DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO. Financial Pillar. 20 November 2014 Thursday Morning Session

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1 DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO. Financial Pillar F3 Financial Strategy 20 November 2014 Thursday Morning Session Instructions to candidates You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or subquestions). ALL answers must be written in the answer book. Answers written on the question paper will not be submitted for marking. You should show all workings as marks are available for the method you use. The pre-seen case study material is included in this question paper on pages 2 to 6. The unseen case study material, specific to this examination, is provided on pages 8 and 9. Answer the compulsory question in Section A on page 11. This page is detachable for ease of reference Answer TWO of the three questions in Section B on pages 14 to 19. Maths tables and formulae are provided on pages 21 to 25. The list of verbs as published in the syllabus is given for reference on page 27. Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered. F3 Financial Strategy TURN OVER The Chartered Institute of Management Accountants 2014

2 Introduction Y was formed in It manufactures and sells top quality confectionery. For many years, Y has been recognised as a successful company and has become a household name particularly throughout Europe. Its fame is built on the very high quality confectionery products it sells through its own high street stores (some of which it owns and some which it leases). Y has just over 3,500 employees. All of Y s products are manufactured in its factory in the European country in which it is based (which is in the eurozone). The products are distributed through a multi-channel network comprising of Y s own stores and online business, franchises and retail partners. In addition, Y has now started to supply confectionery to large retail stores and supermarkets on a contract basis. These stores sell Y s products and also own brand label confectionery that Y manufactures for them. Y s product range includes a wide variety of milk, white, plain and diabetic chocolate products. Previously Y s main sales had been chocolate products but now the company has expanded into producing other forms of confectionery which do not contain chocolate in any form, for example cakes and other sweets (candies). Y s customers continue to have strong regard for the quality of its products. Although Y exports its products throughout the world, its largest market is within Europe. Y s customers vary from individuals to corporate clients which purchase Y s products to present to their own clients as corporate gifts. Although individual customers buy from Y s stores, franchises or online, corporate clients purchase goods directly from Y on a contract basis. Business structure Y has a simple business structure. It has a head office (which includes its corporate treasury function) and two divisions: Direct Customer Sales (DCS), and Manufacturing and Commercial (MC). The activities of each division are as follows: DCS DCS has the following sales outlets: Y s own stores Franchises Online sales MC MC undertakes all purchasing of ingredients and manufacturing of Y s products. It then supplies these products internally to: DCS for its sales through its own outlets externally to: Corporate clients External retail stores and supermarkets which sell Y s products under Y s own label and also under the stores own labels. Both divisions are investment centres but have limited capital investment authority, for expenditure up to EUR 10,000 per item. Major capital investments, above EUR 10,000 per item, have to be authorised by head office. DCS does not allow any of its outlets to make any capital investment at all without its prior approval. Each of DCS s sales outlets is regarded as a profit centre, including online sales which is a single profit centre in its own right. Brand development is carried out by both of the divisions. Any brand development costs, such as promotion, above EUR 10,000 must be approved at head office. Financial Strategy 2 November 2014

3 The decline of high street sales has led Y to reduce the number of its stores and expand other sales outlets. This has resulted in some staff being re-trained and re-deployed. Y currently has just over 300 of its own stores and fewer than 200 franchises. It also has developed its own website. This has been very popular and has enabled its international business to grow. In addition, as internet shopping has become more popular, Y has been able to develop its online sales business and has introduced click and collect services using its stores and franchise businesses as the collection points. Mission, Aim and Objectives Y s mission statement, agreed by the Board of Directors last year is: To delight customers by providing luxurious products which strengthen the brand. Y s overall aim is to increase shareholder value by improving profit margins through increased sales and reduced costs. Despite the difficult economic conditions in Europe, the chocolate market has continued to grow in the last five years. Y s customers engage particularly with chocolate products in response to austere economic conditions seeing them as an affordable alternative to higher priced gifts. Y is now placing greater emphasis on trying to de-seasonalise its sales by not being reliant on the seasonal peak sales periods. Y is encouraging customers to buy its products throughout the year through all of its sales channels. This demands a strong focus on developing brand awareness. Y intends to achieve the continued development and growth of its business by meeting two strategic objectives which are to: 1. Engage with the widest range of customers through the development of Y s markets and products through a wide variety of sales channels. The focus of this is on the delivery of products the customer demands, where they are required and when they are wanted. 2. Enhance the customer experience through strong and effective customer relationship management. The focus of this is on clear and consistent branding and marketing to encourage customer retention and loyalty all the year round. Y s Board and Divisional Management The Board comprises a non-executive Chairman, a newly appointed Chief Executive, the Managing Directors of the two divisions, the Finance Director and three non-executive directors. The company applies good corporate governance principles and practice and the Board has a committee structure which includes an Audit Committee. The divisional structures reflect their different activities. The Managing Director of each division has a team comprising three divisional directors covering the functions of Finance, Human Resources and Information Technology. In addition, the DCS division has three divisional directors, one each responsible for Y s stores, franchises and online sales. In addition to the divisional directors for Finance, Human Resources and IT, the MC division has three divisional directors, one responsible for procurement, one for manufacturing and one for commercial clients, retail stores and supermarkets. The structure for Y s Board and its divisions is presented at Appendix 1. Financial overview Extracts from the statement of profit or loss for the year ended 31 December 2013 and statement of financial position as at 31 December 2013 are shown in Appendix 2. They show that in the last financial year, Y achieved an operating profit margin of 12% and profit after tax of 7.7%. Despite its best efforts in heavily re-investing in the business, Y s bottom-line profit has stagnated. The Board is concerned that the expected actual profit for the year ended 31 December 2014, when compared with the forecast, is not looking as promising as was first thought. The Board is also mindful that some of Y s borrowings are due for re-payment in November Financial Strategy

4 In response to these concerns, the Board of Directors has determined the following financial objectives for Y: That it should operate on a sound financial basis in order to increase profit and shareholder value That it should pay a regular and consistent dividend each year. Environmental and Corporate Social Responsibility Y aims to carry out its business with as little damage to the environment as possible and to operate in a fair manner with regard to all its stakeholders. It is keen to ensure that each of its suppliers adheres to high ethical and environmental standards with regard to sources of materials and treatment of employees. Y imports cocoa from Africa and Indonesia. Y has initiated schemes to encourage sustainable farming of cocoa and farmers are being trained in effective agricultural methods. The introduction of an industry approved certification programme has enabled farmers to achieve higher levels of income from increased production and to access additional training directed at improving their production yields. All raw materials sourced from Africa and Indonesia are priced in US Dollars (USD). All of Y s products contain only the ingredients listed on the packaging. The packaging also shows nutritional content and gives advice on recommended volumes of consumption. Y tries to ensure that the packaging used for its products is recyclable and kept as minimal as possible to balance concerns over material usage with commercial marketing requirements. Environmentally friendly lighting has been introduced in Y s factory which has reduced consumption of electricity and emission of carbon dioxide. Y has introduced annual independent health and safety audits in its factory and retail outlets. All factory staff have undertaken food safety and health and safety in the workplace training at the required industry standard level. Workplace benefits, such as life and medical insurance, staff discounts and membership of local gymnasia, as well as competitive salaries and wages are offered to all of Y s employees. Strategic developments In order to achieve its overall mission, aim and objectives, Y intends to expand its online channel to increase its sales to corporate clients and external retail stores and supermarkets. These sales yield a higher margin than that achieved through sales in Y s own high street stores. The Board also intends to further rationalise the number of its high street stores. Financial Strategy 4 November 2014

5 Appendix 1 STRUCTURE CHART FOR Y Board of Directors Non-Executive Chair Chief Executive Finance Director Managing Director (DCS) Managing Director (MC) 3 Non-executive directors Direct Customer Sales Division Manufacturing and Commercial Division Managing Director DCS Divisional Directors of: Finance Human Resources Information Technology Y s Stores Franchises Y s Online Sales Managing Director MC Divisional Directors of: Finance Human Resources Information Technology Procurement Manufacturing Corporate clients, external retail stores and supermarkets November Financial Strategy

6 Appendix 2 Y s statement of profit or loss and statement of financial position Statement of profit or loss for the year ended 31 December 2013 EUR 000 Revenue 248,589 Cost of sales ( 128,523) Gross profit 120,066 Operating costs ( 90,239) Operating profit 29,827 Finance income 120 Finance costs ( 5,008) Profit before tax 24,939 Tax ( 5,736) PROFIT FOR THE YEAR 19,203 Statement of financial position as at 31 December 2013 EUR 000 ASSETS Non-current assets Intangible assets: goodwill 2,407 Property, plant and equipment 158,822 Total non-current assets 161,229 Current assets Inventories 44,856 Trade and other receivables 21,348 Cash and cash equivalents Total current assets Total assets 12,368 78, ,801 EQUITY AND LIABILITIES Equity Share capital (EUR 0.5 shares) 31,122 Share premium 12,120 Retained earnings Total equity 42,101 85,343 Non-current liabilities Borrowings 116,484 Provisions for liabilities 2,294 Total non-current liabilities 118,778 Current liabilities Trade and other payables 33,936 Provisions for liabilities 1,744 Total current liabilities 35,680 Total liabilities Total equity and liabilities 154, ,801 End of Pre-seen Material The unseen material begins on page 8 Financial Strategy 6 November 2014

7 This page is blank TURN OVER November Financial Strategy

8 SECTION A 50 MARKS [You are advised to spend no longer than 90 minutes on this question.] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 11, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One Unseen Y implemented a number of changes to the business during 2014 in an attempt to boost revenues, including a shift in focus from selling its products through its own stores to selling through external supermarkets. As a result, Y closed many of its own stores. It also heavily promoted its products for sale through external supermarkets by commissioning television adverts and paying for prominent displays at the ends of aisles and near to points of sale. There have therefore been some large one-off costs in the first half of The shift in business strategy has resulted in a significant increase in both the volume of goods sold and total revenue in the first 9 months of However, there has been a negative effect on profit margins which fell markedly. Taking the one-off costs into account, revised forecast results for the year ending 31 December 2014 show a lower profit after tax figure than in the previous year. Once they were aware of the situation, the directors recognised that they had an obligation to inform investors of revised profit after tax expectations for the year ending 31 December Six months earlier they had indicated to the market that results for the current financial year would be comparable with the results for In mid-october, the directors decided to issue a public profit warning. The Finance Director was given the task of producing a best estimate of revised expectations for Data for Y as at 20 October 2014 The following data was collected on 20 October 2014 to enable the Finance Director to calculate a forecast profit after tax figure for Y in respect of the year ending 31 December 2014: Revenue is forecast to be 20% higher than in The gross profit margin is forecast to be 38% on average during Operating costs are assumed to be 5% higher than in 2013 due to reorganisation costs and higher marketing costs. The following items are assumed to remain the same as in the previous financial year: o The corporate income tax rate (as a percentage of profit before tax). o Finance income. o The average interest rate charged on borrowings of 4.3%. Borrowings are forecast to be EUR million on 31 December 2014, which can be assumed to be the average balance throughout Additional data relating to the year ending 31 December 2014: Share capital and share premium account remain unchanged since 31 December A dividend of EUR 0.18 per share is expected to be paid in December Note that financial data for Y for the year ended 31 December 2013 is provided on page 6 of the preseen. Financial Strategy 8 November 2014

9 Profit warning announcement The profit warning was announced on 1 November At the start of the day, before the announcement, Y s share price was EUR 3.39 per share (giving a P/E of 11.0) based upon the market s expectation that profit after tax in 2014 would be the same as By the end of the day the share price fell sharply by 35% in response to the profit warning announcement. Refinancing borrowings Y relies on bank borrowings from 30 banks. Each borrowing is arranged separately with the bank. EUR 30 million of bank borrowings is due to be repaid in 2015 and initial refinancing negotiations with the banks are expected to begin next month, December The Treasurer of Y is concerned about how the profit warning might affect these negotiations. Alternative financing schemes The following two financing schemes are being considered as alternatives to refinancing with bank borrowings in Either one or both schemes could be adopted. A B Issue a scrip dividend instead of the proposed annual dividend of EUR 0.18 per share planned to be paid before 31 December Sell 10 retail properties for EUR 20 million in total and lease the properties back under a 10 year arrangement. It has been estimated that the present value of cash flows arising on the sale and leaseback of the property discounted at the post tax cost of debt is minus EUR 818,000. That is, the sale and leaseback scheme is expected to be more expensive than retaining the properties. This appraisal was based on a forecast increase in property values of 10% over the whole 10 year period. The requirement for Question One is on page 11 TURN OVER November Financial Strategy

10 This page is blank Financial Strategy 10 November 2014

11 Required: (a) Calculate: Y s forecast profit after tax for the year ending 31 December 2014 based on the data provided to the Finance Director. The share price predicted by the forecast profit after tax results calculated above and assuming Y s P/E ratio remains unchanged at (8 marks) (b) Assume you are the Finance Director and have been asked to write a report addressed to the board of directors of Y in which you: (i) Advise on: The nature of the unrecognised intangible assets that are likely to form a significant part of Y s market value. The risks to Y s market value of an increasing focus on the sale of products through external supermarkets rather than Y s own stores. (9 marks) (ii) Explain possible reasons why Y s share price did not move as predicted by the result obtained in (a) above on 1 November 2014, the day the profit warning was announced. (5 marks) (iii) Advise on the key performance measures and other factors that the banks are likely to consider when reviewing Y s refinancing request in December Your answer should include calculations of the impact of the revised forecast on key performance measures. Up to 6 marks are available for calculations. (12 marks) (iv) Evaluate the financing schemes A and B. Your answer should include reference to the interrelationship between decisions concerning investment, financing and dividends. (13 marks) Marks for structure and presentation: (3 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks) End of Section A Section B begins on page 14 TURN OVER November Financial Strategy

12 This page is blank Financial Strategy 12 November 2014

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14 SECTION B 50 MARKS [You are advised to spend no longer than 45 minutes on each question in this section.] ANSWER TWO OF THE THREE QUESTIONS Question Two Company G is a successful IT services company formed 10 years ago. It was listed on its local stock exchange 3 years ago. Company G has a broad customer base mainly consisting of small and medium sized companies. Company G has achieved rapid growth in recent years by obtaining repeat business from satisfied customers and also by acquiring other IT services companies. The directors of Company G have identified Company H, an unlisted company, as a possible acquisition target. Company H has a number of large multinational clients and, in general, its clients tend to be larger than those of Company G. If successful, the acquisition would go ahead on 1 January Forecast financial data for Company G and Company H as at 31 December 2014 is summarised below: Company G Company H Share capital (ordinary $1 shares) $150 million $40 million Market share price $4.90 Not applicable as unlisted. Additional information: If Company H were to remain an independent company, its directors estimate that reported profit after tax would be $15 million for 2015 and then grow by 2% a year in perpetuity. If the acquisition were to go ahead, Company G s directors estimate that Company H s profit after tax would be 5% higher for 2015 than if the company remains an independent company and that profit after tax would then grow by 3% a year in perpetuity. The average ungeared cost of equity for the industry is 8%. Both Company G and Company H are wholly equity financed. Profit after tax can be assumed to be a good approximation of free cash flow attributable to investors. The directors of Company G are considering offering to purchase Company H at a price of $7.00 per share. It is estimated that transaction costs of $8 million would be payable on the acquisition and that $2 million would be required in the first year to cover the costs of integrating the two businesses. Financial Strategy 14 November 2014

15 Required: (a) Calculate: The value of Company G on 31 December 2014 before taking the possible acquisition of Company H into account. The value of Company H on 31 December 2014 before taking the possible acquisition of the company by Company G into account. The overall increase in value created by the acquisition of Company H by Company G. (b) (i) Explain how value might be created by the proposed acquisition. (8 marks) (4 marks) (ii) Advise on the challenges that Company G is likely to face in realising the potential added value after the acquisition. (4 marks) (c) Evaluate the proposed offer price of $7.00 per share for Company H from the viewpoint of: Company H s shareholders. Company G s shareholders. Up to 4 marks are available for calculations (9 marks) (Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Section B continues on the next page TURN OVER November Financial Strategy

16 Question Three Company J is a listed pharmaceutical wholesaler. The company was formed 10 years ago and has grown rapidly since then. Three years ago the company was floated on its local Stock Exchange. A few years ago, the company increased the proportion of debt finance following advice from external consultants that high gearing maximises shareholder wealth. However, in the past year there has been a deterioration in economic conditions and in liquidity available in financial markets. Against this background, the company s high level of gearing has led to difficulty in refinancing borrowings and issuing bonds on the capital markets. The directors have therefore decided to take steps to reduce the company s dependency on debt finance. The company is currently funded by: 600 million shares with a nominal value of $1.00 each. Bank borrowings of $900 million due for repayment in 10 years. Approximately 50% of Company J s shares are held by large financial institutions. The remaining 50% are held by a large number of small investors. Shares are currently trading at $1.50 per share. The directors are discussing how best to reduce gearing. One possibility is to raise additional equity finance by means of a rights issue and use the funds raised to repay bank borrowings. The terms of the rights issue being considered are as follows: Total proceeds of the issue to be $200 million if the issue is fully subscribed. 1 new share for each 3.6 shares held. New shares to be issued at a discount of 20% to the current share price. However, some directors have expressed concern as to whether a rights issue would be successful at this point in time, especially if at a relatively low discount rate of 20% to the current share price. The following suggestions were made at a recent board meeting: To increase the rights issue discount to 30% of the current share price but still raise $200 million. To consider alternative sources of finance such as preference shares or a private placement of shares. Financial Strategy 16 November 2014

17 Required: (a) (i) Calculate, at a rights discount of 20% AND 30% to the current share price, the impact of the planned rights issue and debt repayment on: Share price. Shareholders wealth. Gearing (debt/(debt + equity) at market values). Assume all shareholders take up the rights and ignore the impact of corporate income tax and any other influences on the share price or debt. (8 marks) (ii) Advise on the implications for both Company J and its shareholders of: Proceeding with the planned rights issue and debt repayment. The choice of rights issue discount rate. (9 marks) (b) Evaluate the appropriateness of each of the following alternative sources of finance for Company J, taking into account the current economic and financial market conditions: Private placement of shares. Redeemable preference shares. (8 marks) (Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION TURN OVER November Financial Strategy

18 Question Four Company M manufactures bicycles and sells them in the wholesale market. It is considering opening up a number of retail stores which would sell complete bicycles and spare parts. This plan is subsequently referred to as Project X. Forecast financial information for Company M as at 31 December 2014: EUR million Shares (EUR 1 face value each share) 600 Share premium account 200 Retained earnings 350 Bank borrowings at 6% interest rate 300 5% bonds 650 Additional information: The current market share price is EUR The bonds are quoted at a yield of 6% and a price of EUR 92 per EUR 100 of bond. Company M has an equity beta of 1.8 and a debt beta of The corporate income tax rate is 25%, payable at the end of the year in which it arises. The risk free rate is 3% and the market premium is 4%. Project X requires an initial investment of EUR 300 million on 1 January 2015 and is forecast to generate annual post tax cash flows of EUR 28 million a year. For the purposes of evaluating this project, annual cash flows should be assumed to arise at the end of the year to which they relate and assume zero growth. The project is eligible for a EUR 150 million 5 year loan from the government at a subsidised interest rate of 3%. The remaining EUR 150 million required for the initial investment would be funded by borrowings at an annual market interest rate of 5%. At the end of the 5 year loan period, the government subsidised loan can be assumed to be replaced by a bank borrowing at 5% annual interest. Company M has a long term gearing target which is very close to the debt/equity balance forecast for 31 December 2014, based on market values. Although this project is being financed using borrowings, increasing gearing, there is no intention of changing the long term gearing target. The next time that additional funding is required, the company is likely to use equity finance such as a rights issue in order to bring company gearing back in line with the long term gearing target. Financial Strategy 18 November 2014

19 Required: (a) Calculate, before taking Project X into account, Company M s: Geared cost of equity. Ungeared cost of equity. Weighted Average Cost of Capital (WACC). (7 marks) (b) Calculate a value for Project X using each of the following alternative approaches: Net present value of project cash flows based on the WACC calculated in (a) above. Adjusted present value, taking project financing into account. (10 marks) (c) Advise the directors of Company M of the validity of each of the results obtained in part (b) above, taking all relevant factors into account. (8 marks) (Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION (Total for Section B = 50 marks) End of Question Paper Maths tables and formulae are on pages 21 to 25 November Financial Strategy

20 This page is blank Financial Strategy 20 November 2014

21 MATHS TABLES AND FORMULAE Present value table Present value of 1.00 unit of currency, that is (1 + r) -n where r = interest rate; n = number of periods until payment or receipt. Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% November Financial Strategy

22 Cumulative present value of 1.00 unit of currency per annum Receivable or Payable at the end of each year for n years Periods (n) 1 (1+ r ) r Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% n Periods (n) Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Financial Strategy 22 November 2014

23 FORMULAE Valuation models (i) (ii) (iii) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: P 0 = d k pref Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-div value: P 0 = Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P 0 is the ex-div value: P 0 = k e d 1 g d k e or P 0 = d [1 + g] 0 k e g (iv) Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P 0 is the ex-interest value: P 0 = i[1 t] kdnet or, without tax: P 0 = i k d (v) (vi) (vii) Total value of the geared entity, V g (based on MM): V g = V u + TB Future value of S, of a sum X, invested for n periods, compounded at r% interest: S = X[1 + r] n Present value of 1 00 payable or receivable in n years, discounted at r% per annum: PV = 1 [1 + n r ] (viii) Present value of an annuity of 1 00 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum: (ix) PV = n r [1 + r ] Present value of 1 00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV = 1 r (x) Present value of 1 00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV = 1 r g November Financial Strategy

24 Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : k pref = d P 0 (ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current ex-interest price P 0 : k d net = i [1 t ] P 0 (iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P 0 : k e = d P 0 (iv) (v) Cost of ordinary (equity) shares, having a current ex-div price, P 0, having just paid a dividend, d 0, with the dividend growing in perpetuity by a constant g% per annum: k e = d 1 + g or d [1 + g] 0 k e = + g P P Cost of ordinary (equity) shares, using the CAPM: 0 k e = R f + [R m R f ]ß 0 (vi) Cost of ordinary (equity) share capital in a geared entity : k eg = k eu + [k eu k d ] V [1 t ] D V E (vii) Weighted average cost of capital, k 0 or WACC WACC = k e (viii) Adjusted cost of capital (MM formula): V E V E + V D + V k d [1 t ] V K adj = k eu [1 tl] or r* = r[1 T*L] E D + V D (ix) Ungear ß: ß u = ß g V E V V [1 t ] E D + ß d [1 t D V + V [1 t ] E D + V ] (x) Regear ß: ß g = ß u + [ß u ß d ] V [1 t ] D V E (xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect) annual discount rate B$ annual discount rate A$ where A$/B$ is the number of B$ to each A$ = Future spot rate A$/B$ in12 months' time Spot rate A$/B$ Financial Strategy 24 November 2014

25 Other formulae (i) Expectations theory: Future spot rate A$/B$ = Spot rate A$/B$ x 1+ nominal countryb interest rate 1+ nominal countrya interest rate where: A$/B$ is the number of B$ to each A$, and A$ is the currency of country A and B$ is the currency of country B (ii) Purchasing power parity (law of one price): Future spot rate A$B$ = Spot rate A$/B$ x 1+ countryb inflation rate 1+ countrya inflation rate (iii) Link between nominal (money) and real interest rates: [1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate] (iv) Equivalent annual cost: Equivalent annual cost = PV of costs over n years n year annuity factor (v) Theoretical ex-rights price: TERP = 1 N + 1 [(N x cum rights price) + issue price] (vi) Value of a right: Theoretical ex rights price issue price N where N = number of rights required to buy one share. November Financial Strategy

26 This page is blank Financial Strategy 26 November 2014

27 LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE VERBS USED DEFINITION Level 1 - KNOWLEDGE What you are expected to know. List Make a list of State Express, fully or clearly, the details/facts of Define Give the exact meaning of Level 2 - COMPREHENSION What you are expected to understand. Describe Communicate the key features Distinguish Highlight the differences between Explain Make clear or intelligible/state the meaning or purpose of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something Level 3 - APPLICATION How you are expected to apply your knowledge. Level 4 - ANALYSIS How are you expected to analyse the detail of what you have learned. Level 5 - EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations. Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate Analyse Categorise Compare and contrast Construct Discuss Interpret Prioritise Produce Advise Evaluate Recommend Put to practical use Ascertain or reckon mathematically Prove with certainty or to exhibit by practical means Make or get ready for use Make or prove consistent/compatible Find an answer to Arrange in a table Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between Build up or compile Examine in detail by argument Translate into intelligible or familiar terms Place in order of priority or sequence for action Create or bring into existence Counsel, inform or notify Appraise or assess the value of Advise on a course of action November Financial Strategy

28 Financial Pillar Strategic Level Paper F3 Financial Strategy November 2014 Thursday Morning Session Financial Strategy 28 November 2014

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