 but only £500,000 available at t1:

Bristol Positive NPV and negative funds in t1 So consider further
Cardiff Negative NPV and negative funds in t1 So ignore
Gloucester Negative NPV and positive funds in t1 So consider further
Swansea Positive NPV and negative funds in t1 So consider further
Tiverton Positive NPV and positive funds in t1 So accept unconditionally

If Gloucester is ignored, because it has a negative NPV, then there is £1,790,000

(£500,000 + 1,290,000 [Tiverton]) available at t1.
Thus choose Swansea (higher ranking than Bristol) and do 68.6% (£1,790/£2,610) of it.
Thus the total NPV would be:
£'000
Tiverton 1,664
Swansea (68.6%  £2,856,000) 1,959
3,623

Alternatively, if Gloucester is considered and its positive t1 cash flow utilised then there is
£3,560,000 capital available (£1,790,000 + £1,770,000) at t1.
Based on the same ranking, for t1 choose 100% Swansea and use the balance (£950,000) to
fund Bristol, ie, (higher ranking than Bristol) and do 73.6% (£950/£1,290) of it. Thus the total
NPV would be:
£'000
Tiverton 1,664
Swansea (100%) 2,856
Bristol (73.6%  £577,000) 425
Gloucester (632)
4,313

Thus it is preferable if the Gloucester project is taken on as this produces the higher total
NPV.

ICAEW 2020 Objectives and investment appraisal 151

 10.2 Capital rationing of £9 million in t0, but projects not divisible:
Only choose the projects with positive NPVs, ie, Bristol, Swansea or Tiverton. The highest
NPV is generated from Swansea (and is higher than Bristol and Tiverton added together).
Thus the NPV would be £2,856,000.
10.3
PV PV Eq. Ann
factor PV factor Cost
£ £ £ £
Replace vans after
one year
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300)
Resale value 9,800
5,500 0.909 5,000
(7,400) 0.909 (8,140)
Replace vans after
two years
t0 Cost of van 1.000 (12,400)
(12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
t2 Maintenance costs (4,800)
Resale value 7,000
2,200 0.826 1,818
(14,491) 1.735 (8,352)
Replace vans after
three years
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
t2 Maintenance costs (4,800) 0.826 (3,965)
t3 Maintenance costs (5,100)
Resale value 5,000
(100) 0.751 (75)
(20,349) 2.486 (8,185)
Thus the cheapest option for Daniels is to replace the vans every year as this produces the
lowest Equivalent Annual Cost (EAC). However it should be noted that this is by no means a
clear decision, as a three-year cycle produces only a slightly higher EAC.
Limitations
 Changing technology, leading to obsolescence, changes in design
 Inflation – affecting estimates and the replacement cycles
 How far ahead can estimates be made and with what certainty?
Note: A further limitation is the ignoring of taxation, which the candidates were told to do.
10.4 The PV of the two investments should be considered:
Original situation Proposed change
Cash 10% Cash 10%
Flow factor PV Flow factor PV
Year 1–7 190,000 4.868 925,000 Year 1 925,000 0.909 840,825
The NPV is higher if Daniels maintains the current cash flow profile and so is better off not
accepting Kithill's proposal. The IRR might be higher by accepting, but the NPV is the key
measure and should be followed.

152 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This question was based on (a) investment appraisal with capital rationing and (b) replacement
analysis. Both of these elements, whilst comprehensive and technical, were straightforward and
most candidates did well. In addition there was a small final part to the question which required
candidates to compare, in effect, net present value and internal rate of return.
As expected most candidates scored full marks for part (a) of the first requirement.
Part (b) of the first requirement was also done well, and most candidates demonstrated how to
rank the projects on the basis of NPV/£ invested.
Part (c) of the first requirement was answered satisfactorily and a good number of scripts
demonstrated how to deal with capital rationing in the second year of the projects.
The second part was answered well, and most students were able to make the right decision.
The third part was also answered well and a good number of students scored full marks for it.
In the final part of the question a majority of candidates gave the correct advice, although few
were able to produce the exact relevant cash flow.

11 Hawke Appliances Ltd (September 2014)

Marking guide

Marks

11.1 (a) New machine 1

Tax relief 2 16
Old machine 0.5 16
Tax due 1 16
Sales, materials, unskilled labour, lost contribution 5.5 16
Tax on extra profits 1 16
Working capital 2 16
Discount factor 0.5 16
NPV 0.5 16
Advise to proceed as NPV is positive 1 16
State market research fee is not a relevant cash flow as it is sunk 1 16
16
(b) Sensitivity of sales price 3
Sensitivity of sales volume 4 7
7
11.2 Asset value 1
P/E with current earnings 1
P/E with one year of growth 1
Future cash flows/earnings 2
Dividend valuation 1
Reasons why acquisitions do not benefit bidding firm 4
Compare cash and shares 4
Max 12
35

ICAEW 2020 Objectives and investment appraisal 153

 11.1 (a)
Y0 Y1 Y2 Y3
£'000 £'000 £'000 £'000
New machine (4,500.000) 1,000.000
Tax relief (W1) 137.700 112.914 92.589 251.797
Old machine 220.000
Tax due (W2) (23.800)
Sales (W3) 8,060.000 15,926.560 7,845.926
Materials (W4) (2,756.000) (5,445.856) (2,682.801)
Unskilled labour (W5) (1,456.000) (2,877.056) (1,417.329)
Lost contribution (W6) (2,288.000) (4,521.088) (2,227.231)
Tax on extra profits (W7) (265.200) (524.035) (258.156)
Working capital (W8) (806.000) (786.656) 808.063 784.593
Total cash flows (4,972.1) 621.058 3,459.177 3,296.799
12% discount factor 1.000 0.893 0.797 0.712
PV (4,972.1) 554.605 2,756.964 2,347.321
NPV 686.790

The NPV is positive and so the investment should go ahead as it will enhance
shareholder wealth.
The market research fee is not a relevant cash flow as it is sunk/committed (candidates
needed to state this to get the mark and not just ignore).
(1)
£'000 £'000 £'000 £'000
Cost/WDV 4,500.000 3,690.000 3,025.800 2,481.156
WDA @ 18%/Bal. allowance (810.000) (664.200) (544.644) (1,481.156)
WDV/sale 3,690.000 3,025.800 2,481.156 1,000.000

Tax on WDA @ 17% 137.700 112.914 92.589 251.797

(2)
WDV b/f 80.000
Balancing charge 140.000
Sale proceeds 220.000
Tax due on bal. charge @ 17% (23.800)
(3)
Sales units 50,000 95,000 45,000
Selling price/unit £155  1.04 £155  1.042 £155  1.043
Sales 8,060.000 15,926.560 7,845.926

(4)
Sales units 50,000 95,000 45,000
Material cost/unit £53  1.04 £53  1.042 £53  1.043
Materials 2,756.000 5,445.856 2,682.801

(5)
Sales units 50,000 95,000 45,000
Unskilled cost/unit £28  1.04 £28  1.042 £28  1.043
Unskilled costs 1,456.000 2,877.056 1,417.329

(6)
Sales units 50,000 95,000 45,000
Lost contribution/unit ([£96 – £74]  2) £44  1.04 £44  1.042 £44  1.043
Variable costs 2,288.000 4,521.088 2,227.231

154 Financial Management: Answer Bank ICAEW 2020

 (7)
Extra profit (sales less materials, 1,560.000 3,082.560 1,518.565
unskilled labour, lost contribution)
Tax at 17% 265.200 524.035 258.156

(8)
Sales 8,060.000 15,926.560 7,845.926
Sales increment 8,060.000 7,866.560 (8,080.634)
Working capital at 10% (806.000) (786.656) 808.063 784.593

(b)
Sales 8,060.000 15,926.560 7,845.926
Discount rate at 12%  0.893  0.797  0.712
PV of sales 7,197.580 12,693.468 5,586.299
Total PV of sales 25,477.347
less: Tax at 17% (4,331.149)
21,146.198

Sensitivity of sales price 686.79

21,146.198

= 3.25%

Sensitivity of sales volume

Contribution (£30  50  1.04) £1,560.000
Contribution (£30  95  1.04  1.04) £3,082.560
Contribution (£30  45  1.04  1.04  1.04) £1,518.565
Discount rate at 12%  0.893  0.797  0.712
PV of contribution 1,393.080 2,456.800 1,081.218
Total PV of contribution 4,931.098
less: Tax at 17% (838.287)
4,092.811
Sensitivity of sales volume 686.79
4,092.811
= 16.8%

11.2 (a) Possible values for Durram

Asset value (book value) = £3.6m
P/E – with current earnings – 11  £0.7m = £7.7m
P/E – with one year of growth – 11  (£0.7m  1.05) = £8.1m
Future cash flows/earnings (12% discount rate) for PV of future cash flows
(£0.7m  1.05)/(12% – 5%) = £10.5m
Dividend valuation (no growth) – £0.7m/12% = £5.8m
(b) Reasons why acquisitions do not benefit the bidding firm
The price paid is too high and synergies go to the target shareholders.
Lack of fit within the existing group of companies, so cost savings and synergies are not
as great as forecast.
Transaction costs – underwriting, legal fees etc – are expensive and reduce any gains
made.
Talented staff in the target company may leave.
The takeover/merger may be because of management hubris rather than an increase
in shareholder value.
The subsidiary is too small and does not warrant the management time required.

ICAEW 2020 Objectives and investment appraisal 155

 Conglomerate discount may exist, ie, the individual parts of the business are worth
more than the group as a whole.
(c) Is it better to pay with cash or shares?
Paying in cash
This is more attractive to the target shareholders as the value is certain, but there may
be personal tax implications.
This may cause liquidity problems for the bidding firm and so it may be necessary to
increase its gearing.
Lower transaction costs will arise with a cash purchase.
Paying with shares
There will be a dilution of ownership and any gains made will now be shared with the
target shareholders.

Examiner's comments:
This question had the highest average mark on the paper. Candidate performance was very
good.
This was a four-part question that tested the candidates' understanding of the investment
decisions and valuation element of the syllabus.
In the scenario a UK manufacturer of household appliances was planning (1) the development of
a new product and (2) the possible purchase of an electrical goods retailer. Part (a) of the first
requirement, for 16 marks, required candidates to advise the company's board, based on an
NPV calculation, whether the proposed product manufacture should proceed. Candidates were
required to deal with relevant cash flows, tax allowances and costs, inflation and working capital.
In part 1(b) of the first requirement, for seven marks, they had to calculate the sensitivity of their
calculations to changes in the proposed selling price and estimated sales volumes. The second
part was worth 12 marks and required candidates to calculate a range of values for the target
retailer and then provide guidance for the board on the inherent dangers of buying another
company and the best method with which to pay for it, ie, cash or shares.
In part (a) of requirement 1 most candidates scored well. The main weakness evident was the
opportunity cost calculation, which was either completely ignored (by the weakest candidates)
or halved instead of doubling the lost volume. Also many candidates included calculations
regarding skilled labour, which was not a relevant cost. A number of candidates failed to
calculate the balancing charge arising on the sale of the old machinery.
Part (b) of requirement 1 was generally done well, but a disappointing number of candidates
used contribution rather than sales revenue in their first set of sensitivity calculations.
In the second requirement candidates coped well, as expected, with the book value and P/E
methods of valuation, but many were unsure of themselves (as in previous papers) when valuing
the company based on discounted cash flows. A high proportion of candidates struggled with
the reasons for the failure of acquisitions, but in general the cohort was stronger when
explaining the implications of buying in cash or shares.

156 Financial Management: Answer Bank ICAEW 2020

12 Alliance plc (December 2015)
Marking guide

Marks
12.1 Calculation of net present value:
Contribution per unit 1
Annual sales units 1
Total contribution per year, Year 1 to Year 4 2
Fixed costs 1
Annual rent 1
Machinery and equipment 1
Tax 1
Tax saved on capital allowances 2
Working capital flows 3
Use of correct discount rate 1
NPV and conclusion 2
16
12.2 Correct contribution figure, after tax 2
Calculation of NPV 1
Correct sensitivity 0.5
Conclusion 1.5
max 4
12.3 Disadvantages of sensitivity analysis – 1 mark per point 3
Advantages of simulation as a technique – 1 mark per point 3
6
12.4 (a) Explanation of hard capital rationing 1
Explanation of soft capital rationing 2
Form that is being adopted by Alliance 1
Use of evidence from the scenario 1
5
(b) Allocation to combination that yields the highest NPV 1
Determination of best combination 2
Conclusion 1
4
35

12.1
0 1 2 3 4
£m £m £m £m £m
Contribution 34.56 41.73 39.44 37.27

Fixed costs (4.00) (4.12) (4.24) (4.37)

Annual Rent (1.50) (1.50) (1.50) (1.50)
Operating cash flows (1.50) 29.06 36.11 33.70 32.90

Tax 17% 0.26 (4.94) (6.14) (5.73) (5.59)

Machinery and equipment (60.00) 5.00

Tax saved on CA's 1.84 1.51 1.23 1.01 3.76
Working capital (2.00) (0.42) 0.13 0.13 2.16
Net cash flows (61.40) 25.21 31.33 29.11 38.23
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value (61.40) 22.92 25.88 21.86 26.11

NPV 35.37

ICAEW 2020 Objectives and investment appraisal 157

 The project has a positive NPV, and therefore Alliance should accept it.
The contribution per unit = £800  0.40 = £320.
The annual sales in units in year one = 9,000  12 = 108,000 units.
The total contribution per year =
Year 1: 108,000  £320 = £34.56m
Year 2: £34.56m  1.15  1.05 = £41.73m
Year 3: £41.73m  0.90  1.05 = £39.44m
Year 4: £39.44m  0.90  1.05 = £37.27m
Working capital:
Year 1: 2.00  1.15  1.05 = £2.42m. Increment 2.00 – 2.42 = £(0.42)m
Year 2: 2.42  0.90  1.05 = £2.29m. Increment 2.42 – 2.29 = £0.13m
Year 3: 2.29  0.90  1.05 = £2.16m. Increment 2.29 – 2.16 = £0.13m
Year 4: Release of working capital £2.16m.
Capital allowances and the tax saved:
Cost/WDV CA Tax
0 60.00 10.80 1.84
1 49.20 8.86 1.51
2 40.34 7.26 1.23
3 33.08 5.95 1.01
4 27.13
Sale –5.00 22.13 3.76
Nominal cost of capital: (1.07  1.03) – 1 = 0.1021. 10.21% or 10%
12.2
Contribution X (1 – 0.17) 28.68 34.64 32.74 30.93
PV factors at 10% 0.909 0.826 0.751 0.683
Present Value 26.07 28.61 24.59 21.13
Total present value £100.40
Sensitivity: £35.37m/£100.40m = 35.2%
A 35.2% fall in sales would result in a zero NPV.
Alliance should consider its estimates of future sales, and decide whether it is likely that
there will be a 35.2% drop. This is especially pertinent when there are similar products on
the market, and Alliance's market share may be eroded to a greater extent than predicted.
12.3 The disadvantages of sensitivity analysis are as follows:
 It assumes that changes to variables can be made independently.
 It ignores probability. It identifies how far a variable needs to change to result in a zero
NPV, but it does not look at the probability of such a change.
 It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to addressing the weaknesses of sensitivity analysis.
The main advantage is that it allows the effect of more than one variable changing at the
same time to be assessed. This gives more information about the possible outcomes and
their relative probabilities.
It is also useful for problems that cannot be solved analytically.
However it should be noted that simulation also is not an optimising technique, and does
not point directly to a correct decision.

158 Financial Management: Answer Bank ICAEW 2020

 12.4 (a) There are two types of capital rationing:
Hard rationing is where the external capital markets limit the supply of funds.
Soft rationing is where the firm imposes its own internal constraints on the amount of
funds to be raised and invested in projects.
This investment limit may be used as a surrogate for other constraints, such as
insufficient managerial capacity to handle all positive NPV projects.
Soft rationing may also arise where it is impractical for the firm to go the market and
raise a small amount of finance.
Alliance's chairman has stated that: "We will continue to see excellent opportunities to
invest in profitable projects across our business and we have no difficulty in raising
finance. However we will be disciplined in our approach to committing to capital
expenditure". The board of Alliance has chosen to limit the capital expenditure budget
(excluding Autowater) to £350 million. It is therefore apparent that Alliance is
employing soft capital rationing.
(b) The £350 million will be allocated to the combination of projects that yields the highest
NPV by trial and error, since they are indivisible.
The possible combinations are:
Projects Initial expenditure NPV
£m £m
A, B, C, D 330 520
A, B, C, E 290 510
B, C, D, E 330 480
A, D, E 340 470
The combination of projects that maximises shareholder wealth is A, B C, D.

Examiner's comments:
This was a four-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario was that a UK company was considering
launching a new product on the market, and also planning additional investment into other
projects.
The first part was well answered by many candidates; common errors that weaker candidates
made were failing to calculate annual demand from monthly data, inflating cash flows which had
already been inflated because of price increases, deducting contribution from sales, treating
WDAs as outflows rather than inflows, failing to put rent in advance and using real discount rate for
money flows. All easy things, where errors should have been avoided. The hardest part was WC
flows (as expected). The second part was not well answered by the majority of candidates, with
weaker candidates using sales instead of contribution. Responses to part 3 were mixed and often
lacked detail or included irrelevant material (eg, advantages of sensitivity). In the final part (a) was
well answered by many students; however weaker candidates thought that hard versus soft capital
rationing meant the difference between indivisible and divisible projects. However, part (b) had
very mixed and unclear answers, with many candidates using NPV/£ invested, which applies to
divisible rather than indivisible projects. The question clearly stated that the projects were
indivisible.

ICAEW 2020 Objectives and investment appraisal 159

 Finance and capital structure

13 Turners plc (June 2014)

Marking guide

Marks

13.1 (a) Ke 1
Kd 3
Loans 1
WACC 3
8
(b) Retentions rate 2
Shareholders' return 1.5
Growth 0.5
Ke 1
WACC 1

6
13.2 Degearing equity beta 1.5
Regear asset beta 1.5
Ke 1
State discount rate should reflect systematic risk 1
State discount rate should reflect financial risk 1
6
13.3 Weighted average beta of enlarged group 1
Ke 1
WACC of enlarged group 1
Implications 3
Capital structure theory; max 2
6
13.4 Diversification plans 5
EMH max 3
5
13.5 Project appraisal methodology and discount rate 4
35

13.1 (a) The current WACC using CAPM is calculated as follows: Ke = 2 + 0.60 (8 – 2) = 5.6%
Calculation of Kd
The cost of the debentures the cost can be calculated using linear interpolation
5% 1%
T0 (108) 1 (108) 1 (108)
T1–4 6 3.546 21.276 3.902 23.412
T4 100 0.823 82.3 0.961 96.1
(4.424) 11.512

IRR = 1%+ (11.512/11.512 + 4.424)(5 – 1) = 3.89%  (1 – 0.17) = 3.23% after tax

Loans have an after-tax cost of 4(1 – 0.17) = 3.32%

160 Financial Management: Answer Bank ICAEW 2020

 Market values:
Equity 233m/0.10  276p = £6,431m
Debentures 1,900m  108/100 = £2,052m
Loans £635m
Total market values £9,118m

WACC = (5.6%  6,431 + 3.23%  2,052 + 3.32%  635)/ 9,118 = 4.91%

(b) The current WACC using the Gordon growth model is calculated as follows:
Calculating growth using the formula r  b.
Retentions rate:
Dividends = share price  dividend yield = 276p  4.2% = 11.6p
Dividend payout ratio = dividend/ EPS = 11.6/25 = 46.4% ∴ Retentions = 1 – 0.464 =
0.536 or 53.6%
Shareholders return is calculated as follows:
Profit after tax (PAT) = EPS  number of shares in issue = 25p  233/0.10 = £582.5m
Return = PAT/opg shareholders funds = 582.5/(5,263 – (2,330  £0.134*)) = 11.77%
*EPS – Dividend: 25p – 11.6p = 13.4p
Growth = r  b = 0.1177  0.536 = 0.063 or 6.3%
Ke = (Do(1 + g)/Po) + g = (11.6(1 + 0.063)/276) + 0.063 = 10.77%
Kd and market values as in (a)
WACC = (10.77%  6,431 + 3.23%  2,052 + 3.32%  635)/9,118 = 8.55%
13.2 The cost of equity should be adjusted to reflect the systematic risk of the new project. The
beta factor for the holiday travel industry should be adjusted for gearing. Degearing the
equity beta, ßa = 1.40/(1 + (3(1 – 0.17)/5) = 0.93
Gear up the asset beta to reflect Turners' gearing:
ße = 0.93  (1 + (2,687(1 – 0.17)/6,431) = 1.25
The Ke should be = 2 + 1.25 (8 – 2) = 9.5%
With regard to the WACC to be used for the project students should state that the discount
rate should reflect the systematic risk of the project and the financial risk of the company.
13.3 If the diversification goes ahead the cost of equity will reflect the systematic risk of both
divisions.
The weighted average beta of the enlarged group = 1.26  0.10 + 0.6  0.90 = 0.666
Ke = 2 + 0.666(8 – 2) = 6.00%
The WACC of the enlarged group will be:
(6%  6,431 + 3.23%  2,052 + 3.32%  635)/9,118 = 5.19%
The implications of a permanent change in the company's WACC from 4.91% to 5.19% are
less clear. An increase in the WACC is usually associated with reductions in value, on the
other hand assuming that the new project has a positive net present value this could result
in an increase in the market capitalisation.
13.4 The diversification plans may not be welcomed by the market. Portfolio theory tells us that
rational shareholders would hold a well-diversified portfolio and that they might not
welcome the company diversifying. Conglomerate companies often trade at a discount.

ICAEW 2020 Finance and capital structure 161

 13.5 Students should mention that if the gearing changes dramatically then it is not suitable to
use WACC/NPV to appraise the project. Instead APV should be used.
The discount rate will be that of an all equity company using the ßa of 0.93 to reflect the
systematic risk. The discount rate will be = 2 + 0.93(8 – 2) = 7.58%.
This will be used to calculate the base case NPV. This will then be adjusted for the benefits
and costs of the actual way that the project has been financed.

Examiner's comments:
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying its activities. The diversification was to be financed in such a way that the gearing of
the company remained unchanged. The first part of the question required candidates to calculate
the current WACC of the company using CAPM and also the Gordon growth model. The second
part of the question required candidates to calculate, using CAPM, the cost of equity to be
included in the WACC that should have been used to appraise the new project. The third part of
the question required candidates to calculate the overall WACC of the company after the
diversification. The fourth part of the question required candidates to discuss whether the
company should diversify its operations. The fifth part of the question required candidates to
discuss how the project should have been appraised assuming that there was a major change in
financial gearing of the company. Also candidates were required to calculate a discount rate that
should have been used in these circumstances.
Part (a) of the first requirement was designed to give a basic eight marks to build on and was set
at a textbook level with no tricks or complications. However, weaker candidates lost many of
these marks by: completely ignoring the cost of a bank loan (two marks) or not deducting tax
(one mark); incorrect calculation of the cost of the redeemable debentures, incorrect
interpolation calculations, incorrect coupon and timing (three marks), correct interpolation but
no tax adjustment (one mark); incorrect equity beta or correct beta but error in computation (one
mark).
Part (b) of the first requirement was a discriminator as expected, however many candidates
demonstrated poor knowledge of what a dividend yield is, many students multiplying earnings
by the dividend yield.
In the second part again many basic errors were made: eg, degearing using market values but
regearing using book values, even though the formulae sheet states market values on the key to
the formulae and despite the examiner's comments regarding March 2014, omitting tax
completely from the computations and poor mathematical ability using beta equations. Also no
explanation of what candidates were doing threw away two marks in this part.
The third part was well answered by many candidates. However in the discursive part of their
answers some candidates mainly discussed capital structure theory.
The forth part had very mixed responses but flexible marking allowed candidates to pick up two
to three marks.
In the fifth part most candidates mentioned APV but many did not calculate the discount rate
needed.

162 Financial Management: Answer Bank ICAEW 2020

14 Middleham plc (Sample paper)
Marking guide

Marks
14.1 Earnings in 20W8 1
Dividend in 20W8 1
Dividend growth rate 1
Dividend per share in 20X2 1
Current ex-dividend share value 1
Cost of equity 1
Cost of preference shares 1
Cost of debentures – two present values calculated 2
Cost of debentures – IRR calculation 1
WACC calculation 3
13
14.2 1 mark per point max 5

14.3 Ungear industry beta 2

Regear using Middleham's data 2
CAPM calculation 1
1 mark per assumption 3
max 7
14.4 1 mark per point max 5

14.5 Forms of efficiency (1.5 marks for each) 4.5

Stock exchange regarded as semi-strong form efficient 1
Market reacts to press announcement if semi-strong form 1.5
Market does not react to press announcement if strong form 1.5
max 5
35

14.1 Cost of equity capital:

Earnings in 20W9 = £0.35  6,400,000 = £2,240,000
Dividends in 20W9 = £2,240,000  40% = £896,000
Dividend growth rate: 896,000  (1 + g)
4
= £1,088,000
4
(1 + g) = 1,088,000/896,000 = 1.2143
4
1+g = 1.2143 = 1.0497
g = 5%
Dividend per share in 20X3 (d0) = £1,088,000/6,400,000 = 17p
Current ex-dividend share value = £1.42 – £0.17 = 125p
Using the dividend growth model: ke = d0 (1 + g)/p0 + g
= 17(1.05)/125 + 5%
= 19.3%
Cost of preference share capital: = 2.5p/20p
= 12.5%
Cost of debentures:
Cash 10% Cash 1%
Year Flow df PV Flow df PV
0 (105) 1.000 (105.00) (105) 1.000 (105.00)
1–10 7 6.145 43.02 7 9.471 66.30
10 100 0.386 38.60 100 0.905 90.50
NPV (23.38) NPV 51.80

ICAEW 2020 Finance and capital structure 163

 IRR = 1% + 51.8/75.18  9 = 7.20%

Post-tax = 7.20  (1 – 0.17) = 5.98%

Weighted Average Cost of Capital:
Total market
Cost value (£'000) WACC
Equity 19.3% 8,000 15.2
Preference shares 12.5% 560 0.7
Debentures 5.98% 1,575 0.9
10,135 16.8

Thus the Weighted Average Cost of Capital = 16.8%

14.2 If this weighted average cost of capital of 16.8% is used in the appraisal of the proposed
investment then the following assumptions must be recognised and if these assumptions
do not hold then the WACC figure has serious limitations if used as a discount factor:
 Historical proportions of debt and equity are to remain unchanged.
 Business risk is to remain unchanged.
 The finance raised is not project specific.
 The project is small in size relative to the size of the company.
Other factors are as follows:
 Is the dividend growth rate sustainable given the lack of track record?
 There could be other sources of finance that have not been considered.
 Future tax rate changes will affect the cost of debt and so the WACC.
 Will the redeemable debentures be replaced by similar funds in 10 years?
14.3 (a) Ungear the equity beta of the industry
1.3= ßa(1 + (1(1 – 0.17)/1))
ßa=0.7104
regear using Middleham's gearing from part 19.1 (prefs are treated as debt)
ße=0.7104(1 + (2,135(1 – 0.17)/8,000))
ße=0.868
Cost of equity capital = Rf + ß(Rm – Rf) = 6 + 0.868 (14 – 6) = 12.94%
(b) Key assumptions comprise:
(1) The objective of the company is to maximise the wealth of shareholders.
(2) All shareholders hold the market portfolio (they are fully diversified).
(3) Shareholders are the only participants in the firm.
14.4 The increased risk created by issuing more debentures is a financial or gearing risk. The
traditional view of gearing is that at low levels of gearing a company's WACC will decrease
(because debt is cheaper than equity) – this will cause the value of the company to rise.
However, as gearing becomes a greater proportion of total long term funds, the cost of
debt will start to increase and WACC will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company's WACC, and therefore value, is
not affected by the level of gearing other than through the effects of tax relief and that this
leads to a fall in WACC and a corresponding increase in the value of the company.
However, at very high levels of gearing bankruptcy costs, tax exhaustion and agency costs
can all cause the cost of debt to increase and, as with the traditional theory, the WACC will
start to rise and the value of the company fall.

164 Financial Management: Answer Bank ICAEW 2020

 14.5 The are three levels of market efficiency:
 Weak form – Share prices reflect information about past price movements and future
price movements cannot be predicted from past movements (Chartism/technical
analysis).
 Semi-strong form – Share prices incorporate all publicly available information rapidly
and accurately. The market cannot be beaten by analysing publicly available
information.
 Strong-form – Share prices reflect all information whether published or not. Insider
dealing has no value.
The London Stock Exchange is generally regarded as at least semi-strong efficient.
If the stock market is semi-strong efficient then Middleham's share price should rise (+NPV
project) or fall (–NPV) when the project is announced to the market eg, in the newspaper,
press release.
If the stock market is Strong-form efficient then Middleham's share price should remain
unaltered as the +NPV or –NPV will already be reflected in the share price ie, as soon as the
decision is made (unlikely).

Examiner's comments:
A generally very well answered question which was the second highest scoring question on the
paper.
A very common error on this relatively straightforward cost of capital question was a failure to
follow the instructions in the question – many candidates chose to use the Gordon growth model
rather than the dividend growth model – an easy way to lose marks. Other common errors were
an inability to accurately calculate the dividend growth rate from the data provided, errors in
calculating market values in the final WACC calculation and in calculating the cost of debt a
number of candidates betrayed basic misunderstanding by firstly applying one discount rate
that produced a negative NPV and then choosing a larger rather than smaller discount rate for
their second choice.
The second to fifth parts were generally well answered.

15 Better Deal plc (March 2010)

Marking guide

Marks
15.1 (a) Dividend growth rate 1
Cost of equity 1
IRR 3
Market value of equity 1
Market value of debt 1
WACC 1

(b) Cost of equity 1

WACC 1
10

ICAEW 2020 Finance and capital structure 165

 Marks
15.2 New market ungeared beta 2
Better Deal's geared beta 2
Cost of equity 1
Cost of debt 1
WACC 1
Reasoning for approach – 1 mark per point max 4
11
15.3 1–2 marks per relevant point max 8

15.4 Key theories regarding dividend policy 3

Additional comments max 3
Relating theory to the scenario max 3
max 6
35

15.1 (a)
Dividend per share 20Y0 (29.5m/165m) = 17.9 pence

Dividend growth rate = 4

29.5 / 25.2 – 1 = 4% p.a.

d1 (£0.179  1.04)
Cost of equity = +g + 4% = 11%
MV £2.65
Cost of debt
Year Cash Flow 5% factor PV 10% factor PV
0 (98.00) 1.000 (98.00) 1.000 (98.00)
1–4 8.00 3.546 28.37 3.170 25.36
4 100.00 0.823 82.30 0.683 68.30
NPV 12.67 NPV (4.34)

IRR = 5% + (12.67/(12.67 + 4.34))  (10% – 5%) = 8.72%

Post-tax = 8.72  (1 – 0.17) = 7.24%
WACC
£m
Total market value of equity = (£82.5m/£0.50)  £2.65 = 437.250
Total market value of debt = £340m  98/100 = 333.200
Total market value 770.450

WACC = (11%  437.250/770.450) + (7.24%  333.200/770.450) = 9.37%

(b)
Cost of equity = (1.1  (11.4% – 5.2%)) + 5.2% = 12.02%
Cost of debt (as above) 7.24%
WACC = (12.02%  437.250/770.450) + (7.24%  333.200/770.450) = 9.95%
15.2
New market geared beta = 1.5
1.5  64 1.5  64
New market ungeared beta = = = 1.07
(64 + (31 83%)) 89.73

1.07  (£437.25m + (£333.2m  83%))

Better Deal's geared beta = = 1.75
£437.25m

166 Financial Management: Answer Bank ICAEW 2020

 So, cost of equity = (1.75  (11.4% – 5.2%)) + 5.2% = 16.05%
Cost of debt = 9%  83% = 7.47%
WACC = (16.05%  £437.25m/£770.45m) + (7.47%  £333.2m/£770.45m) = 12.33%
It would be unwise to use the existing WACC (9.37%) as Better Deal's plan involves
diversification and therefore a change in the level of systematic risk. Thus a new WACC
must be calculated. Systematic risk is accounted for by taking into account the beta of the
petroleum market and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then 're-geared' by taking into account the level
of gearing of the new funds being raised. Using this, the WACC can be calculated.
15.3 CAPM theory is based on the fact that there is one factor that affects the expected return on
a security (or portfolio) and that is systematic risk. This measure of risk is given by the equity
beta of a security (or portfolio).
Multiple factor models are based on the idea that other factors will also determine the
return as there are other aspects of risk attached to securities, not just the market portfolio.
Arbitrage pricing theory states that there are many factors, but it does not state what these
factors are.
Some models have been developed which actually state factors, such as the French and
Fama model, which stated that the size of the company (size) and the difference between
book and market values of the shares (value) would also influence the level of returns.
Since their original model, the momentum has been added as a fourth factor which shows
the difference in returns between shares that are increasing in value and those that are
decreasing in value.
Multiple factor models have been designed to get around the problem caused by the
simplicity of the CAPM, but they are complex to understand and the factors are difficult to
identify and quantify.
15.4 Key theories regarding dividend policy:
(1) Traditional view
(2) Modigliani and Miller theory
(3) Residual theory
The key points of these should be expanded to attract a good mark.
Additional areas for comment:
(1) Dividend signalling
(2) Clientele effect
(3) Pecking order
Candidates will also have been given credit for covering these topics.
Credit would also be given for (1) relating, where possible, dividend theory to the Better
Deal scenario and (2) producing a cohesive answer.

Examiner's comments:
Most candidates scored well on this question and it had the highest average mark in the paper.
It was based on a supermarket operation and covered the topics of cost of capital and dividend
policy. The first part was worth 10 marks and required candidates to calculate the company's
WACC based on (a) the dividend growth model and then (b) the CAPM model.
The second part was worth 11 marks and tested the candidates' understanding of geared and
ungeared betas and required them to calculate the relevant cost of capital for the company to
use if it diversified its operations into a new product range. The fourth part made up six marks
and candidates had to explain the relationship between a company's dividend policy and the
value of its shares.

ICAEW 2020 Finance and capital structure 167

 Part (a) of the first requirement was pretty straightforward and candidates generally did well.
However, a number of them were unable to calculate the rate of dividend growth correctly and a
disappointing number of candidates calculated the cost of redeemable debentures as if they
were irredeemable.
As expected, most candidates scored full marks for the calculation in part (b) of the first
requirement.
The second requirement was more difficult, but many candidates scored well here. However,
key errors made were (1) book values rather than market values were used when re-gearing
beta and (2) too few candidates calculated the new WACC figure as required.
The final requirement was done well and candidates who produced a well-rounded answer will
have scored high marks.

16 Puerto plc (December 2013)

Marking guide

Marks

16.1 Operating profit 1

Interest 1
Taxation 1
3
16.2 Market capitalisation 0.5
Market value of debt 0.5
Gearing 30 November 0.5
No. of shares issued to SMC 0.5
Total no. of shares in issue 0.5
Market capitalisation of new share price 1
Market value of debt 1
Gearing 1 December 0.5
5
16.3 Relevant discussion 9
max 5
16.4 Cost of equity 1
Cost of debt 1
WACC at 30 November 1
Degear the equity beta 2
Regear the asset beta 2
Cost of equity 1
Cost of debt 1
WACC after 1 December 1
10
16.5 Relevant discussion 7
max 6
16.6 Relevant discussion 10
max 6
35

168 Financial Management: Answer Bank ICAEW 2020

 16.1 Income statement for the year to 30 November 20X4
£'000
Operating profit (2,280 + 3,000) 5,280
Interest (24,000  6% + 6,000  7%) (1,860)
Profit before tax 3,420
Taxation @ 17% (581)
Profit after tax 2,839

16.2 Gearing (debt/equity) by market values at 30 November 20X3:

Market capitalisation: 492 million  10p = £49.2 million
Market value of debt: £68 million + £6 million = £74 million
Gearing 74/49.2 = 150%
Gearing (debt/equity) by market values after the restructuring on 1 December 20X3:
Number of shares in issue:
Issued to SMC (£68/4)  30 = 510 million.
Total number of shares in issue = 492 + 510 = 1,002 million.
Market capitalisation at the new share price (10p  1.35 = 13.5p): 1,002  13.5p =
£135.27 million.
Market value of debt: Secured bank loans £6 million + Risky Bank £24 million = £30 million.
Gearing 30/135.27 = 22.18%
16.3 Profitability: Puerto has been loss making and the purchase of the additional vehicle leasing
business will make the business profitable.
Financial risk: The interest cover of Puerto before the restructuring is less than one. This
increases to 5,280/1,860 = 2.8 after the restructuring which appears to be reasonable and
should give the markets and stakeholders some comfort.
The 150% gearing of Puerto at 30 November is far in excess of the industry average of 25%
which means that the company is in serious risk of bankruptcy. This improves to 22% after
the restructuring which is below the industry average and should give the markets and
stakeholders confidence. However this is only the case if the share price does increase to
13.5p. Puerto may be in danger of breaching SMC's covenant if the share price does not
reach 13.5p. If the share price remains at 10p the gearing will be:
Market capitalisation: 1,002  10p = £100.2 million
Debt £30 million
Gearing 30/100.2 = 30%
A gearing ratio of 30% breaches the Risky Bank plc covenant and, depending on the action
taken by Risky Bank plc, could cause problems for Puerto. Any other sensible comment will
be awarded marks.
16.4 The WACC of Puerto at 30 November 20X3:
Ke = 2.8 + 2.13  5 = 13.45%
Kd = 7% (non-convertible loans) and
3% (convertible loans)
Note: Since Puerto is not paying tax at this date no adjustment for tax is necessary.
WACC using the weightings previously calculated:
(13.45%  49.2 + 7%  6 + 3%  68)/(49.2 + 74) = 7.37%
The WACC of Puerto at 1 December 20X3 immediately after the restructuring:
Ke. Since the financial risk of Puerto has changed the equity beta will have to be adjusted to
the new gearing level:
Degear the equity beta (Note: No tax adjustment is necessary since Puerto is not paying tax
prior to the restructuring): ßa = 2.13/(1 + (74/49.2)) = 0.8506

ICAEW 2020 Finance and capital structure 169

 Regear the asset beta to calculate Puerto's new equity beta (Note: Puerto is now paying tax
and tax adjustments are therefore necessary): ße = 0.8506 (1 + (30(1 – 0.17)/135.27)) =
1.007
Ke = 2.8 + (1.007  5) = 7.835%
Kd (1-tax) (Note: Puerto is now paying tax): 7%(1 – 0.17) = 5.81% and 6%(1 – 0.17) = 4.98%
WACC = (7.835%  135.27 + 5.81%  6 + 4.98%  24)/(135.27 + 24 + 6) = 7.35%
16.5 Prior to the restructuring Puerto had a very high level of gearing at 150% compared to the
industry average of 25%. Consequently the cost of equity reflected this extreme level of
financial risk.
The traditional view of gearing is that at lower levels of gearing a company's WACC will
decrease – this will cause the value of the company to rise. However, as gearing becomes a
greater proportion of total long term funds, the cost of debt will start to increase and WACC
will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company's WACC and therefore value is
not affected by the level of gearing other than through the effects of tax relief and that this
leads to a fall in WACC and a corresponding increase in the value of the company.
However, at Puerto's very high level of gearing bankruptcy costs, tax exhaustion and agency
costs can all cause the cost of debt to increase and, as with the traditional theory, the WACC
will start to rise and the value of the company fall.
Now Puerto has a more normal level of gearing at 22% the WACC should now remain
around 7.35%. Any other sensible comment will be awarded marks.
16.6 Prior to the restructuring Puerto is very highly geared at 150% and is also not profitable. The
various stakeholders' reaction to the restructuring is likely to be:
 Shareholders: Shareholders have limited liability and may be tempted to take risks.
However in this case the shareholders have not received dividends since 2008 and the
share price has only recently risen. This may be because the industry has stabilised but
also may be in anticipation of a restructuring. Shareholders are likely to welcome the
restructuring since there is a very real possibility of increasing their wealth through
dividend income and capital gains. However the shareholders may be concerned
about the change in control due to the new shares issued to SMC.
 SMC: SMC was in a very vulnerable position before the restructuring since interest
cover was below one and there was a very real possibility of the company being unable
to meet interest payments. Since the loan was unsecured SMC would be uncertain as
to how much it might receive if Puerto was wound up. Converting their loan to equity
means that with the company now profitable there is a very real chance of them
realising their investment.
 Risky Bank plc: Risky Bank plc are secured and since the interest cover is now more
substantial at 2.8 and gearing is below the industry average, assuming a share price of
13.5p, the company is on a sound financial footing. The same comments apply to the
original secured bank loans.
 Employees: Employees should welcome the restructuring since the company now has
a much more certain future and they will feel more confident about keeping their jobs.
 Suppliers: Suppliers will also welcome the restructuring since Puerto will now be more
likely to continue and they will not lose the business that it creates for them.
 Customers: Customers of Puerto will be pleased that the company is now on a sound
financial footing and that it will be able to provide them with services in the future.
 Government: Puerto will now be paying tax.
Any other sensible point will be given marks.

170 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
The scenario of this question was that a company had been in difficulty and was considering a
reconstruction, whereby debt would be converted to equity. The company would then purchase
an additional business opportunity, which would be financed by new borrowings.
The first part, for three marks, required candidates to restate the income statement in 12
months' time assuming that the reconstruction went ahead. The second part, for five marks,
required candidates to calculate the gearing ratio, by market values, both before and
immediately after the reconstruction. Part three, for five marks required candidates to comment
upon the financial health of the company both before and after the reconstruction. Also
candidates had to consider a covenant imposed by the providers of the finance for the new
business. Part four, for 10 marks, required candidates to calculate, using the CAPM, the WACC
of the company both before and after the reconstruction. This involved adjusting the equity beta
for gearing and consideration of taxation. The fifth part, for six marks, required candidates to
consider, with reference to relevant theories, how the reconstruction would affect the WACC in
the long term. The final part, for six marks, required candidates to consider the likely reaction to
the reconstruction of various stakeholders in the company.
The first part was well answered by the majority of candidates. However it was disappointing to
see that some candidates did not really demonstrate a full understanding of the scenario and
also included the interest in the income statement for the loan which had been converted to
equity.
The majority of candidates answered part two well, however some candidates failed to
understand the scenario and showed gearing increasing rather than decreasing, whereas a
correct interpretation of the facts would show a substantial decrease.
Part three was reasonably well answered, however those who had misinterpreted the question
scored poorly.
In part four many candidates did not take account of the fact that the company was not paying
tax until after the reconstruction. When taking into account the effect of the change in gearing
on the equity beta, weaker candidates showed that they need to practise gearing adjustments.
In part five a lot of candidates gave a generic answer and did not relate to the scenario of the
question.
The final part was well answered and many students identified a sufficient number of
stakeholders.

17 Abydos plc
Marking guide

Marks
17.1 Capital allowances/tax saving 2
Base case NPV 3–4
Financing side effects 2–4
Give credit for technique max 10

17.2 Reward sensible discussion

Bonus mark for mention of real options max 6
16

ICAEW 2020 Finance and capital structure 171

 17.1 Expected APV
To calculate the base case NPV, the investment cash flows are discounted at the ungeared
cost of equity, assuming the corporate debt is risk free (and has a beta of zero).
E
ß a = e
E +D(1– t)
0.6
= 1.4  = 0.901
0.6 + 0.4(1– 0.17)
The ungeared cost of equity can now be estimated using the CAPM:
Keu = 5 + 0.901(12 – 5)
= 11.31% (say, approximately 11%)
Capital allowances
These are on the £10 million part of the investment that is non-current assets (not working
capital or issue costs).
Capital allowance Tax saving
Year Value at start of year 18% 17%
£'000 £'000 £'000
1 10,000 1,800 306
2 8,200 1,476 251
3 6,724 1,210 206
4 5,514 993 169

Year 0 1 2 3 4
£'000 £'000 £'000 £'000 £'000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 17% (510) (578) (646) (731)
Tax savings from capital allowances 306 251 206 169
Investment cost (11,500)
Issue costs
After tax realisable value 4,000
Net cash flows (11,500) 2,796 3,073 3,360 7,738
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (11,500) 2,519 2,495 2,456 5,099

The expected base case net present value is £1,069,000.

Financing side effects

Issue costs

£1 million, because they are treated as a side-effect they are not included in this NPV
calculation.
Present value of tax shield

Debt issued by project = £5m

Annual tax savings on debt interest = £5m  8%  17% = £68,000
PV of tax savings for four years, discounted at the gross cost of debt 8%, is:
£68,000  3.312 = £225,216

 1  1  
  1– 4  = 3.312 
 0.08  1.08  

172 Financial Management: Answer Bank ICAEW 2020

 £'000
Adjusted present value
Base case NPV 1,069
Tax relief on debt interest 225
Issue costs (1,000)
294

The adjusted present value is £294,000.

17.2 Validity of the views of the two directors

Sales director
The sales director believes that the net present value method should be used, on the basis
that the NPV of a project will be reflected in an equivalent increase in the company's share
price. However, even if the market is efficient, this is only likely to be true if:
 the financing used does not create a significant change in gearing (finance ratio 
current gearing so gearing may change).
 the project is small relative to the size of the company.
 the project risk is the same as the company's average operating risk (but different line
of business).
Finance director

The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then
adjusted for financing side effects such as issue costs and the tax shield on debt interest.
The main problem with the APV method is the estimation of the various financing side
effects and the discount rates used to appraise them. The ungearing process assumes risk
free debt (5%) which it is not as it costs 8%.
Problems with both viewpoints

Both methods rely on the restrictive assumptions about capital markets which are made in
the capital asset pricing model and in the theories of capital structure. The figures used in
CAPM (risk-free rate, market rate and betas) can be difficult to determine. Business risks are
assumed to be constant.
Neither method attempts to value the possible real options for abandonment or further
investment which may be associated with the project.

18 Biddaford Lundy plc (March 2012)

Marking guide

Marks
18.1 Total funds calculations 1
Total geared funds 1
Gearing calculation 2
One mark per relevant point max 5
9
18.2 Rights issue calculations 2
Theoretical ex-rights price 1
Value of a right per new share 1
4

ICAEW 2020 Finance and capital structure 173

 Marks
18.3 Current EPS 1
Current P/E ratio 1
Interest savings 2
New EPS 1
New P/E ratio 1
Reduction in EPS 1
Relevant discussion max 3
10
18.4 Amended EPS 1
Ordinary shares required 1
Number of shares in rights issue 1
Rights issue price 1
Relevant discussion on rights issue success 2
max 6
18.5 1–2 marks per relevant point made 6
35

18.1 Gearing level Par value Market value

£m £m
Ordinary share capital (50p) 67.50 (135m  £2.65) 357.75
Retained earnings 73.20
7% Preference share capital (£1) 60.00 (60m  £1.44) 86.40
4% redeemable debentures (20X7) 45.00 (45m  0.9) 40.50
Total funds 245.70 484.65

Total geared funds (£m) 105.000 126.90

Gearing % 1 (Gearing/Total Funds) 42.7% 26.2%

Or
Gearing % 2 (Gearing/Equity) 74.6% 35.5%

Traditional view
Loan finance is cheap because (a) it is low risk to lenders and (b) loan interest is tax
deductible. This means that as gearing increases, WACC decreases.
Shareholders and lenders are relatively unconcerned about increased risk at lower levels of
gearing.
As gearing increases, both groups start to be concerned – higher returns are demanded
and so WACC increases.
Thus, WACC decreases (value of equity increases) as gearing is introduced. It reaches a
minimum and then starts to increase again. This is the optimal level of gearing.
Modigliani and Miller (M&M) view
Shareholders immediately become concerned by the existence of any gearing.
Ignoring taxes, the cost of 'cheap' loan finance is precisely offset by the increasing cost of
equity, so WACC remains constant at all levels of gearing. There is no optimal level –
managers should not concern themselves with gearing questions. M&M '58 position Vg =
Vu.
Taking taxation into account, interest is cheap enough to cause WACC to fall despite
increasing cost of equity. This leads to an all-debt-financing conclusion. M&M '63 position
Vg = Vu + DT (Tax shield).

174 Financial Management: Answer Bank ICAEW 2020

 Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, investor worries about the costs of the business going into
enforced liquidation ('bankruptcy') become significant and required returns (both equity
and debt) would increase at high levels of gearing.
Conclusion: A business should gear up to a point where the benefits of tax relief are
balanced by potential costs of bankruptcy and interest rate increases – here WACC will be
at a minimum and value of the business at a maximum.
Presumably the directors feel that the current level of gearing is beyond the optimum ie,
where the WACC is minimised and the company's value is maximised (perhaps because as
an engineering company its operational risk is very high and gearing adds additional
financial risk). Alternatively, they are incorrectly looking at the book value gearing ratio, as
the market value ratio doesn't look particularly bad.
18.2
£m
Value of current ordinary shareholding 135m £2.65 357.750
Rights issue (135m/9) (£45m  60%) 15m £1.80 27.000
Theoretical ex-rights values 150m £2.565 384.750

Theoretical ex-rights share price [TERP] (£384.75m/150m) £2.565

Value of a right (£2.565 – £1.800) per new share £0.765
OR per existing share £0.765/9 = £0.085
18.3
Current earnings per share (EPS) £32.4m/135m £0.240
Current P/E ratio £2.65/£0.24 11.04
£m
Current earnings figure 32.400
Savings on debenture interest (£45m  60%  4%  83%) 0.896
Amended earnings figure 33.296
New EPS £33.296m/150m £0.222
New P/E ratio (using TERP) £2.565/£0.222 11.55

The earnings per share figure will fall by 7.5% (from £0.240 to £0.222).
The proposed rights issue will, as the board suggests, cause a dilution of the EPS figure as
the additional shares issued have a greater negative impact than the interest saved from the
debenture redemption. Whilst in theory (TERP) the market price of BL's ordinary shares will
fall, at least initially, it is very difficult to predict what will happen to the market value of the
shares in practice. As gearing is being reduced the market may react favourably (ie, there
would be a share price increase). However, based on market values the gearing level is
currently not high (26.2% or 35.5%), and so the market may react negatively (ie, there would
be a share price decrease) if it considers that insufficient use is being made of the tax
savings that gearing affords.
18.4 Current earnings per share (EPS) £32.4m/135m £0.240

Amended EPS (with a 5% reduction) £0.24  95% £0.228

New earnings figure £33.296m

Thus required total ordinary shares ex-rights £33.296/£0.228 146.035m
New shares to be issued via rights 146.035m – 135.000m 11.035m
Rights issue price per share £27.000m/11.035m £2.45

ICAEW 2020 Finance and capital structure 175

 This rights issue price is only £0.20 less than the current market value, ie, a 7.5% discount
and this is likely to be an insufficient inducement for shareholders. As a result the issue
would fail to raise the £27 million of funds required for the debenture redemption.
18.5 Issue costs are a significant part of a rights issue. They have been estimated at around 4%
on £2 million raised but, as many of the costs are fixed, the percentage falls as the sum
raised increases.
Shareholders may react badly to firms who continually make rights issues as they are forced
either to take up their rights or sell them, since doing nothing decreases their wealth. They
may sell their shares in the company, driving down the market price.
Unless large numbers of existing shareholders sell their rights to new shareholders there
should be little impact in terms of control of the business by existing shareholders.
Unlisted companies often find rights issues difficult to use, because shareholders unable to
raise sufficient funds to take up their rights may not have available the alternative of selling
them if the firm's shares are not listed. This is less likely to be a concern for a listed company
like Biddaford Lundy.

Examiner's comments:
This question was, overall, done poorly and produced the weakest set of answers in the
examination.
In general, the first part was not done well. The book value of equity often excluded retained
earnings. When calculating the market value, a majority of candidates included retained
earnings in the equity figure. Very few of them could calculate the gearing ratio correctly – far
too many included preference shares as equity. In the discursive part of the answer, some
candidates made no reference to the theories on capital structure at all and some referred to the
'Modigliani and Miller traditional theory'. Disappointingly, very few candidates made reference
to the ratios that they had calculated (high/low gearing level etc).
Answers to the second part were better and the most common mistake was to confuse the
market value and the book value of debt when calculating the redemption figure.
The third part was very poorly answered. The vast majority of candidates ignored the reduction
in interest post-redemption. Also, far too many candidates restricted their discussion to a
consideration of the impact of the rights issue on the shareholders' wealth. This was not relevant
to the question, which was about gearing.
In the final part there were some good attempts, but often candidates' answers just consisted of
identifying a 5% fall in EPS.

176 Financial Management: Answer Bank ICAEW 2020

19 BBB Sports plc (December 2015)
Marking guide

Marks
19.1 (a) Calculation of WACC using CAPM:
Cost of equity 1
Cost of debt:
Use of ex interest debenture price 1
PV calculation 1
IRR calculation 1
Post-tax cost of debt 1
Ex-div share price 1
Market value of equity 0.5
Market value of debt 0.5
WACC calculation 1
8
19.1 (b) Calculation of WACC using Gordon growth model:
Earnings per share 1
Proportion retained 1
Total earnings 0.5
Calculation of ARR 1.5
Growth rate 0.5
Cost of equity 1
WACC calculation 0.5
6
19.2 Suitable WACC for appraising Climbhigh:
Commentary on use of appropriate equity beta 2
Degearing and regearing calculations 2
New cost of equity 1
Revised WACC 1
6
19.3 Overall WACC of BBB if Climbhigh goes ahead:
Overall equity beta 1
Overall cost of equity 1
Overall WACC 1
Appropriate commentary upon implications 3
6
19.4 Political risk areas – 1 mark per point 4
Ways of limiting the effects of political risk factors 4
max 6
19.5 Ethical considerations – 1 mark per point 3
35

ICAEW 2020 Finance and capital structure 177

 19.1 (a) The current WACC using CAPM.
Ke = 2 + (1.1  (7 – 2)) = 7.5%
Kd = The ex-interest debenture price is £94 (99 – 5).
Timing – years Cash Flow Factors at PV Factors at PV
£ 5% £ 10% £
0 (94) 1 (94) 1 (94)
1–4 5 3.546 17.73 3.170 15.85
4 100 0.823 82.30 0.683 68.30
6.03 (9.85)
IRR = 5 + (6.03/(6.03 + 9.85))  5 = 6.90%
Kd = 6.90  (1 – 0.17) = 5.73%
The ex div share price is 360p – 10p = 350p.
The market value of equity is: 350p  (365m/0.20) = £6,387.50m
The market value of debt is: £2,200m  (94/100) = £2,068m
The debt/equity ratio is: 0.24:0.76.
The current WACC is: (5.73  0.24) + (7.5  0.76) = 7.1%
(b) The current WACC using the Gordon growth model.
The growth rate is calculated using r  b:
Earnings per share = Share (ex div)  earnings yield = 350p  0.07 = 24.5p.
The proportion of profits retained (b) = (24.5 – 10)/24.5 = 59%
Total earnings = EPS  the number of shares in issue = 24.5p  1,825m = £447m (The
number of shares in issue = £365m/£0.20 = 1,825m)

The accounting rate of return (r) = £447m/ [£5,153 – (1,825m  £0.145)]m = 9.1%
The growth rate is: 0.091  0.59 = 0.054 or 5%
Using the Gordon growth model Ke = ((10  1.05)/350) + 0.05 = 0.08 or 8%
WACC = (8  0.76) + (5.73  0.24) = 7.46%
19.2 The gearing of BBB will be unchanged after the diversification and it is therefore
appropriate to apply the existing gearing ratio of debt:equity 0.24:0.76 in the calculation of
the WACC to be used to appraise the Climbhigh project.
However, the cost of equity to be included in the WACC calculation should reflect the
systematic risk of the climbing wall industry. This can be achieved by using an appropriate
equity beta in the CAPM. An equity beta for a company operating in the climbing wall
industry is 1.90, but the company has a different gearing ratio to BBB and gearing
adjustments will have to be made.
Degearing the equity beta: Ba = 1.90  (6/(6 + 4 (1 – 0.17)) = 1.22
Regearing using BBB's gearing ratio Be = 1.22  ((0.76 + 0.24(1 – 0.17))/0.76) = 1.54
Ke = 2 + (1.54 (7 – 2)) = 9.7%
The appropriate WACC to appraise the project is:
(9.7  0.76) + (5.73  0.24) = 8.75%

178 Financial Management: Answer Bank ICAEW 2020

 19.3 The overall equity beta of BBB if it undertakes the Climbhigh project will be:
(1.10  0.80) + (1.54  0.20) = 1.19
The overall Ke will be: 2 + (1.19  (7 – 2 )) = 7.95%
The overall WACC will be: (7.95  0.76) + (5.73  0.24) = 7.42%
The overall WACC (using CAPM) excluding the Climbhigh project was 7.1% and with the
project it is 7.42%.
This is not a material change in the company's WACC and, considering the discount rate
alone, there should not be any material reduction in the company's value.
However, the actual effect will depend on the market's view of the diversification.
19.4 BBB is considering investing in other countries, some of which are developing countries.
BBB could face the political risk of action by a country's government, which might restrict its
operations. If a government tries to prevent the exploitation of its country by BBB, it may
take various measures including:
 Quotas: Limiting the quantities of goods that can be bought from BBB and imported.
 Tariffs: A tariff on goods imported by BBB, thereby making locally produced goods
more competitive.
 Non-tariff barriers: Legal standard of safety or quality could be imposed on BBB.
 Restrictions: Restricting BBB from buying other climbing wall companies.
 Nationalisation: A government could nationalise foreign-owned companies and their
assets.
 Minimum shareholding: A government could insist on a minimum shareholding in
companies by residents.
BBB can limit the effects of political risk by:
 Negotiations with the host government: The aim of such negotiations is to obtain a
concession agreement.
 Insurance: In the UK the Export Credits Guarantee Department provides protection
against various threats.
 Production strategies: It may be necessary to strike a balance between contracting out
to local sources and producing directly.
 Management structure: Possible methods include joint ventures or ceding control to
local investors.
19.5 The finance director should disregard the suggestion made by the contractor.
He should act with integrity and not be corrupted by self-interest, or the interests of other
parties.
He should be objective in his dealings with the contractor, and not be influenced by his
assertion that it is acceptable to disregard safety standards and cut corners.

Examiner's comments:
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying into a different industry sector. The diversification would have been in non-domestic
countries, some of which would be in developing countries.
Part (a) of the first requirement saw many basic errors, which really should not be occurring
given how many times this has been set. The errors included inability to calculate numbers
correctly, incorrect use of the CAPM equation, incorrectly calculating the number of shares in

ICAEW 2020 Finance and capital structure 179

 issue, not calculating the ex-div share price and/or the ex-interest debenture price, for the cost
of debt calculating positive and negative values and interpolating outside the range calculated
and no tax adjustment for the cost of debt. Again there were many basic errors in part (b) of the
first requirement, despite very similar questions in the revision question bank, many had no idea
at all. However there were some good answers, but even those forgot to correctly calculate the
retained profits. Many students calculated unrealistic growth figures and blindly used them with
no reality check.
The second part was often confused with the third part. No reality checks again, with some
students clearly demonstrating that they have a very shallow knowledge of the topic; errors
included calculating unrealistic equity betas, eg, Beta = 20.485, degearing using MV and
regearing with BV despite the formulae sheet clearly stating MV should be used, degearing and
regearing with same debt/equity ratio and ending up with a different figure from the original.
Explanations were very brief. Despite this being set before and there being a detailed example
in the Study Manual, the third part saw very poor attempts by most candidates. Candidates'
explanations of the relationship between the value of the company and the discount rate were
very poor.
Answers to the fourth part were fine when they talked about political risk as required, but weaker
candidates just talked about foreign exchange and hedging, or focussed on climbing wall
regulations. Answers to the final part were fine where they used the language of ethics, but
many just stated that it was unethical because it was unethical. Many candidates incorrectly
thought that this was a money laundering issue.

180 Financial Management: Answer Bank ICAEW 2020

 Business valuations, plans, dividends and growth

20 Cern Ltd (December 2012)

Marking guide

Marks
20.1 (a) Freehold land and property adjustment 1
Investments adjustment 1
Preference shares adjustment 1
Debentures adjustment 1
Net assets value per share 1
Calculation of dividend per share 1
Choice of yield 0.5
Valuation per share 1
Non-marketability discount 0.5
Calculation of average EBIT 1
Calculation of profit after tax 1
EPS 1
Choice of P/E ratio 0.5
Valuation per share 1
Non-marketability discount 0.5
13
(b) Basic weaknesses of net asset, dividend yield and P/E valuations 2
Other issues – 1 mark per point 5
Max 4
(c) 1 mark per point Max 4
20.2 Calculation of each possible replacement cycle – 2.5 marks 10
31

20.1 (a)
Net asset valuation: £
Intangibles 900,000
Freehold land and property 4,500,000
Plant and equipment 3,600,000
Investments 1,350,000
Inventory 540,000
Receivables 1,080,000
Cash 180,000
12,150,000

Less
Current liabilities 1,080,000
Preference shares 648,000
Debentures 1,980,000
8,442,000
£8,442,000/3,600,000 = £2.345 per share
Dividend yield valuation:
Dividend in 20X2 = £180,000
Number of shares = 3,600,000

181 Financial Management: Answer Bank ICAEW 2020

 Dividend per share = £0.05
Average dividend yield of other two quoted firms: 3.7% (or the minimum 3.4%)
Valuation = £0.05/0.037 = £1.35 (or £0.05/0.034 = £1.47)
Less discount to reflect non-marketability (25% – any % will suffice) = £0.34 or £0.37
Valuation = £1.01 per share (or £1.10 per share)
Price/earnings valuation:
Average PBIT = (1,080 + 440 + 1,800)/3 = £1,106,667
Less interest £180,000 and tax £157,533 (£926,667  17%) = PAIT £769,134 – 43,200 =
£725,934
EPS = £725,933/3,600,000 = £0.2016
Average price-earnings ratio of the other two quoted firms: 8.3 (or the minimum 7)
Valuation = £0.2016  8.3 = £1.67 (or £1.41)
Less discount to reflect non-marketability (25%) = £0.42 (any % deduction will suffice)
Valuation = £1.25 per share (or £1.06)
(b) In addition to a discussion of basic elements surrounding the weaknesses of net asset
valuation (historic cost, omission of internally-generated intangibles) and dividend
yield and price/earnings valuations (comparator statistics, unrepresentative annual
figures), the following areas were worthy of comment in this specific scenario:
 The erratic profits in recent years suggests the earnings value may be somewhat
unreliable.
 Purchasers may prefer a valuation based on the present value of forecast future
cash-flows.
 Given the dividend yield and price/earnings valuations, Cern's directors may
prefer to sell off the firm on a break-up basis rather than as a going concern.
 Is the discount for non-marketability reasonable?
(c) (1) Synergy: the '2 + 2 = 5' effect
(2) Risk reduction via diversification
(3) Removal of a competitor
(4) Vertical integration: safeguard Fenton's position by acquiring a supplier or
distributor
(5) Access a new market (possibly overcoming barriers to entry)
(6) The acquisition of skills/knowledge
(7) Speed compared to organic growth
(8) Asset-stripping
20.2
Maximum annual production/sales (units) 300,000 285,000 270,000 255,000
Annual revenue @ £12 per unit (£) 3.60m 3.42m 3.24m 3.06m
Annual variable costs @ £8 per unit 2.40m 2.28m 2.16m 2.04m
Annual contribution 1.20m 1.14m 1.08m 1.02m
One-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 320,000
Maintenance costs (12,000)
Contribution 1,200,000
Net cash flow (480,000) 1,508,000

182 Financial Management: Answer Bank ICAEW 2020

 NPV (480,000) + (1,508,000  0.909) = £890,772/0.909 = £979,947
Two-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 200,000
Maintenance costs (12,000) (14,000)
Contribution 1,200,000 1,140,000
Net cash flow (480,000) 1,188,000 1,326,000
NPV (480,000) + (1,188,000  0.909) + (1,326,000  0.826) = £1,695,168/1.736 = £976,479
Three-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 80,000
Maintenance costs (12,000) (14,000) (16,000)
Contribution 1,200,000 1,140,000 1,080,000
Net cash flow (480,000) 1,188,000 1,126,000 1,144,000
NPV (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,144,000  0.751) =
£2,389,112/2.487 = £960,640
Four-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 10,000
Maintenance costs (12,000) (14,000) (16,000) (18,000)
Contribution 1,200,000 1,140,000 1,080,000 1,020,000
Net cash flow (480,000) 1,188,000 1,126,000 1,064,000 1,012,000
NPV (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,064,000  0.751) +
(1,012,000  0.683) = £3,020,228/3.170 = £952,753
Therefore, the directors should change their existing policy of replacing the processing
machine every three years to replacing it every year, as that gives the greatest annual
equivalent net revenue.

Examiner's comments:
Whilst there were many strong responses to the valuation questions, less well-prepared
candidates were undoubtedly exposed by the question and were particularly weak in dealing
with the technicalities of both the dividend yield and price/earnings valuation techniques. In the
second section, whilst many candidates were able to list classic text-book commentary on the
respective valuation techniques, far fewer were able to augment this basic analysis with
insightful commentary on the relevance of the techniques to the specific scenario set out in the
question. The third and final section of the first part of the paper, on take-over motives, was,
however, generally very well answered across the board.
The second part of the question was, again, very well answered by the stronger candidates but
performance was somewhat polarised as those candidates who had clearly banked on there
being a traditional NPV question found their lack of a firm grasp of the replacement
methodology exposed. Even some candidates who scored well on the calculations themselves
arrived at incorrect conclusions as a result of treating the calculated figures as equivalent annual
costs rather than net revenues.

ICAEW 2020 Business valuations, plans, dividends and growth 183

21 Wexford plc (December 2008)
Marking guide

Marks
21.1 Forecast income statement 8
Forecast balance sheet 8
16
21.2 Rights issue: Up to 2 marks per valid point max 7
Floating rate loan: Up to 2 marks per valid point max 6
Report format 1
14
30

21.1 Rights Issue

Forecast income statement for the year ending 30 November 20X9
£'000
Revenue (270  1.15) 310,500
Direct costs ((171 – 19)  1.18) 179,360
Depreciation (18 + (20%  25)) 23,000
Indirect costs (40 + 10) 50,000
Profit from operations 58,140
Interest 5,000
Profit before tax 53,140
Taxation (17%) 9,034
Profit after tax 44,106
Dividends declared ((22.68/44.82)  44,106) 22,319
Retained profit 21,787

Forecast balance sheet at 30 November 20X9

£'000 £'000
Non-current assets (carrying amount) (152.59 + 25 – 23) 154,590
Current assets:
Inventory (35 + 10) 45,000
Receivables ((49/270)  310.5) 56,350
Cash at bank (balancing figure) 45,316
146,666
301,256
Capital and reserves:
£1 Ordinary shares (50 + 10) 60,000
Share premium (25 – 10) 15,000
Retained earnings (81.41 + 21.787) 103,197
178,197
Non-current liabilities:
10% Debentures (repayable 20Y5) 50,000
Current liabilities:
Trade payables ((43/152)  179.36) 50,740
Dividends payable 22,319
73,059
301,256

184 Financial Management: Answer Bank ICAEW 2020

 Floating rate loan
Forecast income statement for the year ending 30 November 20X9
£'000
Revenue 310,500
Direct costs 179,360
Depreciation 23,000
Indirect costs 50,000
Profit from operations 58,140
Interest (5 + (25  8%)) 7,000
Profit before tax 51,140
Taxation (17%) 8,694
Profit after tax 42,446
Dividends declared ((22.68/44.82)  42.446) 21,479
Retained profit 20,967
Forecast balance sheet at 30 November 20X9
£'000 £'000
Non-current assets (carrying amount) 154,590
Current assets:
Inventory 45,000
Receivables 56,350
Cash at bank (balancing figure) 43,656 145,006
299,596
Capital and reserves:
£1 Ordinary shares 50,000
Retained earnings (81.41 + 20.967) 102,377
152,377
Non-current liabilities:
10% Debentures (repayable 20Y5) 50,000
Loan 25,000
75,000
Current liabilities:
Trade payables 50,740
Dividends payable 21,479
72,219
299,596

21.2 REPORT
To: The board of directors
From: Company Accountant
Date: x – x – xx
Subject: Methods of financing expansion plans
In terms of gearing, the rights issue will produce lower gearing than the floating rate loan
(ie, a lower level of financial risk), although in neither case does the proposed level of
gearing appear beyond the ability of the company to service (see interest cover below).
In terms of eps, the rights issue will produce a figure of 73.5p per share, whilst the floating
rate loan will boost eps to 84.9p per share.
In terms of interest cover, with the rights issue interest cover is a comfortable 11.6 times
against 8.3 times with the floating rate loan. In neither case, therefore, does interest cover
appear to be a cause for concern.
In terms of cost of capital, the floating rate loan may reduce the company's cost of capital as
a result of the tax shield applying to loan interest (depending on what happens to the cost
of equity as a result of the increased financial risk).

ICAEW 2020 Business valuations, plans, dividends and growth 185

 The issues surrounding the use of the rights issue are as follows:
 Issue costs likely to be more than the arrangement fees associated with the floating
rate loan.
 There may also be underwriting costs if the company decides to protect its position.
Shareholders' reaction may be negative.
 Control – no dilution of control for those shareholders who take up their rights.
 The need to discount the offer price to ensure that the issue is fully subscribed and to
cover the possibility that the market price of shares might fall between the
announcement of the rights issue and its conclusion.
 The use of a rights issue leaves credit lines free to finance further expansion and
enables the freehold land and buildings to be used to secure other lines of finance, if
required.
The issues surrounding the use of the floating rate loan are as follows:
 The advantage of avoiding being tied into higher fixed rates if market interest rates fall.
 The risk of interest rates rising and the uncertainty of cash budgeting that this creates.
 Issue costs (arrangement fees) – likely to be less than those associated with a rights
issue.
 The potential for early repayment if the company finds this to be beneficial.
 Marks were also available for discussion of security and/or covenants, increased
operating gearing and the potential cash flow issues surrounding the loan.

Examiner's comments:
A question which most candidates found to their liking with many scoring very strongly in the
numerical first section. The second section once again served to polarise performance between
stronger and weaker candidates.
For the most part candidates performed well on first section of the question, although there
were some common errors among weaker candidates, most notably the incorrect treatment of
both the cash and dividend figures. Weaker candidates completely overlooked the fact that cash
was the balancing figure in the whole exercise and simply chose to leave the original cash figure
unchanged. In similar fashion, the dividends were often left at their original level with no
changes incorporated to reflect profits in 20X9.
In the second section, stronger candidates combined relevant discussion of the two sources of
finance with the calculation of relevant calculations to underpin that discussion. However, a
feature among weaker candidates was their failure to undertake any calculations in spite of the
precise instruction in the question. Another common feature of weaker answers was a lack of
breadth in their response. For example, there was a tendency for some candidates to correctly
identify the issue of the potential impact on the firm's cost of capital but then to write at great
length all they knew on the underlying theory. Whilst this invariably earned the full marks
available for this aspect of the answer, this represented minimal reward in the context of the
overall question and was often achieved at the cost of many more marks that were available for
discussion of other relevant issues.

186 Financial Management: Answer Bank ICAEW 2020

22 Loxwood (March 2014, amended)
Marking guide

Marks
22.1 Total asset value 1
Total revalued assets 2
Dividend valuation 2
Earnings valuation 2
EV/EBITDA multiples 4
Profit before tax 2
Profit after tax 1
Retained profit after dividends 1
Strengths and weaknesses of each valuation method 10
25
22.2 SVA explanation 3
Problems of future cash flow and residual value 4
7
22.3 Discount at an effective 1% pa 1
Present value calculation 2
Compare to £500k offered and advise not to sell land 1
Ignore £120,000 as common to both alternatives 1
5
22.4 Professional accountants' conduct:
Be honest and truthful 1
Avoid making exaggerated claims of what they can do, and
their qualifications and experience 2
Avoid making disparaging claims of others 1
Not use confidential information from other clients in campaign 1
max 3
40

22.1
Hampton Richmond
Total asset value (historic) £21.7m £22.7m
Value per share (£21.7m/17.6m) £1.23 (£22.7m/9.8m) £2.32

Total revalued assets

[45.2 + 25.1 - 11.3 – 24.75] [24.1 + 35.2 – 13.7 – 15.44]
£34.25m £30.16m
Value per share (£34.25m/17.6m) £1.94 (£30.16m/9.8m) £3.08
Dividend valuation
Dividends (W1) d1 1.140  1.075 1.216  1.09 £88.363m
£81.7m
ke – g 9% – 7.5%  10.5% – 9% 
Value per share £81.7m/17.6m £4.64 £88.363m/9.8m £9.02
Earnings valuation (Earnings  P/E)
£3.258m  15.2 £2.702m  15.2 (Hampton)
£49.52m £41.07m
Value per share £49.52m/17.6m £2.81 £41.07m/9.8m £4.19
When it comes to valuation using an EV/EBITDA multiple, we can use the multiples of
Hampton and Walton (as listed companies) to estimate a value for Richmond.

ICAEW 2020 Business valuations, plans, dividends and growth 187

 Hampton
EV = £74.27m, being:
Market capitalisation = £2.81  17.6m shares (above) = £49.52m, plus
Market value of debentures = 1.10  £22.5m = £24.75m
EBITDA of Hampton = £5.5m + £2.9m = £8.4m
EV/EBITDA multiple = £74.27m/£8.4m = 8.84

Walton

Need to calculate a market capitalisation, using earnings  P/E:

£m
PBIT 36.2
Less interest (£70m  7%) (4.9)
Profit before tax 31.3
Tax at 17% (5.3)
Profit after tax / earnings 26.0

Market capitalisation = £26m  16.5 = £429m

Market value of debentures = 1.25  £70m = £87.5m
EV of Walton = £516.5m
EBITDA is £36.2m + £6.5m = £42.7m
EV/EBITDA multiple = £516.5m / £42.7m = 12.1

Applying these multiples to the EBITDA of Richmond:

EBITDA = £4.8m + £0.9m = £5.7m
Appling EV/EBITDA multiple of Hampton: £5.7m  8.84 = £50.388m
Appling EV/EBITDA multiple of Walton: £5.7m  12.1 = £68.97m

Commentary
Asset values – historic so not equal to MV and only considers tangible assets and ignores
income. Revalued figures are better as more up to date, but still have the same
disadvantages.
The P/E ratio is a better guide for Hampton as it will give the company's actual market value
at 28 February 20X4 but based only on a small number of shares changing hands at any
one time – a premium would normally be paid above MV to get control. Also, have there
been significant changes since 28 February which would affect the value?
It is a takeover bid and so, presumably, Walton will be looking forwards and intending to
generate future earnings from Hampton, not liquidate (asset strip) it as in asset values. For
Richmond (a private company) it would be reasonable to use Hampton's P/E ratio (same
market), but it will be necessary to discount (by 25% to 50%) this valuation because
Richmond's shares will be less marketable. For both companies, are the current year's
earnings reasonable ie, not distorted in any way? Synergy is also ignored in the calculations.

When it comes to the EV/EBITDA valuation, the market value of Richmond's debt (£15.44m)
will need to be deducted to obtain an equity valuation, giving a range between
£34.948 million and £53.53 million.
These figures are before any discount that might be made for the non-marketability of
Richmond's shares. If we were to apply say a 25% discount, this would give a range of
values between £26.21 million and £40.15 million.

188 Financial Management: Answer Bank ICAEW 2020

 It should also be noted that care needs to be taken when using the EBITDA multiple of
either Walton or Hampton when valuing Richmond. These companies may be trading on
higher or lower multiples than the average for the sector due to various market factors.
The dividend growth model (DGM) gives the highest valuations for both companies, but the
cost of equity and dividend growth rate will need to be treated with caution as they are very
close to each other giving high values. This puts the valuation in some doubt. Particularly
one should bear in mind that the market has priced Hampton at a much lower figure (via
P/E) than the value given by the DGM. Similar comments re synergy apply.
WORKING
£m £m
Profit before interest and tax 5.500 4.800
less: Interest (£22.5m  7%) (1.575) (£19.3m  8%) (1.544)
Profit before tax 3.925 3.256
less: Tax at 17% (0.667) (0.554)
Profit after tax/Earnings 3.258 2.702
less: Dividends (35%  £3.258m) (1.140) (45%  £2.702m) (1.216)
Retained 2.118 1.486

22.2 Shareholder value analysis (SVA) concentrates on a company's ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a
business is equal to the sum of the present values of all of its activities.
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). SVA links a business' value
to its strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
Company projections tend to show cash flows growing steadily upwards into an indefinite
future. In the real world, economies falter, competition increases and margins decline.
The majority of a DCF value estimate comes from the 'residual value', the worth of the
company at the end of the projection period. That, naturally, depends heavily on the cash
flows estimate in the final year modelled – a result, logically, of the trend in the early years.
22.3 £60k inflating at 3% pa discounted at 4% pa is the same as £60k discounted at an effective
1% pa so:
[£60,000  9.471] + [£120,000  0.905] (assuming land sold at year 10) = £676,860 (Present
Value) vs £500,000 offered, so do not sell the land.
£120,000 ignored as common to both alternatives
22.4 When marketing themselves and their work, professional accountants should:
 be honest and truthful.
 avoid making exaggerated claims about (a) what they can do (b) their qualifications and
experience.
 avoid making disparaging references to the work of others.
 not use confidential information from other clients in the campaign.

ICAEW 2020 Business valuations, plans, dividends and growth 189

 Examiner's comments:
This question had the lowest average mark on the paper and, in general, was done very badly
indeed.
It was a four-part question that tested the candidates' understanding of the investment decisions
and valuation element of the syllabus.
In the scenario a firm of ICAEW Chartered Accountants is advising three clients in its Business
Valuations Unit (BVU):
Client One is considering a takeover bid for two of its competitors. Candidates were given
financial data about the client and its target companies. Using this data they were asked to
calculate a range of suitable prices for the targets and a commentary on the strengths and
weaknesses of each of the valuation methods used.
Client Two had read a newspaper article which outlined a court case in which a company had
been valued using Shareholder Value Analysis (SVA). Candidates were required to explain how
SVA works and the problems that can arise from its employment.
Client Three was a landowner who, in effect, needed to calculate the present value of 60 acres of
his agricultural land for which he had been offered 10 years of rental income. Candidates were
given annual discount and inflation rates.
Finally, in the last part, candidates were asked to outline the ethical issues that the firm should
consider when planning a marketing campaign for its BVU.
In the first part many candidates' calculations of value were very poor or non-existent. For
example they were unable to identify the net assets figure straight from the financial data made
available with many just using assets rather than assets less liabilities. Also they couldn't change
that number (for asset revaluation) with the two adjustments that were given in the data. Many
used the profit before interest figure as earnings (and therefore the basis for the dividend
figure). Interest and tax details were provided for calculating profit after interest and tax.
In the second part there was a poor understanding of the SVA method of valuation, in particular
the issues associated with future cash flows and residual value.
The third part was probably the worst overall performance in the paper. Very few candidates
demonstrated an understanding of basic discounting. Many discounted the cash flows using the
annual inflation rate rather than cost of capital. In addition many compared terminal values and
present values to get to their decision.
Many candidates answered the final part by dealing with ethics in the context of valuing
companies, rather than in the context of the promotional campaign. In other words they didn't
answer the question.

190 Financial Management: Answer Bank ICAEW 2020

23 Sennen plc (June 2014)
Marking guide

Marks

23.1 (a) Sales revenue 1

Operating profit 0.5
Tax 1
After tax synergies 1
Working capital 1
Additional CAPEX 1
Free cash flow 0.5
Present value 1
Terminal value 2
Value per share 2
Advantages and disadvantages 2
13
(b) Sensitivity to change in after tax synergies 3

(c) Operating profit 0.5

Interest 0.5
Investment income 0.5
Tax 0.5
Share price 1
Strengths and weaknesses 2
5
(d) Relevant discussion 3

(e) Advice on suitability of each method 8

23.2 Ethical issues 3

35

23.1 REPORT
To: Partner in NWCF
From: Accountant
Date: x – x – xx
Subject: Possible acquisition of Sennen plc
(a)
Year
0 1 2 3
£m £m £m £m
Sales revenue 21.00 22.05 23.15
Operating profit 3.15 3.31 3.47
Tax (17%) –0.54 –0.56 –0.59
After tax synergies 0.53 0.55 0.58
Working capital –0.21 –0.22 –0.23 –0.24
Additional CAPEX –0.42 –0.44 –0.46
Free cash flow –0.21 2.50 2.63 2.76
Present value factor (7%) 1.00 0.935 0.873 0.816
Present value –0.21 2.34 2.30 2.25

ICAEW 2020 Business valuations, plans, dividends and growth 191

 £m
Present value of free cash flow years 0–3 6.68

Terminal value: (2.76(1 + 0.02)/(0.07 – 0.02))  0.816 45.94

Enterprise value 52.62

Less debt –10.00
Add short term investments 2.00
Equity 44.62

Value per share in pence (44.62/17  100p) 262

This methodology has the advantage of valuing the free cash flows of the company and
is not distorted by accounting policies which can affect other methods. However the
valuation is dominated by the terminal value. The methodology is also heavily
dependent upon the inputs to the model such as estimating cash flows and growth.
For example, reducing the estimated sales growth after the competitive advantage
period to, say, 1% would reduce the terminal value to (2.76(1 + 0.01)/(0.07 – 0.01)) 
0.816 = £37.91m, a reduction of 47p per share.
(b) The sensitivity of the enterprise value to a change in the after tax synergies: PV of
synergies/total value:
1 2 3
£m £m £m
After tax synergies 0.53 0.55 0.58
PV @ 7% 0.5 0.48 0.47

£m
Present value years 1–3 1.45
Amount in terminal value (0.58(1 + 0.02)/(0.07 – 0.02))  0.816 9.65
Total present value of synergies 11.10

£11.10m/£54.62 = 20.3%.
Synergies represent 20.3% of the value of debt plus equity.
(c) The earnings per share has to be calculated:
£m
Operating profit £20m  0.15 3
Less interest £10m  0.05 (0.5)
Add investment income £2m  0.03 0.06
Taxable 2.56
Tax at 17% (0.44)
Profit after tax 2.12
Earnings per share £2.12m/17m = 12.47p

Note: Credit any attempt to calculate prospective EPS rather than historic.
The share price using the p/e ratio for recent takeovers = 12.47p  17 = 212p
The p/e ratio basis is a market measure and has the advantage of valuing the shares by
comparison to other takeovers. However we do not know how comparable to Sennen
the other companies are. Also the valuation is based on historic EPS and a more
realistic measure might be a prospective EPS.
(d) The range in values is 212p – 262p.
The free cash flow valuation can be considered as a maximum value, however the
valuation is quite sensitive at 20.3% to the synergistic savings which may or may not be
made and the growth rate of sales in perpetuity.

192 Financial Management: Answer Bank ICAEW 2020

 Both measures offer a premium to the current share price of 160p and the Board of
Morgan should feel comfortable offering the shareholders of Sennen a bid premium.
(e) Students should take into account that the company is highly geared and their answers
should reflect this. They should consider both the shareholders of Sennen and Morgan
in their answers. Some areas that they may mention and expand upon for each method
are as follows:
 The ability of Morgan to raise extra funds by borrowing and/or an issue of shares,
maybe a rights issue
 Does Morgan have any cash reserves
 Dilution of control
 The tax position of Sennen's shareholders
 Risk
23.2 There is a serious conflict of interest with the management team who are party to the MBO
also considering making an offer for the company. The management team should be acting
in the interests of the shareholders of Sennen and be recommending to the shareholders
the best price for their shares. It would be highly unethical for any member of the
management team who are party to the MBO to take part in negotiations with Morgan or to
make recommendations to Sennen's shareholders.

Examiner's comments:
This was a six-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company had
identified a takeover target.
The acquirer has had a policy of expanding by acquisition and, as a result, is highly geared
compared to its peers. Also there is a potential bid from the management of the target in the
form of a management buyout (MBO). Part (a) of the first requirement required candidates to
use Shareholder Value Analysis (SVA) to value the target. The valuation included after tax
synergies, also candidates were required to state the strengths and weaknesses of the valuation
method. Part (b) of the first requirement needed candidates to calculate how sensitive the
valuation using SVA was to a change in the synergies. Part (c) of the first requirement required
candidates to value the target using p/e ratios and to state the strengths and weaknesses of the
valuation method. Part (d) of requirement one required candidates to discuss the range of
values and whether the acquirer should have offered the target company's shareholders a bid
premium. The final part of the first requirement required candidates to discuss the methods that
the acquirer could have used to pay for the shares of the target. The second requirement of the
question required candidates to discuss the ethical position of the members of the MBO team.
In part (a) of requirement one, the basic discounting was fine with some candidates making the
usual timing errors, however the inclusion and computation of the perpetuity flow and
discounting it was variable. Few candidates made adjustments to the present value of the free
cash flows for the debt and investments. Many candidates wasted time by stating the seven
drivers of SVA, which was not required.
In part (b) of requirement one many candidates were able to calculate the present value of the
after tax synergies but did not realise that this should then be stated as a percentage of the value
calculated in part (a).
Part (c) of requirement one was very disappointing since p/e valuations have been tested several
times in the past. Many candidates lost marks by making no attempt to calculate the earnings.
Instead a common calculation was to divide the target share price by the p/e ratio given in the
question for recent takeovers in the sector and then multiplying the resultant figure back up
again:
17  eps = 160p, eps = 9.41p, Offer price = 9.41p  17 = 160p!

ICAEW 2020 Business valuations, plans, dividends and growth 193

 Part (d) of requirement one had reasonable responses. However weaker candidates did not
make reference to their range of values calculated in parts (a) and (c) of the requirement.
Part (e) of requirement one was quite well answered but weaker candidates did not refer to the
offeror being already highly geared compared to its peers.
In the second requirement many candidates ignored the ethical position of the members of the
MBO team.

24 Tower Brazil plc (September 2014)

Marking guide

Marks
24.1 Theoretical ex-rights price:
Funds to be raised by rights issue 1
Market value 1
TERP calculation 1
3
24.2 (a) Current EPS 1.5
Current earnings plus debenture interest saved 2
New earnings 1
New EPS 1
(b) New EPS if EPS reduces by 10%
New total shares 1
Current shares in issues 1
New shares to be issued 0.5
Rights issue price/share 0.5
Rights issue would be unsuccessful as above current 1
market price 1.5
11
24.3 Gearing level (BV) 1
Gearing level (MV) 2
Advise whether there is gearing problem max 3
Gearing theory max 3
9
24.4 Dividend policy and share price 7
Impact of special dividend 2
9
24.5 Ethical implications 3
35

24.1 Theoretical ex-rights price

£m
Funds to be raised by rights issue: 60%  £46,750  1.10 30.855

Current market capitalisation 16.50m £4.20 69.300

1 for 2 rights issue 8.25m £3.74 30.855
24.75m 100.155

TERP = £100.155/24.75m £4.05/share

194 Financial Management: Answer Bank ICAEW 2020

 24.2 (a) Current earnings per share (£5.825m – £0.480m)/16.5m £0.324
£m
Current earnings figure (£5,825m – £0.480m) 5.345
plus: Debenture interest saved (£28.050m  5%  83%) 1.164
New earnings figure 6.509

New EPS £6.509m/24.75m £0.263

(b) If EPS reduces by 10%, then new EPS is £0.324  (1 – 10%) £0.2916
New total shares £6.509m/£0.2916 22,322m
Current shares in issue 16.500m
New shares to be issued 5.822m
Rights issue price/share £30.855m/5.822m £5.30
As this is above the current market price (£4.20) the rights issue would not be
successful.
24.3
Gearing level (BV) £54,750/£97,670 56.1%

Gearing level (MV) Equity MV £69,300

PSC MV 6,400
Debt MV (£46,750  1.10) 51,425
127,125 £57,825/£127,125 45.5%

So gearing at MV is under 50%. Gearing would be a problem if it was causing WACC to rise
(tax advantage outweighed by debenture holders and shareholders wanting a higher
return) and MV to fall.
Gearing theory – Traditional view/Modigliani & Miller (MM) view/Modern view – balance
between tax benefits and bankruptcy costs.
24.4 Dividend policy and share price – Traditional view/MM and irrelevance theory/Modern view
– including signaling, clientele effect and agency theory.
Impact of special dividend – the market is not in favour of such dividends generally, ie, the
share price may well fall as a result, and so it seems to defeat the object of retaining profit
for investment.
24.5 Unpublished information of a price sensitive nature should remain confidential, not be
disclosed and not be used to obtain a personal advantage.

Examiner's comments:
This question had the second highest average mark on the paper and the majority of candidates
did well enough to 'pass' it.
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus.
In the scenario the board of a UK manufacturer was concerned about the company's gearing
levels. The board is considering either (a) a rights issue to buy back debt or (b) reducing future
dividend payments.
In the first part for three marks candidates were required to calculate the company's theoretical
ex-rights price. The second requirement was worth 11 marks. Half of these were allocated to
part (a) which required candidates to calculate next year's EPS figure (based on the fact that
some of the debt would have been repaid). In part (b) of this requirement candidates were
required to calculate and explain the implications for the rights issue of restricting the change in

ICAEW 2020 Business valuations, plans, dividends and growth 195

 the company's EPS to 10%. The third part for nine marks asked candidates to calculate the
company's current gearing levels and then advise the board, with reference to their calculations
and generally accepted theory, whether or not the company had a gearing 'problem'. The fourth
part was a more discursive section and candidates were asked to explain (again with reference
to generally accepted theory) the possible impact of a change in dividend policy on the
company's share price. Finally, for three marks, the final part tested the candidates'
understanding of the ethical implications facing an ICAEW Chartered Accountant when in
possession of price-sensitive information.
In the first part most candidates scored full marks, but many failed to calculate correctly the
market value of the debt being redeemed via the rights issue.
Part (a) of the second requirement was reasonably well done, but many candidates struggled
with (or ignored) the calculation of the adjustment to the interest charge caused by the
debenture redemption. Also, as noted in previous papers, many candidates calculated,
incorrectly, the earnings figure before preference dividends.
Part (b) of the second requirement was also reasonably well done, but many candidates tried to
adjust the earnings figure rather than, as was required, the number of shares.
In the third part it was the calculation of gearing using market values that caused most problems
(again, as in previous papers). A disappointing number of candidates included retained
earnings in their market value of equity figure. Most candidates' understanding of the theory of
gearing and market value were good, but, in general, there was too little application of this
understanding to the actual scenario.
The fourth part was mostly done well, but too few candidates gave a sufficient range of points
regarding the 'real world' impact of the dividend policy and most candidates ignored the
special dividend.
In general the final part was answered well.

25 Brennan plc
Marking guide

Marks
25.1 Sales calculations 1.5
Operating profit 1
Tax 1
Working capital investment 1.5
Non-current asset investment 1.5
Discount rate 1
Post year six cash flows 1.5
Short-term investments 1
Comment 3
13
25.2 1–2 marks per valid comment max 7
20

196 Financial Management: Answer Bank ICAEW 2020

 25.1
Year
1 2 3 4 5 6
Sales (£m) (W1) 212.00 224.72 238.20 252.50 267.65 283.70
Op profit (15%) 31.80 33.71 35.73 37.87 40.15 42.56
Tax at 17% (5.41) (5.73) (6.07) (6.44) (6.83) (7.24)
Working capital investment (W1) (0.84) (0.89) (0.94) (1.00) (1.06) (1.12)
Non-current asset investment (W1) (1.44) (1.53) (1.62) (1.72) (1.82) (1.93)
Free Cash Flows 24.11 25.56 27.10 28.71 30.44 32.27
Factor 9% (W2) 0.917 0.842 0.772 0.708 0.650 0.596
PV 22.11 21.52 20.92 20.33 19.79 19.23
PV of cash flows years 1–6 = £123.9m
Post year 6 cash flows (in perpetuity) = 32.27/0.09  0.596 = £213.7m
Total SVA value = £123.9m + £213.7m + £2.5m = £340.1m
The majority of the value calculated (63%) comes from the residual value, which is based on
the assumption of zero growth in cash flows from year 6. This is highly dependent on the
growth being as predicted in the period of competitive advantage.
The SVA value is significantly higher than the market capitalisation of £250 million. This may
be caused by the market assuming a lower growth rate or a higher discount rate than those
used in the SVA calculation.
WORKINGS
(1)
Year
0 1 2 3 4 5 6
Sales (increasing at 6%) 200.00 212.00 224.72 238.20 252.50 267.65 283.70
Increase in sales 12.00 12.72 13.48 14.29 15.15 16.06
Working capital (7%) 0.84 0.89 0.94 1.00 1.06 1.12
Non-current asset investment (12%) 1.44 1.53 1.62 1.72 1.82 1.93
(2) Discount factor = 3 + 0.75(11 – 3) = 9%
25.2 The current market capitalisation of Brennan is below its net assets value which suggests
that Brennan plc may be worth more if it was liquidated. However this assumes that the net
book value of assets matches the market value of the assets and this may not be the case in
reality. This does give a possible explanation for the low market capitalisation of Brennan,
the market may see no future in the company and is already valuing it on a break up basis.
There are other factors which may cause the market to place such an apparently low
valuation on Brennan.
The dividend policy offers a relatively low payout of 10%. If there are no plans to reinvest
retained earnings then cash balances will be substantial. This could also help to explain the
high net assets valuation.
The stock market may be suspicious of the level of control exercised by the founding family.
The founding family appears to control the board and also own a substantial number of
shares and as such they may be able to dominate the smaller shareholders. The market may
view the current management as less able than similar companies due to this family
dominance and this affects the valuation.
Brennan is currently all equity funded, which the market may think is inadvisable and does
not allow Brennan to exploit the advantage of debt being cheaper than equity due to the
tax shield.

ICAEW 2020 Business valuations, plans, dividends and growth 197

 Risk management

26 Fratton plc (June 2011)

Marking guide

Marks
26.1 (a) Forward market:
Forward rate 1
Net receipt 1
Money market:
Euro borrowing 1
Sterling conversion 1
Interest 1
Option market:
Type of option 1
Number of contracts 1
Premium in euros 1
Premium in sterling 1
Scenario 1: Option not exercised 1
Scenario 1: Sterling receipt 1
Scenario 2: Option exercised 1
Scenario 2: Gain on option 1
Scenario 2: Sterling receipt 1
14
(b) Transaction costs 1
Exact date does not need to be known 2
Cannot tailor contracts 1
Hedge inefficiencies 1
Limited number of currencies 1
More complex than forwards 1
7
26.2 (a) Buy a 3–6 FRA at a fixed rate 1
Calculation of amount bank to pay Fratton 1
Payment on the underlying loan 1
Net payment on the loan 1
4
(b) Sell three-month interest rate futures 1
Number of contracts 1
Calculation of gain 1
Futures outcome 1
Payment in the spot market 1
5
30

26.1 (a) Forward market

Bank sells £ at €1.1856/£
Forward rate = €1.1797 (1.1856 – 0.0059)
So €2,960,000/1.1797 = £2,509,112.49

198 Financial Management: Answer Bank ICAEW 2020

 Money market
To hedge a euro receivable, Fratton needs to create a euro liability which, with interest,
will exactly equal the receivable in three months' time:
€2,960,000/1.004 = £2,948,207.17
Convert to £ at spot (1.1856) to give £2,486,679.46.
Which with three months' interest at 0.2875% gives £2,493,828.66.
Options
Fratton should enter into a call option to buy £ at €1.18/£
Number of contracts = €2,960,000/1.18 = £2,508,475/10,000 = 250.85 = 250 contracts
The premium would be €60,000 (0.024  10,000  250)
Which at spot would cost £50,654.28 (60,000/1.1845)
Scenario 1:
Spot on expiry €1.12/£ – Exercise price €1.18/£ – intrinsic value: nil – exercise? No
£ receipt at spot = €2,960,000/1.12 = £2,642,857.14 (net £2,592,202.86)
Scenario 2:
Spot on expiry €1.20/£ – Exercise price €1.18/£ – intrinsic value: €0.02 per £ – exercise?
Yes
Gain on option of €50,000 (0.02  10,000  250)
Sell €3,010,000/1.20 = £2,508,333.33 (net £2,457,679.05)
(b) Advantages:
 Transaction costs of futures should be lower and they can be traded.
 The exact date of receipt or payment of the foreign currency does not need to be
known because the futures contract does not have to be closed out until the
underlying transaction takes place (subject only to the expiry date of the futures
contract).
Disadvantages:
 The contracts cannot be tailored to the user's exact requirements.
 Hedge inefficiencies are caused by standard contract sizes and basis.
 Only a limited number of currencies are available with futures contracts.
 The procedure for converting between two currencies neither of which is the $ is
more complex with futures compared to a forward contract.
26.2 (a) As a borrower Fratton should buy a 3–6 FRA and can thereby fix a borrowing rate of
2.60%.
At 3.00% rates have risen, so the bank will pay Fratton £2,500 (2.5m  {3.00%-2.60%} 
3/12). Payment on the underlying loan will be 3%  2,500,000  3/12 = £18,750
Net payment on the loan: £16,250 (18,750 – 2,500) – an effective rate of 2.60%
(b) Fratton will need to sell three-month £ interest rate futures contracts.
Fratton will need to sell five contracts (2,500,000/500,000  3/3)
Sell at 97.20 and buy at 97.00 for a gain of 0.20%.
Futures outcome: 0.20%  500,000  3/12  5 = £1,250
Payment in the spot market: 2,500,000  3%  3/12 = £18,750 – £1,250 = £17,500
(=2.80%)

ICAEW 2020 Risk management 199

 Examiner's comments:
This four-part question combined the interest rate and exchange rate risk management
elements of the Financial Management syllabus and was generally well answered by the well-
prepared candidates. There is now significant evidence that candidate performance in this
relatively new area is increasing to the levels seen in other areas of the syllabus. The average
mark achieved was 20.3/30 (67.6%).
The first part of the question required candidates to illustrate how they would hedge foreign
exchange risk in the scenario set out in the question using the forward market, the money
market and the options market. For the most part, this was well answered although weaker
candidates often made fundamental errors in the choice of exchange rate in the first part and
then often chose the wrong type of option to hedge the foreign exchange exposure.
Part (b) of the first requirement of the question required candidates to discuss the advantages
and disadvantages of using futures contracts as opposed to forward contracts to hedge foreign
exchange risk. For the most part this posed few problems for stronger candidates.
The second part of the question required candidates to illustrate the use of a forward rate
agreement to manage interest rate risk. Again, this was generally well answered and confirmed
the continuing improvement amongst most candidates in this area of the syllabus.
The final part of the question required candidates to illustrate the use of interest rate futures
contracts to manage interest rate risk. The vast majority of candidates scored well on this
question, although the most common omission was the identification of the actual interest rate
achieved as a result of the transaction.

27 Sunwin plc (December 2012)

Marking guide

Marks
27.1 Type of contract 1
Value of one contract 1
Number of contracts needed 1
Premium 1
If index rises – abandon 1
Outcome if index rises 1
Gain if index falls 1
Outcome if index falls 1
8
27.2 (a) Type of contract 1
Number of contracts 1
Futures outcome 1
Net outcome 1
Effective interest rate 1
Hedge efficiency 1
6

200 Financial Management: Answer Bank ICAEW 2020

 Marks
(b) Type of contract 1
Number of contracts 1
Premium cost 1
Case 1 – exercise 0.5
Case 1 – futures outcome 1
Case 1 – effective interest rate 2
Case 2 – do not exercise 0.5
Case 2 – effective interest rate 2
9
(c) 1 mark per point max 3
26

27.1 Sunwin requires an option to sell – a December put option with an exercise price of 5,000.
Portfolio value = £5.6m Exercise price = 5,000
Value of one contract = 5,000  £10 = £50,000
Number of contracts required = £5.6m/50,000 = 112 contracts
Premium: 70 points  £10 per point  112 contracts = £78,400
(a) If the index rises to 5,900, the put option gives Sunwin the right to sell @ 5,000, so the
option would be abandoned (with zero value).
Overall position: £
Value of portfolio 6,608,000
Gain on option –
Less premium (78,400)
6,529,600

(b) If the index falls to 4,100, the put option gives Sunwin the right to sell @ 5,000, so the
option would be exercised (value = £9,000 {900  £10}  112 contracts = £1,008,000).
Overall position: £
Value of portfolio 4,592,000
Gain on option 1,008,000
Less premium (78,400)
5,521,600

27.2 (a) Sunwin needs to sell a three-month contract

Number of contracts = 4m/0.5m  9/3 = 24 contracts
Futures outcome:
Selling at the opening rate of 96 and buying at the closing rate of 95 yields a gain of 1%
Therefore 1%  0.5m  3/12  24 = £30,000
Net outcome:
Spot market £4m  4.5%  9/12 = (£135,000) plus the futures receipt of £30,000 =
(£105,000)
Effective interest rate 105,000/4m  12/9 = 3.5%
Hedge efficiency:
Increase in spot rate = 1.5% so increase in interest = £60,000 (1.5%  4m)  9/12 =
£45,000
So the hedge efficiency = 30,000/45,000  100 = 66.7%
(b) Traded interest rate options on futures:
Sunwin requires a March put option with a strike price of 96.25 (100 – 3.75)
The number of contracts required = 4m/0.5m  9/3 = 24 contracts @ 0.18%
So the premium = 24  0.18%  0.5m  3/12 = £5,400

ICAEW 2020 Risk management 201

 Case 1:
Spot price 4.4%
Futures price 95.31
Strike price 96.25
Exercise? Yes
Gain on future 0.94% therefore 0.94%  0.5m  3/12  24 = £28,200
Borrowing cost at spot £132,000
Option (£28,200)
Premium £5,400
Effective interest rate £109,200/4m  12/9 = 3.64%
Case 2:
Spot price 2.1%
Futures price 97.75
Strike price 96.25
Exercise? No
Gain on future –
Borrowing cost at spot £63,000
Option –
Premium £5,400
Effective interest rate £68,400/4m  12/9 = 2.28%
(c) (1) The time period to expiry of the option – the longer the time to expiry, the more
the time value of the option will be.
(2) The volatility of the underlying security price – the more volatile, the greater the
chance of the option being 'in the money', which increases the time value of the
option.
(3) The general level of interest rates (the time value of money) – the time value of an
option reflects the present value of the exercise price.

Examiner's comments:
Following its introduction into the syllabus at the last review, this subject area was initially very
challenging for many candidates. However, at this sitting and in a reflection of an emerging
trend on the paper in more recent sittings, candidates' grasp of the material appears to get
stronger and stronger, so much so that it was this question, rather than the traditional NPV
question, that provided many candidates with the basis of their pass on the paper.
Most candidates performed strongly on the first part of this question, although where errors
were made they primarily related to incorrect calculation of the number of contracts and the
premium.
The only real areas of weakness in most candidates' responses to the second requirement were
in their being unable to effectively calculate hedge efficiency (many candidates simply did not
even make an attempt to do so) and in the mis-calculation of time-period adjustments and,
consequently, premiums. However, overall candidate strength in this area of the syllabus is
pleasing to see.

202 Financial Management: Answer Bank ICAEW 2020

28 Padd Shoes Ltd (March 2014)
Marking guide

Marks

28.1 (a) Sterling receipt if rupee weakens by 1% 2

(b) Option 2.5
(c) Forward contract 2.5
(d) Money market hedge 3
10
28.2 Relevant discussion 8

28.3 Government stability 1

Political and business ethics 1
Economic stability 1
Import restrictions 1
Remittance restrictions 1
Special taxes, regulations for foreign companies 1
Trading risks – physical risk, credit risk, liquidity risk etc 1
Maximum 5

28.4 Option 2
FRA 2
No hedge 1
Recommendation 2
7
30

28.1
INR 200,000,000
Sterling receipt at spot rate = £2,094,394
95.4930
(a) Sterling receipt if rupee INR 200,000,000 INR 200,000,000
£2,073,658
weakens by 1% (95.4930  1.01) 96.4479
INR 200,000,000
(b) Option (@ exercise price) £2,093,145
95.5500
Less cost (£8,000)
£2,085,145
(c) Forward INR 200,000,000 INR 200,000,000
£2,089,438
contract (95.4930 + 0.2265) 95.7195
Less cost (£4,500)
£2,084,938

(d) Money Market Hedge

INR 200,000,000
Borrow in rupees INR 197,628,450
1.012
INR 197,628,450
Convert @ spot rate £2,069,560
95.4930
Lend in sterling £2,069,560  1.008 £2,086,116

ICAEW 2020 Risk management 203

 28.2 Padd's directors' attitude to risk is important.
The interest rates and the forward rate discount suggest that the rupee will weaken. A
weaker rupee will produce less sterling on conversion, so hedging may be worthwhile.
The worst case scenario from 28.1 is if the rupee weakens by 1% over the next three
months.
The MMH (which would give a fixed sterling amount) gives the highest sterling figure,
followed closely by the OTC option, with which there is some flexibility for the directors.
The forward contract (which would also give a fixed sterling amount) produces a
comparatively poor sterling remittance. It has a high arrangement fee.
Were sterling to remain at spot rate then this would give the best outcome and a
strengthening of the rupee would enhance the sterling receipt even more.
28.3 Government stability
Political and business ethics
Economic stability
Import restrictions
Remittance restrictions
Special taxes, regulations for foreign companies
Trading risks – physical risk, credit risk, liquidity risk etc
28.4
LIBOR + 1 4% 7%

Option
Exercise? Indifferent Yes
Rate (4%) (4%)
Premium (0.75%) (0.75%)
(4.75%) (4.75%)
Annual interest payment (on £8.5m) (£403,750) (£403,750)

FRA
Pay at LIBOR +1 (4%) (7%)
(Payment to)/receipt from bank (0.5%) 2.5%
(4.5%) (4.5%)
Annual interest payment (on £8.5m) (£382,500) (£382,500)

No hedge
Pay at LIBOR + 1 (4%) (7%)
Annual interest payment (on £8.5m) (£340,000) (£595,000)

If LIBOR is 3% then it's better not to hedge and at 6% the FRA seems to be the cheapest
option.
It also depends on the board's attitude to risk.
The FRA eliminates down side risk (rates rising) as well as upside risk (rates falling).

Examiner's comments:
The average mark for this question was the highest in the paper, equated to a clear pass and so,
overall, was done well.
This was a four-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK footwear manufacturer/exporter and included relevant
exchange rates and interest rates. The question tested (a) candidates' understanding of foreign

204 Financial Management: Answer Bank ICAEW 2020

 exchange risk management, (b) the more general risks associated with trading overseas and (c)
how to hedge against interest rate movements.
The first requirement, for 10 marks, required candidates to calculate (a) the impact of a
strengthening of sterling on a proposed export contract and (b) the outcome of three possible
hedging strategies for that contract. The second requirement was worth eight marks and here
candidates had to advise the company's board as to which hedging technique was preferable (if
any), based on their calculations in the first requirement. The third requirement, for five marks,
asked candidates to advise the company of the risks (non-currency) to consider when trading
abroad. Finally, for seven marks, candidates had to recommend whether or not the company,
which has borrowed a large amount, should hedge against the impact of interest rate
movements on that loan.
The first requirement was very similar to past exam questions but despite this many candidates
did not get all of the calculation marks available. Typical errors were (a) using a call option rather
than a put and (b) ignoring contract costs.
The discussion in the second requirement was, in many cases, brief and very basic for eight
marks.
The third requirement was, as expected, answered well.
The fourth requirement caused many students difficulty. Too few of them produced sufficient
workings to enable them to produce suitable recommendations.

29 Lambourn plc (Sample paper)

Marking guide

Marks
29.1 (a) Net currency exposure 1
Forward rate 1
Cost of payment 2

(b) Type of option and strike price 1

Number of contracts 1
Calculation of premium 1
Decision to exercise 1
Gain on future 1
Total cost 1
(c) Sell December contracts 1
Number of contracts 1
Futures outcome 1
Spot market outcome 1

(d) Deposit amount 1

Sterling equivalent of deposit amount 1
Total cost including interest 1
17

ICAEW 2020 Risk management 205

 Marks
29.2 (a) December contracts 1
Put option 1
Strike price 1
Number of contracts 1
Calculation of premium 1
Decision to exercise 1
Gain on future 1
Gain outcome 1
Net position 1
Effective interest rate 1
10
(b) Basis risk 1.5
Rounding 1.5
3
30

29.1 (a) Lambourn's net foreign currency exposure is the net $ payment due = $1,550,000.
The sterling payments and receipts can be ignored.
The forward rate would be 1.6666 – 0.0249 = $1.6417/£.
The cost of the payment would therefore be 1,550,000/1.6417 = £944,143.
(b) The current spot rate is $1.6666/£ so Lambourn should buy December put options on
£ with a strike price of $1.67 as $1.65/£ and $1.63/£ are worse than current spot rate.
Number of contracts = $1,550,000/1.67/10,000 = 92.8 = 93 contracts
Premium = 93  10,000  0.0555 = $51,615 at spot ($1.6666) would cost £30,970
Outcome if the spot rate is $1.6400/£: Exercise the option
Option $1.67 Spot $1.64 so profit of ($0.03  93  10,000) = $27,900
Convert $1,550,000 – $27,900 = $1,522,100/1.64 = £928,110 + £30,970 = £959,080
Alternatively:
This will realise 10,000  93  $1.67 = $1,553,100
Excess $ = $3,100 which at spot would realise £1,884 (3,100/1.6454)
Cost = (10,000  93) + 30,970 – 1,884= £959,086
(c) Sell December futures @ 1.6496
$1,550,000/1.6496 = £939,622
Therefore 939,622/62,500 =15.03 = 15 contracts
Futures market outcome:
Sell at 1.6496
Buy at 1.6400
Profit 0.0096  15  62,500 = $9,000
Spot market outcome: Buy $1,541,000 @ $1.6400/£ = £939,634
(d) Lambourn requires $1,550,000 in six months' time – the company therefore needs to
deposit $1,546,135 now (1,550,000/1.0025).
To buy $1,546,135 now will cost £927,718 (1,546,135/1.6666).
The cost of this payment with six months' interest is £941,634 (927,718  {1+0.015}).

206 Financial Management: Answer Bank ICAEW 2020

 29.2 (a) Contract: December
Contract type: Put option
Strike price: 96.25 (to cap the interest rate at 3.75% pa)
Number of contracts: £1.5m/£0.5m  6/3 = 6 contracts
Premium: December put options at 96.25 = 0.96%
Therefore: 6  0.96%  £500,000  3/12 = £7,200
Closing prices:
Case 1 Case 2
Spot price 4.4% 2.1%
Futures price 95.31 97.75
Outcome:
Options market:
Strike price (sell) 96.25 96.25
Closing price (buy) 95.31 97.75
Exercise? YES NO
Gain on future 0.94% N/A
Outcome 0.94%  £500,000  3/12 N/A
 6 = £7,050
Net position:
Borrow at spot rate 33,000 15,750
Gain from option (7,050) N/A
Option premium 7,200 7,200
£33,150 £22,950
Interest rate 33,150/1,500,000  12/6 22,950/1,500,000  12/6
= 4.42% pa = 3.06% pa
(b) Futures may give less than 100% efficiency because of:
 basis risk – the price of a future may differ from the spot price on a given date.
Basis is nil at expiry but before then the change in the spot rate is not matched by
the change in the futures price preventing a hedge from being 100% efficient.
 rounding – frequently the number of contracts has to be rounded as dealing in
fractional contracts is not possible. This can also cause inefficiency.

Examiner's comments:
This risk management question produced the highest average mark of the three questions. This
reflects the fact that a firm knowledge of the techniques involved provides candidates with a
good opportunity to score highly on such questions, particularly when (as many do) they benefit
from the application of the 'follow-through' principle when such questions are marked. As usual,
however, there was very little middle ground – the failing candidates on the paper overall had
little or no grasp of the techniques involved in this question and scored poorly.
The most common errors in the first part were a failure to correctly calculate the firm's net
transaction exposure, often including the sterling amounts, incorrect identification of the correct
type of option, a failure to accurately calculate the number of contracts and the use of the wrong
rate when calculating the premium.
The second part was generally well answered.

ICAEW 2020 Risk management 207

30 Bridge Engineering plc (December 2015)
Marking guide

Marks

30.1 Intrinsic value:

Calculation of value of call options 1
Calculation of value of put options 1
Time value – deduct intrinsic value from the option premium 2
4
30.2 Explanation of each of the three factors:
Time period to expiry 1
Market price volatility 1
General level of interest rates 1
3
30.3 Explanation of the two factors:
Exercise price 1
Share price 1
2
30.4 How Bridge can protect itself:
Put options 1
Choice of exercise price 1
Calculations 2
4
30.5 To hedge against a rise in LIBOR:
Date of option 0.5
Put option 0.5
Exercise price 0.5
Calculation of number of contracts 1.5
Premium payable 1
Effective interest rate scenario (a):
Exercise? 0.5
Gain 1
Total interest payable 0.5
Net cost of the loan 1
Effective interest rate 0.5
Effective interest rate scenario (b):
Exercise? 0.5
Total interest payable 0.5
Total cost 1
Effective interest rate 0.5
10
30.6 Advantages of traded interest rate options:
Hedge downside risk, and take advantage of upside 1
FRAs and interest rate futures lock in the interest rate 1
Options set a maximum interest rate 1
Liquid market, can be closed out if not needed 1

208 Financial Management: Answer Bank ICAEW 2020

 Marks
Disadvantages of traded interest rate options:
Cost of the premium 1
Margin requirements 1
Contracts are standard sizes so may not fit perfectly 1
FRAs can be tailor made 1
Max 7
30

30.1 Intrinsic value

Only options that are in the money have an intrinsic value.
For the call options:
 the call options with an exercise price of 280p are in the money and have an
intrinsic value of 7p (287 – 280).
 the call options with an exercise price of 290p are out of the money and have a zero
intrinsic value.
For the put options:
 the put options with an exercise price of 290p are in the money and have an
intrinsic value of 3p (290 – 287).
 the put options with an exercise price of 280p are out of the money and have a zero
intrinsic value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:
Calls Puts
Exercise price January March January March
280 1.5 9 1.5 10.5
290 2.5 11 2.5 13.0
30.2 The three factors that affect the time value of the options on Stickle's shares are:
 the time period to expiry of the option. The longer the time to expiry, the more the
option is worth.
 the volatility of the market price of Stickle's shares. For example, if Sickle's share price
becomes more volatile this will increase the probability of the options becoming either
in the money or, if they are already in the money, becoming deeper in the money. This
would increase the value of the options.
 the general level of interest rates. The exercising of the option will be at some point in
the future, and so the value of the option depends on the present value of the exercise
price. For example, for the call options on Stickle's shares if interest rates rise the
options will become more valuable.
30.3 The factors that affect the intrinsic value of the options on Stickle's shares are:
 The exercise price:
– For a call option: The lower the exercise price in relation to the share price the
higher will be the intrinsic value and this will make the option more valuable.
– For a put option: The higher the exercise price in relation to the share price the
higher will be the intrinsic value and this will make the option more valuable.

ICAEW 2020 Risk management 209

  The share price:
– For a call option: As the share price rises the option becomes deeper in the
money and more valuable as the intrinsic value increases. The reverse is the case
for a fall in the share price.
– For a put option: As the share price falls the option becomes deeper in the money
and more valuable as the intrinsic value increases. The reverse is the case for a rise
in the share price.
30.4 Bridge can protect itself against a fall in the Stickle share price by holding put options that
expire on 31 March 20X6.
The choice of exercise price will depend on the level of cover required and how much
premium Bridge is willing to pay.
If the Stickle share price is 250p at the end of March the results of holding put options will
be as follow:
With an exercise price of 280p
Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the put options 280 – 250 = 30p
Premium: 10.5p
The maximum loss: 37 – 30 + 10.5 = 17.5p
Alternative: 287 – 280 + 10.5 = 17.5p
With an exercise price of 290p
Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the options 290 – 250 = 40p
Premium: 16p
Maximum loss: 37 – 40 + 16 = 13p
Alternative: 287 – 290 + 16 = 13p
30.5 To hedge against a rise in LIBOR from 0.62% pa during the period from 31 December 20X5
to 31 July 20X6, Bridge will need to hold September put options with an exercise price of
99.38 (100 – 0.62).
Using options on three-month interest rate futures to hedge a seven-month period, the
number of contracts to be held is: (£20 m/£0.5 m)  (7/3) = 93.33; round to 93 contracts.
This leaves the company slightly under hedged.
The premium payable is: 93  0.52%  0.5m  3/12 = £60,450.
The results of the hedge on 31 July 20X6 are as follows:
(a) LIBOR is 0.80% pa and the futures price is 99.15.
Exercise the options? Yes, since the exercise price is 99.38 and more than the futures
price.
Gain on futures: 99.38 – 99.15 = 0.23%. 0.23%  0.5m  93  3/12 = £26,738.
Borrowing cost: 0.80 + 4.00 = 4.80% pa.
Total interest payable to the bank: 20m  0.048  7/12 = £560,000
Net cost of the loan including the option premium:
560,000 + 60,450 – 26,738 = £593,712
The effective interest rate is: (593,712/20m)  (12/7) = 5.09% pa
Alternative: LIBOR + 4.00 – Gain on exercise + premium = 0.80 + 4.00 – 0.23 + 0.52 =
5.09% pa

210 Financial Management: Answer Bank ICAEW 2020

 (b) LIBOR is 0.40% pa and the futures price is 99.66
Exercise the options? No, since the exercise is 99.38 and less than the futures price.
Borrowing cost: 0.40 + 4.00 = 4.40% pa
Total interest payable to the bank: 20m  0.044  7/12 = £513,333
Total cost including the option premium: 513,333 + 60,450 = £573,783
The effective interest rate is: (573,783/20m)  (12/7) = 4.92% pa
Alternative: LIBOR + 4.00 + premium = 0.40 + 4.00 + 0.52 = 4.92% pa
30.6 The advantage of using options on interest rate futures rather than FRAs or interest rate
futures is that Bridge can hedge the downside risk (LIBOR rising) and take advantage of
upside potential (LIBOR falling).
Both FRAs and interest rate futures will lock Bridge into an estimate of LIBOR on 31 July
20X6.
The options will set a maximum on the interest rate that Bridge will have to pay.
The major disadvantage of using options on interest rate futures is the cost of the premium.
Both options on interest rate futures and interest rate futures are traded instruments and
there is a liquid market. Should Bridge not require the loan on 31 July 20X6 it can close out
the contracts.
There will be margin requirements, and there is the possibility of having to meet margin
calls.
With both these instruments basis risk exists and it is not possible to construct a perfect
hedge, since the contracts are in standard sizes of £500,000.
FRAs on the other hand are over-the-counter instruments, and can be tailor made to
Bridge's requirements.
The disadvantage of FRAs is that there is no liquid market for them should Bridge not need
to borrow the £20 million on 31 July 20X6.

Examiner's comments:
This was a six-part question that tested candidates' understanding of the risk management
element of the syllabus. The scenario was that a company had used derivative instruments to
hedge risk that locked the company into one rate or asset price. The finance director of the
company wished to know more about the use of financial options in risk management. Two risks
in particular that the finance director was concerned about were the risks associated with buying
shares and the interest rate risk associated with taking out loans.
There were many weak answers to the first part of the question, but there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. The
second part was poorly answered, which is surprising since this has been examined before.
However, again, there were some excellent answers.
There were many weak answers to the third part of the question, however there were some
excellent answers, which demonstrated a good understanding of the characteristics of options.
In the fourth part, many students successfully applied the knowledge that they had acquired
from their studies of FTSE 100 index options. However, basic errors included using calls instead
of puts and picking the incorrect month of exercise. The fifth part has been examined before, yet
there were many basic errors which included using calls instead of puts, an incorrect number of
contracts, the wrong date for the contracts and an inability to calculate an effective interest rate.
The final part was well answered by the majority of candidates.

ICAEW 2020 Risk management 211

 March 2016 exam answers

31 Aranheuston Pharma plc (March 2016)

Marking guide

Marks

31.1 Net present value of the AP525 product:

Sale of old equipment 0.5
Calculation of tax due on sale 1
New equipment cost and subsequent sale 1
Calculation of tax relief on equipment 2
Sales 1
Variable costs 1
Rent 1
Fixed costs 1.5
Taxation 2
Working capital 2
Discount factor 1
Ignore depreciation, head office costs, interest (1 mark each) 3
Conclusion 1
18
31.2 Sensitivity:
Variable costs 0.5
Taxation 1
Discount factor 1
Correct calculation of sensitivity and appropriate conclusion 2.5
5
13.3 Shareholder value analysis:
Value drivers 2
Methodology 2
Key features of the approach 2
6
31.4 Agency theory/conflicts:
(a) Takeover
Empire building, vested interests (1 mark per valid point) 3

(b) Debt levels (1 mark per valid point) 3

Time horizons (1 mark per valid point) 3
max 6
35

212 Financial Management: Answer Bank ICAEW 2020

 31.1
Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Old equipment – Sale 70,000
Tax due (1) (11,900)
New equipment cost/sale (1,150,000) 100,000
Tax relief on equipment (2) 35,190 28,856 23,662 90,792
Sales (3) 2,705,040 742,846
Variable costs (4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (5) (164,800) (169,744) (174,836)
Taxation (6) 13,600 41,616 (204,584) (55,694)
Working capital (7) 0 (267,800) 193,537 74,263
Net cash flow after taxation (1,123,110) (442,128) 1,216,049 536,971
8% factor 1.000 0.926 0.857 0.794
PV (1,123,110) (409,411) 1,042,154 426,355
NPV (64,012)

Ignore depreciation as it is not a cash flow.

Ignore HO costs as they are allocated – and therefore not incremental cash flows.
Ignore interest as it is part of the cost of capital.
AP525 produces a negative NPV, and so should not be undertaken as it would reduce
shareholder wealth.
Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
(1)
WDV b/f 0
Balancing charge 70,000
WDV/sale 70,000

Tax (17%  balancing 11,900

charge)

(2)
Equipment purchase/WDV 1,150,000 943,000 773,260 634,073
WDA @ 18%/Bal.allowance (207,000) (169,740) (139,187) (534,073)
WDV/sale 943,000 773,260 634,073 100,000

Tax
(17%  WDV/Bal.allowance) 35,190 28,856 23,662 90,792

(3)
Sales (March 20X6 prices) 2,600,000 700,000
Inflate at 2% pa  (1.02)2  (1.02)3
"Money" sales income 2,705,040 742,846

(4)
Variable cost 1,180,000 220,000
(March 20X6 prices)
Inflate at 3% pa  (1.03)2  (1.03)3
"Money" variable cost 1,251,862 240,400

ICAEW 2020 March 2016 exam answers 213

 (5)
Fixed costs
(March 20X6 prices) 290,000 290,000 290,000
less: HO cost allocation (130,000) (130,000) (130,000)
160,000 160,000 160,000
Inflate at 3% pa  1.03  (1.03)2  (1.03)3
"Money" fixed costs 164,800 169,744 174,836

(6)
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) _ (164,800) (169,744) (174,836)
Trading profit/(loss) (80,000) (244,800) 1,203,434 327,610

Tax reclaim/(payable) @ 17% 13,600 41,616 (204,584) (55,694)

(7)
Total working capital 0 260,000 70,000 0
 1.03  (1.03)2
"Money" total working capital 0 267,800 74,263 0

Incremental working capital 0 (267,800) 193,537 74,263

31.2 PV of variable costs

Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Variable costs (1,251,862) (240,400)
Taxation @ 17% 212,817 40,868
Net cash flow after taxation (1,039,045) (199,532)
8% factor 0.857 0.794
PV (890,462) (158,428)

Total PV of variable costs (£890,461 + £158,428) £(1,048,890)

£(64, 012)
% change in variable costs required 6.1%
£(1, 048, 890)
Thus, ignoring all other factors, variable costs would need to fall by 6.1% before the NPV
became positive and the AP525 was viable. This is a relatively small change required to
make the NPV positive.
31.3 With shareholder value analysis (SVA), a company's value is based on the present value of
its future cash flows, so it is forward-looking. This is theoretically the most superior valuation
method. SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) List of capital
Predictions are very difficult, as cash flows are technically in perpetuity. Once a company's
period of competitive advantage is over then its growth rate is much slower and a terminal
(residual) value is calculated, based on its cash flows to perpetuity. This terminal value is
often the major part of the overall value of the company.

214 Financial Management: Answer Bank ICAEW 2020

 Once the total value of the company has been calculated, based on the future cash flows
and value drivers, then, to calculate the value of equity, it is necessary to add the value of
any short-term investments held and deduct the market value of any debt held.
31.4 (a) A takeover – eg, empire building by directors, making acquisitions which are not in the
shareholders' best interest (negative NPV). Or, alternatively, a takeover might lead to
the directors being made redundant, so they would avoid a takeover which would have
been in the shareholders' best interest (positive NPV).
(b)  Debt levels – it is an all-debt financed equipment purchase here, but the directors
are likely to be cautious over risk and may prefer lower levels of debt than would
be at the optimal level (where share price maximised) for the shareholders.
 Time horizons – directors may take a short-term view of the firm as their
performance is usually judged in the short-term. However, shareholder wealth is
affected by the long-term performance of the company. Thus directors might turn
down a possible investment that has short-term losses, but a long-term positive
NPV. This would not occur in the case of AP525, as it has a negative NPV.

Examiner's comments:
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good indeed.
This was a four-part question that tested the candidates' understanding of the investment
decisions element of the syllabus. In the scenario a pharmaceutical company was considering
the development of a new product and the possible takeover of a competitor. In the first part,
for 18 marks, candidates were required to calculate the net present value of the proposed
product development. They were given forecast life-cycle data for the new product and had to
take account of non-relevant cash flows, inflation rates and corporation tax implications.
Secondly, for five marks, they were required to calculate the sensitivity of that decision to the
variable costs of the product. For a further six marks they were asked to outline how Shareholder
Value Analysis (SVA) could be used when valuing a target company. Finally, for six marks,
candidates were required to apply their understanding of agency theory to three specific
elements of the scenario.
The first part was very well answered by most candidates. However, common errors noted were:
 no balancing charge calculated on the old equipment to be disposed of.
 rental costs (fixed) were inflated and/or in arrears, not in advance.
 tax savings from negative cash flows in Year 0 and Year 1 were omitted.
 working capital – did not net to zero, was applied to the wrong years, the inflation
calculations were poor.
Also, many candidates lost marks for not explaining why depreciation, head office costs and
interest charges were not relevant cash flows. 'Not relevant' was insufficient. In the second part,
the sensitivity calculations were generally fine. The most common errors were (a) using sales or
contribution figures rather than variable costs and (b) missing out the effect of taxation in the
calculations.
As in previous papers the candidates' understanding of SVA was generally poor. A
disappointing number of them concentrated, wrongly, on NPV rather than PV and discussed
SVA in regard to a project and not the valuation of a target company. Thus, many candidates did
not mention terminal value. Agency theory was generally answered well. The weakest area here
was candidates' explanation of the conflicts that might arise in relation to short-term versus long-
term performance appraisal in the context of the project. Too many used a takeover context
instead.

ICAEW 2020 March 2016 exam answers 215

32 Oliphant Williams plc (March 2016)
Marking guide

Marks

32.1 Calculation of gearing ratio:

Book value 1.5
Market value 1.5
3
32.2 Gearing and share price:
View on gearing 2
Comparison of book value and market value 2
No industry comparison available 1
Reduction in gearing will have positive effect on share price 1
6
32.3 Impact of rights issue:
Calculation of funds needed for debenture redemption 2
Calculation of TERP 3
Value of a right 0.5
Current value of 10,000 shares 0.5
(a) Effect of taking up the rights 1
(b) Effect of selling the rights 1
(c) Effect of ignoring the rights 1
9
32.4 OW share price:
Current EPS 1
Current PE ratio 1
Calculation of new earnings figure 2
New EPS 1
MV per share post rights 1
Commentary 1
7
32.5 Dividend policy:
M&M theory 2
Traditional theory 2
Other theories 2
Change in dividend policy likely to have effect 1
7
32.6 Ethical implications:
Objectivity 1
Integrity 1
Professional behaviour 1
3
35

216 Financial Management: Answer Bank ICAEW 2020

 32.1
Long term finance Book value Market value
£m £m
Ordinary share capital 96.0 326.4
retained earnings (RE) 43.8 n/a
Preference share capital (PSC) 28.0 50.4
3.5% debentures 160.0 168.0
327.8 544.8

Total fixed return capital (debentures + PSC) 188.0 218.4

Gearing % 188.0 57.4% 218.4 40.1%

327.8 544.8
32.2 The main theories of gearing and market value are the traditional view, M&M 1958 and
1963.
The modern view is that the optimum gearing level (where company value is maximised) is
a balance between the benefits of the tax shield and bankruptcy costs. The impact on OW's
WACC (and value) depends on where its optimum gearing level is.
OW's gearing at book value is over 57%; this is rather high and may depress OW's market
value.
However, gearing at market value is 40%. This is much lower, which may have a positive
effect on the value of OW's shares.
It is hard to say where OW's optimal gearing level is likely to be, as there are no industry
comparisons.
If OW's gearing level is currently above its optimal level, then a reduction in its gearing will
have a positive effect on its share price and vice versa.
32.3 Total funds needed for debenture redemption = £160m  50%  110.40/100 £88.32m
Shares
m £m
Currently 192.0 £1.70 326.400
Rights issue (2 for 5) 76.8 £1.15 88.320
268.8 £1.5429 414.72

TERP = £1.5429
Value of a right = £1.5429 – £1.15 £0.3929
Current wealth 10,000  £1.70 17,000
(a) Take up rights £ £
Investment ex-rights 10,000  7/5  1.5429 21,600
Cost of extra shares 10,000  2/5  £1.15 (4,600) 17,000
(b) Sell rights
Investment ex-rights 10,000  1.5429 15,429
Sale of rights 10,000  2/5  £0.39 1,571 17,000
(c) Ignore rights
Investment ex-rights 10,000  1.5429 15,429
32.4 OW's current earnings per share (EPS) £21.12m/192.0m £0.11
OW's current p/e ratio £1.70/£0.11 15.5
[or £326.4m/£21.12m = 15.5 for 2 marks]

ICAEW 2020 March 2016 exam answers 217

 £m
OW's current earnings 21.120
plus: Interest saved (after tax) £160m/2  3.5%  83% 2.324
OW's new earnings 23.444

OW's new earnings per share (EPS) £23.444m/268.8m £0.0872

OW's MV/share post-rights £0.0872  15.5 £1.35
Thus if OW's P/E ratio remains unchanged post-rights, its market value will fall (from
£1.70 per share) by approx. £0.35 per share (20.6%). This fall has been caused by a dilution
in the EPS figure (the extra shares have outweighed the impact of the debenture interest
saved).
However the debenture redemption will cause a fall in gearing. This decline in gearing may
prompt an increase in OW's p/e ratio (because of lower financial risk).
32.5 M&M theory – share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities (positive NPV's).
Any loss in dividend income will be offset by gains in the share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or
capital gains in the future. Cash now is more certain than cash in the future.
Supplementing these main theories:
 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on OW's share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change,
Communication with them is important.
32.6 ICAEW provides ethical guidance that will ensure that recipients of corporate finance
advice can rely on the objectivity and integrity of advice given to them by members. The
other ethical principle at risk here is that of professional behaviour.

Examiner's comments:
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a "pass" standard in the question, however.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it. It was
based around a design company which was planning to restructure its balance sheet. This would
be achieved by financing the redemption of long-term debt via a rights issue of ordinary shares.
The first part of the question, for three marks, required candidates to calculate the current
gearing levels of the company, using both book and market values. In the second part, for six
marks, they were asked to discuss the impact of a change in the company's gearing levels on its
share price. Candidates were expected to make reference to relevant theories and their
calculations from the first part. The third part, for nine marks, required the candidates to
calculate the theoretical ex-rights price (TERP) of the company and the impact of the proposed
rights issue on the wealth of a shareholder holding 10,000 of the company's shares. The fourth
part (seven marks) tested candidates' understanding of (a) the company's P/E figure and (b) the
impact of the debt redemption on the company's earnings figure. The fifth part, again for seven
marks, required candidates to apply their understanding of dividend policy theory to the
scenario. Finally, for three marks, the final part required candidates to comment as an ICAEW
Chartered Accountant on the ethical implications of issuing misleading information to
shareholders.

218 Financial Management: Answer Bank ICAEW 2020

 Many candidates' answers to the first part were disappointingly weak. Typical errors were: (a)
not including preference shares as debt (contra to the study manual and past questions) and (b)
ignoring retained earnings in their book value calculations, but including it in their market value
calculations.
In the second part, many candidates only scored three marks by focusing just on the theory of
gearing and company value. Those scoring higher marks noted that there was a lack of industry
comparison available in the question and, better still, noted the importance of where the
company is now in relation to its optimum gearing level.
In the third part, a significant number of candidates calculated a TERP in excess of the current
market value – clearly this is wrong. This was mainly because they assumed that the par value of
ordinary shares was £1 (not 50p) and insisted that the share price was £3.40, not £1.70, as given
in the question. Many candidates did not calculate the correct debenture redemption figure.
Most candidates did well with the impact of the rights issue on the shareholder's wealth, but
many calculated a large increase in wealth when it should be zero or a loss from doing nothing.
Candidates' performance in the fourth part was very variable indeed and was probably the
weakest set of answers on the whole paper. Very few candidates adjusted the company's
earnings figure for saved interest (less tax). A disappointing number calculated the P/E ratio,
wrongly, as follows: £1.70/£21.12m.
The fifth part was answered very well, as expected. The final part was also answered well, but a
high number of candidates included money laundering in their answers – not relevant here.

33 Tully Carlisle Ltd (March 2016)

Marking guide

Marks
33.1 (a) Hedging strategies:
Forward contract 2
Money market hedge 3
OTC currency option 3
8
(b) Advice on hedge:
Use of spot rates to analyse costs 3
Conclusion re options 1
Effect of continually weakening rouble on spot rate 1
Advantages of options (flexibility) 2
Other factors to consider (risk attitudes, political risk) 2
9
(c) Three month forward rate:
Interest rate parity 2
Calculation of three-month forward rate using IRP
formula 2
Calculation of discount 1
5
33.2 Interest rate swap:
Calculation of interest rate differences 1
Details of swap 2
Net new rate for TC 1.5
Net new rate for SSM 1.5
Details of new interest payments 2
8
30

ICAEW 2020 March 2016 exam answers 219

 33.1 (a) Forward contract

Payment in sterling would R145.6m R145.6m

(£1,834,677)
be (78.81+ 0.55) (79.36)
plus: arrangement fee 145.6  £40 (£5,824)
(£1,840,501)

Money market hedge

Payment in sterling would R145.6m R145.6m R143,589,740 lent

be (1+ (5.6% / 4)) 1.014

Converted at spot rate R143, 589, 740 (£1,821,973)

78.81
Borrowed at 3.6% p.a. £1,821,974  (3.6%/4) (£16,398)
(£1,838,371)

OTC currency option

A call option would be used (ie, at 79.85R/£)

R145.6m
Payment in sterling would be (£1,823,419)
79.85
plus: Option premium 145.6  £90 (£13,104)
(£1,836,523)

R145.6m
(b) Sterling payment at spot rate (£1,847,481)
78.81

R145.6m
Comparative payment at earlier dates 31/12/X4 (£1,832,599)
78.81

R145.6m
31/12/X5 (£1,903,019)
78.81
Stronger sterling gives the lowest payment, and weaker sterling the highest.
The forward contract discount suggests a weakening of the rouble. It has weakened
from December 20X5 to February 20X6, so this may be a trend.
In order (lowest to highest cost)
Option (£1,836,523)
Money market hedge (£1,838,371)
Forward contract (£1,840,501)
Spot (£1,847,481)
The option gives the best outcome (it has a slightly lower cost than the money market
hedge and the forward contract). However, if the rouble continued to weaken then the
sterling cost would fall further. For example, a 1% increase in the spot value of sterling
over the next three months would make this the lowest sterling payment
(145.6mR/(78.81  1.01) = £1,829,146.
An option gives flexibility (the ability to abandon, or to take advantage of any upside)
unlike the money market hedge or forward contract (which are both fixed, binding, and
have no upside/downside).
The directors' attitude to risk is important, as is a consideration of issues such as the
potential for political risk associated with operations in Russia.

220 Financial Management: Answer Bank ICAEW 2020

 1+Average rouble interest rate (3mths)
(c) Average spot rate  = Forward contract rate (3mths)
1+ Average sterling interest rate (3mths)

The rouble interest rates are higher than those of sterling. Using the interest rate parity
(IRP) equation above, the value of sterling against the rouble will rise. The rouble's loss
of value is called a discount.
Average UK rate 3.25% pa or 0.8125% per 3 months
Average Russian rate 6.1% pa or 1.525% per 3 months
Average spot = (90.62 – 78.81)/2) + 78.81 = 84.715
Forward = 84.715  (1.01525/1.008125) = 85.31 ie, a discount of 0.6
Average discount given = 0.59, so IRP is working
33.2
TC SSM Difference
Fixed 5.2% 6.4% 1.2%
Variable LIBOR + 1.2 LIBOR + 1.6 0.4%
Difference between differences 0.8%

This potential gain can be split evenly, ie, 0.4% to each party. This means that TC would pay
LIBOR + 0.8% (LIBOR + [1.2% – 0.4%] and SSM would pay fixed 6.0% (6.4% – 0.4%).
The interest rate swap would look like this:
TC SSM
Currently pays (5.2%) (LIBOR + 1.6)
TC pays SSM (LIBOR) LIBOR
SSM pays TC (balancing figure) 4.4% (4.4)
New net payment (LIBOR + 0.8) (6.0%)

TC and SSM would both pay at less (0.4% in each case) than their available fixed and
variable rates.
TC SSM
New net interest rate (LIBOR + 0.8) 4.3% pa 6.0% pa
£'000 £'000
Interest on £18.5m pa (795.5) (1,110.0)

Alternatively
£'000 Rate £'000 £'000 Rate £'000
Interest paid now 18,500 (5.2%) (962.0) 18,500 (5.1%) (943.5)
SSM pays TC 4.4% 814.0 (4.4%) (814.0)
TC pays SSM (3.5%) (647.5) 3.5% 647.5
New interest
payment (795.5) (1,110.0)

ICAEW 2020 March 2016 exam answers 221

 Examiner's comments:
The average mark for this question was very good and most candidates demonstrated a good
understanding of this area of the syllabus.
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus. In the scenario a construction company was investigating
firstly how it might manage its exposure to foreign exchange rate risk and then whether a
proposed interest rate swap on borrowed funds was worthwhile. Part (a) of the first requirement,
for eight marks, required candidates to calculate the sterling cost arising from a range of
hedging techniques applied to a large Russian purchase contract. In part (b), for nine marks,
candidates were required to advise the company's board whether it should hedge the Russian
(rouble) payments. Part (c), for five marks required candidates to explain, with relevant workings,
the concept of interest rate parity (IRP). In the second part, for eight marks, the company was
planning to swap its borrowings from a fixed rate to a variable rate of interest and candidates
were asked to provide workings for the board demonstrating how the swap would work and
calculating the resultant annual interest payments.
Most candidates' answers to part (a) of the first requirement were very good, but the most
common error noted was that a minority of candidates used the wrong approach with regard to
the call option. Answers to part (b) were not as good as hoped. Too many candidates discussed
recent spot movements or forward contract versus money market hedge versus option, rather
than both. In part (c) the concept of IRP was, in most cases, answered well, but many candidates
used 12-month rather than three-month figures. A minority of candidates did not mention IRP,
and so scored zero.
In the second requirement, the interest rate swap was done very well and most candidates
scored maximum marks. The weakest area was with the initial overall saving on interest cost
(0.8%), which a small percentage of candidates did not calculate correctly.

222 Financial Management: Answer Bank ICAEW 2020

 June 2016 exam answers

34 Zeus plc (June 2016)

Marking guide

Marks

34.1 Valuation using NPV:

Gross profit calculation 3
Selling and admin costs 1.5
After tax operating cash flows 1
New equipment 0.5
Tax saved on capital allowances 2.5
Working capital 2.5
Continuing value 3
Discount factor 10% 0.5
NPV 0.5
15
34.2 Multiple of current earnings:
Profits after tax 1
Use of mean P/E ratio 1
2
34.3 Advantages and disadvantages of valuation methods:
Advantages of NPV valuation 0.5
Disadvantages of NPV valuation 0.5
Advantages of mulitples valuation 0.5
Disadvantages of multiples valuation 0.5
Reservations regarding the NPV valuation – 0.5 marks each 2
Reservations regarding the mulitples valuation – 0.5 marks
each 2
max 5
34.4 Offer for sale 1
Offer for subscription 1
2
34.5 Underwriting:
Explanation of underwriting 1
Advantages for Zeus 2
Disadvantages for Zeus 2
max 4
34.6 Suggestions:
2 marks each for any two:
MBO
Private equity (MBI)
Sell to another internet company
Demerger
Liquidation max 4

34.7 Ethical issues:

Identification of threats 1
Ways to mitigate them – 0.5 marks each 2
3
35

ICAEW 2020 June 2016 exam answers 223

 34.1
0 1 2 3 4
£m £m £m £m £m
Gross profit 111.21 133.85 161.10 193.90
Selling and administration (73.50) (77.18) (81.04) (85.09)
Operating cash flows 37.71 56.67 80.06 108.81
Tax 17% (6.41) (9.63) (13.61) (18.50)
After tax operating cash flows 31.30 47.04 66.45 90.31
New equipment (10.00)
Tax saved on CA's 0.31 0.25 0.21 0.17 0.77
Working capital (26.00) (5.29) (6.37) (7.67) 45.33
Continuing value 1,013.48
Net cash flows (35.69) 26.26 40.88 58.95 1,149.89
PV factors at 10% 1.00 0.91 0.83 0.75 0.68
Present value (35.69) 23.90 33.93 44.21 781.93
NPV 848.28
Gross profit = £92.4 million (140  66%)
Gross profit year:
1 = 92.4  1.18  1.02 = £111.21 million
2 = 111.21  1.18  1.02 = £133.85 million
3 = 133.85  1.18  1.02 = £161.10 million
4 = 161.10  1.18  1.02 = £193.90 million
Selling and administration £70 million (72 – 2) increasing at 5% pa, as depreciation is not a
cash flow.
Continuing value = (90.31  1.01)/(0.10 – 0.01) = £1,013.48 million
Ignoring balance sheet asset values (valuing the income that the assets generate)
Capital allowances and the tax saved thereon
Cost/WDV CA Tax
£m £m £m
0 10.00 1.80 0.31
1 8.20 1.48 0.25
2 6.72 1.21 0.21
3 5.51 0.99 0.17
4 4.52 4.52 0.77
Working capital
Total Increment
£m £m
0 (26.00) (26.00)
1 (31.29) (5.29)
2 (37.66) (6.37)
3 (45.33) (7.67)
4 45.33
34.2 Profits after tax at 30 June 20X6 = £10 million.
The value of Venus based on the mean p/e ratio = £550 million (10  55).

224 Financial Management: Answer Bank ICAEW 2020

 34.3 The advantages of the NPV valuation are that it values the future cash flows of the company
and takes into account both risk and the time value of money. However it has the
disadvantage that the inputs into the model are critical in arriving at a reliable estimate of
the value of Venus.
The major advantage of the multiples valuation is that it values Venus by comparison to its
peers, and reflects the future growth potential of the market. However the disadvantages
are that no company is truly comparable with another, and establishing a maintainable
earnings figure is problematic.
In relation to Venus, reservations include:
For the NPV valuation: Is 18% growth realistic for the next four years? How has this figure
been estimated? Does the 10% discount factor truly reflect the risk of the company? Is it
reasonable to calculate the continuing value by treating the fourth year after tax operating
cash flow as a growing perpetuity? How has the 1% growth figure been calculated? Is it
reasonable to assume that the gross profit percentage will increase by 10%?
For the multiples valuation: The p/e ratio of 55 is the mean of a sample of comparable
companies, but what is the spread of p/e ratios, and have outliers been excluded? Is taking
historic earnings realistic – should prospective earnings be calculated instead?
34.4 With an offer for sale shares in Venus would be sold to an issuing house, which would then
offer the shares for sale to the general public.
With an offer for subscription (or direct offer) the shares in Venus would be offered directly
to the public ie, not through an issuing house.
34.5 Underwriting is a form of insurance, which ensures that all securities are sold and Zeus can
be certain of obtaining the funds required.
The danger for Zeus of not using a underwriter for the IPO is that there might be insufficient
demand for all the securities to be issued. This is especially important when a fixed issue
price is set in advance of the issue date, and the market is volatile. The market appetite for
Venus's stocks might be less than expected, especially with the value placed on the
company, which depends on high future growth.
The major disadvantage of underwriting is the cost. The cost depends on the characteristics
of the company issuing the security and the state of the market. With a company such as
Venus, the cost is likely to be at the upper end of the scale. Fees usually range from 1% to
2% of the total finance to be raised.
Another disadvantage of underwriting is that it may signal that the company is not confident
in the issue being fully taken up.
34.6 A management buy-out is a possibility. However due to the value of and risk associated with
Venus it is more likely that a private equity firm would be interested in being involved in a
management buy-in. Private equity firms have access to large amounts of debt.
Zeus could sell-off Venus to another internet company that is involved in the fashion
industry and is seeking to expand.
With an MBO, MBI or sell-off, Zeus would receive cash but there may be difficult
negotiations regarding the price. In addition, the shareholders of Zeus would not be able to
participate in the future growth of Venus.
Zeus could spin-off (or demerge) Venus; the existing shareholders would then hold shares
in the demerged company as well as in the remaining group. Shareholders could then
participate in the growth of Venus as an independent company.
Liquidation or selling of the assets would generate cash, but this would be a last resort.

ICAEW 2020 June 2016 exam answers 225

 34.7 For SA there is an issue of confidentiality here, and a potential conflict of interest. This can
be resolved by:
 the use of different partners and teams for different clients.
 taking the necessary steps to prevent the leakage of confidential information between
different teams and sections within the firm's "Chinese walls".
 regular review of the situation by a senior partner or compliance officer not personally
involved with either client.
Advising clients to seek additional independent advice, where it is appropriate.

Examiner's comments:
This was a seven-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is divesting
itself of a division by offering it to the public through an Initial Public Offering.
The first part was well answered by many candidates. Common errors that weaker candidates
made were: including operating cash flows in time zero; incorrect calculation of the continuing
value; adding the 18% growth and 2% price increase figures together instead of compounding
them; omitting to explain why certain inputs were not to be included in the cash flows; applying
a non-marketability discount to the final valuation.
The second part was also well answered by the majority of candidates. However, many
candidates applied a non-marketability discount to the p/e ratio, which was inappropriate for the
valuation of an IPO. Responses to the third part were mixed and often did not relate to the
scenario of the question despite the requirement specifically asking for this. Very few students
submitted correct answers to the fourth part of the question, and often made up definitions.
Responses to the fifth part were mixed, with a lot of candidates showing that they did not
understand what underwriting means. Responses to the sixth part were good, although often
candidates did not consider the scenario of the question. The final part was well answered by
the majority of candidates. However, as in previous sittings, a number of candidates did not use
the language of ethics.

35 Ross Travel plc (June 2016)

Marking guide

Marks

35.1 (a) Calculation of WACC using Gordon growth model:

Ex-div share price 0.5
Shares in issue 0.5
Total earnings calculation 1
Total dividends 0.5
Retentions 1
Calculation of rate of return 2
Calculation of growth rate 0.5
Cost of equity 1
Cost of debt 3
MV of equity 1
MV of debt 1
12

226 Financial Management: Answer Bank ICAEW 2020

 Marks
(b) Calculation of WACC using CAPM:
Cost of equity 1
Cost of debt 1
2
35.2 Limitations of the Gordon growth model:
One mark per point to a maximum of 3

35.3 WACC for appraisal of Happytours:

Explanation of need to reflect risk 3
Degearing of the beta for the new sector 1.5
Regear using Ross's capital structure 1.5
New cost of equity 0.5
Calculation of WACC 0.5
max 6
35.4 New debentures:
Higher yield likely to be required: risk, coupon rate;
maturity 2
Calculation of issue price 4
Calculation of nominal value to be issued 1
7
35.5 Convertible debentures:
Explanation and features of convertible debentures 3
Advantages – 0.5 marks each 2.5
Disadvantages – 0.5 marks each 1
max 5
35

35.1 (a) WACC using the Gordon growth model:

The growth rate = g = r  b Where r = the current accounting rate of return
b = the proportion of profits after tax retained
The profits after tax = the current ex-div share price  the earnings yield  the number
of shares in issue.
The ex-div share price = 565p (576p – 11p)
The number of shares in issue = 640m (£32m/£0.05)
The total earnings = £216.96m (565p  0.06  640m)
Total dividends = £70.40m (11p  640m)
Retentions = £146.56m (£216.96m – £70.40m) b = 67.55% (£146.56m/£216.96m)
r = Earnings/Opening equity capital employed = £216.96/(£3,104m – £146.56m) =
7.33%
g = 7.33%  67.55% = 4.95% say 5%
ke = (d1/MV) + g = (11p(1.05)/565p) + 0.05 = 7%
The cost of debt (kd) =
Year Cash Flow 1% PV 5% PV
0 (105) 1 (105.00) 1 (105.00)
1–4 6 3.902 23.41 3.546 21.28
4 100 0.961 96.10 0.823 82.30
14.51 (1.42)

ICAEW 2020 June 2016 exam answers 227

 The yield to maturity is a little under 5% = 1 + ((14.51/(14.51 + 1.42)  (5 – 1)) = 4.64%
kd = 3.85% (4.64  (1 – 0.17))
Market values:
Equity = £3,616m (565p  640m)
Debt = £638.4m (£608m  1.05)
WACC = (7%  3,616 + 3.85%  638.4)/(3,616 + 638.4) = 6.5%
(b) WACC using the CAPM:
ke = 2 + (0.65  5) = 5.25%
kd = 3.85%
WACC = ((5.25%  3,616) + (3.85%  638.4))/(3,616 + 638.4) = 5%
35.2 Particular issues are as follows:
 The model relies on accounting profits.
 It assumes that b and r remain constant.
 It can be distorted by inflation.
 It relies on historic information.
 It assumes that all new finance is from equity or that gearing is held constant.
35.3 The discount rate to appraise the Happytours project must reflect its systematic risk. Ross
operates in the public transport sector; the holiday and sightseeing sector of the
transportation industry is likely to have a higher systematic risk since it relies more on
discretionary spending than the public transportation sector.
The discount rate should also reflect the financial risk of Ross; in this case the finance will be
raised in such proportions that the market value gearing will remain constant.
A beta factor from a company operating in the new sector should be selected to reflect the
systematic risk. However gearing adjustments are likely to be necessary.
Equity beta of the new sector = 1.3.
Degear the beta factor: 1.3  (1/(1 + (1  0.83)) = 0.71.
Regear the beta factor using Ross's capital structure:
0.71  ((3,616 + (638.4  0.83)/3,616) = 0.81.
Ross's current equity beta is 0.65 and the equity beta for the new industry sector is 0.81,
which reflects its higher systematic risk.
ke becomes = 2 + (0.81  5) = 6.05%
WACC = ((6.05%  3,616) + (3.85%  638.4))/(3,616 + 638.4) = 5.72%
35.4 The yield to maturity that investors in the debentures will require should reflect the riskiness
of the debentures, the coupon rate and the maturity date. The new debentures have a
longer maturity date and a lower coupon rate than Ross's current debentures. Therefore it is
likely that investors in the new debentures will require a higher yield to maturity than
investors in the existing debentures.
The issue price of the new debentures is arrived at by discounting their cash flows at an
appropriate yield to maturity.
Using the yield to maturity of the current debentures of 4.64%, the issue price will be:
5
Annuity factor for five years at 4.64% = (1 – 1/(1 + 0.0464) )/0.0464 = 4.373%
(Note: If an annuity factor and discount factor at 5% are used, full marks will be given.)
The issue price per £100 nominal value = (4  4.373) + 100  1/1.0464 = £97.20
5

228 Financial Management: Answer Bank ICAEW 2020

 The total nominal value that will have to be issued to raise £75 million = £75m/0.972 =
£77.16 million.
35.5 Convertible debentures are fixed return securities that can be either secured or unsecured.
They may be converted, at the option of the holder (and sometimes the company) into
ordinary shares in the same company at a future date, or a series of future dates.
The coupon on convertible debentures is normally lower than on redeemable debentures
because of the value of the conversion rights.
Advantages for Ross include the following:
 Obtaining finance at a lower rate of interest than on redeemable debentures
 Encouraging possible investors with the prospect of a future share in profits
 Introducing an element of short-term gearing
 Avoiding the problem of redemption if the conversion rights are taken up
 Being able to issue equity cheaply if the debentures are converted
Disadvantages for Ross include the following:
 Dilution of control if the conversion rights are taken up
 Uncertainty as to whether the conversion rights will be taken up and the debentures
have to be redeemed in cash

Examiner's comments:
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was that a company is expanding its
operations into a different sector of its market.
There were many basic errors in the first part which really should not be occurring given how
many times this has been set. The errors included the inability to calculate numbers correctly;
incorrectly calculating the number of shares in issue; not calculating the ex-div share price
and/or the ex-interest debenture price; for the cost of debt calculating positive and negative
values and interpolating outside of the range calculated; no tax adjustment for the cost of debt
and using book values for the WACC calculation. In the second requirement part (b) it was
disappointing to see that many candidates were deducting the risk free rate from the market risk
premium. Also a number of candidates were using the 1.3 equity beta from the sightseeing tour
sector rather than Ross's existing equity beta of 0.65.
The second part was well answered by the majority of candidates. Answers to the third part were
mixed and often there were no reality checks made, with some candidates clearly demonstrating
that they have a very shallow knowledge of the topic. Errors included calculating unrealistic
equity betas (over 300 in one script); degearing using Ross's market values and regearing the
gearing ratio of the holiday and sightseeing tour sector; regearing using book values despite
the formulae sheet stating market values; degearing and regearing with the same debt/equity
ratio and ending up with a different figure from the start; when regearing changing the gearing
ratio, even though the question states that this will not change; very brief or non-existent
explanations of the rationale.
Despite the fourth part being set before, and with a very similar detailed example in the Study
Manual, most candidates made a poor attempt. Few candidates used the redemption yield of
the existing debentures, which they had calculated in the first part; there were only brief or no
explanations of the terms of the debenture issue.
The fifth part was well answered by the majority of candidates, but some answers gave
explanations of Modigliani and Miller, which was not relevant to this question.

ICAEW 2020 June 2016 exam answers 229

36 Heaton Risk Management (June 2016)
Marking guide

Marks

36.1 (a) Sterling receipt using forward contract:

Appropriate forward rate 1.5
Calculation of sterling receipt 0.5
Sterling receipt using currency futures:
September futures 1
Number of contracts 1
Loss arising 1
Calculation of sterling receipt 1
Sterling receipt using OTC currency option:
Call option 1
Premium 1
Cost of lost interest 1
Exercise the option 1
Net sterling receipt 1
11
(b) Hedging techniques:
Forwards and futures do not allow for upside potential 1
Options protect against downside 1
Options allow benefit from upside 1
Option premium is expensive 1
Other advantages and disadvantages – 0.5 marks each 4
Recommendation for Orchid 1
9
36.2 August put options 1
Exercise price 1
Number of contracts 0.5
Premium 0.5
(a) Let options lapse 1
Overall position 0.5
(b) Exercise the option 1
Calculation of gain 1
Overall position 0.5
7
36.3 Factors affecting time value of options:
Three factors:
Identification of each – 0.5 marks each 1.5
Explanation – 0.5 marks each 1.5
3
30

36.1 (a) Forward contract:

The appropriate forward rate = $/£ 1.5392 (1.5402 – 0.0010)
This will result in a sterling receipt of = £1,624,220 ($2,500,000/$1.5392)
Currency futures:
Orchid will buy September futures to hedge the dollar receipt.

230 Financial Management: Answer Bank ICAEW 2020

 The number of contracts = ($2,500,000/$1.5379)/£62,500 = 26.01 (round to 26
contracts)
The futures contracts will be closed out on 30 September 20X6 resulting in a loss of:
$9,588 ((1.5379 – 1.5320)  26  £62,500).
The sterling receipt will be: £1,625,065 (($2,500,000 – $9,588)/£1.5325))
OTC currency options:
Orchid will use a call option to buy sterling with an exercise price of $1,5300.
The premium will cost: £75,000 ($2,500,000  £0.03)
The cost including interest lost on surplus cash deposits = £75,900 (£75,000  (1+ 0.36
 4/12))
If the spot rate for buying sterling on 30 September 20X6 is $/£1.5325, Orchid will
exercise the options and buy sterling at $/£1.5300.
The sterling receipt will be = £1,633,987 ($2,500,000/$1.5300)
The net receipt after taking the option premium and lost interest into account =
£1,558,087 (£1,633,987 – £75,900)
(b) The sterling receipt for each of the three hedging techniques:
Forward contract £1,624,220
Currency futures £1,625,065
OTC currency option £1,558,087
The forward contract and futures contracts both lock Orchid into an exchange rate and
do not allow for the upside potential of the dollar strengthening against sterling more
than expected.
The options however protect Orchid against the downside risk of sterling
strengthening against the dollar and allow for the upside potential of the dollar
strengthening against sterling; however, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include the
following.
Forwards:
 Tailored specifically for Orchid
 However there is no secondary market should the customers not pay Orchid
Currency futures:
 Not tailored so one has to round the number of contracts
 Requires a margin to be deposited at the exchange
 Need for liquidity if margin calls are made
 However there is a secondary market
 Basis risk exists
OTC currency options:
There is no secondary market.
It is unlikely that the dollar is going to strengthen enough to cover the cost of the
option premium, and so it is not recommended that the company use foreign currency
options. There is very little difference between the receipt using forwards or futures
(£845).
Since there is potential for margin calls using futures, it is recommended that Orchid
use forward contracts to hedge its foreign currency risk.

ICAEW 2020 June 2016 exam answers 231

 36.2 To protect the current value of the portfolio over the next three months Sheldon should
hold August put options with an exercise price equal to the current FTSE 100 index of
6,525.
The number of contracts = 148 (£9,657,000/6,525  £10)
The premium will cost = £235,320 (159  £10  148)
(a) Sheldon should let the options lapse since the Index has gone up and is higher, at
7,075, than the exercise price of the put option.
Overall position £
Portfolio value 10,471,000
Less option premium (235,320)
10,235,680

(b) Sheldon should exercise the options since the index has fallen to 5,875, which is below
the put option exercise price.
The gain on exercising the options = £962,000 ((6,525 – 5,875)  £10  148)
Overall position £
Portfolio 8,695,000
Gain on options 962,000
Original value 9,657,000
Less option premium (235,320)
9,421,680

36.3 The three factors that affect the time value of the FTSE 100 options are:
 Time to maturity – For example: The longer the time to maturity the more chance there
is that the option will be in the money at expiry. Also there will be a greater interest
element in the option value.
 The risk free rate – For example: The level of the risk free rate will affect the interest
element in the options value. The higher it is the more interest element.
 Volatility – For example: Higher volatility will increase the option value since there is
more chance of the option being in the money, or deeper in the money, at expiry.

Examiner's comments:
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that a risk management company is
giving advice to two clients: to one client, on hedging foreign exchange rate risk and to the
second on hedging the fall in the value of a portfolio of FTSE 100 shares.
The first requirement was well answered by most candidates. However some of the errors
demonstrated by weaker candidates included calculating the number of futures contracts using
the spot rate rather than the futures price; stating that currency futures should be initially sold;
treating an over the counter option like a traded option; confusing puts and calls. There were
average responses from a lot of candidates to part (b), often without any reference to the
numbers calculated in part (a); however there were some excellent answers. There were some
excellent answers to the second part from the majority of candidates. Weaker candidates
confused calls and puts and demonstrated that they clearly did not know the difference between
the two. There were many excellent answers to the third part, with a good understanding of the
factors that contribute to the time value of options. However weaker candidates tended to only
give one correct factor and then made up the other two.

232 Financial Management: Answer Bank ICAEW 2020

 September 2016 exam answers

37 Northern Energy Ltd (September 2016)

Marking guide

Marks

37.1 FRA 2
Option 2
No hedge 1
Interest rate swap not applicable 1
Appropriate commentary 3
9
37.2 (a) Currency futures contracts 5
(b) OTC currency option 3
(c) Forward contract 2
(d) Money market hedge 3
13
37.3 Spot rate calculations 2
Appropriate commentary – 1 mark per point 6
8
30

37.1
LIBOR + 2 7% 9%

FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on £9.5m) (£688,750) (£688,750)

Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
Total interest payment over 12 months (on £9.5m) (£712,500) (£712,500)

No hedge
Pay at LIBOR + 2 (7%) (9%)
Total interest payment over 12 months (on £9.5m) (£665,000) (£855,000)

An interest rate swap would not be appropriate here as it is short-term and would in all
likelihood be very difficult to arrange.
If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest
interest figure. The figures are not conclusive, and the board's attitude to risk will be
important. The FRA eliminates downside risk (rates rising) as well as upside risk (rates
falling).

ICAEW 2020 September 2016 exam answers 233

 37.2 (a) Currency futures contracts
Dollars will be purchased. Therefore sell £ on futures exchange.
Contracts to be sold = £4.8m/1.5095/£62,500 = 50.9, (round to 51 [or 50])
At 31/1/X7 Buy futures at 1.4945
Sell futures at 1.5095
Profit 0.015  51  $62,500 $47,813

$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate ($4,752,187)/1.4895 (£3,190,458)
(31/1/X7)
(b) OTC currency option
If the spot rate at 31/1/X7 was $1.4895 then the option would be exercised.
A call option would be used (ie, at $1.5020/£)
Receipt in sterling would be $4.8m (£3,195,739)
1.502
plus: Option premium 4.8m  £0.011 (£52,800)
(£3,248,539)

(c) Forward contract

Payment in sterling $4.8m $4.8m (£3,191,913)
(1.5150 – 0.0112) 1.5038
plus: Arrangement fee 4.8m  £0.004 (£19,200)
(£3,211,113)
(d) Money market hedge
Payment in sterling $4.8m $4.8m $4,743,083 lent
would be [1+ (3.6% / 3)] 1.012
Converted at spot rate $4,743,083 (£3,130,748)
1.5150
Borrowed at 6.9% p.a. £3,130,748  (72,007)
(6.9%/3)
(£3,202,755)

37.3
Sterling payment at spot rate 30/9/X6 $4.8m (£3,168,317)
1.5150
Sterling payment at spot rate 31/1/X7 $4.8m (£3,222,558)
1.4895
The forward contract premium suggests a strengthening of the $. A weaker £ means a
higher payment, and vice versa for a stronger £.
Order (cheapest first)
Spot at 30/9/X6 £3,168,317
Currency futures contracts £3,190,458
MMH £3,202,755
Forward contract £3,211,113
Spot at 31/1/X7 £3,222,558
OTC option £3,248,539

234 Financial Management: Answer Bank ICAEW 2020

 Thus three of the four hedging results lie between the two spot rates.
The futures contracts give gives best outcome (lower than the MMH, FC and OTC).
However, if the dollar were to weaken by January 20X7 (against expectations) then it might
be best to not hedge at all.
Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no
upside/downside). Futures contracts can be cheaper (lower transaction costs), but contracts
cannot be tailored to user's exact requirements.
The directors' attitude to risk is also important in deciding which strategy to pursue.

Examiner's comments:
This question had easily the highest percentage mark on the paper. Overall, the candidates'
performance was very good. This was a three-part question which tested the candidates'
understanding of the risk management element of the syllabus. In the scenario a UK electricity
generator was considering hedging (1) the interest costs of a large loan and (2) its exposure to
foreign exchange rate risk on a planned purchase from an American supplier. In the first part, for
nine marks, candidates were required to calculate the interest payments that would arise on its
planned loan were it to make use of an FRA, an option or a swap. Two different rates of LIBOR
were given to the candidates. Candidates were then required to recommend which of the
hedging techniques the company should choose at each of the LIBOR rates. The second
requirement was worth 13 marks and asked candidates to calculate the sterling cost arising from
a range of hedging techniques applied to the American purchase. Finally the third part, for eight
marks, required candidates to advise the company's board whether it should hedge the
American (dollar) payments.
The first part was answered well by many candidates. However, common errors made were:
• candidates based their calculations on a borrowing period of six months rather than 12
(the loan was to be taken out for 12 months, starting in six months' time).
• the majority of candidates failed to calculate the implications of not hedging the borrowing
and so comparisons were difficult.
• a significant number of candidates abandoned the option when LIBOR was 5% because
they compared 5% v 6.5% instead of 7% v 6.5% ie, they failed to recognise that the
company was borrowing at LIBOR + 2% pa.
Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing
(ie, 12 months). Most candidates' answers to the second part were very good, but the most
common errors noted were:
• currency futures – many chose the wrong date for calculating the number of futures
contracts, bought futures instead of sold them and calculated the profit on the futures trade
in £ instead of $.
• OTC currency options – far too many candidates exercised puts rather than calls.
The forward contract calculations were generally very good as were those for the money
market hedge. The main stumbling blocks with the latter were (1) choosing the wrong
interest rate and (2) using three months rather than four. The advice given by candidates on
the foreign exchange hedging in part three was generally good, but, if candidates did not
calculate the relevant spot rates then they lost marks. The performance of overseas
candidates in this section was, overall, very poor.

ICAEW 2020 September 2016 exam answers 235

38 Roper Newey plc (September 2016)
Marking guide

Marks

38.1 (a) Dividend growth rate 1.5

Cost of equity 0.5
Cost of preference shares 1
Cost of redeemable debt 4
Cost of irredeemable debt 2
WACC calculation 2
11
(b) Cost of equity 1
WACC 1
2
38.2 Advice that 7% is an inappropriate rate, with reasons
3
38.3 Reasons for using CAPM
5
38.4 Calculation of ungeared beta 1.5
Geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Reasons for using a new WACC, and how it is calculated 4
10
38.5 Explanation of APV 4
35

38.1 (a)
Ordinary dividend per share in 20X6 (£3,797,500/15,500,000) 24.5 pence
Ordinary dividend growth rate = £0.201/£0.245, which over four years 5% p.a.
Cost of equity (ke) = (d1) + g (£0.245  1.05) 9.95%
+ 5%
MV £5.20
Cost of preference shares (kp) d (£540,000/9m) £0.06 5.55%
=
MV £1.08

236 Financial Management: Answer Bank ICAEW 2020

 Cost of redeemable debt (kdr)
Year Cash Flow 2% factor PV 3% factor PV
0 (103.00) 1.000 (103.00) 1.000 (103.00)
1–3 4.00 2,884 11.54 2.829 11.32
3 100.00 0.942 94.20 0.915 91.50
NPV 2.74 NPV (0.18)

IRR = 3% – (0.18/(2.74 + 0.18)) = 2.94%

less: Tax at 17% (2.94%  83%) = 2.44%
Cost of irredeemable debt (kdi) £5  83% 4.32%
£96
WACC
Total MV's
£'000 Cost  weighting WACC
Equity 15.5m  £5.20 80,600 9.95%  80,600/106,615 7.52%
Pref. shares 9m  £1.08 9,720 5.55%  9,720/106,615 0.51%
Red. debt £6.5m  103/100 6,695 2.44%  6,695/106,615 0.15%
Irred. debt £10.0m  96/100 9,600 4.32%  9,600/106,615 0.39%
26,015 1.05%
Total market value 106,615 8.57%

38.1 (b)
Cost of equity (1.2  (9.5% – 1.9%)) + 1.9 = 11.02%

Weighted cost of equity 11.02%  80,600/106,615 8.33%

Weighted cost of debt (as above) 1.05%
WACC 9.38%
38.2 Roper is using 7% as its hurdle rate. In fact a more accurate figure would be 8.57% (say 9%)
or 9.38% (say 10%). This means it could be making poor investment decisions. If it takes on
a project with an IRR of 8% this will be destroying shareholder value as the IRR is less than
the company's cost of capital.
38.3 CAPM theory:
Systematic vs unsystematic risk, and portfolio theory
Beta – a measure of systematic risk against market average
CAPM gives an alternative cost of equity which is used to calculate the WACC
38.4 New market geared beta = 1.9
New market ungeared beta = 1.9  90 (1.9  90) 1.54
(90 + (25  83%)) 110.75
Better Deal's geared beta = 1.54  (£80.600m + 9.720 + (£16.295m  83%)) 1.98
£80.600m
So, cost of equity = (1.98  (9.5% – 1.9%)) + 1.9 = 16.95%
Cost of debt = 6%  83% 4.98%
WACC = (16.95%  £80,600/£106,615)) + (4.98%  £26,015/£106,615)) = 14.03%
It would be unwise to use the existing WACC (9.38%) as Roper's plan involves
diversification and therefore a change in the level of systematic risk. Thus a new WACC
must be calculated. Systematic risk is accounted for by taking into account the beta of the
petroleum market and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then "re-geared" by taking into account the
level of gearing of the new funds being raised.

ICAEW 2020 September 2016 exam answers 237

 Cost of new debt (which is higher than existing because of the increased risk discussed
above) is used.
Using this, the new WACC can be calculated.
38.5 Adjusted PV (APV) – if the capital structure changes maybe the cost of capital will as well
(M&M 1963). If new debt is raised to finance/part-finance a new investment, what is the new
cost of capital? To find this one needs to know the new MV of the company's shares and to
know this one needs to know the NPV. This cannot be calculated without the new cost of
capital. So it's a conundrum, unless a simplifying assumption is made as in this question ie,
the finance is issued in such a way as to leave the gearing unchanged.
Thus use the APV approach:
1 Calculate the base cost of the project – assume that the company is not geared.
2 Calculate the PV of the tax shield (tax saved via interest payments)
Combine 1 and 2. If APV is positive, then proceed.

Examiner's comments:
This question had, marginally, the lowest percentage mark on the paper. The majority of
candidates achieved a 'pass' standard in the question, however.
This was a five-part question that tested the candidates' understanding of the financing options
element of the syllabus. It was based around a UK engineering company which was planning to
diversify into the UK fracking industry. As a result various calculations regarding its current and
future cost of capital were deemed necessary. The first part of the question, for 13 marks,
required candidates to calculate the current weighted average cost of capital (WACC) of the
company using (1) the dividend growth model and (2) the CAPM. In the second part, for three
marks, candidates were asked to explain whether the company should continue to use its
existing hurdle rate for its decisions on large-scale investments. The third part, for five marks,
required candidates to explain the underlying logic of employing the CAPM within a WACC
calculation. The fourth part was worth 10 marks. Here, candidates were tested on their ability to
re-work their CAPM calculations, which was necessary because of the company's proposed
diversification into fracking, which would alter the level of systematic risk. Finally, for four marks,
candidates were asked to explain the circumstances in which it would be appropriate to use the
adjusted present value approach to investment appraisal.
Most candidates did well in the first requirement, part (a) but common errors were:
• inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
• not using the market value (MV) when calculating the cost of preference shares.
• for the cost of redeemable debentures – not using the ex-interest MV, choosing four years
to redemption rather than three, inaccurate IRR calculation from NPV's.
• irredeemable debentures – not using the ex-interest MV, using the post-tax coupon rate as
the cost of debt.
Combining the costs of the redeemable and irredeemable debt, rather than treating them
separately.
Part (b) was done very well. Only a few candidates failed to calculate the CAPM correctly.
The second part was generally well answered and most candidates were able to identify the key
issue – ie, Roper could be making poor investment decisions. In the third part too few
candidates answered the question fully and concentrated more on a discussion of de-
gearing/re-gearing. In the fourth part the de-gearing/re-gearing calculations were mostly done
well, but too many candidates' explanation of their approach here concentrated on 'how' rather
than 'why' it was done. The fifth part was, overall, done well and candidates demonstrated a
reasonable understanding of APV.

238 Financial Management: Answer Bank ICAEW 2020

39 Darlo Games Ltd (September 2016)
Marking guide

Marks

39.1 (a) Net assets at historic cost 1

Revalued net assets 2
P/E ratio 1
Discount for lack of marketability 0.5
Dividend yield 1
Discount for lack of marketability 0.5
PV of future cash flows:
To 20X9 2
Post 20X9 2
Calculation of WDAs and tax 4
14
(b) Advantages of each method 5
Disadvantages of each method 5
10
39.2 SVA explanation 4
Assessment of information 4
8
39.3 Ethical issues around confidentiality 3
35

39.1 (a)
Per
share
Net Assets £4,998 £10.00
(historic cost)
500
Net Assets (£4,998 +£3,150 +£3,370 – £2,400 – £3,200) £5,918 £11.84
(revalued) 500 500

P/E ratio (£2,340  10) £23,400 £46.80

500 500

Less (say) 30% for lack of marketability of

shares £32.76
Dividend yield (£740/ 8%) £9,250 £18.50
500 500

Less (say) 30% for lack of marketability of

shares

ICAEW 2020 September 2016 exam answers 239

 PV of future cash flows y/e 20X7 y/e 20X8 y/e 20X9 Total
£'000 £'000 £'000 £'000 £'000
Pre-tax cash profits 2,900 3,000 3,100
Tax at 17% (W2) (465) (487) (422)
Net cash flow 2,435 2,513 2,678
  
12% factor 0.893 0.797 0.712
PV 2,174 2,003 1,907 6,084
Post 20X9 net cash
inflows 2,000

Discounted to infinity  1/12%

16,667
Discounted to PV from
20X9  0.712
11,867
Total PV of future cash
flows 17,951
£17,951/500 £35.90

W1
WDV b/f 920 754 618
WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0

W2
Pre-tax cash profits 2,900 3,000 3,100
WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482

Tax due at 17% (465) (487) (422)

(b) Net Assets (historic cost) – tends towards low historic values, so an undervaluation.
Intangibles are ignored. Earnings potential and future earnings are ignored.
Net Assets (revalued) – as above, except that the asset values used are current.
P/E ratio – Looks at earnings. Will it be a majority stake? If so, then control will be
gained, so shares for this controlling stake should cost more. In this scenario it gives a
much higher value than assets. However, are these earnings stable into the future? Is
the company over-reliant on the two successful games from 20X3? Future earnings –
are there new games planned? Will they be successful?
Dividend yield – this is based on dividend income and is applicable where it's to be a
minority stake. Are these dividends stable? Will there be dividend growth?
PV of future cash flows – considers cash flows not profits and estimates forwards. These
are large estimates, especially the terminal value. Is it over-reliant on the two successful
games (as above)?
Overall – a value close to £30/share should be a minimum price.

240 Financial Management: Answer Bank ICAEW 2020

 39.2 SVA is an alternative method of calculating the value of a company, based on future cash
flows and seven "value drivers". These value drivers can, in most cases, be managed by the
company and so the influence of company strategy will be evident.
Value driver Information available
Length of project Yes
Sales growth rate Implied
Profit margin Implied
Fixed assets investment Implied
Working capital investment No
Tax rate Yes
Discount rate Yes
39.3 An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client's or employer's affairs, however gained, is
confidential. That information should then:
 be kept confidential;
 not be disclosed, even inadvertently such as in a social environment; and
 not be used to obtain personal advantage.

Examiner's comments:
This was a three-part question that tested the candidates' understanding of the investment
decisions element of the syllabus and there was also a small section with an ethics element to it.
In the scenario a software development company was considering investing in a company that
designs games for use on computers and mobile phones. Candidates were given financial
information relating to the target company.
In the first requirement, part (a) was worth 14 marks and required candidates to calculate the
value of one share in the target company using five different valuation methods. Whilst in part
(b), for 10 marks, candidates had to explain, making reference to their previous calculations, the
advantages and disadvantages of using each of the valuation methods. The second
requirement, for eight marks, candidates were required to explain the reasoning underpinning
the shareholder value analysis (SVA) method of valuation. They also had to explain whether SVA
could be used to value this particular target company, bearing in mind the information
provided. Finally, in the third requirement, for three marks, candidates had to explain the ethical
issues arising for an ICAEW Chartered Accountant who is privy to price-sensitive information
which is not in the public domain.
Generally the first requirement part (a) was answered well. A surprising number of candidates
were unable to calculate the share value based on the net asset basis (historic cost), but were
able to calculate it with the net asset basis revalued. The P/E and dividend yield valuations were
generally done very well. Most candidates scored well using the PV of future cash flows method
of valuation.
Candidates' discussion was limited to mainly knowledge in the first requirement part (b) – few
considered whether the techniques were suitable for a majority/minority holding despite being
guided in that direction in the question. The vast majority of candidates ignored the 'elephant in
the room', ie, the fact that the target company's computer games had a limited life of three to
five years and the successful games were three years old.
In general candidates' understanding of the theory of SVA was good, but too few were able to
explain adequately whether it could be used in this particular scenario. Candidate's
understanding of the ethical issues was generally good.

ICAEW 2020 September 2016 exam answers 241

 December 2016 exam answers

40 Ribble plc (December 2016)

Marking guide

Marks
40.1 Net present value calculation:
Contribution 3
Rent, managers costs, consultancy saved 4
Contribution lost 2
Fixed overhead 2
Tax, working capital, capital allowances 6
NPV and conclusion 3
20
40.2 (a) Sensitivity to sales revenue:
Contribution 1
Tax and discount factor 1.5
PV calculation 0.5
Sensitivity and conclusion 1
4
(b) Sensitivity to the residual value of equipment:
Maximum loss of scrap value 0.5
Increase in the balancing charge 1
PV calculation 0.5
Sensitivity and conclusion 1
3
40.3 Real options:
1 mark to identify, and 1.5 marks to explain
(two real options required) 2.5  2 5

40.4 Ethical issues identified (1 mark each point) 3

35

40.1

0 1 2 3 4
Units million 0.096 0.115 0.098 0.083
Selling price £ 299.00 299.00 299.00 299.00
Variable costs per unit £ –164.45 –172.67 –181.3 –190.37
Contribution per unit £ 134.55 126.33 117.7 108.63

242 Financial Management: Answer Bank ICAEW 2020

 £m £m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Rent –1 –1 –1 –1
Managers lump sum 0.1 –0.12
Managers salary –0.12 –0.12 –0.12 –0.12
Consultancy saved 0.05 0.05
Contribution lost –0.24 –0.29 –0.25 –0.21
Fixed overhead –0.30 –0.31 –0.32 –0.33
Taxable –0.9 11.31 12.86 9.84 8.24
Tax @ 17% 0.15 –1.92 –2.19 –1.67 –1.40
Working capital –1 –0.2 0.18 0.15 0.87
Machinery and equipment –24.00 4
Tax saved on CAs 0.73 0.60 0.49 0.40 1.16
Cash flows –25.02 9.79 11.34 8.72 12.87
Discount factor @ 10% 1 0.909 0.826 0.751 0.683
PV –25.02 8.90 9.37 6.55 8.79

NPV 8.59
The NPV is positive and Ribble should therefore accept the project to increase shareholder
wealth.
Marks are awarded for not including the research and development costs of £100,000 and
allocated fixed overheads, since they are sunk costs and allocated costs respectively.
Units:
1 8,000  12 = 96,000
2 96,000  1.2 = 115,200
3 112,200  (1 – 0.15) = 97,920
4 97,920  (1 – 0.15) = 83,232
Lost contribution:
1 (96,000 units/10)  £25 = £240,000
2 (115,200 units/10)  £25 = £288,000
3 (97,920 units/10)  £25 = £244,800
4 (83,232 units/10)  £25 = £208,080
Working capital

cumulative Increment
0 –1 –1
1 –1.2 –0.2
2 –1.02 0.18
3 –0.87 0.15
4 0 0.87

ICAEW 2020 December 2016 exam answers 243

 Capital allowances and the tax saved thereon

Cost/WDV CA Tax @ 17%

0 24.00 4.32 0.73
1 19.68 3.54 0.60
2 16.14 2.91 0.49
3 13.23 2.38 0.40
4 10.85
Sale 4.00 6.85 1.16
40.2 Sensitivity to sales revenue:
1 2 3 4
£m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Contribution lost –0.24 –0.29 –0.25 –0.21
Total 12.68 14.24 11.28 8.81
Total  (1 – 0.17) 10.52 11.82 9.36 7.31
Discount factor @ 10% 0.909 0.826 0.751 0.683
PV 9.56 9.76 7.77 4.99

Total PV = 32.08
Sensitivity NPV/PV
(8.59/32.08) 27%

Given the risky nature of this project, the board of Ribble might consider the project to be
too sensitive to changes in the sales revenue.
Sensitivity to the residual value of equipment:
£m
Maximum loss of scrap value 4
Increase in the balancing charge  17% –0.68
Net cash flows 3.32

PV @ 10% ( 0.683) 2.27

Although this represents 26% (2.27/8.59) of the overall NPV, the project is insensitive to the
residual value, since there would be a substantial NPV even if the value fell to zero.
40.3 Ribble has:
The option to delay the project for one year to see whether the competitor launches their
hoverboard onto the market.
The option to abandon the project should sales levels be below those estimated eg, if the
rival company's hoverboard is launched and proves to be more popular than the
Ribbleboard.
There is a follow on option in that Ribble could expand if the competitor's product fails
and/or sales of the Ribbleboard are better than expected.
Candidates might also state growth or flexibility options.
40.4 The CEO should disregard the comments that Ribble should continue to manufacture an
unsafe hoverboard. The CEO should act with integrity and ensure that he is not corrupted
by self-interest. He should be objective and not come under the undue influence of other
board members. He should act with professional competence and exercise sound and
independent judgement.

244 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This was a four-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is
considering launching on to the market a new version of an existing product.
The first part was well answered by many candidates, but the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; only taking account
of half of the relevant costs; not stating that research and development costs should be ignored;
not stating that allocated overheads should not be included in the NPV computations.
Responses to the second part were mixed, with many candidates not taking into account all the
relevant cash flows and many ignoring taxation. There were few candidates who made
meaningful comments regarding the sensitivity of the project to changes in the inputs.
Responses to the third part were good, although some candidates wasted time by mentioning
more than the required two real options.
Responses to the fourth part of the question were also mixed, and many did not relate to ethical
issues, instead discussing commercial issues. Where the ethical issues were discussed, a number
of candidates did not use the language of ethics.

41 Bristol Corporate Finance (December 2016)

Marking guide

Marks

41.1 (a) CAPM calculation 1

(b) Discount calculation 2

TERP 1
Discussion 2
5
(c) Yield to maturity calculation 2
Issue price 2
Total nominal value 1
Discussion 2
7

(d) Interest cover calculation 1.5

Gearing 1.5
Advantages and disadvantages – max of 3
Commentary on gearing – max of 3
Commentary on cost of capital – max of 3
Advice 2
Maximum available 12

41.2 (a) Sources/forms of finance – 0.5 mark each point 3

(b) Exit routes – 0.5 mark each point 2

(c) Financial information – 0.5–1 mark each point 5

35

ICAEW 2020 December 2016 exam answers 245

 41.1 (a) The cost of capital = Ke = 3 + (1.1  (8 – 3)) = 8.5%
(b) A 1 for 2 rights issue will require 40/2 = 20 million new shares to be issued.
The price per share = £70 million/20 million = £3.50
A discount on the current market price of: (5.00 – 3.50)/5.00 = 30% (or £1.50)
The theoretical ex-rights price is:
Number of shares Value per share £ Number  Value £
Existing shares 2 5.00 10.00
New shares 1 3.50 3.50

Total shares 3 Total value 13.50

Theoretical ex-rights price = £13.50/3 = £4.50.
The actual share price will depend on the market's reaction to the rights issue eg,
whether it is fully taken up, and whether the proceeds are invested in positive net
present value projects.
If we were told the net present value of the projects this could be incorporated in the
theoretical ex-rights price of £4.50, giving a more realistic estimate of the actual share
price post rights issue.
(c) The yield to maturity of the Wood plc debentures is calculated as follows:
The ex-interest price of the debentures = 110 – 7 = £103
Timing Cash Flow Factors at PV Factors at PV
Years £ 5% £ 10% £
0 (103) 1 (103) 1 (103)
1–4 7 3.546 24.82 3.170 22.19
4 100 0.823 82.30 0.683 68.30
4.12 (12.51)
IRR = 5 + (4.12/(4.12+12.51)  5 = 6.24% Say 6%
The issue price is:
Timing Cash Flow Factors at PV
Years £ 6.00% £
1–10 7 7.360 51.52
10 100 0.558 55.80
Issue price 107.32

The total nominal value will be: 70/(107.32/100) = £65.22 million.

Wood plc has similar risk to Middleton so it may be reasonable to assume that
debenture holders would require the same yield to redemption in return for investing
with either company. But how similar is similar? Eg, how comparable is Wood to
Middleton in terms of gearing? However the Wood plc debentures have only four
years until redemption, whilst the Middleton debentures mature in 10 years. It is likely
that debenture holders would require a higher yield to redemption for investing in the
Middleton debentures to compensate them for the risk of investing for a further six
years.
(d) The gearing and interest cover ratios of Middleton immediately after the debenture
issue will be as follows:
Interest cover: Interest 65.22  7% = £4.57m. Interest cover = 25.00/4.57 = 5.47 times
Gearing by market values assuming the current market price per share:
Market capitalisation 40  5 = £200m. Gearing (D/E) 70/200 = 35%

246 Financial Management: Answer Bank ICAEW 2020

 In time both interest cover (more operating profits) and gearing (greater equity value)
are likely to improve with the acceptance of positive NPV projects and any favourable
market reaction to the issuance of debt and its tax shield (see below).
General advantages and disadvantages of debt v equity, points that candidates might
mention include: Control issues; obligation to return capital; interest v dividends
(including tax relief); issue costs; liquidation of the investment (can the investor get out
easily?); risk/reward.
Note: Candidates might also comment on EPS and produce the following figures:
Current EPS 51.9p (20.75m/40m)
EPS with a rights issue 34.6p (20.75m/60m)
EPS with a debenture issue 42.4p (( 25 – 4.57)  0.83))/40m
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 5.47 times.
Gearing is between the industry maximum and average of 40% and 30% respectively,
interest cover is between the industry minimum and average of five and six
respectively. Since this is the first time that Middleton has borrowed both shareholders
and the stock market might be concerned and prefer these ratios to be around the
averages or better. Some shareholders might be attracted to investing in Middleton
because currently it has no gearing. However if the £70 million is to be invested in
positive NPV projects both shareholders and the stock market should welcome the
company borrowing.
Borrowing should reduce the current 8.5% cost of capital of the company since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. Also the company receives tax relief on the interest that it pays. Because there
is increased financial risk when a company borrows the shareholders may require a
higher return but this is unlikely to offset the cheaper proportion of debt finance. The
company value should increase as a result of the cost of capital reducing and new
funds being invested in positive NPV projects.
Advice: It would be prudent for the company to restrict its borrowing to the industry
average gearing level especially since its interest cover would be near to the minimum
for the industry. I would advise the company not to borrow the full £70 million, perhaps
this could be achieved by revising its plans for raising the finance. For example an issue
of both debt and equity to ensure that gearing and interest cover ratios are more
favourable. Or selling surplus assets.
41.2 (a) The source and form is typically:
The management team invest in equity (Candidates may mention that the funding for
this can be raised from various sources for example: Family; savings; sale
of/refinancing of personal assets; etc)
A venture capital provider will invest in equity and debt
Other financiers – for example banks would provide loans
(b) The various parties who invest in the MBO will require an exit route, typically after
between three to five years. This may be in the form of:
 selling the company to a third party
 a secondary MBO or MBI
 floating the company on the Stock Exchange
 if the company is not successful the least desirable exit would be liquidation

ICAEW 2020 December 2016 exam answers 247

 (c) The financial information section of the business plan will typically include:
 an historic financial analysis
 the amount and timing of the finance required
 key risks and a contingency plan
 anticipated gearing
 the purpose of any finance required
The following forecasts should be included:
 cash flow in months for the first year of the plan
 revenue forecasts in months or longer for the first year with evidence
 financial forecasts in quarterly or annual intervals up to five years
Often a project appraisal and sensitivity analysis will be included.

Examiner's comments:
This was a seven-part question that tested the candidates' understanding of the financing
options element of the syllabus. The scenario of the question was that a corporate finance firm is
giving advice to two clients. Client one (requirement 1) is a company seeking to raise additional
funds and client two (requirement 2) is a management buyout team.
Part (a) of the first requirement of the question was well answered by the majority of candidates.
However in the CAPM equation a surprising number did not deduct the risk free rate from the
market return.
Part (b) of the first requirement was also well answered by the majority of candidates. However,
considering that the area has been examined many times before some basic errors were made
which included: incorrectly calculating the number of new shares to be issued; not calculating
the discount that the rights price represents on the current share price of the company (despite
this being specifically asked for).
Also, many candidates were unable to comment on whether and why the actual share price
might not be equal to the theoretical ex-rights share price after the rights issue.
Responses to part (c) of the first requirement were mixed and, since the topic has been
examined many times before, rather disappointing. Candidates were asked to calculate the yield
to redemption (YTR) of debentures that a similar company to the client company already had in
issue. They then had to use the YTR that they had calculated to price a new debenture issue, and
to calculate the total nominal value of the new issue. Common errors included: using the cum-
interest debenture price in the YTR computation; attempting to calculate the YTR on the new
issue; deducting tax from the YTR; incorrectly calculating the total nominal value of the new
issue; many mathematical errors in the YTR computations; calculating, and using, the interest
yield of the debentures rather than the YTR for the new issue, using the coupon rate to calculate
the issue price (and not arriving back at the par value!); for the new issue, using the cost of
equity to calculate the issue price.
Also comments on whether the YTR of the similar company was appropriate to use for the client
company were poor.
Responses to part (d) of the first requirement were extremely disappointing considering that
similar questions have been asked before. In the scenario the candidates were provided with
average and maximum gearing ratios for the industry sector that the client operated in, and also
a definition of gearing as debt/equity by market values. Also the candidates were given the
average and minimum interest cover for the industry. Candidates were instructed in the question
requirement to refer to this data when discussing whether the client company should raise the
finance required by debt or a rights issue.
Many candidates gave very generic answers to this part of the question, just brain dumping the
advantages and disadvantages of debt and equity without referring to the industry data or the
scenario of the question. Disappointingly a large number of candidates also gave a detailed

248 Financial Management: Answer Bank ICAEW 2020

 description of Modigliani and Miller's theory on capital structure without any reference to the
traditional theory and how it might or might not be appropriate. However it was alarming to see
many candidates calculating the gearing ratio as debt/(debt + equity) and then comparing their
number with the industry data, which had been calculated in a different way. In one instance a
candidate calculated the gearing ratio using both methods and then picked the most favourable
when comparing with the industry data. This lack of understanding is not acceptable from
candidates sitting a finance examination. Also few candidates gave supported advice on how
the additional finance should be raised.
Turning to interest cover, there were some basic errors made here which included: calculating
interest cover on profits after tax; incorrect interest calculations not using the total nominal value
to be raised.
Responses to part (a) of the second requirement were poor, with few candidates showing an
understanding of how a management buyout is financed. Responses to part (b) of the second
requirement were also poor, and few candidates described realistic exit routes for the financiers
that contribute to the funding of a management buyout.
Responses to part (c) of the second requirement were mixed, and many candidates described
areas such as business strategy, which would not appear in the financial information section of a
business plan.

42 Orion plc (December 2016)

Marking guide

Marks

42.1 (a) Forward contract 2

(b) Currency futures:

Buy 1
Number of contracts 1
Profit 2
Sterling receipt 1
5
(c) OTC option:
Premium 1
Lost interest 1
Choose to exercise 1
Sterling receipt 1
4
42.2 Advantages and disadvantages:
Forwards 2
Futures 3
Options 2
Advice 1
8
42.3 Explanation of interest rate parity 2
Calculation of forward rate and explanation of discount 3
5
42.4 Explanation of economic risk 2
Application to Orion 2
Risk mitigation – 0.5 mark each for identifying and explanation 2
6
30

ICAEW 2020 December 2016 exam answers 249

 42.1 (a) The forward rate is: $/£ 1.4430 (1.4340 + 0.0090)
This results in a sterling receipt of £3,465,003 ($5,000,000/$1.4430)
(b) Orion should buy March sterling futures (ie, to buy £ with $).
The number of contracts to buy is: ($5,000,000/$1,4410)/£62,500 = 55.52 contracts.
Round to 56 contracts. Slightly over hedged. (Full marks given if 55 contracts used.)
On 31 March the futures will be closed out and sold at $1.4487. This will result in a
profit of: ($1.4487 – $1.4410)  (£62,500  56) = $26,950
Sterling will be purchased on the spot market and the total receipt will be: ($5,000,000
+ $26,950)/$1.4490 = $3,469,255
(c) Over the counter option:
The option premium is $5,000,000  3p = £150,000.
The premium with interest lost is £150,000  (1 + 0.03  4/12) = £151,500
If the spot price on 31 March is $/£1.4490 Orion will exercise the options.
The sterling receipt will be ($5,000,000/$1.4390) – £151,500 = £3,323,135
42.2 The forward contract and futures contracts both lock Orion into an exchange rate and do
not allow for upside potential.
Forwards:
 Tailored specifically for Orion
 No secondary market
Currency futures:
 Not tailored, so need to round the number of contracts
 Requires a margin to be deposited at the exchange
 Need for liquidity if margin calls are made
 Secondary market
OTC currency options:
 The options are expensive
 No secondary market
 However the options allow Orion to exploit upside potential and protect downside risk
Advice:
Without hedging, the sterling receipt would be £3,450,656 (5,000,000/1.4490)
The OTC option results in a much lower receipt at £3,323,135.
Both the forwards and futures result in a higher sterling receipt, with the futures being
marginally better resulting in a receipt of £3,469,255 compared to £3,465,003.
Since futures require margins, and they are not a perfect hedge due to rounding and basis
risk, it is recommended that a forward contract is used as it is much simpler for a similar
result.
42.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are
possible if the rates out of alignment. The forward rate tends to be an unbiased predictor of
the future spot exchange rate.

250 Financial Management: Answer Bank ICAEW 2020

 The forward rate in four months is calculated as follows:
Middle spot rate  (1 + the middle US interest rate)/(1 + the middle UK interest rate) =
Forward rate.
$1.4338  (1 + 0.05  4/12)/(1 + 0.0315  4/12) = $1.4426
Because the dollar is depreciating against sterling it is at a discount.
The discount is $0.0088 (1.4426 – 1.4338). The spread increases or decreases this, in this
case $/£ 0.0086 – 0.0090.
42.4 Economic risk is the risk that longer-term exchange rate movements might reduce the
international competiveness of a company. It is the risk that the present value of a
company's future cash flows might be reduced by adverse exchange rate movements.
Orion is an importer and exporter. It buys its raw materials in euros, exports the sports
nutrition products to the USA and receives payment in dollars.
If over a period of several years the pound appreciates against the dollar and depreciates
against the euro the sterling value of Orion's income will fall and its cash flows decline.
Points that can be mentioned to mitigate economic exposure include:
 diversify operations world-wide both for purchasing raw materials and selling its
products.
 market and promotional management; the company must carefully decide in which
markets to operate.
 product management; economic exposure may mean high-risk product decisions.
 pricing strategy must respond to the risk of fluctuations in exchange rates.
 production management; economic exposure may influence the supply and location of
production.

Examiner's comments:
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that of a company reviewing its foreign
exchange rate risk hedging strategy.
The first part was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; treating an over the counter option like a
traded option; calculating the option premium in $ rather than £; omitting interest on the option
premium.
There were a lot of average responses to the second part, some without any reference to the
numbers calculated in the first part. Many candidates did not give a firm conclusion. However
there were some excellent answers.
Responses to the third part were mixed, with many candidates demonstrating a lack of
understanding of interest rate parity. Very often computations did not make sense and were very
difficult to follow.
Few candidates gave adequate answers to the fourth part, and showed little knowledge of what
economic risk is. However again there were some excellent answers.

ICAEW 2020 December 2016 exam answers 251

 March 2017 exam answers

43 Sentry Underwood plc (March 2017)

Marking guide

Marks

43.1 Forecast income statements:

Sales 0.5
Variable costs 1
Fixed costs 0.5
Interest 1.5
Tax 0.5
Dividends 1.5
Retained earnings 0.5
6
43.2 Earnings per share 2
Gearing calculation 4
6
43.3 Increase in sales required:
Current EPS 0.5
Target profit before tax 1.5
Interest added back 1
Fixed costs added back 1
Contribution/sales ratio 1
Target sales figure 1
6
43.4 Rights issue v debenture issue
1 mark per valid point up to a maximum of 8 8

43.5 Explanation of dividend policy theory 6

43.6 Identification of relevant ethical issues 3

35

43.1
Rights issue Debt issue
£m £m
Sales (£78.5m  1.20) 94.200 94.200
Variable costs (72%  sales) (67.824) (67.824)
Fixed costs (£13.85m + £2m) (15.850) (15.850)
Profit before interest 10.526 10.526
Interest (Workings) (1.421) (3.021)
Profit before tax 9.105 7.505
Tax @ 17% (1.548) (1.276)
Profit after tax 7.557 6.229
Dividends payable (4.920) (3.000)
Retained earnings 2.637 3.229

252 Financial Management: Answer Bank ICAEW 2020

 WORKINGS
£20,3m  7% 1.421 1.421
£20.0m  8% 1.600
1.421 3.021

43.2
Rights issue Debt issue
£m £m
Ordinary share capital (additional 8m shares) 20.500 12.500
Share premium (8m new shares  £1.50) 12.000 0.000
Retained earnings 13.923 14.515
46.423 27.015
Debentures 20.300 40.300
Total long term funds 66.723 67.315

Profit before tax £7.557 £6.229

Shares 20.500 12.500

£0.369 £0.498

Gearing £20.300 £40.300

£66.723 £67.315

30.4% 59.9%
43.3
Current EPS £5.568m £0.445m
12.500
£0.445m

20.500
Target earnings £9.123m
Add back tax (17%) ÷ 83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
Target contribution £28.263m
Contribution/sales ratio ÷ 28%
Target sales £100.939m

Current sales £78.500m

Target sales/current sales 1.286
(£100.939m/£78.500m)
Thus sales would need to increase by 28.6% or £22,439m

43.4 Sentry's current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights
issue) and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue
increases EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue
option (30.4% compared to 59.9%). It's also lower than Sentry's current level of gearing
(46.0% [£20,300/44.086]).

ICAEW 2020 March 2017 exam answers 253

 However if one takes the market value into account then the current gearing figure (34.5%)
is much lower. Current MV of equity = 40.000m (£3.20  12.5m). Current MV of debt =
£21.112 million (1.04  £20.3m). (£21.112/[£21.112 + £40.000]) = 34.5%
The interest cover ratio of 7.4 is higher than that for the debenture issue (3.5) and the
existing figure (5.7).
The rights issue (£20m) represents 50% of Sentry's current market capitalisation (£3.20 
12.500 = £40m). This could deter current shareholders from investing and so there might
be a dilution of shareholders (and control).
Debenture issue:
This creates a very high level of gearing (59.9%) and the interest cover is 3.5 (compared to
the current cover figure of 5.7). So the extra financial risk taken on might concern the
shareholders.
It would need sales to increase by 29% for the EPS under the rights issue to remain at its
current level – is this achievable? Roger Smyth's comments suggest otherwise.
Other issues to consider:
The current debentures are due to be repaid in 20X9–20Y0. This will create additional
financial pressure.
Issue costs – the cost of issuing debentures is likely to be cheaper.
Tax shield – the debenture issue would give Sentry more chance to take advantage of the
tax shield and its WACC may fall accordingly, unless the gearing level was then deemed by
investors to be too high.
43.5 Reference to main dividend policy theory:
M&M theory – share value is determined by future earnings and the level of risk. The
amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities (ie, those with positive NPV's).
Any loss in dividend income will be offset by the gains in share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or
capital gains in future. Cash now is more certain than in the future.
Supplementing these main theories:
 Impact of signalling
 Clientele effect
A change in dividend policy may have a negative impact on Sentry's share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change, ie,
communication with them is effective.
43.6 ICAEW provides ethical guidance that will ensure that shareholders can rely on the
objectivity and integrity of information given to them by members. The other ethical
principle at risk here is that of professional behaviour.

254 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This question was generally answered well and most candidates achieved a 'pass' standard.
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it.
In the scenario, a listed UK drinks manufacturer planned to raise £20 million to finance a major
change in the company's trading strategy. This additional funding would be raised either via a
rights issue or a debenture issue. In the first part, for six marks, candidates were required to
prepare a forecast income statement for both of these methods of funding. The second part was
also worth six marks and asked candidates to calculate (a) the EPS and (b) the gearing ratio for
both methods of funding. The third part, for six marks, tested sensitivity analysis – what level of
sales would be necessary to maintain the EPS at its current level. The fourth part was worth eight
marks. It brought together the three parts above and required candidates to discuss the
implications for the shareholders of the two funding methods. The fifth part, for six marks, tested
candidates' understanding of dividend theory. Finally, in the sixth part, for three marks,
candidates had to explain the ethical issues arising for an ICAEW Chartered Accountant who is
aware of a plan to overstate the company's forecast sales figures.
The third part was a good discriminator and, whilst many candidates were able to work
backwards to a forecast sales figure, a large minority scored very poorly here.
Most candidates did very well in the first part and the majority scored full marks. The most
common errors occurred with the estimated variable costs, interest charges and dividend
payments. A small minority of candidates were unable to calculate the number of new shares
issued via the rights issue and used, erroneously, a 1 for 1 issue (rather than dividing £20 million
by the issue price of £2.50).
The second part was generally well answered, but a number of candidates were unable to
identify the earnings figure from the income statement and used the retained profit figure
instead. A significant number of candidates were unable to calculate the correct gearing ratios.
Typical errors here were: (a) calculating debt/equity instead of debt/debt + equity, despite
instructions to the contrary, (b) omission of forecast retained profits, (c) addition of par value of
new shares rather than sum raised and (d) using market values rather than book values, again
contrary to the instruction given.
Overall the answers to the fourth part were disappointing. Too many candidates said little
beyond the fact that EPS and gearing would move up/down, depending on the funding method
chosen. Very few considered the impact on interest cover or the required size of the equity
issue. The discussion of financial risk was, generally, limited and too many candidates spent too
much time on M&M theories.
The fifth part was, overall, answered very well, although some candidates discussed capital
structure theory here. The sixth part was, in general, answered very well.

ICAEW 2020 March 2017 exam answers 255

44 White Rock plc (March 2017)
Marking guide

Marks
44.1 (a) Relevant money cash flows
Newcastle sales & contribution 2
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Working capital 0.5
Machinery sale 0.5
Tax saving on machinery 1
Lease cancellation 0.5
Tax saving 0.5
Newcastle working capital 1.5
Discount factor 1
Irrelevant costs: lease, head office, fixed 2
11

London sales 1
London variable costs 1
London fixed costs 1
Tax on profit 0.5
Factory closure 0.5
Tax on closure 0.5
Lease payments 0.5
Tax saved on lease 0.5
Machinery sale 0.5
Tax saving 1.5
London working capital 1.5
Discount factor 1
10
44.1 (b) Advice 1

44.2 Divisible and indivisible projects:

Project rankings 2
NPV with divisible projects 2
NPV with indivisible projects 2
6

44.3 EMH and behavioural factors:

Explanation of EMH – levels of efficiency 4
Examples of irrational behaviour 4
Maximum available 7
35

256 Financial Management: Answer Bank ICAEW 2020

 44.1(a)
Closure March 20X7 : 20X7 20X8 20X9
y0 y1 y2
£m £m £m
Newcastle sales (W1) 1,326.000 1,575.900
Newcastle VC's (sales  35%) (464.100) (551.565)
Tax on profit (W2) (146.523) (174.137)
Factory closure (1,600.000)
Tax on closure (@ 17%) 272.000
WC reversal 800.000
Machinery sale 1,700.000
Tax saving on machinery (W3) 238.000
Lease cancellation (3,000.000)
Tax saving on cancellation 510.000
Newcastle working capital (W4) (132.600) (24.990) 157.590
Total cash flows (1,212.600) 690.387 1,007.788
Discount factor 1.000 0.901 0.812
PV (1,212.600) 621.970 817.943
NPV 227.314

Newcastle lease will be paid anyway, so the cost is irrelevant.

Allocated Head Office costs are irrelevant as they are not incremental.
Newcastle factory-wide fixed costs are irrelevant as they are incurred
anyway.

W1
Newcastle sales £1.3m  1.02 1,326.000
£1.5m  1.02  1.03 1,575.900

W2
Newcastle contribution
(sales  65%) 861.900 1,024.339

Tax @ 17% 146.523 174.137

W3
WDV 3,100.000
Balancing Allowance (1,400.000)
Sale 1,700.000

Tax saved (17% 

£1,400,000) 238.000

W4
Working capital (132.600) (157.590) 0.000
Balance b/f 0.000 132.600 157.590
Increment (132.600) (24.990) 157.590

ICAEW 2020 March 2017 exam answers 257

 20X7 20X8 20X9
Closure March 20X9 : y0 y1 y2
£m £m £m
London sales (W1) 7,344.000 5,778.300
London variable costs (sales  40%) (2,937.600) (2,311.320)
London fixed costs (W2) (1,428.000) (1,470.840)
Tax on profit (W3) (506.328) (339.344)
Factory closure (2,300.000)
Tax on closure 391.000
Lease payments (1,800.000) (1,800.000)
Tax saved on lease 306.000 306.000
Machinery sale 600.000
Tax saving on machinery (W4) 94.860 77.785 252.355
London working capital (W5) 65.600 156.570 577.830
Total cash flows (1,639.540) 1,212.427 1,483.981
Discount 1.000 0.901 0.812
PV (1,639.540) 1,092.277 1,204.432
NPV 657.169

W1
London sales £7.2m  1.02 7,344.000
£5.5m  1.02 
1.03 5,778.300

W2
London fixed costs £1.4m  1.02 (1,428.000)
£1.4m  1.02 
1.03 (1,470.840)

W3
London contribution (sales  60%) 4,406.400 3,466.980
less: London fixed costs (1,428.000) (1,470.840)
London 'profit' 2,978.400 1,996.140

Tax on 'profit' @ 17% (506.328) (339.344)

W4
WDV 3,100.000 2,542.000 2,084.440
WDA (558.000) (457.560) (1,484.440)
WDV/sale 2,542.000 2,084.440 600.000

Tax saved (WDA  17%) 94.860 77.785 252.355

W5
Working capital (734.400) (577.830) 0.000
Balance b/f 800.000 734.400 577.830
Increment 65.600 156.570 577.430

44.1(b) White should choose March 20X9 for closure of the London factory as it has the higher
NPV and will enhance shareholder wealth the most.

258 Financial Management: Answer Bank ICAEW 2020

 44.2
Project 1 2 3 4 Total
£'000 £'000 £'000 £'000 £'000
Investment required (£m) 6,000 4,500 4,700 3,850 19,050
Net Present Value 621 563 869 622

NPV/£ invested £0.104 £0.125 £0.185 £0.162

Ranking 4 3 1 2

Divisible projects 1 2 3 4 Total

£'000 £'000 £'000 £'000 £'000
Invested 1,950 4,500 4,700 3,850 15,000
NPV 202 563 869 622 2,256

Funds used 32.5% 100% 100% 100%

of of of of
P1 P2 P3 P4

Indivisible projects

Using trial and error:

1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 6,000 4,500 3,850 14,350
NPV 621 563 622 1,806

1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 6,000 4,700 3,850 14,550
NPV 621 869 622 2,112

1 2 3 4 Total
£'000 £'000 £'000 £'000
Invested 4,500 4,700 3,850 13,050
NPV 563 869 622 2,054
The highest NPV is achieved via the combination of projects 1, 3 and 4. This would
generate an NPV of £2,112,000.
44.3 The efficient markets hypothesis (EMH) holds that stock markets are considered in the main
to be efficient, ie, all share prices are 'fair'. Investment returns are those expected for the
risks undertaken. Information is rapidly and accurately incorporated into share values.
When share prices at all times rationally reflect all available information, the market in which
they are traded is said to be efficient. In efficient markets investors cannot make consistently
above-average returns other than by chance.
An efficient market is one in which share prices reflect all of the information available. There
are three levels of efficiency:
Weak form – prices only change when new information about a company is made available.
There are no changes in anticipation of new information. Information arrives in a random
manner (the random walk theory) and so the chartist theory (technical analysis) will not hold
up here. The market is efficient in the weak form if past prices cannot be used to earn
consistently abnormal profits.

ICAEW 2020 March 2017 exam answers 259

 Semi strong form – prices reflect all information about past price movements and all
knowledge that is publicly available/anticipated. The market can anticipate price changes
before new information is formally announced. The market is efficient in the semi-strong
form if publicly available information (eg, historical share prices, dividend announcements)
cannot be used to earn consistently abnormal profits.
Strong form – share prices reflect all information about past price movements, all
knowledge that is publicly available/anticipated and from insider knowledge available to
specialists or experts. The market is efficient in the strong form if all information (private and
public) cannot be used to earn consistently abnormal profits.
Behavioural finance questions the validity of the EMH and posits that investors' irrational
behaviour may affect share price movements. Examples of irrational behaviour are:
Overconfidence Representativeness Narrow framing
Miscalculation of probabilities Ambiguity aversion Positive feedback
Cognitive dissonance Availability bias Conservatism

Examiner's comments:
This question had the lowest percentage mark on the paper. The majority of candidates
achieved a 'pass' standard in the question, however.
This was a three-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
It was based around a UK cosmetics manufacturing company which has three factories (in
London, Newcastle and Manchester). In the first part of the question, for 22 marks, the company
had decided to close the London factory and relocate some of its production to the Newcastle
factory. Its board is not sure of the best closure date (20X7 or 20X9). Candidates were given
financial information about the two factories and were asked to calculate the relevant money
cash flows associated with closing the London factory (a) in 20X7 and (b) in 20X9. From these
calculations candidates were required to calculate the NPV for each scenario. The second part,
for six marks, considered the Manchester factory and tested candidates' understanding of
capital rationing. The third part, for seven marks, required candidates to explain the key
principles of the Efficient Market Hypothesis and the influence of behavioural factors.
As expected, in the first requirement parts (a) and (b) were very effective discriminators. A good
number of candidates did really well here, but a significant minority really struggled and were
unable to identify the relevant cash flows adequately. This was largely due to an inability to stand
back and think the scenario through carefully before diving in and doing the calculations.
Typical errors made were:
 The inclusion of opportunity costs (despite instructions to the contrary)
 Including irrelevant cash flows, eg, leases, head office costs, fixed costs
 Inaccurate inflation adjustments
 Poor working capital calculations
 Too many candidates mixed together the London and Newcastle sales/contribution figures
 Many candidates considered only 20X7 cash flows for the 20X7 closure date and will have
lost marks
Most candidates scored well in the second part and the most common error was a failure to
apply the trial and error approach for the indivisible projects.
The third part was answered well by most candidates.

260 Financial Management: Answer Bank ICAEW 2020

45 ST Leonard Foods (March 2017)
Marking guide

Marks
45.1 Net payment due 1
No hedge 2
OTC option 3
Money market hedge 3
Forward contract 2
11
45.2 Hedging advice comparing the methods
under each exchange rate 8

45.3 Rates payable with LIBOR 4% 2

Rates payable with LIBOR 6% 2
Annual interest calculation 1
Conclusion 2
7
45.4 FRAs v futures – 1 mark per valid point 4
30

45.1
Net payment due at 30/6/X7 = €1,750,000 – €600,000 €1,150,000

Spot rate @ 30/6/X7 Spot rate @ 30/6/X7

€1.1875 – 1.1960/£ €1.2745 – 1.2860/£

Do not hedge €1,150,000 (£968,421) €1,150,000 (£902,314)

1.1875 1.2745

OTC option €1.1875 – €1.2745 –

1.1960 1.2860
Call option
Exercise option Yes No
Rate 1.2540 1.2745

Sterling payment €1,150,000 €1,150,000

1.2540 1.2745

(£917,065) (£902,315)
plus: Premium cost
(€1,150k/€100  £0.70) (8,050) (8,050)
Total cost (£925,115) (£910,365)

ICAEW 2020 March 2017 exam answers 261

 Money market hedge
Lend euros now €1,150,000 €1,150,000 €1,143,709
1 + (2.2%/4) 1.0055

Convert at spot rate €1,143,710 (£903,975)

1.2652

Sterling borrowed at 4.6% pa 903,975  [1 + (4.6%/4)] (£914,370)

Forward contract
Sterling payment €1,150,000 1,150,000 (£913,133)
(1.2652 – 0.0058) 1.2594

Arrangement fee (5,500)

(£918,633)
45.2 In summary
Spot rate – €1.1875/£ Spot rate – €1.2745
Do not hedge (£968,421) (£902,314)
OTC option (£925,115) (£910,365)
MMH (£914,370) (£914,370)
Forward contract (£918,633) (£918,633)
Sterling payment @ current spot rate €1.150m/1.2652 (£908,947)
The forward rate suggests that the euro will strengthen (sterling will weaken) over the next
three months. STL would prefer sterling to be stronger (purchases are then cheaper).
With an exchange rate of €1.1875/£
Sterling is much weaker, and the MMH and forward contract produce the lowest sterling
payments.
With an exchange rate of €1.2745/£
Sterling is stronger, and the option and no hedge produce the lowest sterling payments.
Once the exchange rate exceeds €1.2577/£ (€1.150,000/£914,370) then the option
produces a lower payment than the MMH (and also, therefore, the forward contract).
Directors' attitude to risk is also important in deciding which approach to take.
45.3
LIBOR 4% LIBOR 6%
FRA Option No hedge FRA Option No hedge
Pay (5.0%) (5.0%) (5.0%) (7.0%) (5.2%) (7.0%)
(Pay)/refund (0.8%) 1.2%
Premium (0.5%) (0.5%)
Total (5.8%) (5.5%) (5.0%) (5.8%) (5.7%) (7.0%)

£'000 £'000 £'000 £'000 £'000 £'000

Annual interest (243.6) (231.0) (210.0) (243.6) (239.4) (294.0)

At the lower LIBOR rate it is best not to hedge, but with LIBOR at 6% the option is slightly
cheaper than the FRA.

262 Financial Management: Answer Bank ICAEW 2020

 45.4 FRA's allow lenders/borrowers to fix a rate of interest. The bank will pay/receive any
difference between the agreed rate and the actual rate paid/received (see workings in 45.3
above).
Interest rate futures are similar to FRA's in that they are contracts on an interest rate, but the
terms, amounts and periods are standardised.
Entitlement to interest rate receipts is bought with futures and the promise to make to
interest rate payments is sold with futures.
The pricing of an interest rate futures contract is calculated as (100–r), so if the rate in a
futures contract is 5% then the contract will be priced at 95. Profits/losses on the buying and
selling of futures are offset against the moves in interest rates.

Examiner's comments:
Most candidates demonstrated a good understanding of this area of the syllabus and this
question had the highest average mark on the paper.
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus.
In the scenario a UK frozen food company was considering hedging its exposure to (a) foreign
exchange rate risk on a planned €1.15 million (net) payment (three months ahead) and (b)
interest rate risk on a £4.2 million loan from its bank (also three months ahead).
The first part was worth 11 marks and asked candidates to calculate, at two spot rates, the
sterling cost arising from a list of hedging techniques that could be applied to the euro
payment. In the second part, for eight marks, candidates were required to advise the company's
board whether it should hedge the euro payment. In the third part, for seven marks, candidates
were required to calculate the annual interest payments that would arise on its planned loan
were it to make use of an FRA, an option or to not hedge at all. Two different rates of LIBOR
were given to the candidates. From these calculations, candidates were then required to
recommend which of the hedging techniques the company should choose at each of the LIBOR
rates given. Finally, for four marks, candidates were asked to explain how FRA's differ from
interest rate futures.
The first part was generally answered well. However, a minority of candidates added the euro
receipt to the euro payment or kept them separate and so will have lost marks. One disturbing
error, which occurred too frequently, was that candidates calculated two different MMH and
forward contract results using the two future spot rates given, rather than a single result for each,
based on the current spot rate. Also, many wasted time by recalculating the correct MMH and
forward contract results for the second set of spot data, rather than just stating 'no change'. The
examining team has no explanation for this as many similar questions have been set in the past
without these issues occurring. With the currency option, the most common errors were (a)
choosing a put rather than a call option and (b) using a traded option rather than an OTC.
Overall, the second part was disappointing in that too few candidates went beyond only
comparing the best outcome at each spot rate. Most answers here needed to demonstrate a
deeper understanding of the issues involved.
In the third part many candidates scored full marks, which was good to see. However, a number
of candidates lost marks as they were confused by the timings in the scenario. Rather than
calculate the annual interest cost as required, they calculated, incorrectly, a three month cost, ie,
between now and when the loan is to be taken out.
Overall, the final part was answered well.

ICAEW 2020 March 2017 exam answers 263

 June 2017 exam answers

46 Brighton plc (June 2017)

Marking guide

Marks
46.1 NPV calculation:
Contribution 3
Costs 1.5
Recognition of sunk costs 0.5
Rent forgone 1
Tax 1
New equipment/capital allowances 3
Working capital 2.5
Discount factor 1
NPV conclusion 1.5
15
46.2 PV of contribution 2.5
Sensitivity % 0.5
Conclusion 1
4
46.3 Listing the seven value drivers 2
Application to the scenario 4
6
46.4 1 mark for each option, 1 mark for application 4

46.5 1.5 marks for each example 3

46.6 State and apply the relevant principles 3

35

46.1
0 1 2 3 4
£m £m £m £m £m
Contribution 2.97 3.18 2.92 2.68
Fixed overheads –0.10 –0.10 –0.11 –0.11
Selling and administration –0.50 –0.52 –0.53 –0.55
Rent forgone –0.40 –0.40 –0.40 –0.40
Operating cash flows –0.40 1.97 2.16 1.88 2.02

Tax 17% 0.07 –0.33 –0.37 –0.32 –0.34

After tax operating cash flows –0.33 1.64 1.79 1.56 1.68

New equipment –8.00

Tax saved on CA's 0.24 0.20 0.16 0.13 0.62
Working capital –1.00 –0.07 0.09 0.08 0.90
Net cash flows –9.09 1.77 2.04 1.77 3.20
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value –9.09 1.61 1.68 1.33 2.19
NPV –2.28

264 Financial Management: Answer Bank ICAEW 2020

 The project has a negative NPV therefore it should not proceed.
Contribution:
1. 5,500  12  £100  45% = £2.97m
2. 2.97  1.02  1.05 = £3.18m
3. 3.18  1.02  0.90 = £2.92m
4. 2.92  1.02  0.90 = £2.68m
Fixed overheads only 50% incremental: £0.2m  0.5 = £0.1m
1. 0.1
2. 0.1  1.03 = 0,103
3 0.103  1.03 = 0.106
4.0.106  1.03 = 0.109
Selling and administration:
1. 0.50
2. 0.50  1.03 = 0.515
3. 0.515  1.03 = 0.531
4. 0.531  1.03 = 0.546
Marketing costs and centrally allocated costs are a sunk costs and therefore not included.
Capital allowances and the tax saved thereon.
Cost/WDV CA Tax
0 8.00 1.44 0.24
1 6.56 1.18 0.20
2 5.38 0.97 0.16
3 4.41 0.79 0.13
4 3.62 3.62 0.62

Working capital
Total Increment
0 –1 –1
1 –1.07 –0.07
2 –0.98 0.09
3 –0.9 0.08
4 0.9
The discount factor should be calculated as follows:
(1.07  1.025) –1 = 0. 0968 It is acceptable to round this to 0.10 (10%).
46.2
£m £m £m £m
Sensitivity:
Contribution  (1– 0.17) 2.47 2.64 2.42 2.22
PV factors 0.909 0.83 0.75 0.68
PV 2.25 2.18 1.82 1.52

Total PV 7.77

Sensitivity
– 2.28/7.77 = –29.3%
Sales revenue will have to increase by 29.3% to arrive at a zero NPV. The project is therefore
relatively insensitive to revenue changes.

ICAEW 2020 June 2017 exam answers 265

 46.3 SVA is the process of analysing the activities of a business to identify how they will result in
increasing shareholder wealth.
Answers should outline the seven drivers and relate them to the project and its negative
NPV:
Sales growth rate – can this be increased, are the estimates realistic.
Operating profit margin – can the 45% contribution be improved by reducing costs.
Investment in non-current assets – can the cost of the project be reduced, perhaps by
leasing plant and machinery.
Investment in working capital – can the project operate with less investment in working
capital without causing liquidity problems.
Cost of Capital – is the cost of capital at its optimum level.
Life of projected cash flows – is the project life cycle correct and is there any value in cash
flows beyond the fourth year.
Corporation tax rate – is the company tax efficient.
46.4 The project has a negative NPV, which signals that Brighton should reject it. The real options
are as follows (any TWO):
A follow-on option – investing into this competitive market now will allow Brighton to invest
more in the future, perhaps when other competitors have left the market.
An abandonment option – Brighton might commence the project with a view to future
investment. However, if it is apparent that the sector is not going to offer future
opportunities, Brighton can abandon the project at any time eg, by selling out to a rival.
A timing option – Brighton could delay its investment and wait and see if competitors leave
the market, making it more attractive to invest later on.
A growth option – As well as manufacturing overseas, Brighton also has the opportunity to
expand overseas via acquistion.
A flexibility option – Manufacturing overseas would perhaps give the flexibility to access
overseas markets more easily.
46.5 The over-riding objective of companies is to create long-term wealth for shareholders.
However this can only be done if we consider the likely behaviour of other stakeholders. For
example (TWO only):
Employees – cutting employee benefits in pursuit of creating short-term profits could have
long-term detrimental effects on shareholder wealth, for example if the company has high
staff turnover which affects productivity or service levels.
Creditors – delaying payments to creditors could have repercussions for future supplies,
which could reduce longer- term shareholder wealth.
Managers – if managers and employees are not motivated adequately, the costs of
inefficiencies will be borne by shareholders.
46.6 The directors of Brighton should develop an ethical policy in respect to using overseas
manufacturers where labour is cheap and safety standards for employees may be low. This
should relate to not using suppliers who make use of child labour or slave labour, or who
employ people in dangerous working conditions. In relation to this, the principles of
integrity, objectivity and professional behaviour are relevant.

266 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This was a six-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was a company considering
launching a new product on to the market.
The first part was well answered by many candidates, however the following were common
errors: incorrect calculation of sales and variable costs; timing errors for cash flows; not stating
that research and development costs should be ignored because they are a sunk cost; not
stating that allocated fixed overheads should not be included in the NPV computations.
Responses to the second part were mixed, with many candidates basing calculations on sales
rather than contribution, and many ignoring taxation. There were few candidates who made
meaningful comments regarding the sensitivity of the project to changes in the inputs.
Responses to the third part were also mixed, with weaker candidates merely listing the seven
drivers with no application to the scenario.
Responses to the fourth part were good, but some candidates listed all real options rather than
just stating two as per the requirement. Only the first two are marked. Responses to the fifth and
sixth part were also good.

47 Easton plc (June 2017)

Marking guide

Marks
47.1 Cost of equity 1
Cost of debt 4
MV equity 1
MV debt 1
WACC 1
8
47.2 Explanation 2
De-gearing 1.5
Re-gearing 1.5
Cost of equity associated with the project 1
6
47.3 Overall equity beta 1.5
Cost of equity 1
WACC 1.5
Commentary 2
6
47.4 2 marks for definitions; 0.5 marks for each examples 6

47.5 Portfolio theory 1

Stock market reaction 1.5
Shareholder reaction 1.5
4
47.6 Identification of APV 1
Description of its application - 1 mark per point 4
5
35

ICAEW 2020 June 2017 exam answers 267

 47.1 The current WACC using CAPM is calculated as follows: Ke = 2 + 0.45 (9 – 2) = 5.15%
Kd using linear interpolation:
The ex-interest debenture price is £105 (109 – 4).
Timing Cash Flow Factors at PV Factors at PV
Years £ 1% £ 5% £
0 (105) 1 (105) 1 (105)
1–8 4 7.652 30.61 6.463 25.85
8 100 0.923 92.30 0.677 67.70
17.91 (11.45)
IRR = 1 + (17.91/(17.91 + 11.45)  4 = 3.44%
Kd = 3.44  (1 – 0.17) = 2.86%
The ex div share price is 252p – 10p = 242p.
The market value of equity is: 242p  (5m/0.01) = £1,210m. The market value of debt is:
£200m  (105/100) = £210m. The debt equity ratio is: 0.15:0.85
The current WACC is: (5.15%  0.85) + (2.86%  0.15) = 4.81%
47.2 The cost of equity should reflect the systematic risk of the project. An equity beta from a
listed company operating veterinary practices can be used as a surrogate in the CAPM.
Since the gearing ratio of the surrogate is materially different to Easton, gearing
adjustments will have to be made.
De gearing to find Ba: 0.80 = Ba (1 + (3  0.83)/7) Solving for Ba. Ba = 0.59
Gearing up to reflect the gearing ratio of Easton to find Be: Be = 0.59 (1 + (0.15  0.83)/0.85)
Solving for Be. Be = 0.68
The Ke to reflect the systematic risk of the project = 2 + 0.68 (9 – 2) = 6.76%
47.3 The overall Be of Easton will reflect the systematic risk of both pet-related products and
veterinary practices.
The overall Be = (0.45  0.75) + (0.68  0.25) = 0.51
Ke = 2 + 0.51 (9 – 2) = 5.57%. The overall WACC = (5.57%  0.85) + (2.86%  0.15) = 5.16%
Easton's WACC has increased to 5.16% from 4.81%. An increase in the WACC is associated
with a reduction in value, but assuming that the project has a positive NPV this could result
in an increase in value.
47.4 Systematic risk is the type of risk that all companies are exposed to, no matter which market
sector they operate in. Systematic risk cannot be eliminated through diversification.
Examples of systematic risk include: interest rate changes, economic recession, oil price
changes and wars.
Unsystematic risk is the risk that affects a particular market sector or individual company.
Most of this risk can be diversified away by investing in a portfolio of randomly selected
securities. Examples of unsystematic risk include: the chairman resigning, strikes by the
employees of a company or changes in regulations that affects a particular market sector.
47.5 Portfolio theory shows that the only logical portfolio to hold is one which is fully diversified.
The reaction of each group might be:
The stock market might not welcome the diversification, since diversified companies usually
trade at a conglomerate discount. The stock markets might assume that Easton does not
have the expertise to operated veterinary practices.

268 Financial Management: Answer Bank ICAEW 2020

 Shareholders who hold a well-diversified portfolio would not welcome Easton diversifying
its operations (as they already regard themselves as well-diversified without this), so the
market value might fall.
47.6 If the financing of the project results in a change in the capital structure of Easton, the
WACC/NPV should not be used. An alternative project appraisal technique is APV.
The project will be appraised as if it were only financed by equity, to arrive at a base case
NPV. The base case NPV is then adjusted for the present value of the costs and benefits of
the actual type of finance used, including the present value of the tax shield on interest paid.
The discount rate will be the all equity discount rate using the Ba for the project: 2 + 0.59 (9 –
2) = 6.13%

Examiner's comments:
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus. The scenario of the question was a company considering diversifying its
activities, and calculating the WACC that should be used to appraise the diversification. Also
there is debate about whether the company should be diversifying in the first place, and how the
markets and shareholders might react.
Responses to the first part were good. However a number of candidates made basic errors when
calculating the cost of debt, with a surprising number not able to carry out interpolation
correctly. Strangely, some candidates correctly calculated the cost of equity using the CAPM, but
then used this number in the DVM as growth. They then attempted to use the DVM model to
calculate the cost of equity.
Responses to the second part were disappointing, but there were some excellent answers.
Common mistakes were: de-gearing the company's existing equity beta; de-gearing the correct
beta but re-gearing using book values rather than market values. Explanations of the rationale
for calculating the cost of equity for the project were poor.
Responses to the third part were mixed. A number of candidates did not calculate the overall
equity beta of the company, and used the equity beta from the second part. Explanations of the
effect of a rise in the overall WACC of the company were poor. Responses to the fourth part were
poor, and many candidates were confused about what the terms systematic and unsystematic
risk mean. Often students quoted incorrect examples of each risk.
Responses to the fifth part were also mixed, with many candidates not able to demonstrate a
good grasp of the topic area. Few candidates mentioned that diversified companies often trade
at a conglomerate discount.
Responses to the sixth part were reasonable. Many candidates were able to identify APV and
describe the process. However, few candidates calculated the appropriate discount rate.

ICAEW 2020 June 2017 exam answers 269

48 Lake Ltd (June 2017)
Marking guide

Marks
48.1 Forward contract 2
Money market hedge 3
Currency futures 4
OTC currency options 5
14
48.2 Implications of hedging techniques 3
Advantages and disadvantages 5
Recommendation 2
10
48.3 2 marks for each risk identified and explained 4
Ways to mitigate the risks 2
6

30

48.1 Forward contract:

The appropriate forward rate is $/£1.3110 (1.3092 + 0.0018). The sterling receipt will be
£991,609 (£1,300,000/$1.3110).
Money market hedge:
Borrow in US$ against the receipt due in three months:
Borrow $1,288,085 = (1,300,000/(1 + 0.037/4)
Buy £ spot = £983,871 (1,288.085/1.3092)
Total receipt of £991,497 (983,871  (1 + 0.031/4))
Currency futures:
Lake will buy September futures to hedge the $ receipt.
The number of contracts to buy is = ($1,300,000/$1.3105)/£62,500 = 15.87 round to 16.
The futures contracts will be closed out on 30 September 20X7 resulting in a profit of:
$12,500 ((1.3230 – 1.3105)  16  62,500)
The sterling receipt will be: £990,566 ((1,300,000 + 12,500)/1.3250).
OTC currency options:
Lake will use a call option to buy £ with an exercise price of $/£1.3200. The premium will
cost = £26,000 (1,300,000  0.02).
Together with interest the premium will cost £26,208 (26,000  (1 + 0.032/4))
If the spot rate for buying £ with $ on 30 September is $/£ 1.3250 the option will be
exercised. The total receipt will be = £958,640 ((1,300,000/1.3200) – 26,208).

270 Financial Management: Answer Bank ICAEW 2020

 48.2 The four hedging techniques result in sterling receipts of:
Forward contract £991,609
A money market hedge £991,497
Currency futures £990,566
OTC currency option £958,640
The forward contract, money market hedge and futures contracts all lock Lake into an
exchange rate. The options protect Heaton against the downside risk of the £ strengthening
against the $, and allow for the upside potential of the $ strengthening against the £.
However, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for Lake.
However there is no secondary market should the customers not pay Lake.
Money market hedge:
The money market hedge is the same as a forward contract. However it is more difficult to
arrange and might use up Lake's credit lines, on the other hand it does allow Lake to
decrease its overdraft immediately.
Currency futures:
Not tailored so one has to round the number of contracts.
Requires a margin to be deposited at the exchange.
Need for liquidity if margin calls are made.
However, there is a secondary market.
Basis risk exists.
OTC currency options:
There is no secondary market.
Advice to Lake:
Spot is $1,300,000/$1.3250 = £981,132
It is unlikely that the dollar is going to strengthen enough to cover the cost of the option
premium, so it is not recommended that the company uses foreign currency options. There
is very little difference in the receipt using forwards, the money markets and futures, and
they are all better than spot.
Since there is potential for margin calls using futures, and the use of credit lines using the
money markets, it is recommended that Lake uses forward contracts to hedge its foreign
currency risk.
48.3 Risks that students might identify and explain are (two only):
 physical risk – the risk of goods being lost or stolen in transit, or the documents
accompanying the goods being lost.
 credit risk – the possibility of payment default by the customer.
 trade risk – the risk of the customer refusing to accept the goods on delivery, or
cancellation of the order in transit.
 liquidity risk – the inability to finance the credit given to customers.
 other risks that would be given marks include political risk and cultural risk.

ICAEW 2020 June 2017 exam answers 271

 These risks may be mitigated with the help of banks, insurance companies, credit reference
agencies and government agencies such as the UK's Export Credits Guarantee Department.
Other ways to reduce these risks include risk transfer. Lake might be able to agree a
contract obligating the courier to pay for losses in excess of its statutory liability.

Examiner's comments:
This was a three-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was a company that has recently started
exporting to the US, and a member of staff is asked to give advice to the board on hedging
FOREX, and other risks associated with overseas trading activities.
The first part was well answered by most candidates. However some of the errors demonstrated
by weaker candidates included: calculating the number of futures contracts using the spot rate
rather than the futures price; stating that currency futures should be initially sold rather than
bought; calculating the futures gain in £ rather than $; choosing put options rather than call
options; treating an over the counter option like a traded option; calculating the option premium
in US$ rather than £; omitting interest on the option premium.
There were average answers to the second part from a lot of candidates, some without any
reference to the numbers calculated in the first part. Many candidates did not give a firm
conclusion, but there were some excellent answers.
Responses to the third part were mixed, with many candidates demonstrating a lack of
knowledge of overseas trading risks. Even though the requirement stated that the risks identified
should be other than FOREX, a number of candidates quoted this as one of their two risks.

272 Financial Management: Answer Bank ICAEW 2020

 September 2017 exam answers

49 Merikan Media plc (September 2017)

Marking guide

Marks
49.1 (a) Valuation:
P/E ratio 2
Dividend yield 2
EBITDA 5.5
Net assets at historic cost 1
Net assets revalued 1.5
12
(b) 1 point per valid point on each of the valuation methods 7
Advice on price range 1
8
49.2 (a) SVA:
Sales and operating margin 2
Tax and depreciation 2
Non-current assets 2
Working capital 1
Terminal value 2.5
Present values 0.5
Short term investments 1
Long term debt 1
12
(b) Methods to fund MBO – 1 mark per point 3
35

49.1 (a)
Total Value per
value share
£'000 £
P/E ratio £6,391,000  8.5 = 54,324 /3,500 15.52
Lower marketability
(25% discount, say) 11.64

Dividend yield £1,750,000/5% = 35,000 /3,500 10.00

Lower marketability
(25% discount, say) 7.50
Enterprise value £'000
Profit before interest
& tax 8,100
Depreciation 3,500
Amortisation 1,200
EBITDA 12,800  6.5 = 83,200
less: Debt at MV 8,000  £110% = (8,800)
74,400 /3,500 21.26
Lower marketability
(25% discount, say) 15.94

ICAEW 2020 September 2017 exam answers 273

 Total Value per
value share
£'000 £
Net assets – historic cost
Ordinary share capital 3,500
Retained earnings 27,206
30,706 /3,500 8.77
8.94
Net assets – revalued
Historic cost (as above) 30,706
Non-current assets (£37,800 – £36,310) 1,490
Current assets (£4,200 – £4,316) (116)
Debentures (£8,000 – £8,800) (800)
31,280 /3,500

(b) Asset valuations are the lowest. They are historic figures and balance sheet-based, with
no intangibles. Merikan is buying Coastal to run it, not to break it up.
P/E and enterprise value are the most relevant as they are forward-looking and based
on profits/earnings.
Using the dividend yield is acceptable, but it is a 100% purchase and the yield
calculation is only relevant for minority interests. Also, this method ignores growth. So
a price range of £12 to £16 per share looks reasonable.
49.2 (a)
Terminal
20X7 20X8 20X9 20Y0 value
£m £m £m £m £m
Sales 70.0 73.5 75.7 77.2 77.2
Operating margin 5.9 6.8 6.9 6.9
Tax (17%) (1.0) (1.2) (1.2) (1.2)
Depreciation 1.5 1.5 1.5 1.5
Operating cash flows 6.4 7.2 7.3 7.3
Replacement non-current assets (1.5) (1.5) (1.5) (1.5)
Incremental non-current assets (0.2) (0.1) 0.0 0.0
Incremental working capital (0.2) (0.1) (0.1) 0.0
Free cash flows 4.5 5.4 5.7 5.8
Discount factor (8%) 0.926 0.857 0.794 0.794
4.6
/8%
Present values 4.2 4.7 4.5 57.2
Total present value 70.6
plus: Short-term investments 0.7
less: Long-term debt
(£10m  £95%) (9.5)
Market value of equity 61.8
So GB's equity is worth approximately £61.8m
(b) Methods by which management might fund its MBO:
From management's equity
From venture capitalists – via equity and debt
Borrowing from bank(s) – debt

274 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This question was generally answered poorly and a very slim majority of candidates achieved a
pass standard. It was a four-part question that tested the candidates' understanding of
investment decisions. In the scenario a UK-listed media group is planning to (1) purchase an
unquoted commercial radio company and (2) sell all of its shares in an unquoted newspaper
company via a Management Buy Out (MBO).
Many candidates did well in part (a) of the first requirement and some scored full marks. However,
overall this was not answered as well as expected. A considerable number of candidates were
unable to calculate the company's net assets and/or earnings figures, which was very
disappointing. The enterprise value (EV) calculation was a recent addition to the syllabus. Overall
this was answered reasonably well, but many candidates did not attempt it at all. Part (b) of the
first requirement was, overall, done well, but to score high marks here candidates needed to
consolidate valuation theory with the figures that they had calculated.
For part (a) of the second requirement there was a wide range of answers. Some candidates did
really well here, whilst others produced very little. The figures themselves were not difficult, and a
methodical approach would have generated a good mark. There was evidence of time pressure,
as there were many incomplete answers. Part (b) of the second requirement was done well by
most candidates. A similar question to this was set recently, but many candidates did poorly
because they failed to concentrate their answers on the directors behind the MBO, rather than
the company itself.

50 Ramsey Douglas Motors plc (September 2017)

Marking guide

Marks

50.1 Cost of equity 2

Cost of preference shares 1
Cost of irredeemable debt 2
Cost of redeemable debt 4
WACC 1
10
50.2 Current market value of redeemable debentures 2
Effect of rise in yield 1
3
50.3 Use of WACC figure – 1 mark per valid point 5

50.4 Identification of key ethical issues 3

50.5 Calculation of appropriate WACC:

Calculation of ungeared beta 1.5
Calculation of geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Appropriate commentary 4
10
50.6 Application of EMH theory – 1 mark per point 4
35

ICAEW 2020 September 2017 exam answers 275

 50.1

Cost of equity (ke) = (d1) (£5,440  1.03)

+g + 3% 11.54%
MV £65,600

Cost of preference shares (kp) = d £640 5.93%

MV £10,800

(£275  83%)
Cost of irredeemable debt (kdi) = 3.80%
£6,000

Cost of redeemable debt (kdr)

Year Cash flow 4% factor PV 5% factor PV
£'000 £'000 £'000
0 (4,200) 1.000 (4,200.0) 1.000 (4,200.0)
1–3 240 2,775 666.0 2.723 653.5
3 4,000 0.889 3,556.0 0.864 3,456.0
NPV 22.0 NPV (90.5)
IRR = 4% + (22/(22 + 90.5)) = 4.20%
less: Tax at 17% (4.20%  83%) = 3.49%
WACC
Total MV's Cost  weighting WACC
£'000 £'000
Equity 65,600 11.54%  65,600/86,600 8.74%
Pref. shares 10,800 5.93%  10,800/86,600 0.74%
Irredeemable debt 6,000 3.80%  6,000/86,600 0.26%
Redeemable debt 4,200 3.48%  4,200/86,600 0.17%
21,000 1.17%
Total market value 86,600 9.91%

50.2 From 50.1 above:

Year Cash flow 5% factor PV
£'000 £'000
1–3 240 2.723 653.5
3 4,000 0.864 3,456.0
Present value 4,109.5

Thus current market value would be £4,109.5/£4,000 = £102.74%

Yield increases to 5% and market value falls to £102.74%. It is an inverse relationship.
50.3 When using WACC to appraise projects the following assumptions are implied:
(1) Ramsey's historic proportions of debt and equity are not to be changed
(2) Ramsey's systematic business risk is not to be changed
(3) The finance is not project-specific (eg, cheap government loans)
In this case the finance is of a material size, being 11% of total funds at market value
(£9.5m/£86.6m) and the historic gearing does not appear to be met (it is 50:50 ignoring
project NPV).
The systematic business risk, as far as we are aware, does not change as it is still the same
industry.
It is not project-specific finance.
Therefore it is unwise to use the existing WACC, but the after-tax cost of the bank loan is not
the WACC either, as this ignores the required returns of shareholders.

276 Financial Management: Answer Bank ICAEW 2020

 50.4 Ethical guidance – key areas of ethical concern regarding the press release:
Integrity – members need to show honesty, fair dealing and truthfulness.
Objectivity – members must not succumb to the undue influence of others.
Interest of shareholders and owners must be taken into account – members must not let
their own self-interest influence their actions.
50.5 New market geared beta = 2.10
(2.10  72) (2.10  72)
New market ungeared beta = = 1.77
(72 + (16  83%)) 85.28

1.77  (£65.6m + £10.8m + (£10.2m  83%))

Ramsey's geared beta = 2.29
£65.6m
So, cost of equity = (2.29  (9.15% – 2.25%)) + 2.25 = 18.05%
Cost of debt = 9%  83% 7.47%
WACC = (18.05%  £65.6m/£86.6m) + (7.47%  £21.0m/£86.6m)) = 15.48%
It would be unwise to use the existing WACC (9.91%) as Ramsey's plan involves
diversification, and therefore a change in the level of systematic risk (beta rises to 2.29 from
1.25). Thus a new WACC must be calculated. Systematic risk is accounted for by taking into
account the beta of the driverless cars market, and this is then adjusted to eliminate the
financial risk (level of gearing) in that market. The resultant ungeared beta is then 're-
geared' by taking into account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed
above) is used.
Using this, the new WACC can be calculated.
50.6 Markets set prices based on the information available. If the market 'takes fright' at the
proposed investment in driverless cars, then the market value of Ramsey's shares will fall
and may not recover. It all depends on the market's view of the company's likely future
success.
Efficiency does not mean that prices return to a 'normal level'. Markets have no memory.
Efficiency means that shares cannot be bought cheaply and then sold quickly at a profit.
Share prices are 'fair', and investment returns are those that would be expected for the risks
undertaken.

Examiner's comments:
This was a six-part question that tested the candidates' understanding of financing options, with
a small ethics element. It was poorly done and had the lowest percentage mark on the paper.
The majority of candidates failed to reach a 'pass' standard. It was based around a UK-listed car
manufacturer that was considering investing in (1) a computerised manufacturing system and (2)
the development of driverless cars.
There were many very good answers to the first part, with candidates securing the full marks
available. The calculation of WACC has been examined frequently. However, in this exam
candidates were, not for the first time, given total figures, rather than unit figures, to work with.
Many candidates, when given the total nominal value and the nominal value per share or
debenture, were incapable of deducing the number of shares or debentures in issue. Also a
significant number altered the share and debt values to make them ex-div, despite the fact that
the question stated that all dividends and interest due for the year had already been paid.

ICAEW 2020 September 2017 exam answers 277

 The second part was a good test of candidates' understanding of the market price and yield of
redeemable debt. Generally, it was answered very poorly. Many candidates commented that if
the redemption yield of the debt were to increase then so would the price of that debt, thus
totally misunderstanding the relationship between required return and value.
Candidates' responses to the third part were also very disappointing. Too many candidates
restricted their answers to a discussion about the impact on the company's gearing levels,
without taking into account the wider aspects of when to employ the current WACC figure. In the
fifth part most candidates scored well with the de-gearing and re-gearing calculations, but only a
few were able to work through to the end of the calculations.
The sixth part caught out the majority of candidates – they were unable to apply EMH theory to
this practical example. Responses that centred on the three forms of efficiency and/or
behavioural aspects scored poorly.

51 Jenson Grosvenor plc (September 2017)

Marking guide

Marks

51.1 Currency option 3

Forward contract 2
Money market hedge 3
Strengthening sterling 1
9
51.2 Hedging advice – 1 mark per relevant point 7

51.3 Explanation of relevant economic risk 3

51.4 Advantages of using currency futures – 2 marks

Disadvantages of using currency futures – up to 4 marks
Maximum available 4

51.5 Call options intrinsic value 1

Put options intrinsic value 1
Time value 2
4
51.6 Factors affecting the time value – 1 mark per point 3
30

51.1
£ £
(a) OTC currency option
Put option £5,200,000 3,200,985
1.6245

Cost £5,200,000 = 52,000  £0.75 (39,000)

100 3,161,985

278 Financial Management: Answer Bank ICAEW 2020

 (b) Forward contract
1.6385 + 0.0085 = 1.6470 £5,200,000 3,157,256
1.6470

Fee £5,200,000 = 52,000  £0.35 (18,200)

100 3,139,056

(c) Money market hedge

Borrow C$ £5,200,000 £5,133,268
1.013

Convert @ spot £5,133,268 3,132,907

1.6385

Lend @ UK 3,132,907
 1.007 3,154,837
(d) Strengthening £
1.6385  1.05 = 1.7204 £5,200,000 3,022,509
1.7204
51.2
Conversion at spot rate £5,200,000 £3,173,634
1.6385
If £ strengthens 3,022,509
Option 3,161,985
Forward 3,139,056
Money market hedge 3,154,837
The current spot rate gives best result.
The worst result is from the strengthening £, and the forward contract discount predicts a
strengthening of the £.
C$ is depreciating, and £ strengthening, which is bad for UK exporters. The forward contract
provides certainty, as does the money market hedge.
An option gives flexibility, but it is expensive.
51.3 Jenson's imports are purchased mostly in euros. If exports were, for example, mostly in
Canadian dollars then Jenson would be disadvantaged by both a strong euro and a weak
dollar (as in 51.1 and 51.2 above).
51.4 Advantages of using currency futures over forward contracts:
 Lower transaction costs
 The exact date of receipt or payment does not have to be known
Disadvantages of using currency futures over forward contracts:
 The contracts cannot be tailored to the user's exact requirements.
 Hedge inefficiencies (due to needing a whole number of contracts, and basis risk) may
occur.
 Only a limited number of currencies can make use of futures contracts.
 If neither currency is $US, then this can complicate matters.

ICAEW 2020 September 2017 exam answers 279

 51.5 Intrinsic value
Only options that are in the money have an intrinsic value.
For the call options:
The call options with an exercise price of 355p are in the money and have an intrinsic value
of 10p (365p – 355p).
The call options with an exercise price of 370p are out of the money and have a zero
intrinsic value.
For the put options:
The put options with an exercise price of 370p are in the money and have an intrinsic value
of 5p (370p – 365p).
The put options with an exercise price of 355p are out of the money and have a zero
intrinsic value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:
Calls Puts
Sept Oct Sept Oct
355 1.0 11.0 2.0 13.5
370 3.5 14.0 4.0 15.5
51.6 The time value of the options will be affected by:
 the time period to expiry of the options.
 the volatility of the market price of the underlying item.
 the general level of interest rates.

Examiner's comments:
Most candidates demonstrated a reasonable understanding of this area of the syllabus and this
question had the highest average mark on the paper. It was a six-part question which tested the
candidates' understanding of the risk management element of the syllabus.
The scenario was centred on a UK-based manufacturer of industrial pumps. The company was
considering hedging its exposure to (1) foreign exchange rate risk on a C$5.2 million receipt
(three months ahead) from a Canadian customer and (2) a fall in the value of a large quoted
shareholding.
Foreign exchange risk is a regular topic in this examination, and the first part was generally
answered well. However, many candidates lost marks unnecessarily, eg, choosing a call rather
than a put option, failing to deal with fees correctly, or choosing the wrong interest rates for the
MMH. Over half of the candidates believed that strengthening sterling meant getting less
foreign currency.
Generally the second part was answered adequately, but bearing in mind how frequently this is
examined, it was disappointing. Too few candidates went beyond only comparing the best
outcome at each rate. Answers here needed to demonstrate a deeper understanding of the
issues involved. Many candidates stated, wrongly, that interest rates indicated that sterling would
weaken. Also too few commented on the negative impact of a stronger pound on an exporter.
In the third part few candidates scored full marks. Those that did explained how a strengthening
pound when exporting and a weakening pound when importing would both be bad for the
company in question. The fourth part was generally answered well, but many candidates just
listed the advantages and disadvantages of currency futures and/or a forward contract, rather
than answering the question as set. The fifth part has been examined before, albeit rarely. A
minority of candidates answered it well and scored full marks, but most were unable to calculate
the values required. The sixth part was answered well and most candidates scored full marks.

280 Financial Management: Answer Bank ICAEW 2020

 December 2017 exam answers

52 Innovative Alarms (December 2017)

Marking guide

Marks
52.1 (a) NPV calculation:
Contribution/contribution lost 5
Fixed overheads 1
Tax charge 1
Sale proceeds 2
Working capital 2
Machinery and equipment 1
Tax saved on capital allowances 2
PV and recommendation 2
16
52.1 (b) Disadvantages of sensitivity analysis 3
Simulation 3
Total possible marks 6
Marks available 4

52.1 (c) Discussion of real options – abandonment, follow-on 4

52.1 (d) Ethical issues

3
52.2 Replacement after one year 1
Replacement after two years 2
Replacement after three years 2.5
Recommendation and limitations 2.5
8
35

52.1 (a)
Units pa 30,000
0 1 2 3
Units 000's
( 1.06) 30.00 31.80 33.71
Selling price £ ( 1.03) 399.00 410.97 423.30

Contribution per unit £

(see skilled) 159.6 164.39 169.32
£'000 £'000 £'000 £'000
Contribution 4,788.00 5,227.60 5,707.78
Contribution lost (1,500.00) (1,637.70) (1,788.15)
Fixed overhead (500.00) (525.00) (551.25)
Taxable 0 2,788.00 3,064.90 3,368.38
Tax @ 17% 0 (473.96) (521.03) (572.62)

ICAEW 2020 December 2017 exam answers 281

 £'000 £'000 £'000 £'000
Sale proceeds 9,759.88
Working capital (2,000.00) (183.60) (200.45) (2,384.05)
Machinery and equipment (8,000.00) 2,000.00
Tax saved on CAs 244.80 200.74 164.60 409.86
Cash flows (9,755.20) 2,331.18 2,508.02 (17,349.55)

PV @ 10% (9,755.20) 2,119.25 2,072.74 13,034.97

NPV (£'000) 7,471.76

The Defender project has a positive NPV, which will increase shareholder wealth. The
project should therefore be accepted.
Working capital
Year Cumulative Increment
£'000 £'000
0 (2,000.00) (2,000.00)
1 (2,183.60) (183.60)
2 (2,384.05) (200.45)
3 2,384.05

Capital allowances and the tax saved thereon

Year Cost/WDV CA Tax
£'000 £'000 £'000
0 8,000.00 1,440.00 244.80
1 6,560.00 1,180.80 200.74
2 5,379.20 968.26 164.60
3 4,410.94
Sale (2,000.00) 2,410.94 409.86

Contribution lost
The contribution of the other product is:

£
Selling price 175
Materials and skilled labour (150)
Contribution 25

Contribution lost per unit of the defender (50)

Year 1 = (50)  30 = (1,500.00)

Year 2 = (50)  1.03  31.80 = (1,637.70)
Year 3 = (50)  1.032  33.71 = (1,788.15)
The skilled labour cost of £15 per hour is common to both alternatives, so may be
ignored. In year 1 the contribution on the Defender is £189.60 ignoring labour. The
contribution lost is £40  2 = £80 ignoring labour. The net gain is £189.60 – £80 =
£109.60 per Defender. If labour costs are included in the figures as above the net gain
is the same ie, £159.60 – £50 = £109.60.
If the gross figures are used in the NPV then they are as follows:
Defender 5,688 6,210 6,781
Lost contribution 2,400 2,620 2,861

282 Financial Management: Answer Bank ICAEW 2020

 Which nets to the same as shown in the NPV calculation above
Sale proceeds £'000
Contribution 5,707.78
Contribution lost (1,788.15)
Net Contribution 3,919.63

Net contribution  3  (1 – 0.17) 9,759.88

(b) The disadvantages of sensitivity analysis are as follows:

 It assumes that changes to variables can be made independently.
 It ignores probability. It only identifies how far a variable needs to change to result
in a zero NPV; it does not look at the probability of such a change.
 It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to address the weaknesses of sensitivity analysis. The main
advantage is that it allows the effect of more than one variable changing at the same
time to be assessed. This gives more information about the possible outcomes and
their relative probabilities and it is useful for problems that cannot be solved
analytically. However it should be noted that simulation is also not an optimising
technique and does not point directly to a correct decision.
(c) Abandonment option: If the defender project is not successful it is unlikely the team
will buy the rights to manufacture the new alarm system. Therefore Innovative has the
option to abandon and sell the assets.
Follow on option: Rather than sell the rights to manufacture the new alarm system
there might be the opportunity to launch a second (and third and so on) version, which
could be highly profitable, or could lose money, for Innovative.
The mention of growth options rather than follow on options would also gain marks.
(d) There is a clear conflict of interest regarding the computation of the sale proceeds of
the rights to manufacture the Defender after the time horizon of three years.
Since the finance director will be a member of the team he should act with integrity
and have the interests of shareholders in mind. In these circumstances he should not
be involved in negotiating the price that the team will buy the rights for. He should be
objective and demonstrate professional behaviour.
52.2 Replacement after one year (£):
(30,000) + (22,500 – 500)/1.15 = (10,870) Annual equivalent cost (AEC) = (10,870)/0.870 =
(12,494)
Replacement after two years (£):
2
(30,000) + (500)/1.15 + (17,000 – 2,500)/(1.15) = (19,471) AEC = (19.471)/1.626 =
(11,975)
Replacement after three years (£)
2 3
(30,000) + (500)/1.15 + (2,500)/(1.15) + (12,000 – 3,500)/(1.15) = (26,736)
AEC = (26,736)/2.283 = (11,710)
The optimal replacement period is that which gives the lowest AEC; in this case, replacing
the vans after three years is preferable.

ICAEW 2020 December 2017 exam answers 283

 Limitations include the following:
 Changing technology, leading to obsolescence
 Changes in design
 Inflation – affecting estimates and the replacement cycles
 How far ahead can estimates be made and with what certainty
 Ignores taxation

Examiner's comments
This was a five-part question, which tested candidates' understanding of the investment
decisions element of the syllabus. The scenario of the question was that of a company launching
a new product onto the market, and also considering how often it should replace its fleet of
delivery vans. Part (a) of the first requirement was well answered by many candidates, but there
were common errors: incorrect calculation of contribution; timing errors for cash flows; incorrect
calculations of the contribution lost; incorrect calculations of the value of the rights at the end of
the project and in some cases ignoring it altogether; not explaining why the project should be
accepted; not providing workings so no marks could be awarded when the figure presented
was incorrect. Responses to part (b) of the first requirement were mixed, with many candidates
not able to adequately explain the disadvantages of sensitivity analysis. The question only asked
for disadvantages, but many candidates wasted time by stating advantages. The explanations of
simulation as an alternative to sensitivity analysis were poor. Responses to parts (c) and (d) of the
first requirement were good. However some candidates did not read the question and stated
real options which did not apply at the end of the project. Responses to the second question
requirement were mixed.

53 Peel Kitchens plc (December 2017)

Marking guide

Marks
53.1 Dividend valuation model:
Ordinary dividend growth 1.5
Ex-div share price 1
Cost of equity 0.5
Cost of debt 4
WACC calculation 2
CAPM 1
10
53.2 Systematic risk unchanged 2.5
Explanation 2.5
5
53.3 Calculations (max 3 marks if no use made of historic information) 6
Discussion and advice 6
12
53.4 Identification and explanation of APV 2
Calculation of discount rate 1
3
53.5 Identification of 50% payout ratio over time 2
Appropriate discussion 3
5
35

284 Financial Management: Answer Bank ICAEW 2020

 53.1 (a) Growth can be estimated by ordinary dividend growth for the past four years,
excluding the special dividend as a one-off:
(1/4)
Growth = (25.2/19.80) – 1 = 0.0621 or 6.21%
Shares in issue = 180m (90  2)
20X7 dividends per share = 14p (25.20/180)
Ex div share price = 278p (292 – 14)
Ke = (14(1.0621)/278) + 0.0621 = 0.1156 or 11.56%
Kd is calculated as the yield to maturity of the 7% debentures  (1 – t):
The ex-interest debenture price is £104 (111 – 7)
Years Cash Flow Factors PV Factors PV
£ 5% 10%
0 (104.00) 1 (104.00) 1 (104.00)
1 to 5 7.00 4.329 30.30 3.791 26.54
5 100.00 0.784 78.40 0.621 62.10
4.70 (15.36)

The yield to maturity = 5 + (4.7/(4.7 + 15.36)  5) = 6.17%

Kd = 6.17  (1 – 0.17) = 5.12
The market value of debt and equity =
Debt £495.04m (476  1.04).
Equity £500.40m (278p  180m)
Total debt and equity = £995.44m
WACC = ((11.56  500.40) + (5.12  495.04))/995.44 = 8.35%
(b) Using the CAPM
Ke = 3 + 1.3  6 = 10.80%
WACC = ((10.80  500.40) + (5.12  495.04))/995.44 = 7.98%
53.2 Ungear existing activities: Peel's equity beta of 1.3 = Ba(1 + 50(1 – 0.17)/50), so Ba = 0.71
Supply of domestic appliances ungeared: This has an equity beta of 1.1 = Ba(1 + 40(1 –
0.17)/60) so Ba=0.71.
So the systematic business risk does not change, which may mean that the existing WACC
as calculated in 53.1 applies.
However, the use of WACC/NPV assumes that, over the life of the project, the gearing ratio
of Peel will remain constant and that the project is marginal. Peel is considering financing a
diversification that represents 20% (200/995) of the company's total market value of debt
and equity, which cannot be considered marginal. As gearing is likely to change, the
existing WACC cannot be used. The finance is not project specific (eg, from a government
loan) so that condition for using the existing WACC is met.
53.3 Gearing (D/E by market values):
The current gearing ratio is 99% (495.04/500.40)
Gearing if the finance is raised with debt = 139% ((200 + 495.04)/500.40)
Gearing if the finance is raised with equity = 71% (495.04/(200 + 500.40))
(Note: This assumes no change in the share price as a result of the diversification. In the
longer term, a positive NPV would affect the ratios calculated.)

ICAEW 2020 December 2017 exam answers 285

 Interest cover (best and worst case, as PBIT varies)
Current:
20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 33.32 33.32
Interest cover 2.37 2.82
Interest cover if debt is raised:
Total interest will equal £45.32m (33.32 + (200  6%))
20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 45.32 45.32
Interest cover 1.74 2.08
EPS (although not explicitly required, students may also calculate and comment on EPS)
Current: 20X4 37.8/180 = 21p
20X7 50.4/180 = 28p
Equity: 20X4 37.8/280 = 13.5p
20X7 50.4/280 = 18p
Debt: 20X4 (78.86 – 45.32)0.83/180 = 15.5p
20X7 (94.04 – 45.32)0.83/180 = 22.5p
The decision to raise the finance wholly by debt or equity will radically change Peel's
gearing ratio and interest cover.
Interest cover: Since 20X3 Peel has been operating with an interest cover between the
average of 2.4 and maximum of 3 for the industry sector that it operates in. Currently Peel
has an interest cover of 2.82, which is near the maximum. Interest cover will be unchanged
if Peel raises equity, however if debt is raised the interest cover will be 2.08, which is near to
the minimum of 2 for the industry sector. In previous years, interest cover would have been
below the minimum.
Gearing ratio: Peel is currently operating with a gearing ratio of 99%, which is around the
average for the industry of 100%. If the company raises debt finance the gearing ratio will
rise to 139%, which is above the industry maximum of 135%; if equity is raised the gearing
ratio will fall to 71%, which is below the industry minimum of 80%.
Given the above, the reaction of the financial markets is likely to be unfavourable if Peel
raises the finance by an issue of debentures. The share price could fall and also the cost of
debt increase. Shareholders are also likely to be concerned if the finance is raised by debt,
and it is unlikely that they would approve the diversification if it were financed in such a way.
Raising the finance by equity would make the company much safer in terms of financial risk.
However, shareholders might be concerned about potential control issues, unless the funds
are raised by way of a rights issue. The financial markets might consider that the company is
not using spare debt capacity.
Given the potential financial risks involved, it would be prudent for Peel to raise the finance
by an issue of shares, or a combination of debt and equity, to keep the gearing ratio and
interest cover more in line with the 20X7 figures.
53.4 If the finance is raised by either debt or equity, then the gearing of Peel will radically
change. In these circumstances, WACC/NPV is not a suitable investment appraisal
technique to use. An alternative technique would be Adjusted Present Value (APV), which
assumes that the project is financed purely by equity. The resultant NPV of cash flows is

286 Financial Management: Answer Bank ICAEW 2020

 then adjusted for the actual benefits and costs of the finance used. A suitable all equity
discount rate, which reflects the systematic risk of the project, would be:
Taking the equity beta of a company in the domestic appliance sector we calculate the
asset beta and use it in the CAPM (53.2 above).
The all equity discount rate using CAPM = 7.26% (3 + (0.71  6)).
53.5 Since dividends are rising and falling with profits, it would appear that Peel has a policy of
maintaining a constant dividend payout ratio. The dividend payout ratios have been:
20X3 20X4 20X5 20X6 20X7
£m £m £m £m £m
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividend 19.80 18.90 22.50 21.60 25.20
Payout ratio 50% 50% 50% 50% 50%
(Note: Candidates are not required to calculate the payout ratio for all years, but a clear
identification of a 50% payout across the period given is required.)
A listed company seeks to give ordinary shareholders a constant dividend with some
growth. This cannot be achieved by having a policy of maintaining a constant payout ratio,
since dividends rise and fall with profits. Peels current dividend policy is not usually
considered appropriate for a listed company and may lead to a fluctuating share price (this
is known as the signalling effect).

Examiner's comments
This was a five-part question that tested understanding of financing options. The scenario of the
question was that of a company diversifying its operations and raising finance by either debt or
equity. Candidates were also asked to discuss the company's dividend policy. Responses to the
first part were mixed. Many candidates did not consider whether their answers were reasonable,
for example using a cost of equity of 50% in their WACC computations. There were basic errors
in many calculations.
Answers to the second part were disappointing, with many candidates demonstrating that they
do not know the basic assumptions regarding the use of WACC. Hardly any candidates
mentioned that since the company is raising a large amount of capital by either debt or equity
the gearing might not remain constant and that, because of its size, the project could not be
considered marginal. Most candidates centred their discussion of systematic risk, which they
assumed would change. However if some very basic calculations were carried out it could be
seen that the systematic risk of the new project was the same as existing projects.
Responses to the third part were extremely disappointing despite an almost identical question
being asked in a recent past paper. The question gave industry gearing and interest cover
figures, so that candidates could perform analysis looking at current gearing and interest cover,
and then gearing and interest cover after raising the new finance by either debt or equity. Five
years' historic information was also given to calculate interest cover figures. It was very
disappointing that a large number of candidates did not use this information or calculated the
gearing in a different way to that specified, or used book values despite the question stating
market values had been used. In addition many candidates did not consider the likely reaction
of shareholders and markets to the finance being raised by either debt or equity. Finally, a large
number of candidates wasted time explaining the theories of M & M when theory was not asked
for in the question.
Responses to the fourth part were mixed, with many candidates identifying APV as an alternative
to WACC/NPV. However few candidates calculated the discount rate that should be used in
APV. Again this has been examined many times before. Responses to the fifth part were also
mixed, with many candidates not able to demonstrate a good understanding of dividend policy.
Few candidates used the historic information to establish the company's current dividend policy.
Many repeated theory, despite this not being required.

ICAEW 2020 December 2017 exam answers 287

54 Jewel House Investments Ltd (December 2017)
Marking guide

Marks
54.1 (a) Forward rate and resulting receipt 2
OTC option 4
6
54.1 (b) Advantages and disadvantages of each 2.5
Advice and recommendation 2.5
Total possible marks 5
Marks available 4

54.1 (c) Discussion of futures – half mark per point 2

54.2 (a) Identification of value and number of contracts 3

Loss on portfolio 1.5
Gain on futures contracts 1.5
6

54.2 (b) Reasons why hedge is not efficient (1 mark per point) 2

54.3 (a) Interest rate differential 1

Rates and flows achieved through swap 3
4
54.3 (b) Calculations 2

54.3 (c) Advantages – 1 mark per point 4

30

54.1 (a) The forward rate is: $/£ 1.2526 (1.2492 + 0.0034)
This results in a sterling receipt of £6,386,716 ($8,000,000/$1.2526)
Over the counter option:
The option premium is $8,000,000  2p = £160,000.
The premium with interest lost is £160,000  (1+0.03  4/12) = £161,600.
If the spot price on 31 March is $/£1.2700, Orion will exercise the options.
The sterling receipt will be ($8,000,000/$1.2400) – £161,600 = £6,290,013.
(b) The forward contract locks Jewel into an exchange rate and does not allow for upside
potential.
Forwards:
 Tailored specifically for Jewel.
 There is no secondary market.
OTC currency options:
 The options are expensive.
 There is no secondary market.
 However, the options allow Jewel to exploit upside potential and protect
downside risk.

288 Financial Management: Answer Bank ICAEW 2020

 Advice:
Without hedging, the sterling receipt would have been £6,299,213
($8,000,000/$1.2700).
The currency option results in a sterling receipt of £6,290,013, which is marginally
worse than the spot rate on 31 March 20X8. However the forward contract results in a
higher sterling receipt of £6,386,716.
It is recommended that a forward contract is used to hedge any unanticipated fall in
the value of the dollar.
(c) Futures are possibly not appropriate, since they have the following disadvantages:
 Not tailored, so it is necessary to round the number of contracts
 Basis risk exists
 Require a margin to be deposited at the exchange
 A need for liquidity if margin calls are made
However, there is a secondary market and if the client decides not to invest it would be
possible to close out the position, which could result in a gain or loss on the futures
trade.
54.2 (a) The value of one contract = 7,195  £10 = £71,950
March contracts will be sold.
The number of contracts = £100,000,000/£71,950 = 1,389.85. Rounded to 1,390.
On 31 March the portfolio value will fall to:
£100,000,000 (7,010/7,261) = £96,543,176, representing a fall of £3,456,824.
Since there is a loss on the portfolio, there will be a gain on the futures contracts.
The futures position will be closed out and the gain will be =
(7,195 – 7,010)  £10  1,390 = £2,571,500.
(b) The hedge is not 100% efficient due to:
Basis risk ie, the futures price at 30 November is not the same as the FTSE 100.
The rounding of the number of contracts.
54.3 (a) First it is necessary to calculate the interest rate differentials:
Jewel Nevis Differentials
Fixed rates 6.5% 5.0% 1.5%
Floating rates LIBOR + 4% LIBOR + 3.5% 0.5%
Net differential 1.0%
This net differential
will be shared 0.50% each
The interest rates that can be achieved through the swap are:
Jewel Nevis
Fixed market rate 6.5% ----
Floating market rate ---- LIBOR + 3.5%
Less the differential 0.5% 0.5%

Rates achieved through the swap 6.0% LIBOR + 3.0%

Cash flows would typically be: LIBOR from Nevis to Jewel and fixed of 2.0% from Jewel
to Nevis.

ICAEW 2020 December 2017 exam answers 289

 (b) Jewel is paying 4.36% (0.36 + 4) on its floating rate borrowings, and would be paying a
fixed rate of 6% through the swap. The initial difference in interest rates is 1.64% (6.00 –
4.36)
For the floating rate to equal the fixed rate of 6% achieved through the swap, LIBOR
would have to rise to 2% (1.64 + 0.36).
(c) The advantages to Jewel of an interest rate swap include the following:
 The arrangement costs are significantly less than terminating an existing loan and
taking out a new one.
 Interest rate savings are possible, either out of the counterparty or out of the loan
markets by using the principle of comparative advantage.
 They are available for longer periods than the short-term methods of hedging
such as FRAs, futures and options.
 They are flexible since they can be arranged for tailor-made amounts and periods.
They are also reversible.
 It is possible to obtain the type of interest rate, fixed or floating, that the company
wants.
 Swapping to a fixed interest rate assists in Jewel's cash flow planning.

Examiner's comments
This was an eight-part question that tested the candidates' understanding of the risk
management element of the syllabus.
Part (a) of the first requirement was well answered by most candidates. However some of the
errors demonstrated by weaker candidates included: using the incorrect spot rate; deducting
the forward discount; not including interest on the option premium, or including interest but
taking a whole year; treating the OTC option as a traded option.
Part (b) of the first requirement produced average answers from a lot of candidates, some
without any reference to the numbers calculated in part (a). Many candidates did not give a firm
conclusion. Responses to part (c) of the first requirement were good.
Responses to parts (a) and (b) of the second requirement were also good, however some
candidates made some basic errors as follows: incorrect calculation of the number of contracts
and the value of one contract by using the current index price and not the current futures price;
incorrect computation of the loss on the portfolio; stating that contracts should be initially
bought not sold; incorrect computation of the gain on futures by using the current index price
and not the futures price.
Responses to the third requirement were good, but many candidates did not read the question
when they demonstrated the cash flows that would typically occur when the swap was
implemented.

290 Financial Management: Answer Bank ICAEW 2020

 March 2018 exam answers

55 Wells Bakers plc (March 2018)

Marking guide

Marks
55.1 (a) Cost of equity (dividend valuation model) 3
Cost of preference shares 1
Cost of irredeemable debt 2
Cost of redeemable debt 4
WACC calculation 4
14
55.1 (b) Cost of equity (CAPM) 1
WACC calculation 1
2
55.2 Appropriate discussion of directors' views 6

55.3 Geared/ungeared beta calculations 3

Cost of equity 1
Cost of debt 1
WACC 1
Discussion 4
10
55.4 Ethics – points re confidentiality 3
35

55.1 (a) Cost of equity (ke)

£1.716m 1/3
Dividend growth rate = = 1.093 over 3 years, so 1.093 – 1 = 3% pa
£1.570m

£1.716m
Latest dividend (d0) = £0.26
6.6m
Ex div market value per share = (£3.46 – £0.26) = £3.20
(d1) (£0.26  1.03)
Cost of equity (ke) +g + 3% 11.36%
MV (£3.20)

d1 £0.07
Cost of preference shares (kp) 5.19%
MV £1.34

(i – t) (£6  83%)
Cost of irredeemable debt (kdi) 4.70%
MV £106

ICAEW 2020 March 2018 exam answers 291

 Cost of redeemable debt (kdr)
Year Cash Flow 5% factor PV 6% factor PV
0 (96) 1.000 (96.000) 1.000 (96.000)
1–3 4 2,723 10.892 2.673 10.692
3 100 0.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)
IRR = 5% + (1.292/(1.292 + 1.308)) = 5.50%
less: Tax at 17% (5.50%  83%) = 4.57%
WACC
Total MVs
£m £m Cost  weighting WACC
Equity (6.6m  £3.20) 21.120 11.36%  21.120/25.470 9.42%
Pref. Shares (1m  £1.35) 1.350 5.19%  1.35/25.470 0.28%
Irredeemable debt (£1.2m  1.06) 1.272 4.70%  1.272/25.470 0.23%
Redeemable debt (£1.8m  0.96) 1.728 4.57%  1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 10.24%

(b) Cost of equity (ke) using the CAPM

Expected market return 10.8%
less: Expected risk-free return (2.4%)
Expected risk premium 8.4%

Applying Wells' beta to the risk premium 1.25  8.4% 10.5%

plus: Expected risk-free return 2.4%
Cost of equity (ke) 12.9%

WACC
Total MVs
£m £m Cost  weighting WACC
Equity (6.6m  £3.20) 21.120 12.90%  21.120/25.470 10.70%
Pref. Shares (1m  £1.35) 1.350 5.19%  1.35/25.470 0.28%
Irredeemable debt (£1.2m  1.06) 1.272 4.70%  1.272/25.470 0.23%
Redeemable debt (£1.8m  0.96) 1.728 4.57%  1.728/25.470 0.31%
4.350 0.82%
Total market value 25.470 11.52%

55.2 Phil Turner – to use the cost of preference shares would be completely wrong, as it is only
one element of the firm's total long-term finance and 7% is the coupon rate, not the current
cost.
Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into
account. It makes sense to use Wells' current WACC figure for the investment appraisal if:
(1) the historical proportions of debt and equity will not change.
(2) the systematic business risk of the firm will not change.
(3) the new finance is not project-specific.
Regarding the above, the bank borrowing will not change the gearing as sufficient equity
will be raised to maintain the gearing at its current level. The systematic business risk of the
firm is likely to change as it is moving into a different market. The finance is not project-
specific.

292 Financial Management: Answer Bank ICAEW 2020

 55.3 New market geared beta = 1.80

(1.80  77) (1.80  77)

New market ungeared beta = 1.44
(77 + (23  83%)) 96.09

1.44  (£21.12m + £1.35m + ( £3m  83%))

Wells' geared beta = 1.70
£21.12m
So, cost of equity = (1.70  (10.80% – 2.40%)) + 2.40 = 16.7%
Cost of debt = 8.5%  83% 7.06%
WACC = (16.70%  £21.12m/25.47m) + (7.06%  £4.35m/£25.47m)) = 15.05%
It would be unwise to use the existing WACC, as Wells' plan involves diversification and
therefore a change in the level of systematic risk (beta rises from 1.25 to 1.70). Thus a new
WACC must be calculated. Systematic risk is accounted for by taking into account the beta
of the retail bakery market and this is then adjusted to eliminate the financial risk (level of
gearing) in that market. The resultant ungeared beta is then 're-geared' by taking into
account the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased systematic risk
discussed above) is used.
Using this, the new WACC can be calculated.
55.4 You work for Wells and are party to confidential information which, if made public, could
influence the market price of Wells' shares.
An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client's or employer's affairs, however gained, is
confidential.
That information should then:
 be kept confidential.
 not be disclosed, even inadvertently such as in a social environment.
 not be used to gain personal advantage.

Examiner's comments
This was a four-part question that tested candidates' understanding of the financing options
element of the syllabus, and there was also a small section on ethics. In the scenario a UK-listed
bakery company was planning to open a number of retail outlets across the UK. This investment
would cost the company £17 million, which would be raised in such a way as to not alter its
existing gearing ratio. In the first part, for 16 marks, candidates were required to calculate the
company's current WACC from the information given, based on (1) the dividend growth model
and (2) the CAPM. The majority of candidates did really well in part (a) of the first requirement
and many scored full marks. Typical errors made were (1) incorrect number of years used in the
dividend growth calculation (2) not adjusting the cum-div and cum-int market prices (3)
forgetting the tax adjustment in the cost of debt and (4) not using market values in the WACC
calculation.
The second part was worth six marks and required candidates to respond to recent comments
made by three of the company's directors about the best discount rate to use when appraising
the
£17 million investment. Overall, candidates' answers to the second part were disappointing. The
comments made were rather general and so marks will have been lost. Too few scripts
considered the conditions that need to apply for the current WACC to be used, ie, gearing and
systematic risk to remain unchanged, and any new finance is not project-specific.

ICAEW 2020 March 2018 exam answers 293

 The third part, for 10 marks, tested the candidates' understanding of (and the need for) de-
gearing and re-gearing beta within the CAPM calculation in the given scenario. It was good to
see that the numerical and discursive elements of the third part were both done well by a good
number of candidates. Where candidates scored badly, it was clear from their calculations that
many did not understand the logic of de-gearing and then re-gearing. Also many were unable to
explain the theory underpinning for those calculations. This is an area of the syllabus that has
been examined regularly recently. The fourth part was worth three marks, with particular
reference to the issue of confidentiality and it was answered well.

56 Hunt Trading plc (March 2018)

Marking guide

Marks
56.1 (a) Sell June futures 1
Number of contracts 1
Profit/loss on futures 4
Interest cost 1
Total cost 1
8
56.1 (b) Options cost – 1 mark for each scenario 3

56.1 (c) Recommendation 2

56.2 (a) No hedge 2

Forward contract 2
Money market hedge 3
7
56.2 (b) Summary of various payments 2
Forward contract discussion 2
Money market hedge discussion 2
Directors' attitude to risk 1
7
56.2 (c) Differences identified – 1 mark per point 3
30

294 Financial Management: Answer Bank ICAEW 2020

 56.1 (a) Futures
Sell June futures

£4,500,000
No of contracts:  6/3 = 18
£500,000
(a) (b) (c)
Interest rate 7.50% 8.00% 5.50%

Opening rate 93.2 93.2 93.2

Closing rate 92.2 91.8 94.1
Movement 1.0 1.4 (0.9)

P/L on futures 18  £500,000  3/12 2,250,000 2,250,000 2,250,000

  
1.0% 1.4% (0.9%)
= = =
Profit/(loss) on futures £22,500 £31,500 (£20,250)
Interest cost = £4.5m  6/12 =£2,250,000  7.5% (£168,750)
8.0% (£180,000)
5.5% (£123,750)
Total cost (146,250) (148,500) (144,000)

(b) Options
(a) (b) (c)
Interest rate 7.50% 8.00% 5.50%
Take up option Y Y N
Interest cost % 7.30% 7.30% 5.50%

Interest cost = £4.5m  6/12 = £2,250,000  7.3% (£164,250)

7.3% (£164,250)
5.5% (£123,750)
Premium (£4,500,000  0.2%) (£9,000) (£9,000) (£9,000)
Total cost (£173,250) (£173,250) (£132,750)

(c) If interest rates increase, then futures are less costly than options.
If rates fall, then options are lower cost.
56.2 (a) (1) Sterling weakens by 5%

Spot rate = €1.1764  0.95 = €1.1176

€1,700,000/1.1176 (£1,521,144)
(2) Forward contract
€
Spot rate 1.1764
plus: Forward contract discount 0.0059
1.1823
£
(£1,700,000)/1.1823 (1,437,875)
plus: Arrangement fee (4,600)
(£1,442,475)

ICAEW 2020 March 2018 exam answers 295

 (3) Money market hedge
(€1,700,000) (€1,700,000)
Lend euros now (€1,666,667)
(1+ 8% / 4) 1.02
€1,666,667
Convert at spot rate (£1,416,752)
1.1764
Sterling borrowed at 6.6% pa (£1,416,752)  [1 + (6.6%/4)] (£1,440,128)
(b) In summary
At spot rate (€1,700,000/1.1764) (£1,445,087)
Sterling weakens by 5% (£1,521,144)
Forward contract (£1,442,475)
Money market hedge (£1,440,128)
The forward rate suggests that the euro will weaken (sterling will strengthen, rather
than weaken by 5%) over the next three months. This is good for UK importers such as
Hunt, as supplies would get cheaper.
The money market hedge gives the lowest price, based on these rates, but if sterling is
likely to strengthen then perhaps do not hedge at all (but there are no guarantees).
The directors' attitude to risk is also important when giving advice on which strategy to
pursue.
(c)  OTCs are, typically, purchased from a bank.
 OTCs are tailor-made and so will lack negotiability.
 Traded options are for standardised amounts and can be traded and a profit/loss
made.
 Traded options are not available in every currency.

Examiner's comments
This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company's need to borrow £4.5 million of short-term finance via a bank loan and
its plan to hedge the interest costs of that loan. In the second half of the question the company
had agreed to purchase €1.7 million of timber from a Finnish supplier. Candidates had to
investigate the foreign exchange risk implications of this contract for the company. In part (a) of
the first requirement of the question, for eight marks, candidates were required to calculate the
cost to the company if it used traded sterling interest rate futures to hedge its interest rate risk.
Part (b) of the first requirement, for three marks, required candidates to calculate the cost to the
company if it used OTC interest rate options to hedge the risk. Part (c) of the first requirement
was worth two marks and asked candidates to conclude, based on their calculations, which of
the hedging methods should be chosen. For the first requirement there were many very good
answers with candidates demonstrating a thorough understanding of the techniques involved.
Those areas where candidates struggled were: (1) a failure to identify that the company would
sell interest rate futures (2) charging 12 months interest rather than six (3) using six months,
rather than three months, in the futures gain/loss calculation and (4) a failure to calculate the
option premium correctly (a very common error).
Part (a) of the second requirement, for seven marks, asked candidates to calculate the (sterling
equivalent) payment to the Finnish supplier if (1) there was a weakening of sterling and (2) two
hedging techniques were employed. In part (b) of the second requirement, also for seven marks,
candidates were required to advise the company's board whether it should hedge the euro
payment. Finally, part (c) of the second requirement, for three marks, asked candidates to
identify the differences between traded currency options and OTC currency options. The
second part was, overall, done well. The calculations in part (a) were good, but typical errors

296 Financial Management: Answer Bank ICAEW 2020

 included (1) choosing the wrong exchange rate (2) strengthening rather than (as required)
weakening sterling and (3) subtracting the forward contract fee from the overall cost of the
transaction. Foreign exchange risk management is an area of the syllabus that is examined
regularly and so candidates' answers to the discussion in part (b) were disappointing. There was
a lack of depth to the candidates' conclusions and too many commented, erroneously, that a
forward contract discount meant that sterling would be weakening.

57 Bishop Homes Ltd (March 2018)

Marking guide

Marks
57.1 Construction costs and land clearance 1.5
Sales 1
Rental income 2
Bad debts 1
New staff 1
Extra costs 1
Tax 1.5
Green machine and tax 3
Net cash flows 2
Discount factors 2
PVs 1
NPV 1
18
57.2 Sales and tax 1.5
Discount factors 0.5
Sensitivity 1
Minimum selling price 1
4
57.3 Incremental construction costs 1
Tax 2
Discount factors 1
NPV and conclusion 1
5
57.4 Sensitivity analysis v simulation – 1 mark per point 4

57.5 Explanation of real options 1

Identification of appropriate real options – 1.5 marks per point 3
4
35

ICAEW 2020 March 2018 exam answers 297

 57.1
20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£'000 £'000 £'000 £'000 £'000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 0 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436

The development produces a positive NPV and so should be accepted as it will enhance
shareholder wealth.
WORKINGS

(1) Rental income (Y2) = 175  £5,940 = £1,039,500

Bad debts (Y2) = 1.5%  £1,039,500 = £15,592
Extra costs (Y2) = 3%  £1,039,500 = £31,185
Rental income (Y3) = 350  £5,940 = £2,079,000
Bad debts (Y3) = 1.5%  £2,079,000 = £31,185
Extra costs (Y3) = 3%  £2,079,000 = £62,370
(2)
20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£'000 £'000 £'000 £'000 £'000
Construction
(75/500  £57m) (8,550) (8,550)
Land clearance (1,400)
Sales 25,500 25,500
Rental income 1,040 2,079 2,079
Bad debts (16) (31) (31)
New staff (46) (92) (92)
Extra costs (31) (62) (62)
Taxable (loss)/profit (1,400) 16,950 17,897 1,894 1,894
Tax at 17% 238 (2,882) (3,042) (322) (322)

(3)
20X9 20Y0 20Y1
Y1 Y2 Y3
£'000 £'000 £'000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100

Tax saving (17%  WDA) 37 30 120

298 Financial Management: Answer Bank ICAEW 2020

 (4)
6% annuity factor for Y4 – Y20 Y20 11.470 or 10.477
Y4 (2.673)  0.840
8.797 8.801

57.2
Y1 Y2 Total
£'000 £'000 £'000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804

1, 436
Sensitivity = 3.7%
38,804

Minimum selling price = (£340,000 – 3.7%) £327,420

57.3
Y0 Y1 Y2 Total
£'000 £'000 £'000 £'000
Incremental construction costs (35,000) 19,000 19,000
Tax on costs (£8.55m  3/57  17%) (77) (76)
Total cash flows (35,000) 18,923 18,924
6% factors 1.000 0.943 0.890
PV (35,000) 17,844 16,842 (314)

The NPV would decrease by £314,000, and so it is less likely that Bishop's board would
proceed with the development.

57.4 Sensitivity analysis advantages:

 It facilitates subjective judgment (by management for example).
 It identifies areas critical to the success of a project, eg, sales volume, materials price.
 It is relatively straightforward.
Sensitivity analysis disadvantages:
 It assumes that changes to variables can be made independently.
 It ignores probability.
 It does not point to a correct decision.
Simulation advantages:
 More than one variable at a time can be changed.
 It takes probabilities into account.
Simulation disadvantages:
 It is not a technique for making a decision.
 It can be time consuming and expensive.
 Certain assumptions that need to be made could be unreliable.

ICAEW 2020 March 2018 exam answers 299

 57.5 NPV analysis only considers cash flows related directly to a project. A project with a
negative NPV could be accepted for strategic reasons. This is because of (real) options
associated with a project that outweigh its negative NPV.
With regard to the Garthwick development the following options could be identified (two
only required):
 Follow-on options – future development of mixed (rental/private) developments.
 Growth options – Bishop could build a few properties and then build more later, if
necessary.
 Flexibility options – Bishop could sell some of its rented properties rather than rent
them and vice versa.
 Abandonment options – Bishop could sell all the properties and quit the development
after two years.
 Timing options – Bishop could delay the start of the clearance and development.

Examiner's comments
The scenario was based around a UK property company that builds low-cost houses for sale and
for rent. The company had the opportunity to invest in a new development of 500 identical low-
energy houses on one of its vacant sites. The company planned to use a house-building firm to
construct the houses over a two year period. The first part was worth 18 marks and required
candidates to make use of the information given and calculate the NPV of the proposed
investment. It was a difficult NPV calculation and so it was good to see that, overall, candidates
did well here. The main areas of difficulty were: (1) the tax calculation for the allowable building
costs (2) the timing of the cash flows and (3) the need to include cash flows (and then discount
them) for Years 4 to 20. The second and third parts, for four marks and five marks respectively,
tested candidates' proficiency with, and understanding, of sensitivity analysis. The second part
was also done well, but some candidates used the price per house figure rather than the total
sales figure and so will have lost marks. The third part was a more difficult proposition and
candidates' answers here were very variable. Those who produced a set of calculations revised
from the first part scored well, but too many produced a discussion rather than calculations. The
fourth part was worth four marks and here candidates were asked to compare the strengths and
weaknesses of sensitivity analysis with those of simulation. The fourth part was, overall, done well
and a majority of candidates scored full marks. In the fifth part, again for four marks, candidates
had to explain the concept of real options and to identify two real options that could apply to the
development in question. In the fifth part most candidates were able to identify examples of real
options from the scenario, but too few explained the more general issue of real options, ie, that
of turning a negative NPV into a positive one.

300 Financial Management: Answer Bank ICAEW 2020

 June 2018 exam answers

58 Helvellyn Corporate Finance (June 2018)

Marking guide

Marks
58.1 (a) Enterprise value 4.5
P/E ratio 1.5
Net assets historic 1
Net assets revalued 1
8
58.1 (b) Discussion of asset v income based measures 3
Recommendation 1
4
58.1 (c) Discussion of SVA, including drivers and problems 3

58.2 (a) Proposal 1:

Sales 1
Contribution 1
Redundancy 0.5
Tax 1
Working capital 1.5
Plant and equipment 0.5
WDA's 1.5
PV 0.5
Proposal 2 – proceeds net of tax 1
Proposal 3 – after tax PV 1.5
10
58.2 (b) 2 marks for each – one advantage, one disadvantage 6

58.2 (c) Comparison of PVs and advice on limitations 3

Recommendation 1
4
35

58.1 (a) Enterprise value

EBITDA = £10,000 (3,500 + 6,000 + 500)
Enterprise value = £65,000 (10,000  6.5)
Net debt = £34,000 (41,000 – 7,000)
The total value of equity = £31,000 (65,000 – 34,000)
The value of one share = £10.33 (31,000/3,000)
Price earnings ratio
EPS = 70.53p (2116/3000)
The value of one share = £8.53 (70.53  12.1)
Net assets (historic)
The value of one share = £5 (15,000/3,000)
Net assets (re-valued)
The value of one share = £7 ((15,000 + 59,000 – 53,000)/3,000)

ICAEW 2020 June 2018 exam answers 301

 (b) The range of values is from £5 to £10.33.
It is unlikely that the board of Evans would be happy with an issue price based on net
assets, either historic or re-valued. The major problem with asset valuations is that they
do not reflect the earning capacity of the assets. The board is more likely to be happy
with an issue price based on income, either P/E ratio or enterprise value, which range
from £8.53 to £10.33.
So an issue price in this range is likely to be acceptable.
I would suggest an issue price of £10 per share. (Candidates may suggest a different
price; any supported price would be given marks.)
(c) Shareholder value analysis (SVA) would be a useful additional valuation methodology
since it is based on the future free cash flows that the company generates. The free
cash flows are forecasted using seven value drivers (sales growth; operating profit
margin; tax rate; investment in non-current assets; investment in working capital; cost
of capital; life of cash flows). The cash flows will be forecast over a planning horizon,
typically three to five years, and then a terminal value calculated.
Problems with this technique include: estimating the inputs into the model; estimating
growth; the length of the planning horizon; the terminal value dominates the valuation.
58.2 (a) Proposal 1
20X9 20Y0 20Y1
£m £m £m
Sales 22.50 20.25 18.23
Contribution 13.50 12.15 10.94
Redundancy (0.50)
Pre-tax 10.44
Tax @ 17% (2.30) (2.07) (1.78)
Working capital 0.20 0.18 1.62
Plant and equipment 9.00
WDAs 0.09 0.08 (1.19)
Total 11.49 10.34 18.09
Factors @ 10% 0.909 0.826 0.751
Present value 10.44 8.54 13.59

Total present value = £32.57 million

Working capital
20X9 2  0.10 = 0.20
20Y0 1.8  0.10 = 0.18
20Y1 1.62
WDAs
3,000
(540)@17% = 0.09
2,460
(443)@17% = 0.08
2017
9,000
6,983@17% = (1.19)
Proposal 2
Sale proceeds net of tax = £31.54 million (38  (1 – 0.17))
Proposal 3
2
The present value of the payments = 15 + 13/(1.1) + 13/(1.1) = £37.56 million
After tax = £31.18 million (37.56  (1 – 0.17)

302 Financial Management: Answer Bank ICAEW 2020

 (b) Winding down operations
Advantages include keeping control – should the company decide to keep Supercover
in business it can do.
Disadvantages include the use of estimates of sales and resale values. The operations
may take longer than three years to wind down.
Selling to another company
Advantages include being paid upfront, and no long term involvement.
Disadvantages include the possible difficulty in finding a buyer; the buyer may wish to
buy Supercover for a cheaper price.
MBO
The main advantage is that Huzzey has a buyer.
The disadvantage is that the sale proceeds are to be paid over two years. If Supercover
goes into liquidation or has cash flow difficulties, the full sale proceeds may not be
received.
(c) The present values are:
Winding down operations £32.57 million
Selling to another company £31.54 million
MBO £31.18 million
To maximise shareholder wealth, Huzzey should wind down operations since it
produces the highest present value. However, the present value relies upon a number
of assumptions about sales volume, the release of working capital and the proceeds of
selling plant and equipment. The present value is not sufficiently higher to warrant
choosing it over the other two proposals, given these uncertainties and the fact that the
figures are pretty similar.
In present value terms there is little to choose between selling to another company or
an MBO. Since it might be difficult to find a buyer for Supercover, the preferred
proposal would be for the current management team of the company to buy it.

Examiner's comments
The scenario of the question was consideration of two tasks for a firm of corporate financiers:
Task 1 The valuation of a company that is considering an IPO.
Task 2 A quoted conglomerate is considering divesting itself of one of its subsidiaries.
The first part was well answered by many candidates, however the following were common
errors: for enterprise value: incorrect EBITDA; no deduction of debt and addition of cash to
arrive at the value of the shares; using the incorrect multiple; calculating a negative share price
and making no comment that this is not possible. For P/E ratio: using profits before tax. For net
assets (historic): using gross assets; using gross assets and only deducting long-term debt. For
net assets basis (re-valued): many candidates re-valued the non-current assets and then made
the same errors as for the net assets (historic) computations.
Overall a large number of candidates reduced their valuations to take into account non-
marketability. Since this is an IPO, such adjustments were not necessary.
Responses to part (b) of the first requirement were mixed. Many candidates only referred to their
range of values and did not recommend an issue price. The justification of the price was quite
poor. Responses to part (c) were good. However, poorer candidates only stated what the seven
value drivers in SVA are, with no further explanation of the methodology. Responses to part (a)
of the second requirement were generally good. However a large number of candidates

ICAEW 2020 June 2018 exam answers 303

 attempted to calculate the Net Present Values and not the Present Values of each of the
proposed divestment methods. Responses to part (b) of the second requirement were mixed,
with candidates often struggling to state sensible advantages and disadvantages. Responses to
part (c) of the second requirement were mixed; many candidates simply picked the highest
present value with little other consideration.

59 Blackstar plc (June 2018)

Marking guide

Marks

59.1 (a) Share price calculations 2

TERP calculation and discussion 3
5
59.1 (b) Yield to maturity calculation 3
Debenture issue price 3
Discussion 2
Total possible marks 8
Marks available 7

59.1 (c) Numerical analysis 4

Advantages of debt v equity 3
Reaction of shareholders and the market 5
Advice 2
Total possible marks 14
Marks available 12

59.2 (a) Special dividend 2

Share repurchase 2
4
59.2 (b) Blackstar's dividend policy 2
Evaluation of alternatives 2
4
59.3 Ethics – issues and safeguards 3
35

59.1 (a) The number of new shares to be issued = 40 million (60  2/3)
The price per share = £3.75 (150/40)
This represents a discount on the current share price of 50% or £3.75. (3.75/7.50)
The theoretical ex rights price is:
Number of shares Value per share Number  value
£ £
Existing shares 3 7.50 22.50
New shares 2 3.75 7.50

Total shares 5 Total value 30.00

The theoretical ex rights price = £6.00 (30/5)

304 Financial Management: Answer Bank ICAEW 2020

 The actual share price will depend on the market's reaction to the rights issue, eg,
whether it is fully taken up, and whether the proceeds are invested in positive net
present value projects. The net present value of the projects could be incorporated in
the theoretical ex-rights price of £6.00, giving a more realistic estimate of the actual
share price post rights issue.
(b) The yield to maturity of Blue's debentures is:
The ex-interest price of Blue's debentures is £104 (109 – 5)
Timing Cash Flow Factors @ 1% PV Factors @ 5% PV
Years £ £
0 (104) (104) (104)
1–5 5 4.853 24.27 4.329 21.65
5 100 0.951 95.10 0.784 78.40
15.37 (3.95)

IRR (Yield to maturity) = 1 + (15.37/(15.37 + 3.95))  4 = 4.18% Say 4%

The issue price of Blackstar's debentures will be:
-7
The annuity factor for seven years (2018 to 2025) = (1 – (1.04) )/0.04 = 6.002
7
The seven year present value factor at 4% = 1/(1.04) = 0.760
The issue price = 6  6.002 + 100  0.760 = £112.01
The total nominal value of the debentures to be issued = 150/1.1201 = £133.91
million. Say £134 million.
Blackstar and Blue are in the same industry sector, so it is reasonable to assume that
the yield to redemption of 4% is acceptable. However the financial risk of Blue might
be different to Blackstar and this should be reflected in the yield to redemption.
Blue's debentures mature in five years, and Blackstar's debentures mature in seven
years. It is likely that investors in Blackstar's debentures would require a higher yield to
redemption than 4%.
(c) The gearing and interest cover ratios of Blackstar immediately after the debenture
issue will be as follows:
Interest cover: Interest £134m  6% = £8.04m. Interest cover = 50.00/8.04 = 6.21 times
Gearing by market values assuming the current market price per share:
Market capitalisation 60m  £7.50 = £450m. Gearing (D/E) 150/450 = 33%
Current EPS 69.2p (50(1 – 0.17)/60)
EPS with a rights issue 41.5p (50(1 – 0.17)/100m)
EPS with a debenture issues 58p (50 – 8.04)(1 – 0.17)/60m
In time both interest cover (more operating profits) and gearing (greater equity value)
are likely to improve, with the acceptance of positive NPV projects and any favourable
market reaction to the issuance of debt and its tax shield (see below).
Advantages and disadvantages of debt versus equity include consideration of control
issues; obligation to return capital; interest payments versus dividend payments
(including consideration of tax relief); issue costs; liquidation of the investment (can the
investor get out easily?); risk versus reward.
Analysis:
The company will have a gearing ratio of 33% and an interest cover of 6.21 times.
Gearing is between the industry maximum and average of 35% and 25% respectively,
but near to the maximum; interest cover is between the industry minimum and average
of 6 and 8 respectively, but near to the minimum.

ICAEW 2020 June 2018 exam answers 305

 Since this is the first time that Blackstar has borrowed, both shareholders and the stock
market might be concerned and prefer these ratios to be near the industry averages or
better. Some shareholders might be attracted to investing in Blackstar because
currently it has no gearing. However if the £150 million is to be invested in positive
NPV projects both shareholders and the stock market should welcome the company
borrowing.
Borrowing should reduce the current cost of capital of the company, since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. The company also receives tax relief on the interest that it pays. Because there
is increased financial risk when a company borrows, the shareholders may require a
higher return but this is unlikely to offset the effect of cheaper debt finance. The
company value should increase as a result of the cost of capital reducing, and new
funds being invested in positive NPV projects.
It would be prudent for the company to restrict its borrowing to the industry average
gearing level, especially since its interest cover would be near to the minimum for the
industry. I would advise the company not to borrow the full £150 million; perhaps this
could be achieved by revising its plans for raising the finance. For example, an issue of
both debt and equity would help to ensure that gearing and interest cover ratios are
more favourable. Selling surplus assets is another possible source of finance.
59.2 (a) A special dividend is a 'one off' dividend payment in addition to the ordinary dividend.
A share repurchase is an alternative to dividend payments. Instead of paying dividends
a company may consider using the cash to repurchase issued shares.
(b) Blackstar's current dividend policy is unlikely to be appropriate for a listed company,
since dividends will rise and fall with profits and may cause signalling issues.
It is more usual for a listed company to pay a constant dividend with some growth. So
both directors A and B are correct in stating that Blackstar should do this. However,
shareholders are unlikely to be happy with the company leaving surplus cash in the
bank where returns will be lower than the company's cost of capital. Surplus cash
should be returned to shareholders in the form of a special dividend or share
repurchase.
59.3 Professional accountants in public practice should be aware of the danger of a conflict of
interest. In its dealings with Goldwing and Blackstar, Evans could implement the following
safeguards:
 Use different partners and teams for the two clients.
 Take all steps to ensure that there is no leakage of confidential information between
the two teams.
 Ensure that there is regular review by a senior partner or compliance officer who is not
personally involved with either client.
 Advise the clients to seek additional independent advice where appropriate.
(Credit also given for mentioning integrity, objectivity and confidentiality.)

Examiner's comments
The scenario of the question involves giving advice to a listed client on two issues:
Issue 1 Whether to raise additional funding by debt or equity.
Issue 2 A review of dividend policy and also an ethical situation.

306 Financial Management: Answer Bank ICAEW 2020

 Responses to part (a) of the first requirement were quite good with many candidates scoring full
marks. Weaker candidates made some of the following mistakes: confusing a 2 for 3 rights issue
for a 3 for 2 rights issue; not calculating the discount the rights issues represented on the current
share price; inadequate discussions on whether the actual share price is likely to be equal to the
theoretical ex-rights price.
Generally responses to part (b) of the first requirement were disappointing, but there were some
excellent responses. Poorer candidates made some of the following mistakes: using the new
debt issues terms to calculate the YTM rather than Blue's; using the cum interest debenture
price in YTM computations; deducting tax from the YTM when calculating the issue price for the
new debenture issue; when interpolating arriving at two negative NPVs by discounting at 5%
and 10%, then arriving at a YTM of more than 5%; incorrect calculations when calculating the
nominal value of the new issue.
Responses to part (c) of first requirement were extremely disappointing despite almost identical
questions being asked in recent papers. The question gave industry gearing and interest cover
figures so that the candidates could perform analysis looking at the gearing and interest cover
should the company decide to borrow. It was very disappointing that a large number of
candidates did not use this information or calculated gearing in a different way to that specified.
In addition many candidates did not consider the likely reaction of the shareholders and markets
to the finance being raised by either debt or equity. Finally, a large number of candidates
wasted time explaining the theories of M & M, when theory was not asked for in the question.
Responses to part (a) of the second requirement were mixed, with a surprising number of
candidates not knowing what a special dividend is. Also the explanations of a share repurchase
were poor.
Responses to part (b) of the second requirement were mixed, with many candidates not able to
demonstrate a good understanding of dividend policy. Many candidates did not identify that the
policy of maintaining a constant payout ratio means that dividends will rise and fall with profits.
Comments on the views of the two directors were often confused and hard to follow. However,
again, there were some excellent responses. The third part was well answered, but a large
number of candidates did not recognise that there was a conflict of interest for Mitchells.

60 Tarbena plc (June 2018)

Marking guide

Marks
60.1 Net payment 1
Forward rate 1.5
Sterling equivalent 0.5
Sell September futures 1
Number of contracts 1
Loss on futures on closeout 2
Dollar purchase 1
Call options to buy dollars 1
Option calculations 3
12
60.2 Advantages and disadvantages of hedging techniques 5
Advice 2
7

ICAEW 2020 June 2018 exam answers 307

 Marks
60.3 Interest rate parity explanation 2
Calculations 3
5
60.4 Purchasing power parity explanation 3
60.5 Points re importance of translation risk – 1 to 2 marks each 3
30

60.1 The net payment = $4,000,000 (10,000,000 – 6,000,000)

The forward rate is: $/£ 1.3166 (1.3078 + 0.0088)
This is result in a sterling payment of £3,038,129 ($4,000,000/$1.3166)
Tarbena should sell Sept sterling futures (ie, to buy $ with £).
The number of contracts to sell is: ($4,000,000/$1.3096)/£62,500 = 48.87 contracts,
rounded to 49 contracts. This means that it is slightly over hedged. (Full marks also to be
given if 48 contracts are used.)
On 30 September, the futures will be closed out and bought at $1.3171. This will result in a
loss of:
($1.3096 – $1.3171)  (£62,500  49) = $(22,969)
Dollars will be purchased on the spot market and the total payment will be:
($4,000,000 + $22,969)/$1.3167 = £3,055,342
Over the counter option, call options to buy dollars will be used:
The option premium is $4,000,000  4p = £160,000.
The premium with interest lost is £160,000  (1 + 0.0328  4/12) = £161,312.
If the spot price on 30 September is $/£1.3167 Tarbena will exercise the options.
The sterling payment will be ($4,000,000/$1.3170) + £161,312 = £3,198,518.
60.2 The forward contract and futures contracts both lock Tarbena into an exchange rate and do
not allow for upside potential.
Forwards:
 Tailored specifically for Tarbena.
 There is no secondary market.
Currency futures:
 Not tailored, so the number of contracts needs to be rounded.
 Requires a margin to be deposited at the exchange.
 There is a need for liquidity if margin calls are made.
 There is a secondary market.
OTC currency options:
 The options are expensive.
 There is no secondary market.
 Options allow Tarbena to exploit upside potential and protect downside risk.
Advice:
Without hedging, the sterling payment would be £3,037,898 ($4,000,000/1.3167).
The OTC option results in a higher payment of £3,198,518.
Both the forwards and futures result in a lower sterling payment of £3,038,129 and
£3,055,342, which are not materially different.

308 Financial Management: Answer Bank ICAEW 2020

 Since futures require margins and they are not a perfect hedge due to rounding and basis
risk, it is recommended that a forward contract is used as it is much simpler for a similar
result.
Tarbena's attitude to risk is also important.
60.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are
possible if the rates out of alignment. The forward rate tends to be an unbiased predictor of
the future spot exchange rate.
The forward rate in four months is calculated as follows:
Middle spot rate  (1 + The middle US interest rate)/(1 + The middle UK interest rate) =
Forward rate.
Middle rates:
Spot $/£1.3079 ((1.2078 + 1.3080)/2)
Interest rates:
Dollar 5.9% ((6 + 5.8)/2)
Sterling 3.13% ((3.28 + 2.98)/2)
The forward rate = $1.3079  (1 + 0.059  4/12)/(1 + 0.0313  4/12) = $1.3169
Because the dollar is depreciating against sterling, it is at a discount.
The discount is $0.0090 (1.3079 – 1.3169). The spread increases or decreases this, in this
case $/£ 0.0088 – 0.0092.
60.4 Purchasing power parity (PPP) is the theory that in the long-term exchange rates between
currencies will tend to reflect the relative purchasing power of the currency of each country.
The theory is based on the idea that a basket of goods in one country will, after the effect of
the exchange rate, cost the same no matter where it is traded. It is sometimes called the law
of one price.
The impact of different inflation rates in different countries will cause prices to change at
different speeds. So even if parity is achieved, disequilibrium will be created. PPP predicts
that the disequilibrium will be removed by changes in the exchange rate.
60.5 There are opposing arguments as to whether translation exposure is important. The
arguments centre on whether the reporting of a translation loss will affect the company's
share price.
There is an argument that, to the extent that cash flows are not affected, translation
exposure can be ignored. Therefore there will be no effect on Tarbena's share price.
On the other hand, those who believe that accounting results are an important determinant
of the share price argue that translation losses should be reduced to a minimum, as
translation losses could reduce Tarbena's share price.

Examiner's comments
The scenario of the questions is that of a board wanting some clarification on forex issues. The
first part was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: using the incorrect spot rate; deducting the forward discount;
incorrect computation for the number of futures contracts; making the incorrect decision of
whether to sell or buy futures; assuming that the futures loss was in £; choosing the put option
and not the call option; not including interest on the option premium, or including interest but
taking a whole year; treating the OTC option as a traded option; not netting receipts and

ICAEW 2020 June 2018 exam answers 309

 payments and presenting calculation on both transactions. The second part saw average
answers from a lot of candidates, some without any reference to the numbers calculated in the
first part. Many candidates did not give a firm conclusion. However there were some excellent
answers. Responses to the third part were mixed, with some good explanations of interest rate
parity. However many candidates did not perform computations, or computations were
incomplete. Responses to the fourth part were poor, with many candidates displaying no
knowledge of what purchasing power parity is. Responses to the fifth part were also poor and
displayed no knowledge of what translation exposure is, or what the likely effects are.

310 Financial Management: Answer Bank ICAEW 2020

 September 2018 exam answers
61 Thomas Rumsey Group plc
Marking guide

Marks
61.1 Revised Economic Value:
Sales correct in summary calculation 1
Sales workings
Y1 Expected Value 1
Y1 Inflation 1
Y2 Expected Value 1
Y2 Inflation 1
Y3 Expected Value 1
Y2 Inflation 1
Variable Cost 1
Fixed Cost 2
Close down costs 1
Tax 1
Sale of Plant and Machinery 1
Tax saved on Plant and Machinery 2
Working capital 1
Discounting 1
Economic Value 1
18
61.2 Revised Economic Value:
Scrap value 1
Tax rebate 1
Discounting 1
New economic value 1
4
61.3 Ethics and fundamental principles:
Behave with integrity 1
Behave objectively with no conflict of interest 1
Behave professionally 1
3
61.4 Impact of real options:
Explain impact of real option on – NPV 1
Identify abandon real option and explain using scenario 2
Identify growth real option and explain using scenario 2
5
61.5 Shareholder Value Added (SVA)
Explain SVA 1
Advantage of SVA 1
Explain seven drivers of SVA 2
Disadvantage of predicting 1
Disadvantage of terminal value on SVA 1
Adjust SVA with short terms investments and debt 1
7
Max 5
35

ICAEW 2020 September 2018 exam answers 311

 61.1
Y1 Y2 Y3
Year to 31/8/X9 31/8/Y0 31/8/Y1
£'000 £'000 £'000
Sales (W1) 6,375 4,411 2,653
VCs (30%) (1,913) (1,323) (796)
FCs (W2) (1,122) (1,144) (1,167)
Close down costs (W3) (637)
Tax (W4) (568) (330) (9)
P&M sale 1,500
P&M tax saving (W5) 101 83 122
Working capital 200 300 1,300
Net cash flows 3,073 1,997 2,966
11% factors 0.901 0.812 0.731
PV 2,769 1,622 2,168
Economic value 6,559

WORKINGS
1
Y1 Y2 Y3
£'000 £'000 £'000 £'000
Sales (£7m  0.7) 4,900 (£5m  0.6) 3,000 2,500
(£4.5m  0.3) 1,350 (£4m  0.4) 1,600  (1.02)3
6,250 4,600  0.7 3,220 2,653
 1.02 (£4m  0.4) 1,600
6,375 (£3m  0.6) 1,800
3,400  0.3 1,020
4,240
 (1.02)2
4,411

2
£'000
Annual fixed cost cash flows = (£1.7m – £0.6m) £1.1m  1.02 1,122 (Y1)
£1.1m  (1.02)
2
Depreciation excluded as not a cash flow 1,144 (Y2)
£1.1m  (1.02)
3
1,167 (Y3)
Close down costs = £0.6m  (1.02)
3
3 £637,000
4
Y1 Y2 Y3
£'000 £'000 £'000
Sales 6,375 4,411 2,653
VCs (1,913) (1,323) (796)
FCs (1,122) (1,144) (1,167)
Close down costs (637)
Taxable profit 3,340 1,944 53
Tax payable @ 17% 568 330 9

312 Financial Management: Answer Bank ICAEW 2020

 5
Y1 Y2 Y3
£'000 £'000 £'000
WDV b/f 3,300 2,706 2,219
WDA @ 18%/Balancing Allowance (BA) (594) (487) (719)
WDV/sale 2,706 2,219 1,500
Tax saving (WDA/BA  17%) 101 83 122
61.2
£'000
Scrap value = £1 million, therefore loss of cash = £1.5m – £1.0m 500
Tax rebate (balancing allowance)  83%
Discounted to Y0  0.731
Economic value decreases by 303
New economic value = £6,559 – £303 6,256

61.3 An ICAEW member is being asked to falsify the economic value of Snowdog and thus
mislead potential buyers, ie, Snowdog's directors. To do so would break the principles of
the ICAEW Ethical Guide which states, inter alia:
 A member should behave with integrity – ie, be honest and truthful. The member's
advice and work should not be influenced by the interests of other parties, which
would be the case here were s/he to overvalue Snowdog.
 A member should strive for objectivity in all professional and business judgements – ie,
there should be no bias, conflict of interest or undue influence of others. The member
has a conflict of interest here. S/he is being asked to act with bias in favour of one party
(Rumsey's directors) over another (Snowdog's directors).
 A member should behave professionally – ie, avoid any action that discredits the
profession. If the member falsified the valuation of Snowdog then the ICAEW's
reputation is at risk.
61.4 NPV analysis only considers cash flows related directly to a project. However, a project with
a negative (or low) NPV could be accepted for strategic reasons. This is because of (real)
options associated with a project that outweigh the poor NPV.
With regard to Snowdog two real options are:
 abandonment – if there is no MBO Snowdog could be closed before the three years
are up.
 growth (calling it follow on or timing also ok) – if Snowdog performs better than
expected it could be kept open longer than three years.
61.5 With SVA a company's value is based on the PV of its future cash flows, so it is forward-
looking.
The advantage is that this is theoretically the most superior valuation method compared
with earnings (which may be manipulated) or assets (which don't focus on the income
generated).
SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital

ICAEW 2020 September 2018 exam answers 313

 The disadvantage is that predictions are very difficult as cash flows are technically in
perpetuity. Once a company's period of competitive advantage is over then its growth rate
is much slower and a terminal (residual) value is calculated, based on its cash flows to
perpetuity. This terminal value is often the major part of the overall value of the company.
Once the total value of the company has been calculated, based on the future cash flows
and value drivers, then, to calculate the value of equity, it is necessary to add the value of
any short-term investments held and deduct the market value of any debt held.

Examiner's comments:
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a 'pass' standard in this question.
This was a five-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario was based on a UK manufacturer of computer hardware. The company's board has
decided to close down one of its subsidiary companies in three years' time. This is due to the
latter's recent poor performance. The board has learned that the subsidiary's senior
management would like to investigate the possibility of a management buy-out (MBO). The
board has decided that the subsidiary's buy-out price would be its current economic value,
based on predicted trading results for the next three years. The first part was worth 18 marks
and required candidates to make use of the information given and calculate the subsidiary's
economic value, based on discounted future cash flows. The second part, for four marks,
candidates were asked to re-work their figures from the first part because of a change in the
data provided. This tested their understanding of sensitivity analysis. The third part was worth
three marks and examined the Ethical Guide, with particular reference to the issues of integrity,
objectivity and professional behaviour. The fourth part, for five marks, tested candidates'
understanding of real options and asked them to identify two real options that could apply to
the subsidiary as alternatives to the MBO. Finally, again for five marks, candidates had to explain
the shareholder value analysis (SVA) approach to company valuation, with its advantages and
disadvantages.
In the first part the majority of candidates produced good answers. Relevant cash flows were, in
the main, correctly identified. However, the expected sales calculations did cause many
candidates problems. Common errors made by candidates were:
 poor expected value (EV) calculations for Year 2. Some candidates showed no real
understanding by producing an EV higher than any of the individual sales figures.
 no explanation of why depreciation is ignored in the cash flows.
 closure costs were ignored as irrelevant when they were not.
 the tax written down value brought forward was treated as a cash outlay.
 an extra writing down allowance was included in Year 0.
 the money discount rate (given) was increased by the inflation rate in the question.
The second part was answered very well by most candidates. They demonstrated a good
understanding of the key factors involved in the sensitivity analysis.
Answers for the third part were very variable. Candidates who scored well will have explained
why the key ethical issues (integrity, objectivity and professional behaviour) are under threat in
the given scenario. Many candidates failed to do this and produced a 'shopping list', without
explanation. In addition, a lot of candidates rolled integrity and objectivity into one issue rather
than two.
The fourth part was done well by the majority of candidates, but it was disappointing to see a
number of scripts where the candidate did not know the definition of a real option. Also, many
candidates did not apply their real option knowledge to the actual scenario. Instead, they listed

314 Financial Management: Answer Bank ICAEW 2020

 many (some irrelevant) options. Finally, some candidates gave more than the two options
required in the question.
SVA has been examined many times recently and, as expected, most candidates produced very
good answers for the final part. Typical errors here were: (a) not knowing the seven value drivers
and (b) applying SVA as if this was an investment appraisal, rather than a company valuation.

62 Heath Care plc

Marking guide

Marks

62.1 (a) Calculation of WACC using Gordon growth model:

Calc growth: opening shareholders' funds 1
Calc growth: r 1
Calc growth: b 1
Calc growth: r  b 1
Cost of equity 2
Cost of preference shares 1
Cost of irredeemable debt cashflows 2
Cost of redeemable debt cashflows 2
IRR pre-tax 1
IRR post-tax 1
WACC: MV of equity  cost equity 1
WACC: MV of red debt  cost red debt 1
WACC: MV of irr debt  cost irr debt 1
WACC: MV of pref div  cost pref shares 1
17
(b) Calculation of WACC using CAPM:
CAPM 1
WACC: MV of equity  cost equity 1
WACC: Revised weightings and WACC 1
3
62.2 Explain Gordon growth model:
One mark per point to a maximum of 2
Explain diversification and beta:
Explain systematic risk – cannot be diversified away 1
Explain non-systematic risk – can be diversified away 1
Explain beta and how determined by market 1
Impact of risk on beta 1
max 5
62.3 WACC assumptions and APV:
Three WACC assumptions – 1 mark per assumption 3
Explain impact of high gearing with numbers 2
APV base case 1
APV PV of tax shield 1
APV adjustment 0.5
APV identification of total 0.5
max 6

ICAEW 2020 September 2018 exam answers 315

 Marks
62.4 Portfolio theory:
Define portfolio 1
Investor spread investments to reduce risk 1
Investors can spread the risk themselves 1
Managers may want to diversify creating agency conflict 1
Heath's managers no experience of care home management 1
Some of Heath's investors may not be diversified 1
max 4
35

62.1 (a) Ke Dividend growth (g = br)

Opening equity capital employed = £2,520 – (£1,050 – £630) £2,100
r= £1,050 12.5%
(£6,300 + £2,100)
b= £420 0.4
£1,050
g=rb 12.5%  0.4 5%
ke = d1 + g (£630 / 6,300 )  1.05 8.13%
 5%
MV (£3.45 – £0.10)

Kp = d/mv £1  9% £0.09 5.89%

(£1.62 – £0.09) £1.53

Kdr Yr Cash Flow 4% PV 5% PV

£ £ £
0 (99) 1.000 (99.00) 1.000 (99.00)
1–3 4 2.775 11.10 2.723 10.89
3 100 0.889 88.90 0.864 86.40
1.00 (1.71)
IRR = approx 4.4%
Kdr = 4.4%  83% 3.65%

Kdi = i/mv £5  83% 4.41%

£94
WACC
MV Cost Weighting WACC
£'000
Ord. shares (6,300  £3.35) 21,105.0 8.13%  21,105.0/24,091.3 7.1
Pref. shares (750  £1.53) 1,147.5 5.89%  1,147.5/24,091.3 0.3
Redeemable debs
(680  £99%) 673.2 3.65%  673.2/24,091.3 0.1
Irredeemable debs
(1,240  £94%) 1,165.6 4.41%  1,165.6/24,091.3 0.2
24,091.3 7.7%

316 Financial Management: Answer Bank ICAEW 2020

 (b)
Ke via CAPM = (8.25% – 3.35%)  1.4 = 6.86%
3.35%
10.21%

MV Cost Weighting WACC

£'000
Ord. shares (6,300  £3.35) 21,105.0 10.21%  21,105.0/24,091.3 8.9%
Pref. shares (750  £1.53) 1,147.5 5.89%  1,147.5/24091.3 0.3%
Redeemable debs
(680  £99%) 673.2 3.65%  673.2/24,091.3 0.1%
Irredeemable debs
(1,240  £94%) 1,165.6 4.41%  1,165.6/24,091.3 0.2%
24,091.3 9.5%

62.2 Gordon's Growth Model (GGM) is also known as Earnings Retention Model. Dividend
growth based on proportion of dividends that are retained and the rate of return on those
retained profits. Thus g = rb. The GGM is based on the premise that these profits are the
only source of funds. Growth is achieved by re-investing earnings. This is then put into the
Dividend Valuation Model to get the cost of equity, assuming the value of a share = PV of
growing future dividends.
CAPM – specific/unsystematic risk can be diversified away by investors, so it is assumed that
investors are rational and that they have a diversified portfolio. Systematic risk can't be
diversified away – macro-economic factors. A company's beta is calculated from the
performance of its share price against the market average and is taken as a measure of the
market's view of the risk attached to the security in question. The higher the perceived risk,
then the higher the beta figure and thus the higher the equity return required by investors.
62.3 When using WACC to appraise projects the following assumptions are implied:
(1) Heath's historic proportions of debt and equity are not to be changed (which they are –
see below).
(2) Heath's systematic business risk is not to be changed (it does not change as it's still the
same industry).
(3) The finance is not project-specific (eg, cheap government loans, which it is not).
In this case the finance is very substantial, ie, 42% of total funds at market value
(£10m/£24m) and as it would be borrowed money then this will affect the company's
gearing level significantly (it is only just over 12% at present and would increase to 38% @
MV).
APV – increased gearing may lead to a fall in WACC because of the tax shield on loan
interest. To find the new WACC requires the new MV of the company's shares. However,
this requires the NPV of the proposed investment to be known, which needs the new
WACC. So:
(1) Calculate a base case value
(2) Calculate the PV of the tax shield
(3) Adjust for issue costs
Total up 1, 2 and 3 to give APV – if positive then proceed with investment.

ICAEW 2020 September 2018 exam answers 317

 62.4 A portfolio is a combination of investments. Many investors attempt to reduce their risks by
holding a portfolio. The idea is that by investing in different securities they are 'not putting
all of their eggs in one basket'. It is better to spread investment risks.
Investors can spread the risk themselves (via their investment strategy) and do not need
managers to do it for them. Indeed, managers may want to diversify in order to protect their
own jobs – which are not diversified. This creates agency conflict.
Heath's managers may well not know anything about running a care home (conglomerate
discount) and so it may be dangerous for investors to allow this investment.
Some of Heath's investors may not be diversified or may be unable to purchase certain
investments because they are private companies.

Examiner's comments:
This question had the second highest percentage mark on the paper. A large majority of
candidates reached a 'pass' standard in the question.
This was a four-part question which tested the candidates' understanding of the financing
options element of the syllabus.
The question was centred on an online retailer of baby products which is based in the UK. The
company's market share has been falling and its board is investigating the possibility of
establishing a small chain of shops across the UK, at a cost of £10 million. This expansion could
be funded by a bank loan, thereby taking advantage of current low interest rates. An alternative
view within the board is that the company should invest in a completely different type of
business, in this case a chain of care homes. In the first part, for 20 marks, candidates were
required to calculate the company's current WACC figure, based on (a) Gordon's Growth Model
and (b) the CAPM. The second part, for five marks, required candidates to compare and contrast
the two valuation methods above. In the third part (six marks) candidates were asked to advise
the company's board whether the existing WACC figure (from the first part) should be used in
when appraising the proposed investment in shops. The candidates' understanding of the APV
technique was also tested here. Finally, for four marks, candidates were required to explain the
portfolio effect and discuss the validity of the proposal to invest in a completely different type of
business.
The requirements of the first part have been examined regularly in recent examinations.
Accordingly, many candidates produced very good answers, scoring heavily. As expected, for
candidates the most difficult element here was the calculation of the dividend growth rate
(based on g = b  r). It was clear that some candidates had no idea how to approach the
calculation of g = b  r. In addition, many candidates calculated unrealistically high figures for g,
b and r (and then the cost of equity) without question. Elsewhere, it was disappointing to see a
number of candidates (wrongly) deducting the ordinary dividend for their preference share
calculations and using the ordinary dividend growth rate with preference dividends. Also, a
surprising number of candidates used 5% (the coupon rate) as the pre-tax irredeemable cost of
debt, omitting to take the current market value of the debt into account. Most candidates' IRR
calculations for the cost of redeemable debt were good. However, too many showed a lack of
understanding from here and produced an illogical IRR calculation from NPV figures that were
correct. The CAPM calculation for cost of equity was very straightforward and the vast majority of
candidates scored full marks. However, a significant number did not put the right numbers in to
the CAPM and so did not calculate the correct cost of equity.
The overall standard of answers given for the remaining parts of the question (theory and
advice) was disappointing when compared to the accuracy of (most of) the calculations in the
first part. Whilst many scripts scored well in the second part, far too many were unable to explain
the basics of Gordon's Growth Model and the CAPM.

318 Financial Management: Answer Bank ICAEW 2020

 For the third part, too few candidates explained the three conditions required to use the existing
WACC and then apply them to the given scenario. Generally, there was a good understanding
of the APV technique, but typical errors here were choosing the wrong cost of equity (it should
be ungeared) and then deducting (rather than adding) the PV of the tax shield.
For the fourth part, most candidates showed a good understanding of portfolio theory.
However, too many failed to distinguish between company and investor portfolios in the
scenario.

63 Eddyson Cordless Ltd

Marking guide

Marks
63.1 Hedging strategies:
No hedge 2
FTC outcome 1
FTC fee 1
MMH: Borrow 1
MMH: Convert 1
MMH: Lend and result 1
Option: strategy 1
Option: no of contracts 1
Option: cost of option premium 2
Option: decision 1
Option: gain 1
Option: due from customer 1
Option: convert to £'s 1
Option: net receipt 1
16
63.2 Advice on hedge:
Summary of hedging outcomes 1
Best outcome at $1.3350 2
Best outcome at $1.4050 2
Impact on Eddyson if dollar ($) strengthens 1
6
63.3 Interest rate parity:
State and explain interest rate parity 2
Average UK and US three month rates 1
Average spot rate 1
Calculation of forward rate/average premium 1
5
63.4 Economic risk:
96% UK sales so little exposure 1
Increase in economic risk as US sales increase 1
Weaker $ would be bad for Eddyson 1
3
30

ICAEW 2020 September 2018 exam answers 319

 63.1 No hedge
Spot rate Spot rate
1.3350 1.4050
$2,300,000 $2,300,000
1.3350 1.4050

£1,722,846 £1,637,011
Forward contract (FC)
1.3775 – 0.0044 = 1.3731 $2,300,000 £1,675,042
1.3731
Fee $2,300,000 (£6,900)
= 23,000  £0.30
$100 £1,668,142

Money market hedge (MMH)

Borrow $ $2,300,000 $2,277,228
1.01
Convert @ spot £2,277,228 £1,653,160
1.3775
Lend @ UK £1,653,160

1.0115 £1,672,171
Option
Buying £s, so a November call option
No. of contracts = $2,300,000 £1,666,667 166.66 167
$1.38 £10,000 contracts

Cost of option 167  0.0199  10,000 $33,233 £24,338

1.3655

Future spot rate 1.3350 1.4050

Bought for (1.3800) (1.3800)
(Loss)/Profit (0.0450) 0.0250

So therefore Abandon option Take up option

Gain on option $0.0250

 10,000
 167
$41,750

Due from customer $2,300,000 $2,300,000

Gain on option 0 41,750
Due from customer $2,300,000 $2,341,750

Converted to £ ($2.3m/1.3350) £1,722,846 ($2,341,750/1.4050) £1,666,726

less: Cost of option (24,338) (24,338)
Net receipt £1,698,508 £1,642,388

320 Financial Management: Answer Bank ICAEW 2020

 63.2
Spot rate Spot rate
1.3350 1.4050
No hedge £1,722,846 £1,637,011
FC £1,668,142 £1,668,142
MMH £1,672,171 £1,672,171
Option £1,698,508 £1,642,388

So with spot rate at 1.3350 (weakening £ and strengthening $) the best outcome for
Eddyson is not to hedge the dollar receipt.
With the spot rate at 1.4050 (strengthening £ and weakening $) the best outcome is to
hedge the dollar receipt via a money market hedge. The FC and the MMH both give a fixed
sterling receipt – the MMH produces a slightly higher figure. The FC and MMH are safest
techniques to use for a risk-averse board.
The £/$ interest rates and the forward contract premium indicate that the market is
expecting the dollar to strengthen (sterling to weaken). This would be good for Eddyson, an
exporter, as sterling receipts would be higher. The board's attitude to risk will be important
here.
63.3
1+ Average dollar interest rate (3 mos.)
Average spot rate  = Average forward rate
1+ Average sterling interest rate (3 mos.)

The dollar interest rates are lower than those of sterling. Using the interest rate parity (IRP)
equation above (which shows that differences in interest rates cannot be exploited as
forward rate will adjust to offset any gains), the value of sterling against the dollar will fall.
The dollar's gain in value is called a premium. So, using the data in the question:
Average UK rate 5.10% pa or 1.01275% per three months.
Average US rate 3.6% pa or 1.009% per three months.
Average spot rate = 1.3715
Forward rate = 1.3715  1.009/1.01275 = 1.3664 ie, a premium of $0.0051/£
Average premium given = $0.0052/£ so IRP is working
63.4 Currently very little economic risk as the majority of Eddyson's sales are in the UK (96%).
However, if more sales are to the US then economic risk would increase – $ sales and €
purchases.
A weakening $ and a strengthening € would both be bad for Eddyson.

Examiner's comments:
This question had the lowest average mark on the paper, but most candidates achieved a 'pass'
standard.
This was a four-part question that tested the candidates' understanding of the risk management
element of the syllabus.
The scenario here involved a UK manufacturer of home and garden appliances. The company
has recently received a large order from an American customer. Its board is considering whether
or not to hedge the foreign exchange rate risk. The first part of the question, for 16 marks,
required candidates to calculate the net sterling receipt for each of four possible strategies.
These were (a) no hedge, (b) a forward contract, (c) a money market hedge and (d) sterling
traded currency options. The second part was worth six marks and required candidates to
advise the company's board, based on their previous calculations. In the third part (five marks)
candidates needed to demonstrate their understanding of interest rate parity. The fourth part

ICAEW 2020 September 2018 exam answers 321

 was worth three marks. Here, candidates were asked to explain whether, taking into account the
information provided, additional sales to the US might expose the company to economic risk.
For most elements of the first part candidates scored well. Forward contracts (FC) and money
market hedges (MMH) are examined regularly and most candidates accrued full marks here.
Candidates need to make the best use of the spreadsheet provided in the examination. In a
number of instances candidates reduced their exchange rates to two decimal places, thus losing
marks unnecessarily. One common error amongst candidates was to add, rather than subtract,
the forward contract fee. It was disappointing to see that some candidates used the two future
spot rates given to calculate alternative sterling receipts for the FC and then also for the MMH.
Both of these hedging techniques produce one, fixed sterling figure each. As expected,
candidates found the currency options element of the question more difficult. Whilst many of
them scored well, common errors noted were:
 choosing a put rather than a call option and then getting the exercise/abandon decision
wrong as well.
 calculating the wrong number of contracts, by failing to use the option exercise price.
 calculating the profit on exercising the option in sterling rather than in $.
 treating it as an OTC option rather than a sterling traded currency option.
Interest rate parity (IRP) has been examined fairly regularly and many candidates did well in the
third part. However, there were quite a few poor scripts and some candidates used 12 months
rather than three months when trying to prove that the IRP was working in this scenario.
The fourth part produced a very varied set of answers. Whilst many candidates scored full marks
here, many scored zero, as they had no understanding of economic risk, frequently mentioning
(wrongly) the impact of tariffs, quotas and political unrest.

322 Financial Management: Answer Bank ICAEW 2020

 December 2018 exam answers
64 Physiotec plc
Marking guide

Marks
64.1 Expected NPV
Contribution working
Expected sales 1
Contribution 1
5% increase 1.5
4% increase 1.5

Initial marketing 0.5

Selling and admin 1.5
Fixed costs 1
Rent foregone 1
Tax 1
Plant and equipment 1
Tax saved on plant and equipment 2
Working capital 2
ENPV 1
Research cost excluded 1
Accept project 1
Discount rate 1
19
64.2 Sensitivity:
Contribution (0.5 if sales are used) 1
Tax 1
Present value 1
Sensitivity % 0.5
Sensitivity absolute figure 0.5
Explanation 2

Max 5
64.3 Advantages and disadvantages:
Per advantage – 1 mark 2
Per disadvantage – 1 mark 2
4
64.4 Options:
Marks awarded for first two only.
Explanation of option to delay (1 if not related to scenario) 2
Explanation of option to abandon (1 if not related to scenario) 2
Explanation of follow on option (1 if not related to scenario) 2
Explanation of growth option (1 if not related to scenario) 2
Max 4
64.5 Ethical and legal principles
Ethical principles 2
Legal principles 1
3
35

ICAEW 2020 December 2018 exam answers 323

 64.1 The Supertape Project
0 1 2 3
£m £m £m £m
Contribution (1) 8.40 9.08 9.82
Initial marketing –0.80
Selling and admin –2.00 –2.08 –2.16
Fixed costs –0.75 –0.75 –0.75
Rent forgone –1.00 –1.00 –1.00
Operating cash flows –1.80 4.65 5.25 6.91
Tax 17% 0.31 –0.79 –0.89 –1.17
After tax operating cash flows –1.49 3.86 4.36 5.74
Plant and equipment –4.00 0.50
Tax saved on Cas (2) 0.12 0.10 0.08 0.29
Working Capital (3) –3.00 –0.25 –0.27 3.52
Net cash flows –8.37 3.71 4.17 10.05
PV factors at 10% 1.00 0.909 0.826 0.751
Present value –8.37 3.37 3.44 7.55
ENPV 5.99
Research cost of £0.5 million should be ignored since they are a sunk cost.
The project should be accepted since it has a positive ENPV, which will increase
shareholder's wealth.
The discount rate: ((1.07)  (1.024)) – 1 = 0.09568. Round to 10%.
Sales and Contribution
Probability Packs Sales @ £5 per pack Prob x Sales
m £m £m
0.5 4 20 10.00
0.3 2 10 3.00
0.2 1 5 1.00
Expected Sales 14.00
(1) Contribution Y1 = £8.40 m (14.00  0.60)
The contribution will be increased each year by volume and sales price increase:
Y2: 8.4  1.05  1.03 = 9.08
Y3: 9.08  1.05  1.03 = 9.82
(2) Capital allowances and the tax saved thereon
Cost/WDV CA Tax
4.00 0.72 0.12
3.28 0.59 0.10
2.69 0.48 0.08
2.21
-0.5 1.71 0.29
(3) Working capital:
Y1: (3.0  1.05  1.03) – 3 = (0.25)
Y2: (3.25  1.05  1.03) – 3.25 = (0.27)
Y3: 3.52

324 Financial Management: Answer Bank ICAEW 2020

 64.2 The sensitivity of the Supertape project to changes in sales revenue:
Contribution X (1 – 0.17) 6.97 7.54 8.15

PV factors at 10% 0.909 0.826 0.751

Present Value 6.34 6.23 6.12

Total present value 18.69

Sensitivity 5.99/18.69 32.05%
A fall in sales from £14 million to: 14(1 – 0.3205) = £9.51 million will result in a zero NPV.
There is a 50% chance that sales will be £10m or less and the management of Physiotec will
have to consider whether it is willing to accept this level of risk. Especially since this is a very
competitive market and it is possible that another product similar to Supertape might be
marketed by a rival company.
64.3 Advantages:
 The information is reduced to a single number for assessing the Supertape project
rather than a range of outcomes.
 Easily understood.
Disadvantages:
 The probabilities of the different sales levels may not be accurate.
 The expected sales of £14 million may not correspond to any of the possible expected
sales levels.
 The expected sales of £14 million will not be achieved unless the project is run many
times.
 The expected sales of £14 million are an average and it does not consider the spread
of possible results. It therefore ignores risk.
64.4 The option to delay. Since a competitor is likely to enter into the market in one year's time,
it might be prudent to start the project in one year, rather than now on 31 December 2018.
The product might be not as good as Supertape or it might be better. Physiotec can make a
more informed decision when it knows what the competitor is intending.
The option to abandon. Since expected values are being used to estimate sales if the worst
case scenario occurs, sales of only 1 million, Physiotec can abandon the project.
Follow on options. Producing Supertape might allow Physiotec to develop future products,
which can be marketed after 31 December 2021, even if the lower level of sales of 1 million
occurs and the project initially has a negative NPV.
Growth options. Physiotech could develop new markets for Supertape eg overseas which
may turn a negative NPV project (initial sales 1 million) into a positive.
64.5 The finance director of Physiotec should disregard the sales director's suggestion since this
would be misleading shareholders and the markets. The finance director would not be
acting in an ethical manner if he tried to hide the fact that the sales level of 4 million is not
certain and that there is only a 50% probability of that level occurring. He would be
breaching the fundamental principles of Integrity, Objectivity, Professional competence and
due care and Professional behaviour.
There are also legal considerations to consider since the professional accountant must be
aware of and comply with current legislative and regulatory measures. Therefore, as well as
being unethical, making this announcement would be illegal.

ICAEW 2020 December 2018 exam answers 325

 Examiner's comments:
This was a five-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario of the question was that a listed UK company is launching a new product onto the
market. The company is a major supplier to the physiotherapy industry.
The first part of the question covered ENPV (expected NPV) analysis using probabilities, whilst
the second part required sensitivity calculations and discussion. The third part of the question
required knowledge of using expected values and the fourth part discussed the real options
available to the company. Finally, the last part of the question discussed an ethical issue.
In the first part most of the attempts were good, however, common errors were: not stating why
the research costs should be ignored ie, that they are sunk costs; incorrect timing of cash flows;
inflating cash flows when it is stated that they remain constant; inflating the net cash flows by the
general level of inflation; not using the Fisher formulae to calculate the nominal cost of capital
and merely adding the general level of inflation to the real cost of capital; discounting money
net cash flows by the real cost of capital. The second part of the question was mainly well
answered; however, the examiners observed an error that has not occurred in past sensitivity
questions. Some candidates attempted to calculate sensitivity using units (rather than £
contribution), going as far as taxing them and discounting them. Some other, common, errors
were: calculating sensitivity using sales rather than contribution; ignoring tax; inverting the
sensitivity calculation; inadequate narrative and not referring to the probabilities provided.
In the third part the advantages and disadvantages were quite poorly answered, with many
candidates clearly making up answers and showing little understanding of the advantages and
disadvantages of using expected values. In the fourth part there were a lot of very good answers,
however poorer candidates did not refer to the scenario. The examiners would like to
emphasise that this is very important to gain high marks. Also, many candidates provided a list
of every real option that they could think of. Candidates should be aware that when two real
options are asked for, only the first two are marked. Finally, in the last part there were a lot of
good answers, but many candidates omitted the legal aspects.

65 North American Cars Ltd

Marking guide

Marks

65.1 (a) Calculation of hedging interest rate risk

FRA rate 1
Interest cost for 12 months 1
Exercise decision 1
Interest 0.5
Premium 0.5
Interest cost for 12 months 2
6
(b) Discussion:
Which is best if LIBOR increases 1
Recommendation with advantages and disadvantages 2
3

326 Financial Management: Answer Bank ICAEW 2020

 Marks
65.2 (a) FOREX calculations:
Forward:
Forward rate (spot + adjustment) 1+0.5
Sterling outcome 0.5
Money market hedge:
Amount to invest in money market hedge 1
Buy $ a spot rate 1
Total cost in £ 1
Option:
Use call option to buy $ 0.5
Exercise decision 0.5
Option premium 1
Premium with interest 1
Sterling outcome 1
9
(b) Results of hedging:
Cost if no hedge 1
Explain how interact with exchange rate 2–3
Specific advantages and disadvantages of techniques 2–3
Recommendation 2
max 8
65.3 Economic risk:
Define related to scenario 2
Explain effect 2
4
30

65.1 (a)
LIBOR 1.25% 0.60%
LIBOR + 3 4.25% 3.60%

FRA Pay to lenders 4.25% 3.60%

Pmt to bank 0.25% 0.90%
FRA rate 4.50% 4.50%
Interest cost for 12 months £36,000 £36,000

Option - Exercise Yes No

Pay interest at 4.00% 3.60%
Premium 1.00% 1.00%
Effective rate 5.00% 4.60%
Interest cost for 12 months £40,000 £36,800
(b) If LIBOR increases to 1.25% the FRA is better than the option by £4,000.
If LIBOR decrease to 0.60% the FRA is slightly better than the option by £800.
The decision on whether to hedge depends on the board's attitude to risk as, for both
the interest rates given, not hedging is cheaper.
If LIBOR does fall (per one board member) the option allows upside potential and
could be cheaper than the FRA but would never be cheaper than not hedging.

ICAEW 2020 December 2018 exam answers 327

 But, given that the overall view of the board is that LIBOR will rise, it would depend on
how far the board believes it would rise. LIBOR would need to rise to over 1.5% before
the FRA is cheaper than doing nothing and by over 2% before the option is cheaper.
65.2 (a) The forward rate is: $/£ 1.4017 (1.3965 + 0.0052)
This results in a sterling payment of ($1,250,000/$1.4017) = £891,774
Using the money markets, NAC will invest in $, $ at the spot rate and borrow in £.
Invest $1,250,000/(1 + 0.044  4/12) = $1,231,932
Buy $ spot $1,231,932/$1.3965 = £882,157
Borrow in £ to give total cost £882,157  (1 + 0.0375  4/12) = £893,184
Over the counter option. Using a call option to buy $:
Exercise price $1.4025. If spot is $1.3980 exercise the option.
The option premium is $1,250,000  £0.006 = £7,500.
The premium with interest is £7,500  (1 + 0.0375  4/12) = £7,594
The sterling payment will be ($1,250,000/$1.4025) + £7,594 = £898,860
(b) Results of hedging using various methods:
Forward £891,774
Money market £893,184
Option £898,860
If no hedge the payment will cost: $1,250,000/$1.3980 = £894,134.
The forward contract and money market hedge lock NAC into an exchange rate. The
options, however, protect NAC against the downside risk of the £ weakening more
than expected against the $ and allow for the upside potential of the $ weakening
against the £; however the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for NAC.
However, there is no secondary market.
Money market hedge:
The money market hedge is more difficult to arrange than a forward contract and
might use up NAC's credit lines.
OTC currency options:
There is no secondary market.
It is unlikely that the $ is going to weaken enough to cover the cost of the option
premium, therefore it is not recommended that the company use OTC foreign currency
options. The forward contract and money market hedge are both better than the spot
rate, however, the forward is the cheapest. It is recommended that NAC use a forward
contract to hedge the foreign exchange risk.
65.3 NAC is an importer and exporter. It buys cars in $, exports some to the Eurozone and
receives payment in €. If over a period of several years the pound weakens (although the
data in the question indicates that it is strengthening) against the dollar and appreciates
against the euro the sterling value of NAC's income will fall and its net cash flows decline.
This will reduce the value of the business (PV of future cash flows).

328 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This was a five-part question that tested the candidates' understanding of the risk management
element of the syllabus. The scenario of the question was that a company imports goods from
the USA and sells them in the UK.
In the first part, section (a) required computations regarding hedging short-term interest rate
risk, whilst section (b) required discussion regarding the techniques used to hedge the short-
term interest rate risk.
In the second part, section (a) required computations regarding FOREX. Section (b) required
candidates to offer advice regarding the techniques that have been used to hedge the FOREX.
The final part required a discussion regarding economic risk and the Eurozone.
Responses to the first part section (a) of the question were quite good with many candidates
scoring almost full marks. However, weaker candidates made some of the following mistakes:
calculating interest payable for a five-month period and misreading the question which states
that the borrowing will be for one year and will take place on 30 April 2019, which is five months
from 30 November 2018; lack of understanding of FRAs, which are OTC and treating them like
futures; treating the OTC interest rate option as an option on interest rate futures. In section (b)
there were reasonable answers, however, common errors include: no recommendation given
and just advantages and disadvantages; no consideration of not hedging as an alternative.
In the second part, section (a) responses were mainly good but common errors were: for the
forward contract using the incorrect exchange rate and deducting instead of adding the forward
discount; for the money market hedge choosing the incorrect interest rates, incorrect
apportionment of the annual interest and using the incorrect spot rate; for the OTC option
choosing the put rather than the call, not taking account of the interest on the option premium,
treating the OTC option as a traded option and incorrect exercise or abandon decisions.
Whereas, in section (b), responses were mixed with quite a few candidates not giving advice.
In the final part of the question, responses were poor with quite a lot of candidates showing a
lack of understanding of what economic risk is and how it affected the company.

66 Continental plc
Marking guide

Marks
66.1 (a) WACC Calculation:
Exclude special dividend when calculating growth 1
Calculate growth 1
Dividend per share 1
Calculate ke 1
Calculate PV of debt 2
Calculate yield to maturity 1
Calculate kd 1
Market value of equity 1
Market value of debt 1
10
(b) Using CAPM to calculate ke 1
1

ICAEW 2020 December 2018 exam answers 329

 Marks
66.2 Ke reflecting systematic risk:
Explanation of choice of beta (deduct 1 if the wrong beta) 4
Degear 1.5
Regear 1.5
Ke calculation using CAPM 1
8
66.3 (a) Gearing if debt finance used:
Debenture price 0.5
Market value 0.5
Gearing 1
(b) Gearing if equity finance used:
Debenture price 0.5
Market value 0.5
Gearing 1
6
66.4 Appropriate source of finance:
Current gearing 1
Practical considerations equity 4
Practical considerations debt 4
Theoretical considerations 5
Conclusion 1
Max 12
35

66.1 (a) Growth can be estimated by past ordinary dividend growth for the past four years
excluding special dividend as it's a one-off:
(1/4)
Growth = (141/105) – 1 = 0.0765 or 7.7%
Shares in issue = 190m
2017 dividends per share = 74p (141/190)
Ex div share price = 4600p
Ke = (74(1.077)/4600) + 0.077 = 0.0943 or 9.43%
Kd =
Time Cash flow Factors at 5% PV Factors at 10% PV
£ £ £
0 (94) 1 (94) 1 (94)
1–4 4 3.546 14.18 3.170 12.68
4 100 0.823 82.30 0.683 68.30
2.48 (13.02)
YTM = 5 + ((2.48/(2.48 + 13.02))5) = 5.8%
Kd = 5.8 (1 – 0.17) = 4.81%
Market values:
Equity 190m  £46 = £8,740m
The total market value of debt = 1,500  0.94 = £1,410
WACC = (9.43 x 8740 + 4.81  1410)/(8740 + 1410) = 8.79%

330 Financial Management: Answer Bank ICAEW 2020

 (b) Using CAPM.
Ke = 3 + 0.74(9 – 3) = 7.44%
66.2The cost of equity will have to reflect the systematic business risk of the diversification and
the financial risk. An appropriate equity beta will have to be selected. Bowlright's beta is
affected by its diversification into bowling alleys and gyms. The Local does not operate in
the gym market sector. The choice of equity beta is therefore that from Fitgroup, which is
0.56.
We will have to consider whether the Fitgroup equity beta should be adjusted for financial
risk. The gearing of Continental is: (1410/8740) = 16% and Fitgroup's gearing is: 150/434)
= 35%. The two gearing ratios are materially different and gearing adjustments will have to
be made:
Degear: 0.56 = Ba (1 + ((150  0.83)/434)) = 0.44
Regear: Be = 0.44 (1 + ((1410  0.83)/8740)) = 0.50
Ke = 3 + 0.50 (9 – 3) = 6%

66.3 (a) If the diversification is financed by debt the price of the debentures will fall to:
94 (1 – 0.05) = 89.3.
The market value of existing debt will now become: 1500  0.893 = £1339.5m
Total debt will be: 1339.5 + 1000 = £2339.5m
Gearing will be: 2339.5/8740 = 27%
(b) If the diversification is finance by equity the price of the debentures will rise to:
94 (1 + 0.05) = 98.7
The market value of debt will now become: 1500  0.987 = 1480.5
The market value of equity will be: 8740 + 1000 = £9740m
Gearing will be: 1480.5/9740 = 15%
Note: These gearing figures are approximate since it is unlikely that the market value of
existing equity will in reality remain the same after the diversification.
66.4 Gearing:
Current Gearing If financed by debt If financed by equity
16% 27% (from 66.3 above) 15% (from 66.3 above)
The view of the board member that gearing is irrelevant has practical and theoretical
implications as follows:
Practical Considerations:
Equity:
Continental currently has gearing around the market average at 16% and financing the
diversification by equity will change this to 15%, which is not materially different.
Shareholders and the markets should not be worried about this change. However, unless
the equity is raised by way of a rights issue, there might be control issues. Even if there is a
rights issue, there will be control issues for shareholders who do not wish to take up their
rights. To ensure that a rights issue would be fully subscribed it is likely to be underwritten,
which will incur a cost. Dividends do not have to be paid, unlike interest. If some of the
equity comes from cutting the special dividend then this may upset shareholders and have
an adverse impact on the value of the equity (signalling).

ICAEW 2020 December 2018 exam answers 331

 Debt:
Financing the diversification by debt will materially increase the gearing from 16% to 27%; it
would be useful to know the maximum gearing in Continentals market sector. This increase
may cause shareholders and the markets concern and it could have adverse implications for
raising future debt finance. Debt interest has to be paid.
Combination of Debt and Equity:
Perhaps the most prudent way to finance the diversification would be to use both debt and
equity in proportions that will maintain Continentals current gearing of 16% ie, more equity
than debt within the £1,000 million raised.
Theoretical Considerations:
From a practical viewpoint, as stated above, gearing does have implications. However, from
a theoretical point of view, it is useful to look at the views of Modigliani and Miller (M&M).
In 1958 M&M showed that in a no-tax world there is no advantage for firms to issue debt.
There is therefore no optimal capital structure. However, one of the main advantages of
issuing debt is that the company gets tax relief on the interest. In 1963 M&M showed that, in
the presence of corporation tax, it is advantageous for companies to issue debt.
The effect of interest being allowable against tax means that the higher the gearing the less
tax a company will pay. This implies that Continental should not consider financing the
diversification by equity at all and should only consider debt financing.
M&M stated that a company that has gearing is worth more than one that does not. This
increase in value being due to the tax shield on debt. Since debt is cheaper than equity, this
implies that WACC will fall as gearing rises, hence increasing the value of the firm.
Continental will therefore increase its value if it borrows the £1,000 million. In the extreme,
M&M 1963 suggests that the optimal gearing is 100%; however, this is impractical and
Continental would certainly risk bankruptcy if it were to gear up to this level.
The traditional theory (aka trade-off theory) suggests there is an optimal capital structure
with a minimum WACC (and maximum firm value). If the 16% industry gearing is considered
optimal by the market, then both methods of finance move the company away from the
optimal, increasing the WACC and reducing the company's value (more so in the case of
debt).
Conclusion:
Although there is merit in what M&M state, it would be prudent for Continental to consider
the practical implications of financing the diversification as stated above and use a mix of
debt and equity.

Examiner's comments:
This was a four-part question that tested the candidates' understanding of the financing options
element of the syllabus.
The scenario of the question was that a company is diversifying its operations and raising finance
by either debt or equity.
The first part required cost of capital computations before the diversification. The second part
required computations regarding a cost of capital appropriate for the diversification. The third
part required gearing calculations if the diversification is financed by debt or equity. The final
part required a discussion of from what source (debt, equity or a combination) the finance
required for the diversification should be raised.
The examiner commented that the first area has been examined many times before and there
are adequate examples in the learning materials. However, this part of the question was not well
answered and common errors were: not stating that the special dividend should be ignored

332 Financial Management: Answer Bank ICAEW 2020

 when calculating growth from past dividends; calculating growth from past dividends and using
the 5th root rather than the 4th root; inverting the growth computation; confusion of digits
between £ and pence; incorrect market value computations; when calculating the IRR of the
debentures incorrect computations with two negative NPVs, incorrect IRR computation and
omitting tax: when using the CAPM for ke using the market return and not the market risk
premium.
Answers to the second part of the question were often weak. Common errors were: inadequate
narrative on why an equity beta should be chosen from the samples of comparative companies
given; choosing the incorrect comparator; using an average of all three or just two of the
comparators; incorrect computations when degearing the equity beta, in some cases ending up
with a higher asset beta than the equity beta; regearing the asset beta using Continental's book
values; using clearly impossible equity betas in the CAPM, for example an equity beta of 28.
In the third part, there were disappointing answers and common errors were: not recalculating
the value of the existing debt; using a combination of book and market values; using just book
values; using the incorrect measure of gearing ie, debt/debt + equity instead of debt/equity
(despite the question stating, twice, that market values and debt/equity should be used).
For the final part, the examiner has said that, given that the question set out four areas that
should be addressed, answers were disappointing in that not all the areas were covered.
Answers tended to be general and not related to the scenario of the question. The scenario
stated that Continental's current gearing is near to the industry average and yet few candidates
referred to this in their answers, nor calculated the current gearing. The question asked for
theory, but this should be related to the scenario and not just a mind dump of the theory.

ICAEW 2020 December 2018 exam answers 333

 March 2019 exam answers
67 Palace Parade Furniture plc
Marking guide

Marks
67.1 (a) P/E values:
Average PBIT 1.5
less interest 1
less tax 1
Average P/E 1
Average P/E  Average earnings 1
Value per share 0.5
Mark-down for lower marketability 0.5
Dividend yield values:
Average yield of listed companies 1
2019 Dividend/Average yield 1
Value/share 0.5
Mark-down for lower marketability 0.5
Asset-based values:
Net assets 1
Value per share 0.5
Revalued net assets 1.5
Value per share 0.5
13
(b) Strengths and weaknesses of valuation methods
For each well explained point Max 2
10
(c) Payment options:
Paying in cash 2
Paying with shares 2
Paying with loan stock 2
Max 4
67.2 Shareholder Value Added (SVA):
Explain Shareholder value analysis (SVA) 3
Seven value drivers 2
DCF estimate 2
Max 4
67.3 Management Buy Out (MBO)
Definition 1
Funding methods:
Management equity 1.5
Venture capitalists 1.5
Borrowing from banks 1

Max 4
35

334 Financial Management: Answer Bank ICAEW 2020

 67.1(a) P/E values:
[If candidates don't use data to get average Earnings as instructed then:
Average P/E of listed companies (8.1 + 10.7 + 9.5 + 9.3)/4 = 9.4
2019 Earnings (TP) £4.482m
Average P/E  2019 Earnings 9.4  £4.482m £42.131m
Value/share £42.131m/8.5m £4.96
Mark-down for lower marketability (non-listed shares) at, say, 70% £3.47]
If they do use data to get average Earnings as instructed then:
£m
Average PBIT for TP [£m] (3.6 + 11.8 + 3.8 + 4.8 + 7.2)/5 = 6.240
less: Interest (£24m  7.5%) (1.800)
Average PBT for TP 4.440
less: Tax @ 17% (0.755)
Average Earnings for TP 3.685

Average P/E as above = 9.4

Average P/E  Average Earnings 9.4  £3.685m £34.639m
Value/share £34.639m/8.5m £4.08

Mark-down for lower marketability (non-listed shares) at, say, 70% £2.86
Dividend yield values:
Average yield of listed companies (7.0% + 8.3% + 8%
+ 7.5%)/4 = 7.7%
2019 Dividend (TP) £2.890m
2019 Dividend/Average yield £2.890m/7.7% £37.532m
Value/share £37.532m/8.5m £4.42

Mark-down for lower marketability (non-listed shares) at, say, 70% £3.09
Asset-based values:
Net Assets (per Balance Sheet) £17.080m
Value per share £17.080m/8.5m £2.01
Revalued Net Assets (£17.080m - £36.2m + £23.2m + £20.8m + £1.15m) 26.030m
Value per share £26.030m/8.5m £3.06
(b)  Based on the above figures the price range is approximately £2 to £3.50 per share.
 This is an offer for 65% of TP's shares. So PPF would then have control of TP – thus
a premium would be payable.
 The P/E ratio is normally a better guide as it considers the earnings creating
potential of the company rather than just the value of its assets. However, 2015-
2019 earnings are erratic, so it is prudent to consider past earnings as well as
current. How typical are 2016 and 2019, for example? This suggests a degree of
risk with TP's earnings – so should PPF offer a lower price? Earnings can be
manipulated by accounting policies.
 PPF will be looking forwards and intending to generate future earnings from TP,
not liquidate (asset strip) it as in asset values. It will be necessary to discount (by,
say 30%) this P/E valuation because TP's shares will be less marketable.
 The dividend yield approach is most effective when an investor is looking for
dividend income rather than control. This is not the case here and future earnings

ICAEW 2020 March 2019 exam answers 335

 will be of more relevance to PPF's directors, acting on behalf of its shareholders.
As with P/E it will be necessary to discount (by, say 30%) the yield valuation
because TP's shares will be less marketable. Growth is ignored.
 Asset values – historic so not equal to MV and only considers tangible assets and
ignores income. Revalued figures are better as they are more up to date, but they
still have the same disadvantages.
Debentures are redeemable very soon in 2020 – this could have a negative impact on
the price payable.
(c) Paying in cash
 This is more attractive to the target shareholders as the value is certain. There may
be personal tax implications.
 This may cause liquidity problems for the bidding firm and so it may be necessary
to increase its gearing.
 Lower transaction costs will arise with a cash purchase.
Paying with shares
 There are no liquidity problems.
 There are no immediate tax issues.
 There will be a dilution of ownership and any gains made will now be shared with
the target shareholders.
Paying with loan stock
 This avoids dilution of ownership.
 There is an assured return for stockholders.
 This could cause gearing problems.
67.2 Shareholder value analysis (SVA) is an income measure (not asset-based) and concentrates
on a company's ability to generate value and thereby increase shareholder wealth. SVA is
based on the premise that the value of a business is equal to the sum of the present values
(PV) of the cash flows generated by all of its activities rather than the earnings or dividends.
The value of the business is calculated from the cash flows generated by drivers 1–6 which
are then discounted at the company's cost of capital (driver 7). SVA links a business' value
to its strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
1. Life of projected cash flows
2. Sales growth rate
3. Operating profit margin
4. Corporate tax rate
5. Investment in non-current assets
6. Investment in working capital
7. Cost of capital
The majority of a DCF value estimate comes from the "residual value", the worth of the
company at the end of the projection period. That, naturally, depends heavily on the cash
flows estimate in the final year modelled – a result, logically, of the trend in the early years.
67.3 MBO – existing management buys the company from the existing shareholders.
Methods by which management might fund its MBO:
From management's equity
From venture capitalists – via equity and debt
Borrowing from bank(s) – debt

336 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This question had (marginally) the lowest percentage mark on the paper. Most candidates
achieved a "pass" standard in this question.
This was a five-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario was based around a large UK-listed furniture manufacturer. This company was
considering diversifying its operations via the purchase of a controlling interest in a (non-listed)
kitchen manufacturer. Candidates were cast as an employee of the bidding company and given
summarised financial statements and other relevant data of the target company. In the first part,
section (a), for 13 marks, candidates were asked to calculate a range of values for the target
company. These were based on P/E, dividend yield and assets. The first part, section (b), for ten
marks, required candidates to comment on their findings and to summarise the strengths and
weaknesses of the valuation methods employed. In the final section (c) of the first part, for four
marks, candidates were asked to outline two methods by which the bid company could pay for
the target's shares. The second part, for four marks, examined SVA as a valuation method.
Candidates were asked to explain the rationale that underpins SVA. Finally, the third part, also
for four marks, asked candidates to explain the workings of an MBO and the methods by which
the management involved could raise the funding required.
The first part, section (a) was generally done well, but many students scored very low marks and
showed little understanding of the figures given and how to use them for valuation. The most
common errors with the P/E valuation were (i) ignoring the averaging instruction given in the
paper and (ii) using PBIT rather than the earnings figure. Excluding the "outliers" (20X6, 20X9)
was acceptable if explained, but several candidates just did it without explanation and will have
lost marks. The dividend yield calculations were, in general, done well. The most common error
was to multiply the current dividend by 7.7% rather than divide it. The asset values were the
weakest calculations overall because a very large number of candidates used assets and not net
assets. In section (b) the discussion was disappointing. Most candidates did not discuss the three
key issues (purchasing a controlling interest, the variable earnings and the imminent [20Y0]
redemption of debentures). These elements certainly distinguished between good candidates
and those just learning and churning. For section (c) of the first part many answers were poor.
Candidates showed a lack of understanding of the scenario by suggesting a rights issue or a
debenture issue. Also, too many candidates suggested using retained earnings rather than cash.
In the second part, it was felt that SVA has been examined regularly in recent exams and
candidates, as expected, did well here. The most common error was to misunderstand a key
issue of SVA's purpose, namely to establish a PV, not an NPV. Finally, in the third part, most
candidates scored at least three marks out of the (maximum) four that were available.

ICAEW 2020 March 2019 exam answers 337

68 Edencatt Packaging plc
Marking guide

Marks

68.1 (a) Calculation of WACC:

Cost of equity calculation:
Latest dividend 1
Dividend growth rate 1
Ex div market value 1
Cost of equity 1
Cost of preference share calculation 1
Cost of debt calculation:
Cost of redeemable debt cashflows discounted 3
IRR pre-tax 1
IRR post-tax 1
Cost of irredeemable debt 2
WACC: MV of equity  cost equity 1
WACC: MV of preference shares  cost preference shares 1
WACC: MV of redeemable debt  cost redeemable debt 1
WACC: MV of irredeemable debt  cost irredeemable debt 1
16
(b) Calculation of WACC using CAPM:
CAPM 1
WACC calculation 1
2
68.2 Appropriate WACC:
New market ungeared beta 1.5
EP's geared beta 1.5
Calculate cost of equity 1
Calculate cost of debt 1
WACC calculation 1
Explanation 4
10
68.3 Adjusted Present Value (APV):
Explanation of APV 2
Situations when appropriate 3
max 4
68.4 Shareholder wealth maximisation
Main long-term objective is wealth maximisation 0.5
Interaction with other stakeholders 3
Max 3
35

68.1(a) Cost of equity (ke)

Latest dividend (d0) £4.455m/5.5m = £0.81

1/5
Dividend growth rate = £0.0810 = 1.102 over 5 yrs. so 1.102 – 1 = 2% pa
£0.0735

338 Financial Management: Answer Bank ICAEW 2020

 Ex div market value per share = (£9.06 – £0.81) £8.25

Cost of equity (ke)

d1  +g £0.81  1.02 + 2% 12.0%
MV £8.25
d £0.08
Cost of preference shares (kp) 6.5%
MV £1.24
Cost of redeemable debt (kdr)
Year Cash Flow 5% factor PV 10% factor PV
0 (97) 1.000 (97.000) 1.000 (97.000)
1–3 5 2,723 13.615 2.486 12.430 3
100 0.864 86.400 0.751 75.100
NPV 3.015 NPV (9.470)

IRR = 5% + (5%  (3.015/(3.015 + 9.470))) = 6.2%

less: Tax at 17% (6.2%  83%) = 5.1%

Cost of irredeemable debt (kdi)

I– t £6  83% 5.5%
MV £91
WACC
Total MV's
£m £m Cost  weighting WACC
Equity (5.5m  £8.25) 45.375 12.0%  45.375/52.719 10.3%
Preference shares (2m  £1.24) 2.480 6.5%  2.480/52.719 0.03%
Redeemable debt (£2.2m  0.97) 2.134 5.1%  2.134 /52.719 0.02%
Irredeemable debt (£3.0m  0.91) 2.730 5.5%  2.730/52.719 0.03%
7.344 0.08%
Total market value 52.719 11.1%

(b) Cost of equity (ke) using the CAPM

Expected market return 9.8%
less: Expected risk-free return (3.6%)
Expected risk premium 6.2%

Applying EP's beta to the risk premium 1.20  6.2% 7.4%

plus: Expected risk-free return 3.6%
Cost of equity (ke) 11.0%

WACC
Total MV's
£m £m Cost  weighting WACC
Equity (5.5m  £8.25) 45.375 11.0%  45.375/52.719 9.5%
Preference shares (2m  £1.24) 2.480 6.5%  2.480/52.719 0.03%
Redeemable debt (£2.2m  0.97) 2.134 5.1%  2.134 /52.719 0.02%
Irredeemable debt (£3.0m  0.91) 2.730 5.5%  2.730/52.719 0.03%
7.344 0.08%
Total market value 52.719 10.3%

ICAEW 2020 March 2019 exam answers 339

 68.2 New market geared beta = 1.65
(1.65  88) (1.65  88)
New market ungeared beta = 1.48
 88+ 12  83%   97.96

EP's geared beta =


1.48  £45.375m + £2.48m + £4.864  83%   1.70
£45.375m

So, cost of equity = (1.70  6.2%) + 3.60 14.1%

Cost of debt = 8%  83% 6.6%
WACC = (14.1%  45.375m/£52.719m) + (6.6%  £7.344m/£52.719m)) 13.1%

It would be unwise to use the existing WACC as EP's plan involves a degree of
diversification and therefore a change in the level of systematic business risk (beta rises
from 1.20 to 1.70). Thus, a new WACC must be calculated. Systematic risk is accounted for
by taking into account the beta of the glass/paper market and this is then adjusted to
eliminate the financial risk (level of gearing) in that market. The resultant ungeared beta is
then "re-geared" by taking into account the level of gearing of the new funds being raised
which remains the same ie, financial risk for EP is constant. Higher cost of debt because of
the higher systematic business risk.
68.3 Adjusted Present Value (APV)
Increased gearing may lead to a fall in WACC because of the tax shield on loan interest. To
find the new WACC requires the new MV of the company's shares. However, this requires
the NPV of the proposed investment to be known, which needs the new WACC. To avoid
this circular argument one would use APV, which:
1. Calculates a base case value
2. Calculates the PV of the tax shield
3. Adjusts for issue costs
Add 1, 2 and 3 to give APV - if it is positive then proceed with investment.
68.4 The overriding objective of companies is to create long-term wealth for shareholders.
However, this can only be done if we consider the likely behaviour of other stakeholders.
For example:
 Managers will have their own objectives (pay, security, power) which could lead to
agency problems
 Employees/Unions – staff morale and job security are important
 Lenders/Creditors – will they receive their expected returns/settlements?
 Government – a firm should behave legally, pay its taxes on time
 Regulators – a firm should follow the relevant regulations
 Society will be interested in, for example, pollution levels

340 Financial Management: Answer Bank ICAEW 2020

 Examiner's comments:
This question had the second-highest percentage mark on the paper. A good majority of
candidates reached a "pass" standard in the question.
This was a four-part question that tested the candidates' understanding of the financing options
element of the syllabus.
In the scenario a UK-listed packing manufacturer was considering diversifying via the purchase
of the entire share capital of a manufacturer of eco-friendly packaging materials. Candidates
were given data to aid them in preparing informed advice for the bidding company's board.
The first part was worth 18 marks and required candidates to calculate the bid company's
current WACC figure, using (1) the Dividend Growth Model and (2) the CAPM. For ten marks,
the second part asked candidates to determine and explain the appropriate WACC to use when
appraising the purchase of the target company. The third part, for four marks, required
candidates to explain when and how to employ the Adjusted Present Value technique. Finally,
for three marks, the fourth part asked candidates to comment on whether maximisation of
shareholder wealth should be the objective of a company's board.
It was good to see that many candidates scored full marks in section (a) of the first part, ie, 16 out
of 16. Amongst the weaker answers, common errors noted with the cost of equity were: treating
the 20X4 dividend (73.5p/share) as the most recent dividend (20X9); using simple averages for
the annual growth rate rather than a compound average; using g=br instead of the compound
rate – which gave a growth rate way in excess of what really happened; and using four years'
growth years, not five. With the cost of preference shares and irredeemable debt, too many
candidates used only the coupon rate and ignored the market value. Typical errors with the cost
of redeemable debt were using the wrong current market value and/or the wrong discount
factors, incorrect use of NPVs to calculate the IRR and using book, rather than market, value for
the WACC calculation. However, in section (b), a few candidates were unable to calculate the
cost of equity using the CAPM, which was a surprise.
Whilst there were some very good answers to the second part, the average score for it was
approximately 5 out of 10, ie, below pass standard. Too many candidates were unable to de-
gear and re-gear properly, and many calculated a geared beta and/or cost of equity that were
well in excess of reality. Not many candidates calculated the after-tax cost of the new debt and
then the new WACC, which was based (only) on the new debt and the new cost of equity. The
written section of this part was generally poor, even though this topic has been set regularly in
recent examinations.
The third part was answered well and most candidates demonstrated a good understanding of
APV. The fourth part was problematic for many candidates. Most of them answered a different
question to that set, ie, they discussed the errors that could be made in investment appraisal if
the wrong discount rate is used. It would appear that they were seduced by a comment made in
the scenario rather than reading the requirement carefully.

ICAEW 2020 March 2019 exam answers 341

69 Cool Sports Ltd
Marking guide

Marks
69.1 Hedging strategies:
Forward contract spot rate 1
Plus contract discount 0.5
Arrangement fee 0.5
Forward contract sterling amount 0.5
OTC Option – call option 1
Exercise spot 1
Option fee 0.5
Option sterling amount 0.5
Currency future -buy rupees, sell sterling 1
Number of contracts 1
Loss on future 1
Total cost 0.5
Future sterling amount 1
MMH – invest in rupees now 1
Rupees converted at spot rate 1
Sterling cost MMH 1
13
69.2 Advice on hedge:
Current spot 1
3-month spot 1
Summary of hedging outcomes and best outcome 1
Discussion 5
Recommendation 1
9
69.3 Interest rate parity:
State and explain interest rate parity 2
Average UK and US three month rates 1
Average spot rate 1
Calculation of forward rate/average premium 1
5
69.4 Ethics:
1 mark per ethical consideration 3
3
30

69.1 (1) Forward contract

R
Spot rate 91.07
plus: Forward contract discount 0.62
91.69

£
Translation of rupees R145m/91.69 (1,581,416)
plus: Arrangement fee R145m/1m  £95 (13,775)
(£1,595,191)

342 Financial Management: Answer Bank ICAEW 2020

 (2) OTC Option
CS will buy rupees so it's a call option
Exercise at 94.25 (vs. spot @ 92.45)
Purchases of rupees R145m/94.25 (1,538,462)
plus: Option fee R145m/1m  £250 (36,250)
(£1,574,712)

(3) Currency futures

Buy rupees. Sell £.
R145m 1,574,034
No of contracts 25.2 contracts
92.12 62,500

Say 25 contracts
At 31/5/19 Buy (92.88)
Sell 92.12
Loss on futures (0.76)  25  62,500 R1,187,500
Contract price R145,000,000
Total R146,187,500

Converted at spot rate on 31/5/19 R146,187,500 (£1,581,260)

92.45

(4) Money Market Hedge

R145m R145m
Invest in rupees now R142,857,100
1+ 6% / 4  1.015

R142,857,100
Convert at spot rate (£1,568,652)
91.07
Sterling borrowed at 3.8% pa (£1,568,652)  [1 + (3.8%/4)] (£1,583,554)

69.2 Current spot At spot rate 1/3/19 R145m

91.07 (1,592.182)

R145m
3-month spot At spot rate 31/5/19 (1,568.415)
92.45
SUMMARY STERLING COSTS £
3-month spot (1,568.415)
Option (1,574.712)
Future (1,581,260)
MMH (1,583.554)
Current spot (1,592.182)
Forward contract (FC) (1,595.191)
From these figures, no hedge looks the cheapest option. The option is cheapest hedge.
MMH, futures & FC will give fixed amounts. Option allows upside but expensive premium.
Other general comments re various methods.
What is the management's attitude to risk?

ICAEW 2020 March 2019 exam answers 343

 The forward discount suggests that the rupee should lose value. This would be good news
for CS as an importer (strengthening sterling).
69.3

Av rupee rate 3 mos.

Av spot rate  = Av f'wd rate = Av discount given in question
Av sterling rate 3 mos.

1.01600
91.48  = 92.18 0.70 OK
1.00825

Theory IRP links currency & money markets (MM).

M interest rates explain difference between forward and spot rates
No gain can be made on interest rates of different currencies
69.4 An ICAEW accountant should behave with integrity and s/he should behave in a
professional manner. With this in mind an ethical employment policy is needed and it could
include:
 Commitment to work within the rules and regulations of the Indian government
 No forced labour
 No child labour
 Employees should have the right to join a trade union
 Employees should receive a living wage in cash
 Reasonable working hours
 Employees should have an employment contract
 Employees should have equal opportunities
 Health and Safety standards should be in line with regulations

Examiner's comments:
This question had the highest average mark on the paper and a large majority of the candidates
achieved a "pass" standard.
This was a four-part question which tested the candidates' understanding of the risk
management element of the syllabus and there was also a small section with an ethics element
to it.
The company in this question was a UK retailer of sportswear. It imports goods from suppliers in
Europe and India. The company's board was planning to increase the proportion of its imports
that originate in India. As a result, the board was considering whether to (1) hedge against
exchange rate movements on Indian imports and (2) establish a production facility in India.
Candidates were cast as an employee in the company's finance team. In the first part, for 13
marks, candidates were instructed to calculate, using four different hedging instruments, the
sterling cost of a large consignment of Indian goods. The second part, for nine marks, required
candidates to advise the company's board whether to hedge the consignment. In the third part,
for five marks, candidates were asked to explain the principle of interest rate parity and, using
data given in the scenario, to show how it works. The fourth part was worth three marks. Here,
candidates were required to outline the main elements of an ethical employment policy that the
company could adopt were it to open a production facility in India.
In the first part, many candidates scored full marks and showed a really good understanding of
the various hedging techniques involved. Typical errors within the weaker answers were:
deducting, rather than adding, the forward rate discount; deducting, rather than adding, the
arrangement fees; not identifying the option/futures correctly, ie, put/sell; the futures loss (or
gain) was shown in £ and not rupees. The second part was done well by many candidates, but a
lot of answers were too general. So there was discussion of the strengths/weaknesses of various

344 Financial Management: Answer Bank ICAEW 2020

 hedging techniques, but little advice given that related to the scenario. In the third part, a good
number of candidates were able to explain IRP and demonstrate it working from the data given.
Key reasons for lower scores here were weak definitions of IRP and using 12-month averages
rather than three months. The fourth part was, in general, answered well.

ICAEW 2020 March 2019 exam answers 345

 June 2019 exam answers
70 Optical Answers plc
Marking guide

Marks
70.1 (a) NPV calculation:
Contribution 3
Selling and admin costs 0.5
Fixed costs 0.5
Rent 1
Tax 1
Plant purchase price 0.5
Plant proceeds 0.5
Taxed saved on CAs 2
Working capital 2
NPV 1
Ignoring market research 0.5
Ignoring centrally allocated fixed costs 0.5
Accept project conclusion 1
Calculation of discount factor 1
15
(b) Sensitivity
Contribution before tax 1
Contribution after tax 1
10% discount factors 0.5
Sensitivity percentage 0.5
Comment 1
4
(c) Options:
2 marks each for the first two identified. Only 1 mark if not
related to the scenario 2
Max 4
(d) Shareholder Value Added (SVA):
Seven value drivers 2
Explanation of how used 2
Max 3
70.2 (a) Captial rationing
Trial and error approach needed 1
Exclude project D 0.5
Possible combinations 1.5
Optimal combination C and E 1

(b) Type of capital rationing 4

Definition of hard capital rationing 1
Definition of soft capital rationing 1
Explanation that soft capital rationing is being used here 1
2 35

346 Financial Management: Answer Bank ICAEW 2020

 70.1 (a)

0 1 2 3
£000s £000s £000s £000s
Sales 2220.00 2057.94 1907.71
Contribution 70% 1554.00 1440.56 1335.40

Selling and admin (100.00) (102.50) (105.06)

Fixed costs (40) (41) (42.03)
Rent (50.00) (50.00) (50.00)
Operating cash flows (50.00) 1364.00 1247.06 1188.31
Tax 17% 8.50 (231.88) (212.00) (202.01)

After tax operating cash flows (41.50) 1132.12 1035.06 986.30

Plant and equipment (2000.00) 200.00

Tax saved on CAs 61.20 50.18 41.15 153.47

Working Capital (250.00) 18.25 16.92 214.83

Net cash flows (2230.30) 1200.55 1093.13 1554.60

PV factors at 10% 1.00 0.909 0.826 0.751

Present value (2230.30) 1091.30 902.93 1167.50

NPV 931.43
Market research should be ignored since it is a sunk cost. 50% of fixed costs should be
ignored since they are centrally allocated.
The project should be accepted since it has positive NPV, which will increase
shareholder's wealth.
Discount factor (1.07  1.025) – 1 = 9.7% Round to 10%
Sales
Year 1 18.5  10  12 = 2220
Year 2 2220  1.03  0.90 = 2057.94
Year 3 2057.94  1.03  0.90 = 1907.71
Working capital
Year 1 250  1.03  0.9 = 231.75 Increment 18.25
Year 2 231.75  1.03  0.9 = 214.83 Increment 16.92
Year 3 214.83.

ICAEW 2020 June 2019 exam answers 347

 Capital allowances and the tax saved
Cost/WDV CA Tax
£000s £000s £000s
2000.00 360.00 61.20
1640.00 295.20 50.18
1344.80 242.06 41.15
1102.74
(200) 902.74 153.47
(b)
Sensitivity
£000s £000s £000s
Contribution 1554.00 1440.56 1335.40

Contribution X (1 – 0.17) 1289.82 1195.66 1108.38

PV factors at 10% 0.909 0.826 0.751

Present Value 1172.45 987.62 832.39

Total present value 2992.46

Sensitivity 931.43/2992.46 31.13%

A fall in sales from £2220 million to: 2220 (1 – 0.3113) = £1529.01 million. OA will have
to consider whether this is an acceptable risk. 31% is a large change so not that
sensitive to volume changes.
(c) Timing options. The option to delay the project and see whether the competitor does
launch a similar product to Handyspecs.
Follow on options; producing Handyspecs could give OA the opportunity to produce a
similar product at the end of the product life cycle of three years, particularly if the
competitor does not enter the market or does but fails. (Mention of Growth options
also acceptable.)
Abandonment options. If sales decline more than expected eg, because the
competitor enters the market, OA has the option to abandon the project.
(d) SVA is useful to highlight the key drivers of value, namely: Cost of capital; Life of
projected cash flows; Sales growth rate; Investment in working capital; Investment in
non-current assets; Corporation tax rate; Operating profit margin. This enables
managers to set targets of achieving value-enhancing strategies in each area. It helps
to focus managers on value enhancement to ensure that shareholder's wealth is the
primary objective.
70.2 (a) Since the projects are indivisible, the combination that will maximise shareholder
wealth will have to be identified by trial and error.
Project D should not be considered since it has a negative NPV.
The possible combinations are:
Projects Cost £m NPV £m
ABC 2+4+3=9 0.5 + 1.5 + 1 = 3
AE 2 + 6.5 = 8.5 0.5 + 2.5 = 3
CE 3 + 6.5 = 9.5 1 + 2.5 = 3.5
B and E is not possible since the expenditure exceeds £10 million.

348 Financial Management: Answer Bank ICAEW 2020

 (b) Hard rationing is where external capital markets limit the supply of funds to a company.
Soft rationing is where internally the firm imposes its own constraints on the amount of
funds raised and used to finance projects.
Since OA has no difficulty in raising funds on the capital markets, the company is
applying soft capital rationing. However, this might not maximise shareholder's wealth
since all projects except D have positive NPVs and should be accepted. The limit of
£10 million also excludes the combination of projects B and E that would cost £10.5
million and produce the highest combined NPV of £4 million.

Examiner's comments:
This was a six-part question, which tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario of the question was that a company is launching a new product onto the market.
Note: Some candidates were not showing workings, which is bad practice and is explicitly
warned against in the CBE software.
Most of the attempts at the first part were good, however, common errors were: not stating why
the research costs should be ignored ie, that they are sunk costs; not stating the reason why 50%
of the fixed costs should be ignored ie, that they are centrally allocated; inflating cash flows
when it is stated that they remain constant; incorrect timing of cash flows; inflating the net cash
flows by the general level of inflation; not using the Fisher formulae to calculate the nominal cost
of capital and merely adding the general level of inflation to the real cost of capital; discounting
money net cash flows by the real cost of capital.
In part the second part, some candidates attempted to calculate sensitivity using units (rather
than £ contribution), going as far as taxing them and discounting them. This is an error that has
appeared in recent examination diets. Other common errors were: calculating sensitivity using
sales rather than contribution; ignoring tax; inverting the sensitivity calculation; inadequate
narrative and not stating whether the project is or is not sensitive to changes in volume.
The third part was quite poorly answered, with many candidates not referring to the scenario of
the question and just giving generic answers.
The fourth part was also quite poorly answered with many candidates outlining company
valuation rather than project appraisal and referencing to the scenario of the question.
There were some good answers to the fifth part, however, many candidates assumed,
incorrectly, that the projects were divisible despite an explicit statement that they were
indivisible. Some candidates allocated projects to the capital budget using NPV per £ invested,
instead of trial and error.
In the final part there were some good answers; however, poorer candidates clearly had not
revised this topic and confused hard and soft rationing with indivisible and divisible projects.

ICAEW 2020 June 2019 exam answers 349

71 Stable plc
Marking guide

Marks

71.1 Calculation of cost of equity:

Ignoring special dividends 0.5
Dividend per share 0.5
Growth rate 1
Cost of equity using Gordon growth model 1
Cost of equity using CAPM 1
4
71.2 Calculation of WACC before diversification:
Market value equity 1
Market value debt 1
Redemption yield of current debentures 2
Calculate cost of debt 1
Calculation of WACC 1
6
71.3 Calculation of WACC to reflect risk of diversification
De-gear Exito's beta equity 1.5
Re-gear using Stable's gearing 1.5
Calculate cost of equity 1
Calculate WACC 1
Explanation of different WACC figures 3
8
71.4 Issue of new debentures
Use pre-tax redemption yield of Stable – 3.98% (full marks if
used 4%) 0.5
Annuity factor and 5 year PV factor 1
Issue price 1.5
Nominal value required 1
Explanation 2
6
71.5 Dividend policy
Theoretical considerations 3
Practical considerations 4
Conclusions 1
8
71.6 Ethical and legal issues
Insider trading 2
Integrity 1
3

35

350 Financial Management: Answer Bank ICAEW 2020

 71.1 Ignoring the special dividends
Number of shares in issue £40/£0.10 = 400m
Dividends per share 2019 £48/400 = 12p
(1/3)
Growth (48/43) = 3.74%
Ke using Gordon growth model = (12(1.0374))/405) + .0374 = 6.81%
Ke using CAPM = 2 + 0.5  5 = 4.5%
71.2 Market values:
Equity 400m x 405p = £1620m
Debt:
The ex-interest price of the debentures is £104 (109 – 5)
The market value of the debt = £410.8m (395  1.04)
The redemption yield of the current debentures can be calculated as follows:
Timing Cash flow Factors at 1% Pv Factors at 5% Pv
£ £ £
0 (104) (104.00) (104.00)
1–4 5 3.902 19.51 3.546 17.73
4 100 0.961 96.10 0.823 82.30
11.61 (3.97)
Redemption yield = 1 + (11.61/(11.61 + 3.97))  4 = 3.98%
Kd = 3.98 (1 – 0.17) = 3.30%
WACC = (4.5 x 1620 + 3.3 x 410.8)/(1620 + 410.80) = 4.26%
71.3 De-gear Exito's beta equity:
1.2 = Ba (1+ (40  0.83)/60)). Ba = 0.773.
Re-gear using Stable's gearing:
Be = 0.773 (1 + (410.8  0.83)/1620). Be = 0.936.
Ke = 2 + 0.936  5 = 6.681%
WACC = (6.68  1620 + 3.3  410.80)/(1620 + 410.80) = 6%
Stable's current WACC is 4.26% and the WACC used to calculate the PV of the free cash
flows of Exito is 6%. The increase in the WACC, from 4.26%, reflects the increase in the
systematic business risk of Exito. This is reflected in the higher Be of 0.942 compared to
Stable's Be of 0.50 at the same level of financial (gearing) risk.
71.4 Using Stable's pre-tax redemption yield of 3.98% (full marks if 4% used):
The annuity factor at 3.98% for 5 years = 4.454.
The year five pv factor at 3.98% = 0.823.
The issue price = 3  4.454 + 100  0.823 = £95.66.
The total nominal value that will have to be issued to raise £80 million = £83.63m
(80/0.9566)
Using the redemption yield on Stable's existing debentures is not likely to be correct since
they have a higher coupon than the new debentures and a redemption date one year
earlier than the new debentures.

ICAEW 2020 June 2019 exam answers 351

 71.5 Theoretical considerations: Candidates will be given marks for an understanding of M & M's
theory of the irrelevancy of dividend policy.
For practical considerations candidates should mention and expand on: Traditional
theory/resolution of uncertainty; signalling; the clientele affect; preference for current
income; taxation; cash.
Conclusion: For practical considerations it would not be appropriate for Stable to miss
paying a dividend to fund the purchase of Exito. The finance should be raised from debt
and equity sources.
71.6 Acting on the sales director's suggestion would be insider trading and illegal, so don't!.
The finance director should act with integrity and display professional behaviour with
regard to the suggestion made by the sales director and he should advise him and the
board accordingly.

Examiner's comments:
This was a six-part question that tested the candidates' understanding of the financing options
element of the syllabus.
The scenario of the question is that a company is raising finance to fund a diversification.
Note: Some candidates were not showing workings, which is bad practice and is explicitly
warned against in the CBE software.
The first part has been examined many times before and there are many adequate examples in
the learning materials. However, this part of the question was not well answered and common
errors were: not stating that the special dividend should be ignored when calculating growth
from past dividends; calculating growth from past dividends and using the 4th root rather than
the 3rd root; inverting the growth computation; confusion of digits between £ and pence;
incorrect dividend per shares calculations; poor maths eg, many expressed an answer which
should have been 34% based on their figures as 3.4%.
Answers to the second part of the question were often weak. Common errors were: incorrect
market value computations; when calculating the IRR of the debentures: using the cum interest
price, incorrect number of years to maturity, incorrect coupon, incorrect computations with two
negative NPVs, incorrect IRR computation and omitting tax; when using the CAPM for ke,
deducting the risk free rate from the market risk premium.
In the third part the answers were disappointing. Common errors were: inadequate narrative on
why Exito's equity beta should be used; incorrect computations when degearing the equity
beta, in some cases ending up with a higher asset beta than the equity beta; degearing Stable's
equity beta; regearing; attempting to use book values when regearing the asset beta; using
clearly impossible equity betas in the CAPM.
The fourth part has been examined many times and there were some disappointing responses,
common errors were: using Stables post tax cost of debt as the discount rate; using the coupon
rate to calculate the issue price; attempting to calculate a YTM computation for the new
debentures; incorrect computations of the total nominal value; unclear explanations of the
appropriateness of using the YTM from the existing debentures to price the new debentures.
The fifth part was well answered by many candidates. However, common errors were: brief
explanation of the theory; few practical considerations; no conclusion.
In the final there were many good answers, but poorer candidates did not discuss the legal
implications.

352 Financial Management: Answer Bank ICAEW 2020

72 Technical Equipment Ltd
Marking guide

Marks
72.1 Hedging strategies:
Forward contract spot rate 1
Plus contract discount 0.5
Sterling receipt 0.5
Money market hedge – borrow in $ 1
Buy £ 1
Total receipt with interest on deposit 1
Buy September futures 1
Number of contracts 1
Gain per £ 1
Total gain 1
Total receipt 1
Put option to sell $ 1
Premium 1
Premium plus interest foregone 1
Exercise option if spot $1.3220 1
Receipt 1
15
72.2 Discussion of hedging instruments:
Forwards 2
Money Market hedge 2
Currency futures 2
OTC currency options 2
Advice – summary of receipts 1
Conclusion 2
Max 9
72.3 Economic risk:
Definition 2
Long term trend example 2
Ways to mitigate risk (1 mark per point) 4
Max 6
30

72.1 Forward contract:

The forward rate is: $/£ 1.3214 (1.3159 + 0.0055)
The sterling receipt is: $6,000,000/$1.3214 = £4,540639
Money market hedge:
Borrow in $ against the receipt. Borrow: $6,000,000/(1 + 0.062  3/12)= $5,908,419
Buy £ spot: $5,908,419/$1.3159 = £4,490,021
Total receipt with interest on deposit: £4,490,021  (1 + 0.044  3/12) = £4,539,412.
Currency futures:
Buy September futures on 30 June.
The number of contracts: $6,000,000/$1.3200/£62,500 = 72.73. Round to 73.

ICAEW 2020 June 2019 exam answers 353

 Close out the contracts on 30 September.
Gain per £ = 1.3206 – 1.3200 = $0.0006.
Total gain: $0.0006  73  £62,500 = $2,737.5
Total receipt: $6,000,000 + $2,737.5/$1.3220 = £4,540,649.
OTC currency options:
Put options to sell $ with and exercise price of $1.3210.
The premium will be: $6,000,000  £0.04 = £240,000.
The premium plus interest foregone will be: £240,000  (1 + 0.0440  3/12) = £242,640.
If the spot is $1.3220 on 30 September, we would exercise the options.
The receipt will be: $6,000,000/$1.3210 – £242,640 = £4,299,374.
72.2 The forward contract, money market hedge and futures contracts lock TE into an exchange
rate and do not allow for upside potential.
Forwards:
 Tailored specifically for TE
 However, there is no secondary market
Money Market:
 Tailored specifically for TE
 In the case of a receipts, accelerates receiving the home currency
 However, there is no secondary market and it may use up credit lines
Currency futures:
 Not tailored so one has to round the number of contracts
 Basis risk is an issue
 Requires a margin to be deposited at the exchange
 Need for liquidity if margin calls are made
 However, there is a secondary market
OTC currency options:
 The options are expensive
 There is no secondary market
 However, the options allow TE to exploit upside potential and protect downside risk
Advice:
 Without hedging the sterling receipt would be £4,538,578
 Forward contract: £4,540,639
 Money market: £4,539,412
 Futures: £4,540,649
 OTC options: £4,299,374
The forward contract, money market hedge and futures are not materially different.
TE has surplus funds so there is no need to accelerate receiving £. With currency futures
there is basis risk and rounding the number of contracts. The OTC option allows for upside
potential, but it is expensive. Therefore, the forward contract is recommended. Also, TE's
attitude to risk can be mentioned by candidates. Candidates may mention that not hedging
gives a very similar result and opt for that alternative, however the future spot rate is only an
estimate and the forward rate indicates that the market shows that the $ is weakening
against the £. Therefore, a strategy of not hedging is not recommended for an exporter.
(Alternative supported conclusions to the advice are awarded marks.)

354 Financial Management: Answer Bank ICAEW 2020

 72.3 Economic risk is the risk that longer-term exchange rate movements might reduce the
international competitiveness of a company. It is the risk that adverse exchange rate
movements might reduce the present value of a company's future cash flows.
TE is an importer and exporter. It buys its products in euros, exports to the USA and
receives payment in dollars.
If, over a period of several years, the pound appreciates against the dollar and depreciates
against the euro, the sterling value of TE's income will fall and its cash flows decline.
Points that can be mentioned to mitigate economic exposure include:
 Diversify operations world-wide both for purchasing raw materials and selling its
products.
 Market and promotional management, the company must carefully decide in which
markets to operate.
 Product management, economic exposure may mean high-risk product decisions.
 Pricing strategy must respond to the risk of fluctuations in exchange rates.
 Production management, economic exposure may influence the supply and location of
production.

Examiner's comments
This was a three-part question that tested the candidates' understanding of the risk
management element of the syllabus.
The scenario of the question is that a company is importing goods from the Eurozone and
exporting them to the USA.
Note: Some candidates were not showing workings, which is bad practice and is explicitly
warned against in the CBE software.
Responses to the first part of the question were mainly good, but common errors were: for the
forward contract using the incorrect exchange rate and deducting instead of adding the forward
discount; for the money market hedge choosing the incorrect interest rates, incorrect
apportionment of the annual interest and using the incorrect spot rate; for the futures, using the
spot rate rather than the futures price to calculate the number of contracts, treating the gain on
futures as £ rather than $, closing out the contracts using the future spot price rather than the
futures price; for the OTC option choosing the call rather than the put, not taking account of the
interest on the option premium, treating the OTC option as a traded option and incorrect
exercise or abandon decisions.
There were some good responses to the second part but some of the errors that poorer
candidates made include: just stating advantages and disadvantages; not showing the result of
not hedging; not considering the direction of currencies shown by the forward discount; no
recommendation.
Responses to the last part of the question were poor with quite a lot of candidates showing a
lack of understanding of what economic risk is and how it might be reduced despite this being
tested in many recent papers.

ICAEW 2020 June 2019 exam answers 355

 September 2019 exam answers
73 Hodder Specialist Engineering Ltd
Marking guide

Marks
73.1 (a) NPV annual income:
Machinery 1
Tax saved via CA's 2
Labour/materials 2
Fixed costs 2
Sales income 1
Tax on profit 1
Working capital 4
Discount factors 1
NPV 1
Ignore depreciation 1
Ignore interest 1
Decision and reason 1
18
(b) NPV one off income:
Sales income 1
Tax on profit 1
NPV 1
Decision 1
4
Max 22
73.2 Sensitivity analysis and simulation
Explain strengths and weaknesses of sensitivity analysis Max 3
Explain strengths and weaknesses of simulation Max 3
Max 5
73.3 Real options
Definition 1
Example 2

3
73.4 Risks
Overseas trading risks 2
Political risks 2
Cultural risks 2
Max 5

35

356 Financial Management: Answer Bank ICAEW 2020

 73.1 (a)
20X9 20Y0 20Y1 20Y2
£'000 £'000 £'000 £'000
Machinery (1,200.000) 140.000
Tax saved via CA's (W1) 36.720 30.110 24.691 88.679
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Sales income 550.000 550.000 550.000
Tax on profit (W4) (59.340) (58.657) (57.960)
Working Capital (W5) (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) 313.730 304.750 574.085
Discount factors 1.000 0.917 0.841 0.772
PV (1,213.280) 287.691 256.295 443.194
NPV – Decision (a) (226.100)

Ignore depreciation as it's not a cash flow

Ignore interest cost as it's in discount rate (WACC)
Decision (a) – do not invest. NPV is negative. Shareholder wealth would decline.
(b)
20X9 20Y0 20Y1 20Y2
Machinery (1,200.000) 140.000
Tax saved via CA's 36.720 30.110 24.691 88.679
Labour/Materials (165.240) (168.545) (171.916)
Fixed costs (35.700) (36.414) (37.142)
Sales income 1,900.000
Tax on profit (W6) 34.160 34.843 (287.460)
WC (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) (142.770) (151.749) 1,694.585
1.000 0.917 0.841 0.772
PV (1,213.280) (130.920) (127.621) 1,308.220
NPV – Decision (b) (163.601)

Alternative presentation for Decision (b) with changes from original NPV:
20X9 20Y0 20Y1 20Y2
£'000 £'000 £'000 £'000
Change in annual income (550.000) (550.000) 1,350.000
  
less: Tax at 17% 0.830 0.830 0.830
  
Discounted at 9% 0.917 0.841 0.772
PV change (418.611) (383.917) 865.030
Overall change to NPV 62.499
NPV in (a) (226.100)
Amended NPV (163.601)

Decision (b) – do not invest. NPV is still negative. Shareholder wealth would decline.

ICAEW 2020 September 2019 exam answers 357

 WORKINGS
W1 20X9 20Y0 20Y1 20Y2
£'000 £'000 £'000 £'000
Machinery cost/WDV b/f 1,200.000 984.000 806.880 661.640
WDA @ 18% (216.000) (177.120) (145.238) (521.642)
WDV/Sale proceeds 984.000 806.880 661.640 140.000

WDA  17% 36.720 30.110 24.691 88.679

W2 20Y0 20Y1 20Y2

£'000 £'000 £'000
Labour and materials costs (162.000) (165.240) (168.545)
Inflated at 2%  1.02  1.02  1.02
Money cash flow (165.240) (168.545) (171.916)

W3 20Y0 20Y1 20Y2

£'000 £'000 £'000
Fixed costs (35.000) (35.700) (36.414)
Inflated at 2%  1.02  1.02  1.02
Money cash flow (35.700) (36.414) (37.142)

W4 20Y0 20Y1 20Y2

£'000 £'000 £'000
Sales income 550.000 550.000 550.000
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Profit 349.060 345.041 340.942

Tax on profit at 17% (59.340) (58.657) (57.960)

W5 20X9 20Y0 20Y1 20Y2

£'000 £'000 £'000 £'000
Working capital investment 50.000 5.000 5.000
Total Working Capital (WC) 50.000 55.000 60.000
 1.00  1.02  (1.02)2
Total WC (inflated) 50.000 56.100 62.424
(50.000) (6.100) (6.324) 62.424

W6 20Y0 20Y1 20Y2

£'000 £'000 £'000
Sales income 0.000 0.000 1,900.000
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Profit (200.940) (204.959) 1,690.942

Tax on profit at 17% 34.160 34.843 (287.460)

358 Financial Management: Answer Bank ICAEW 2020

 73.2 Sensitivity analysis
 It facilitates subjective judgment (by management for example).
 It identifies areas critical to the success of a project, eg, sales volume, materials price.
 It is relatively straightforward.
But
 It assumes that changes to variables can be made independently.
 It ignores probability.
 It does not point to a correct decision.
Simulation
 More than one variable at a time can be changed.
 It takes probabilities into account.
But
 It is not a technique for making a decision.
 It can be time consuming and expensive.
 Certain assumptions that need to be made could be unreliable.
73.3 NPV analysis only considers cash flows related directly to a project. However, a project with
a negative (or low) NPV could be accepted for strategic reasons. This is because of (real)
options associated with a project that outweigh the poor NPV.
Follow-on option. Initial NPV is negative, but future contracts could be profitable.
73.4 There will be risks trading overseas - local finance costs, tax systems, dividend restrictions.
Also, there are political risks, eg, import quotas, tariffs, nationalisation, minimum
shareholding for local residents. Finally, there could be cultural risk – business practices and
social mores may be very different.

Examiner's comments:
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a "pass" standard in this question.
This was a four-part question that tested the candidates' understanding of the investment
decisions element of the syllabus.
The scenario was based around a UK engineering company, which provides a powder-coating
service for UK customers in the consumer goods sector. This company was considering
diversifying its operations via a three-year contract with DCL, a UK car manufacturer. An
alternative plan was to expand its existing market into India and China. Candidates were cast as
an employee in the company's finance team and were given relevant data. In the first part, for
22 marks, candidates were required to prepare NPV calculations for the DCL proposal. This
would enable them to advise the company's board whether it was worth proceeding with the
contract. In the second part, for five marks, candidates had to compare the strengths and
weaknesses of sensitivity analysis and simulation as methods of assessing the risk of the DCL
proposal. In the third part, for three marks, candidates were asked to explain real options and to
identify a real option that could apply to the DCL scenario. The final part, for five marks, asked
candidates to outline the potential risks that the company could face were it to expand its
existing operations into China and India.
Most candidates scored well on the NPV calculation. Errors made by weaker candidates
included inflating sales figures already given in money terms and inflating costs a year too
early/late. In addition, many candidates included interest costs when they were covered by the
WACC and included depreciation which isn't a cashflow. Regarding the tax charge, a common
error made was the taxing of capital and working capital flows. Some candidates started WDAs a
year too late. The working capital calculation was difficult, and many candidates inflated the

ICAEW 2020 September 2019 exam answers 359

 working capital increments rather than the balances. Finally, some candidates inflated the
discount rate, which was already given in money terms.
In part two, reasonable marks were earned by most candidates, as expected. Weaker candidates
were too brief and often excluded comments on probability.
In part three, it was observed that candidates continue to be poor at defining what is meant by
'real options' despite the number of times this has been examined in recent exams. There was a
clear requirement for the identification of one option that could apply in the scenario. Weaker
candidates gave two or more or picked an inappropriate one such as abandonment or delay.
The final part was generally well done.

74 Jackett Clarke Travel plc

Marking guide

Marks

74.1 Forecast income statement:

Sales 1
Variable costs 1
Fixed costs 1
Interest (½ mark for rights issue and 1½ marks for debt issue) 2
Tax 1
Dividends (2 marks for rights issue and 1 mark for debt issue) 3
9
74.2 EPS and gearing ratio:
EPS calculation (1 mark for rights issue and 1 mark for debt issue) 2
Gearing ratio (1½ marks for rights issue and 1½ marks for debt issue) 3
5
74.3 Debt vs Equity discussion:
Current EPS 1
Current gearing 1
Discussion of issues 5
7
74.4 TERPS
Calculation 2
Reasons for differences between the theoretical and actual ex-right price 4
6
74.5 Efficient market theories
Chartist approach 1
Explanation of EMH 4
5
74.6 Ethics
Insider trading is illegal 1
Explanation of ICAEW ethical principles (integrity, objectivity,
professional behaviour) 2
3
35

360 Financial Management: Answer Bank ICAEW 2020

 74.1 Stewart – Income Statement for the year to 30 September 20Y0
Rights issue Debt issue
£'000 £'000
Sales 52,200 52,200
Variable costs (28,710) (28,710)
Fixed costs (11,000) (11,000)
Profit before interest and tax 12,490 12,490
Interest (W1) (805) (1,155)
Profit before tax 11,685 11,335
Taxation (17%) (1,986) (1,927)
Profit after tax 9,699 9,408
Dividends paid (W2) (3,000) (2,400)
Retained profit 6,699 7,008

WORKINGS
W1 Rights Debt
£'000 £'000
Current interest cost 805 805
Extra interest cost (£7m  5%) 0 350
Total interest cost 805 1,155

W2 £'000 £'000
Current dividend (16m  £0.15) 2,400 2,400
Extra dividend ([16m/4]  £0.15) 600 0
Total dividend 3,000 2,400

74.2
Rights Debt
£'000 £'000
Earnings per share £9,699/20,000 £0.485
£9,408/16,000 £0.588
Current debt 11,500 11,500
Extra debt 0 7,000
New total debt 11,500 18,500

Current long-term funds 36,250 36,250

Extra funds raised 7,000 7,000
Retained profit 20Y0 6,699 7,008
Current long-term funds 20Y0 49,949 50,258

Gearing ratio £11,500/£49,949 23.0%

£18,500/£50,258 36.8%

74.3
Current EPS £7,694/16,000 £0.481
Current gearing £11,500/£36,250 31.7%

ICAEW 2020 September 2019 exam answers 361

 Other points for consideration by shareholders:
 The EPS will be higher with an issue of debt, but gearing will be higher as well, which
increases financial risk.
 Interest cover (currently 12.5 [£10,075/£805]) will be lower if the debt issue is chosen
(10.8), but it will increase with a rights issue (15.5). In both cases the cover figure is
sufficient.
 A rights issue could lead to a dilution of control for the shareholders.
 An issue of debt issue could give a tax shield advantage.
 An equity issue would be more expensive.
 The existing debt is due to be repaid 20Y1 – this has cash flow implications for the
company in the near future.
 The board's attitude to risk is important.
74.4
Current market capitalisation 16,000 £2.58 £41,280
Rights issue 4,000 £1.75 £7,000
Totals 20,000 £2.41 £48,280
So theoretical ex-rights price = £2.41
Reasons for differences between the theoretical and the actual ex-rights market price:
 The project NPV is not included in the ex-rights price
 Information released by Jackett regarding the use of funds raised
 Additional information re Jackett or the market
 Market expectations regarding the expansion
 Level of take up of rights issue
 General market conditions
 Events (macro) – eg, interest rates
 Events (micro) – eg, new managers at the company
 Events (industry) – eg, takeovers
 A rights issue might give a negative signal and a lowering of the market value
 Level of market efficiency
74.5 Michael Ayres is, wrongly, proposing a Chartist approach to share prices. He is assuming
that the market is not efficient at all and that prices follow pre-set patterns.
The Efficient Market Hypothesis (EMH) posits that there are no patterns to share prices.
Markets have no memory. Past prices have no influence on future prices. Efficiency means
that shares cannot be bought cheaply and then sold quickly at a profit. Share prices are
"fair" and investment returns are those expected for the risks undertaken. When share
prices, at all times, rationally reflect all available information, the market in which they are
traded is said to be efficient. In efficient markets investors cannot make consistently above-
average returns other than by chance.
There are three levels of market efficiency: weak form, semi strong form and strong form.
Behavioural finance is an alternative view to the EMH. This considers investors' irrational
tendencies, leading to a weakening of market efficiency.
74.6 Legal – this is insider trading so is illegal.
Ethics - you are an ICAEW Chartered Accountant. The ICAEW's ethical guidance includes:
 A member should behave with integrity – ie, be honest and truthful. The member's
advice and work should not be influenced by the interests of other parties.

362 Financial Management: Answer Bank ICAEW 2020

  A member should strive for objectivity in all professional and business judgements –
ie, there should be no bias, conflict of interest or undue influence of others.
 A member should behave professionally – ie, avoid any action that discredits the
profession.
Ann Baker's request would be counter to all three of these elements of the ethical guidance.

Examiner's comments:
This question had the lowest percentage mark on the paper. A considerable proportion of
candidates scored less than a pass mark (55%) in this question.
This was a six-part question that tested the candidates' understanding of the investment
decisions element of the syllabus and there was also a small section with an ethics element to it.
In the scenario, the candidate (an ICAEW Chartered Accountant) was employed in the finance
team of Jackett, a UK-listed travel agency and tour operator. Currently, Jackett arranges flights
and package holidays in Europe and North America. The company's board was keen to explore
the implications of expanding its operations into South East Asia and Australia. This would cost
an initial £7 million, to be raised via a rights issue or a debenture issue. Jackett's board had
commissioned a market research report. Candidates were given the key financial implications
noted in the report.
The first part was worth nine marks and required candidates to calculate the next year's profit
figures under the two alternative funding methods. Using these figures, candidates were required
in the second part, for five marks, to calculate the amended earnings per share figures and
gearing ratios. The third part was worth seven marks. It asked candidates to make use of their
calculations and discuss the implications for Jackett's shareholders of the company using equity
or debt to raise the £7 million required. For six marks, the fourth part required candidates to:
calculate the theoretical ex-rights price that would arise with the equity issue; and, explain why
this might be different to the actual ex-rights price. The fifth part was worth five marks and it
tested, via the scenario, candidates' understanding of the efficient market theory. Finally, for three
marks, the sixth part tested, via the scenario, candidates' understanding of ethical guidance.
In the first part many candidates scored full marks (nine). Weaker candidates failed to calculate
the extra interest (new debt) correctly – this was simply 5% of £7 million. Also, with the dividend
calculation, a common failing was the maintenance of a constant payout ratio rather than
dividend per share as specified in the question.
There were very mixed responses to the second part. A small minority of candidates continue to
calculate EPS using retained earnings. Many candidates could not calculate the gearing ratios
correctly. Errors included: the use of market values when book values were required; using
debt/equity when debt/debt+equity was specified; not including the share premium account
when issuing new shares; and, not including retained earnings in the equity book value.
The third part was, overall, disappointing, as most candidates did not calculate the current year
EPS and gearing, and so had nothing meaningful to compare their figures with. A significant
number of candidates wasted time going through the M&M and traditional capital structure
theories when they were not required.
In part four, most candidates could calculate the theoretical ex-rights price correctly, but a
significant minority couldn't because they used the nominal value of the existing and/or new
shares. Many candidates were too brief in explaining why the actual price might be different to
the theoretical price in a four-mark requirement.
The fifth part was also disappointing. Many candidates asserted that the employee was using
weak form efficiency as he'd identified patterns in share price movements, yet in their
explanation of weak form efficiency they stated that this couldn't be done. Few identified that
the employee was promulgating the Chartist theory.
The final part was, generally, done well.

ICAEW 2020 September 2019 exam answers 363

75 Barratt Waters Shine plc
Marking guide

Marks
75.1 (a) Hedging strategies:
Forward contract spot rate 1
Plus contract discount 0.5
Arrangement fee 0.5
Forward contract sterling amount 0.5
MMH – amount to borrow 1
Convert at spot 1
Sterling value 1
Option – November put option 1
Use option 0.5
Option premium 0.5
Sterling value 0.5
8
(b) Advice on hedge:
Sterling receipt at spot rate 1
Discussion 5
6
(c) Forwards compared to futures:
Forward contract 1.5
Currency future 1.5
3
75.2 (a) FTSE hedge outcome:
Sell futures 1
Number of contracts 1
Rounded number of contracts 0.5
Loss in 3 months 1
Futures position – change 1
Gain on future 1
Net decrease in portfolio value 0.5
6
(b) Reason not 100% effective:
Basis risk 1
Rounding contracts 1
2
75.3 LIBOR Hedge:
Total cost (a) and (b) 0.5
Exercise option (½mark for each rate) 1
Total cost (a) and (b) 0.5
Annual cost (1 mark for each rate) 2
Discussion 1
5
30

364 Financial Management: Answer Bank ICAEW 2020

 75.1 (a) Forward contract (FC)
46.85 + 0.13 = 46.98 AP 22,400,000 £476,799
46.98
Fee AP 22,400,000 = 22.4  £260 (£5,824)
AP 1,000,000
£470,975
Money market hedge (MMH)
Borrow AP AP 22,400,000 AP 22,068,966
1.015
Convert @ spot AP 22,068,966 £471,056
46.85
Lend @ UK £471,056
 1.009 £475,295
Option
Selling AP's, so a November put option
Use option AP 22,400,000 £486,428
46.05
Premium AP 22,400,000 = 22.4  £740 (£16,576)
AP 1,000,000 £469,852
(b) Sterling receipt at spot rate = AP 22,400.000 £478,122
46.85
 Summary of range of sterling receipts from hedging.
 MMH gives highest receipt, but it's a fixed amount.
 Current spot rate gives high receipt, but the forward rate suggests a strengthening
of sterling against the peso. This would be bad news for Barratt, an exporter.
 Management's attitude to risk is important.
 General points about various hedging techniques.
(c) A forward contract is a binding agreement to buy/sell a specified quantity of one
currency in exchange for another item for settlement at a future date and at a price
agreed today. Forward contracts are not always easily available.
A currency future is a standardised exchange-traded contract to buy/sell a quantity of
one currency in exchange for another for notional delivery at a set date in the future.
The contracts cannot be tailored to the user's exact requirements. There may be hedge
inefficiencies – rounding of contracts and basis risk (pricing differences between spot
and futures markets). Limited currency availability.
75.2 (a) Barratt concerned about an index fall, so sell futures.
Portfolio value £8,350,000

Futures price 7,115

Price/index point  10
Value/contract = 71,150

No of contracts £8,350,000 117.4

71,150
Rounded to 117

ICAEW 2020 September 2019 exam answers 365

 In three months' time £
Closing portfolio value (£8,350,000  7055/7130) 8,262,167
Opening portfolio value (8,350,000)
Loss in value (87,833)

Futures position
Sell at 7,115
Buy at (7,055)
Change 60

No of contracts 117

£10
Gain on future 70,200
Net decrease in portfolio value (£17,633)

(b) The hedge will not be 100% efficient because of:

 basis risk; and,
 rounding contracts
75.3
(a) (b)
LIBOR 3.5% 5.5%
plus 1.5% 1.5%
Total cost 5.0% 7.0%

Option cost 5.3% 5.3%

Exercise option? NO YES

Rate 5.0% 5.3%

Premium 1.0% 1.0%
Total cost 6.0% 6.3%

Borrowed £12,500,000 £12,500,000

 
6.0% 6.3%
Annual cost £750,000 £787,500

Note: Annual cost of no hedge (at 5% & 7% pa) £625,000 £875,000

 At low interest rates, it's better not to hedge.
 At high interest rates, it's better to hedge.
 The option premium is expensive.
 What is the board's attitude to risk?

Examiner's comments:
This question had the second highest percentage mark on the paper. The majority of candidates
achieved a "pass" standard in this question.
This was a five-part question which tested the candidates' understanding of the risk
management element of the syllabus.

366 Financial Management: Answer Bank ICAEW 2020

 In the scenario, the company (Barratt) is a UK-listed manufacturer of pharmaceuticals.
Candidates, again, were employed in the finance team and were asked to work through three
tasks and advise senior management accordingly. Part one considered the first task – foreign
exchange hedging for a large export contract. Part one (a) was worth eight marks and asked
candidates to calculate the sterling receipt for the export contract using three different hedging
techniques. In part one (b), for six marks, candidates were required to advise the board whether
it should hedge against exchange rate movements for the contract in question. Part one (c)
asked candidates to compare forward contracts and futures as hedging techniques. The second
part was worth eight marks and considered the second task – using FTSE100 index futures to
hedge the value of Barratt's investment in a portfolio of UK shares. The third part, for five marks,
considered the final task – the implications of taking out an interest rate option. Barratt was
borrowing a large amount from its bank at a variable rate. Candidates had to prepare
calculations of the costs of hedging the interest charges and advise the board.
In part (a) of the first part most candidates scored well. Common errors were: adding, rather
than deducting, fees and premiums; using the wrong interest rates in an MMH; and, using a call
rather than a put.
In part (b) of the first part there were some very good answers, but many candidates asserted
doing nothing as using the current spot rate produced the highest income, despite the money
not being received for three months. The discussion section for weaker candidates was often
very brief.
In part (c) of the first part most candidates produced satisfactory answers.
In the second part most candidates scored adequately on the index futures calculations.
Common errors were: using the wrong price to calculate the number of contracts; not specifying
the need to sell first; and, miscalculating the new portfolio value and the profit on the futures
contracts. Most candidates identified correctly why the hedge would be inefficient, but weaker
candidates rolled the two separate reasons into one.
In the final part there was much variation in the marks. This was due to many candidates not
reading the question carefully enough. It specified that the interest option had already been
taken out, whereas many candidates answered as if that decision was still to be made.

ICAEW 2020 September 2019 exam answers 367

368 Financial Management: Answer Bank ICAEW 2020
Appendix
370 Financial Management: Appendix ICAEW 2020
 Formulae and Discount Tables
Formulae you may require:
(a) Discounting an annuity

1 1 
The annuity factor: AF1 n = 1 – 
r  (1+ r)n 

Where AF = annuity factor

n = number of payments
r = discount rate as a decimal

(b) Dividend growth model:

D0 (1+ g)
ke = +g
P0

Where ke = cost of equity

D0 = current dividend per ordinary share
g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share

(c) Capital asset pricing model: rj = rf + ßj (rm – rf)

Where rj = the expected return from security j
rf = the risk free rate
ßj = the beta of security j
rm = the expected return on the market portfolio

 D(1 – T) 
(d) e = a 1+ 
 E 

Where e = beta of equity in a geared firm

a = ungeared (asset) beta
D = market value of debt
E = market value of equity
T = corporation tax rate
Note: Candidates may use other versions of these formulae but should then define the symbols
they use.

ICAEW 2020 Formulae and Discount Tables 371

 Discount Tables
Present value of
Interest Number of Present value of £1 receivable at
rate years £1 receivable at the end of each of
p.a. n the end of n years n years
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
10% 1 0.909 0.909
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
9 0.424 5.759
10 0.386 6.145
15% 1 0.870 0.870
2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
20% 1 0.833 0.833
2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
10 0.162 4.192

372 Financial Management: Appendix ICAEW 2020

ICAEW 2020 Notes
Notes ICAEW 2020