There was no evidence of time pressure in this exam and the majority of candidates were able to attempt all questions within the time limit.

Transcription

1 Examiner s General Comments Performance on F3 in May was a distinct improvement over some previous diets. This improvement was evident in both home and overseas centres although there were significant differences in performance among centres. It is difficult to say why this might be, although the proximity of a good tuition college might be one factor that influences good performance. It is evident that in the poorly performing centres many candidates are wholly unprepared and many also appear to have language difficulties. There was no evidence of time pressure in this exam and the majority of candidates were able to attempt all questions within the time limit. A comment must be made about the sequence in which candidates attempt to answer the paper. Answering one of the optional questions first is good exam technique if it is a question the candidate feels he/she can attempt well and thereby gain confidence. However, to leave the compulsory question 1, that counts for 50% of the total marks, until last is a risky strategy that requires very good time management. As in previous diets there were a number of candidates who answered all three questions in a haphazard manner, attempting to answer part of one question in the middle of another question or questions. This disorderly approach was usually consistent with poor overall performance in the exam. In a narrative section where the marking guide says up to 2 or 3 marks are available for each valid point, 0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to 2 marks for good discussion of the point and, if available, 3 marks where candidates have also provided appropriate illustrative examples. Where marks are shown for calculations, the mark shown is the maximum available assuming all calculations are correct. Some credit is given for recognition of correct approach and understanding even if the numbers are not correct. The published solutions are intended as a guide only. Marks are also awarded for other valid comments made by candidates that might not be mentioned in the marking guide or the published solutions. Detail by question Question One was a compulsory case study style question that aimed to evaluate an acquisition by a European based company of a chain of supermarkets in Asia. The calculations for part (a) were particularly well answered and generally well presented. The discussions required for part (b) were less well attempted and many candidates provided a long list of standard issues that often had little relevance to the scenario. Question Two required calculations of company value and WACC based on three different capital structures. The approach required application of Modigliani and Miller s theory of capital structure. It was not a popular question and was only answered by a minority of candidates. Page 1

2 Question Three dealt with working capital management and required calculations of the working capital cycle under different assumptions and assessment of whether the company was over trading. It further required discussion of how a lender would assess creditworthiness. It was a popular question and answered satisfactorily on the whole, although many candidates did not attempt the calculations at all. Question Four was the most popular of the optional questions. It required calculation of the NPV of a proposed investment in a new IT system. The calculations were generally handled well. Discussion of the appropriateness of a DCF approach in the circumstances of the scenario was generally poor and candidates frequently failed to relate their answer to the scenario. The discussion about how to proceed in part (b)(ii) was better answered. Page 2

3 Question One Requirement Required: (a) For each of the years 2007 to 2011 inclusive: (i) Calculate, in respect of B: Earnings per share P/E ratio Dividend payout ratio (8 marks) (ii) Evaluate B s financial performance. Your answer should include reference to the attainment of Financial objective 1. Up to 3 marks are available for relevant additional calculations. (9 marks) (iii) Explain the possible rationale behind B s dividend pay-out history. (6 marks) (b) (i) Assuming you are the Financial Director of B, write a briefing paper for the Board of B regarding the proposed acquisition of Alpha Supermarkets in which you: Calculate the expected financial benefit to B of the rebranding exercise on a discounted cash flows basis over a three year time period. (10 marks) (ii) Evaluate the potential risks and opportunities arising from the proposed acquisition AND advise whether to proceed. (14 marks) Additional marks available for structure and presentation: (3 marks) (Total for Question One = 50 marks) Page 3

4 Suggested Approach Part (a)(i) Calculate EPS, P/E ratios and dividend payout ratios for all five years from information in the scenario. Part (a)(ii) Provide additional calculations of growth in earnings and EPS Discuss key points as shown in the marking scheme Part (a)(iii) Recognise that the dividend objective has always been met Discuss other key points as shown in the marking scheme Part (b) Provide a report structure for this part of the question report heading, an introduction or purpose of report, and suitable sub headings. Part (b)(i) Provide a suitable layout for the figures (see suggested solutions) Calculate NPV of the 15 stores in A$, converting to EUR at the spot rate given in the question. Part (b)(ii) Discuss risks and opportunities of the proposed investment recognising the key points as highlighted in the marking scheme. Provide advice to the Board of B on how to proceed. Marking Guide for Question One Part (a)(i) Calculate EPS, P/E ratios and dividend payout ratios Marks Calculations: EPS 2.5 P/E ratios 2.5 Dividend payout ratios 3.0 Maximum for part (a)(i) 8.0 Part (a)(ii) Evaluation of performance Calculations (e.g. Earnings & EPS growth) 3.0 Drop in earnings, slow recovery 2.0 Share price followed same pattern 2.0 Strong P/E reflects market confidence 2.0 Page 4

5 Recognition of drop in EpS growth due to share issue 2.0 Gearing discussion and calculation 2.0 Maximum for part (a)(ii) 9.0 Part (a)(iii) Dividend payout history Meet fin obj 2 (50% payout) throughout /2009 dividend per share kept high Reflected in high dividend payout 2.0 Steady dividend to reassure investors 2.0 Appear to have had sufficient cash to maintain High payout 2.0 But risk damaging future growth due to high payout 2.0 Maximum for part (a)(iii) 6.0 Page 5

6 Part (b)(i) Calculation of NPV of rebranding exercise Marks Initial investment 1.0 Reinvestment (years 1 and 2) 1.0 Revenue and costs 2.0 Tax 3.0 Discounting 1.0 Conversion at spot 1.0 Aggregation for 15 stores 1.0 Maximum for part (b)(i) 10.0 Part (b)(ii) Evaluate risks and opportunities Marks Risks: Risk of loss NOT material to B Reputation risk is key if the project is set up incorrectly. FX including exchange controls 5.0 Political/country risk Competitor risk Financing risk (very small for project) Opportunities Foothold in new market Huge follow on opportunities Increased group earnings (very small for project 5.0 but large in the future after further expansion) Advice 4.0 Maximum for part (b)(ii) 14.0 Additional marks available for structure and presentation 3.0 TOTAL MAXIMUM FOR QUESTION ONE 50.0 Page 6

7 Examiner s Comments for Question One This question aimed to test candidates ability to evaluate financial performance, dividend policy and the financial benefits of a re-branding exercise using DCF/NPV techniques. On the whole this question was very well attempted and a noticeable feature of candidates answers was a greater use of information from the pre-seen. The calculations required were particularly well handled and many candidates achieved maximum marks for part (a)(i) of the question. These calculations were fairly straightforward but it has been apparent in past exams that many candidates are unable to bring forward knowledge gained on previous subjects and many have been unable to calculate correctly EPS or a P/E ratio so the improvement in May is welcome. The discussions required in parts (a)(ii) and (b)(ii) were less well answered. In both parts, many candidates failed to recognise the key issues arising from the scenario, focussing instead on general principles of dividend policy (in (a)(ii)) or on the far less important supplementary issues listed above in respect of (b)(ii). Candidates who either wrote very little at all or who focussed exclusively on supplementary issues were unlikely to achieve a pass mark in these sections, with many failing to get more than 30% of the marks available. Comments on the individual parts of Question One are provided below. Part (a)(i) As already noted in the introduction to this Guide, this part of the question was generally answered very well. Almost all candidates managed to calculate EPS and P/E ratios correctly. A few did not understand how to calculate dividend payout ratio, typically dividing the share price by the dividend per share. Part (a)(ii) This part of the question was answered at least satisfactorily by most home candidates although few managed to gain very good marks. Common errors that prevented higher marks were: Calculating average growth rates over the 5 year period this calculation gained some credit but the key requirement was to evaluate a trend over the 5 year period, separating out the fall in earnings and share price between 2007 and 2008 from the gradual recovery since Calculating and discussing single year figures, such as Return on Capital Employed again, not an error as such but it was the 5 year trend that should have been the focus of the answer and there is insufficient information to calculate RoCE and other, similar ratios for more than 1 year. Part (a)(iii) This part of the question develops the evaluation in part (a)(ii) in greater detail in respect to dividend payments. A major weakness in some scripts was that the answer did little else other than repeat what had been said earlier. A similar weakness was to limit discussion to book knowledge of dividend policy issues such as the clientele effect and signalling and failing to recognise that the share price has remained resilient since 2008 indicating that the company was generating sufficient cash and earnings to be able to support the dividend payouts. Indeed, the company was shown to have a substantial amount of cash and cash equivalent in the Page 7

8 Statement of Financial Position. At strategic level, candidates are required to apply their technical knowledge to the scenario presented. Part (b)(i) Good marks were generally obtained here but common errors were: Showing the first year tax depreciation allowance in year 0 instead of year 1. Showing the reinvestment of operating cash flows as inflows instead of outflows. Incorrect calculation of tax depreciation allowances there were too many variations of incorrect approaches here to say any one was common. Not multiplying the NPV of a single store by 15. Top management would surely be more interested in the total NPV rather than that for a single store. Calculating forward exchange rates. The question uses an A$ discount rate so the correct approach is to convert the A$ NPV to EUR at the spot rate. Part (b)(ii) This part of the question was typically answered at least satisfactorily by home candidates but less well by candidates in overseas centres. As in part (a)(ii), few candidates managed to gain very good marks. The main weakness was typically an inability to identify the key issues. Many candidates simply provided a check list of political, economic, cultural risks etc with standard discussion that did not relate either at all or sufficiently closely to the scenario. Discussion about financial risk and repatriation of currency were of very little significance in the context of this scenario.. Such comments gained some credit but the money to be invested in the rebranding exercise is very small relative to the size of B. Indeed, the risks to B of the project failing are very small and immaterial. The exception being the risk of damage to B s reputation and future expansion opportunities if the re-branding is not carried out in a sensitive and acceptable manner. Page 8

9 Question Two Requirement Required: (a) Calculate the following, based on Modigliani and Miller s (MM s) capital theory with tax and assuming the project goes ahead: (i) The total value of FF (before deducting debt) on a discounted cash flow basis for each of the financing structures A, B and C. (6 marks) (ii) FF s WACC for each of the financing structures A, B and C. (6 marks). (b) (c) Note that MM formulae are provided on pages 23 and 24. Explain your results in (a) above with reference to MM s capital theory with tax, illustrating your answer by drawing graphs of your results in (a) above. Use the graph paper provided. (9 marks) Advise, with reasons, which financing structure FF should adopt. (4 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Suggested Approach Part (a)(i) Calculate the value of FF using each of funding structures A, B and C recognising that MM s formula is required for B and C. Part (a)(ii) Calculate the WACC for each of funding structures A, B and C recognising that MM s formula is required for B and C. Part (b) Explain the results of your calculations Provide two graphs; one showing that, according to MM, value increases at different levels of borrowing, the other showing that WACC decreases as gearing increases. Part (c) Provide advice about which financing structure maximises shareholder wealth Briefly explain the limitations of MM s theory Page 9

10 Marking Guide for Question Two Marks Part (a)(i) Calculate value of FF Funding structure A 3.0 Funding structures B and C 3.0 Maximum for part (a)(i) 6.0 Part (a)(ii) Calculate WACC for each funding structure Funding structure A 1.0 Funding structures B and C using MM formula: 5.0 Maximum for part (a)(ii) 6.0 Part (b) Explain results Change in WACC 3.0 Change in value 2.0 Graphs 4.0 Maximum for part (b) 9.0 Part (c) Advice on choice of funding structure Advise structure which maximises shareholder wealth 3.0 MM limitations 1.0 Maximum for part (c) 4.0 TOTAL MAXIMUM FOR QUESTION TWO 25.0 Page 10

11 Examiner s Comments for Question Two This question examined understanding of capital structure with specific reference to the theories of Modigliani and Miller. Part of the requirement involved a graphical presentation of the candidate s answer. This was not a popular question; presumably the combination of MM and graphs was too daunting. Many candidates appeared to choose this question as a make weight. However, those who understood what was required tended to gain good marks. Part (a)(i) When valuing FF using financing structure A (all equity) most candidates could calculate the value of the shares by multiplying the share price by the number of shares ($11 x 30 million = $330 million). Many stopped there and did not add in the present value of the future cash flows of the project - $110 million. Even those who attempted a valuation of alternative A frequently did not attempt to value FF using financing alternatives B and C. Those who did proceed typically made the following errors: Attempting a valuation but not using the MM formula of Vg = Vu + TB as required by the question. Starting with a value of $330 million rather than $440 million. Even on the own answer principle many candidates did not use their own figure for Vu. Part (a)(ii) Most candidates recognised that under financing alterative A the WACC remains at the cost of equity. The main weakness after that was to use the standard WACC formula instead of MM as required by the question. Some credit was given to those candidates who first calculated an adjusted cost of equity using the formula Keu +[Keu Kd] Vd (1-t/Ve + Vd) and then used their calculated figure in the standard WACC formula. However, the expected approach was to use the formula Kadj = Keu[1 tl], which is clearly identified as Adjusted cost of capital (MM Formula) on page 24 of the exam booklet. Part (b) Few candidates could adequately explain MM s capital theory although most recognised the influence of the tax shield on WACC and firm value if financing is with debt. The graphs, when attempted at all, were generally poor and some candidates provided a graph showing the direction of costs of capital using the traditional theory rather than MM s. Part (c) If candidates got this far they generally offered sensible advice that the financing structure chosen should be the one that resulted in the lowest WACC. Some credit was given for recognising MM s limitations in respect of financial distress, but it was important to recognise that gearing here is very low so this should not be a major consideration. Page 11

12 Question Three Requirement Required: (a) (i) Calculate what the overdraft requirement would have been on 30 April 2012 if working capital days for the period had remained at 31 October 2011 levels. (5 marks) (ii) Explain the particular pressures faced by companies in times of rapid expansion in respect of working capital and profit margins. Illustrate your answer with reference to KK. (8 marks) (iii) Recommend strategies that KK should consider in order to reduce the amount of funds tied up in working capital. (5 marks) (b) Discuss the key factors that a potential lender is likely to consider when assessing the creditworthiness of a business which is experiencing rapid growth. (7 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Suggested Approach Part (a)(i) Calculate the value of: accounts receivable; accounts payable; and inventory if working capital days had remained unchanged, Calculate what the overdraft would have been. Part (a)(ii) Calculate profit margin Calculate working capital cycles Discuss the key pressures on the components of working capital Ensure the answer refers to KK Part (a)(iii) Provide recommendations for reducing funds tied up in working capital (Note no discussion of the financing of WC is required) Part (b) Discuss key factors to assess credit worthiness as shown in the marking guide. Page 12

13 Marking Guide for Question Three Marks Part (a)(i) Calculate overdraft requirement Accounts receivable, payable and inventory 3.0 New overdraft 2.0 Maximum for part (a)(i) 5.0 Part (a)(ii) Explain pressures Profit margins 2.0 Accounts receivable 2.0 Accounts payable 2.0 Inventory 2.0 WC cycle 2.0 Maximum for part (a)(ii) 8.0 (Max 5 marks if no reference to KK) Part (a)(iii) Recommend strategies Up to 2 marks per key point about components of WC (Accounts payable & receivable, Inventory) to max. 5.0 (No marks for discussion of funding) Maximum for part (a)(iii) 5.0 Part (b) Discussion of key factors to assess credit worthiness Forecast cash flows 2.0 Competitive position 2.0 Strength of management 2.0 Purpose of overdraft 2.0 Capital structure 2.0 Credit agency ratings 2.0 Maximum for part (b) 7.0 Total Maximum for Question Three 25.0 Page 13

14 Examiner s Comments for Question Three This question focused on short term funding issues of a company apparently overtrading and also how a lender might assess credit worthiness. Although a popular question, many candidates did not attempt part (a)(i) which required re-calculation of an overdraft balance assuming working capital days had remained unchanged over a 6 month period. However, the discussion sections were generally well attempted and most candidates were able to relate their answers to the scenario. Part (a)(i) Those candidates who did attempt this part of the question frequently made one or more of the following errors: Calculating the operating cycle rather than the value of the balances on the individual working capital components. Using an average change in the net number of working capital days. The answer using this approach was close to the correct answer but the approach was incorrect. Part (a)(ii) This part of the question was generally well answered although many candidates discussed irrelevant pressures rather than focusing on pressure on working capital. A further weakness was in not relating the answer to KK s situation. Part (a)(iii) Again, this part of the question was generally well attempted. Common errors/omissions were: Discussing different financing methods rather than how to reduce the funds tied up in working capital. Not recognising the weaknesses in some actions, for example suggesting KK should reduce the credit period and failing to recognise, or not mentioning, that this could lose sales. Not a common error, but a surprising few suggested KK should reduce sales. Part (b) This part of the question was generally well answered although many answers focused on an analysis of past performance rather than looking at how well KK might be going to do in future. Page 14

15 Question Four Requirement Required: (a) (b) (i) Calculate the net present value (NPV) of the proposed IT project as at 1 July 2012, ignoring the additional cash flows that might arise from new business. (5 marks) (ii) Calculate the additional annual cash inflow from new business that is required in order to achieve a breakeven result. Use your answer from part (a)(i) as the starting point for your calculation. (6 marks) (i) Discuss the appropriateness of using a conventional discounted cash flow approach to appraise an IT project. (6 marks) (ii) Advise what other financial and strategic factors should be considered when deciding whether to proceed with this project. (8 marks) (Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Suggested Approach Part (a)(i) Calculate NPV of the proposed IT project Show NPV as a loss Part (a)(ii) Calculate additional cash flow requirement using the annuity factor for 4 years at 12% and grossing up at 52%. Part (b)(i) Discuss appropriateness of the DCF approach to this specific situation. Note key point that obtaining a discount rate is especially difficult. Part (b)(ii) Provide advice on financial and strategic factors PP should consider before deciding whether to proceed. Page 15

16 Marking Guide for Question Four Marks Part (a)(i) Calculation of NPV Initial investment, redundancy, maintenance costs 1.5 Annual staff saving 1.0 Discounting 1.5 Showing NPV as loss 1.0 Maximum for Part (a)(i) 5.0 Part (a)(ii) Calculation of additional cash flow requirement Use of annuity 3.0 (Max 1 if divide by 4) Conversion to equivalent revenue 3.0 Maximum for Part (a)(ii) 6.0 Part (b)(i) Discussion of appropriateness of DCF approach Pros: All projects assessed on similar basis 2.0 Cons: Qualitative aspects hard to quantify 2.0 Appropriate discount rate difficult to obtain 2.0 Maximum for Part (b)(i) 6.0 Part (b)(ii) Advice on financial and strategic factors Adjustment for risk 2.0 Fit with business operational and strategic plans 2.0 Company reputation and competitive position 2.0 State of the industry and economic conditions in general 2.0 Staffing issues 2.0 Other available projects that have positive NPV 2.0 Availability of funding for the project 2.0 Maximum for part (b)(ii) 14.0 Total Maximum for Question Four 25.0 Page 16

17 Examiner s Comments for Question Four This question involved an architectural partnership evaluating a new IT system using DCF analysis of project costs. Candidates were required to consider whether a standard DCF approach was appropriate in the circumstances and also how to incorporate non quantifiable benefits in a project appraisal. Part (a) Most candidates could adequately attempt the NPV calculation for part (a)(i) but few could answer fully the break even value required in part (a)(ii). Common errors or omissions that prevented higher marks were: In part (a)(i) including cash flows from the new business the question says to ignore them. Incorrect timing there were many variations on this type of error, such as showing the redundancy payments in year 1 instead of year 0 or maintenance costs starting in year 0 instead of year 1. In part (a)(ii) many candidates could correctly calculate annual net cash flow although some simply divided by 4 rather than by the 4 year annuity factor. The majority of candidates stopped there and did not then uplift the net cash flow by 52% to get the (gross) annual cash inflow. Part (b)(i) This was surprisingly poorly answered. Many candidates failed to recognise the difficulty of identifying intangible benefits and determining an appropriate discount rate. Part (b)(ii) The part of the question was generally well answered. A common failing was to discuss shareholders and/or dividend policy the question deals with a partnership and so such issues are not relevant here. Page 17