This was the first sitting of F3 on PC. It was a pilot sitting and only open to UK re-sit candidates. The overall pass rate was 51%.

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1 F3 FINANCIAL STRATEGY Examiner s general comments This was the first sitting of F3 on PC. It was a pilot sitting and only open to UK re-sit candidates. The overall pass rate was 51%. Question One involved a proposed acquisition of a company in a similar line of business. In general, this question was well answered. The discounted cash flow calculations were relatively easy to produce on EXCEL and handled well apart from a lack of clarity for the reader/marker in following the logic applied. A major disappointment, however, was the common paucity of knowledge and understanding of certain finance topics which were the subject of part (iii) of the question. A similar problem arose in Question Two, involving the choice of finance by rights issue, lease or bank loan, where advice on the appropriateness of each proposed source of finance was poorly handled. A number of candidates attempted Question Two without being able to recall how to calculate cash flows for either the buy or finance lease options. Candidates who had revised these topics thoroughly and were familiar with the similar question in the Specimen Paper were able to gain high marks for this question. Question Three required NPV, IRR and MIRR calculations and the consideration of wider issues relating to a proposed project. There was a wide disparity of marks according to the competence and knowledge of candidates of the calculations and concepts involved. The IRR and MIRR calculations were particularly straightforward and quick to perform where candidates used the appropriate EXCEL functions. Question Four was the least popular question. It related to dividend policy and Modigliani and Miller s theory of dividend irrelevancy. There were some excellent answers to this question but many other candidates only presented the theory without then going on to apply it to the scenarios presented. Further comments are provided under Examiner s Comments for individual questions. Use of WORD and EXCEL As this was the first sitting on PC, some additional observations may be useful on candidates use of WORD and EXCEL in a PC based examination. The use of WORD was generally good. There was a tendency to write in long paragraphs and the good exam practice of using short, punchy paragraphs that we had become accustomed to in paper exams was largely forgotten. EXCEL was clearly very helpful to some students but caused considerable problems for others. There was a surprisingly large disparity in the level of competence and presentation of answers in EXCEL. It is important that candidates label each spreadsheet by changing the tab label to the appropriate question number. A separate spreadsheet should be used for each question (or part question if required). The Chartered Institute of Management Accountants Page 1

2 Labelling is important. Using EXCEL is not an excuse for leaving out column or line labels in DCF calculations. For example, a line heading such as tax at 30% in a DCF calculation is still useful as a quick audit trail for the marker and reader alike. When using EXCEL, it is not always necessary to write out each formula used in a spreadsheet in long form alongside the relevant calculation. It is often sufficient for the formula to be typed into the individual cell in a format that is easy for the marker to pick up when passing the cursor over the cell. There will, of course, be some instances where a cell reference will refer to other cell references. Simplicity is key here. A one-step link is fine. For example, a cell which is simply the sum of a column or row of numbers close by, is not difficult to unravel. There were, however, answers where the process required to unravel workings was akin to a treasure hunt and involved unravelling three or more stages of cell references, each one referring to two or more additional cells at each stage. Such an approach rarely produced the correct result because candidates tended to lose the logic of the trail somewhere along the way. The use of EXCEL functions such as IRR is encouraged. It is sufficient to indicate the use of a function by a simple statement such as Using the EXCEL IRR function, IRR =. The IRR function can then be inserted into the neighbouring cell and the relevant cash flows imported into the formula using cell references. It is not also necessary to write out the IRR formula and list the different inputs separately. In conclusion, the main messages when using PC are to ensure: Clear labelling - of documents and EXCEL tabs. Clarity of layout not forgetting all the good habits learnt in a paper exam in both WORD and EXCEL documents. Simplicity and clarity of approach making sure that calculations are easy to follow. Note on the marking guide In a narrative section where the marking guide provides for up to 2 or 3 marks per valid point, as a general rule, 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. The Chartered Institute of Management Accountants Page 2

3 SECTION A 50 MARKS Question One Required: (a) (i) Calculate a range of values for NN as at 01 January 2011 using: The price achieved in the recent sale of a 5% parcel of shares. P/E basis. Discounted cash flow basis, ignoring potential synergistic benefits and integration costs. (11 marks) (ii) Explain briefly the suitability of each method used in part (a)(i). (6 marks) Assume you are an external consultant engaged by Aybe to evaluate the proposed acquisition of NN. Write a report, suitable for presentation to the Directors of Aybe, in which you: (i) Evaluate the proposed initial offer price of EUR75million from the viewpoint of both the shareholders of NN and the shareholders of Aybe, concluding with advice on an appropriate adjusted offer price. (11 marks) (ii) Discuss the potential problems and issues that could arise from the integration of NN into the SC Division of Aybe. (7 marks) (iii) Advise on issues that affect the choice of debt finance (bonds or bank borrowings, C$ or EUR), including their potential impact on Aybe s bank covenants. (12 marks) Additional marks available for structure and presentation. (3 marks) (Total for Question One = 50 marks) Rationale To test the ability to evaluate the financial and strategic implications of a proposed acquisition from both the viewpoint of the acquiring company and of the shareholders of the company being acquired. The question also tests company valuation techniques, pricing and financing issues. The Chartered Institute of Management Accountants Page 3

4 Suggested Approach (a)(i) Calculate: The value using the price achieved at the recent sale multiplied by the number of shares in issue. The value on a P/E basis, using the P/E ratio of the proxy company and earnings in each of the years 2009 and Also inflate the P/E ratio to reflect the fact that NN is likely to have a higher P/E ratio than QQ because of the rapid growth it is experiencing. Calculate the cost of equity of the proxy company, QQ. Use this cost of equity as the discount rate when discounting the cash flows of NN. (a)(ii) For each of the methods used in (a)(i) above, discuss how suitable it is for use in valuing NN. (i) Firstly, consider the viewpoint of NN s shareholders. Compare the offer price of EUR 75 million against the range of valuations calculated in part (a) above to assess whether the valuation is likely to be accepted. Take into account that a premium would be expected and further growth is expected. Also, that the Directors of NN are eager to realise their investment. Secondly, consider the viewpoint of Aybe s shareholders. Recalculate the DCF of expected future cash flows taking into account potential synergistic benefits and integration costs. Compare this result with the offer price of EUR 75 million. Consider risks and other relevant factors. End with a conclusion on an appropriate adjusted offer price. (ii) Identify and discuss the potential problems and issues that could arise during the integration process. (iii) Calculate Aybe s gearing levels and interest cover (as specified by the loan covenants) both before and after the proposed acquisition. Identify and discuss these and other issues affecting the choice of debt finance. Marking Guide Parts (a)(i)- Valuation of Company NN on three specified bases (11 marks) Marks Latest share price (parcel of shares) P/E basis Calculation Calculations on different bases Discounted cash flows Range of values Maximum part (a)(i) Calculate an appropriate discount rate (including use of CAPM and risk adjustment) Earnings PV calculation for years 1-3 PV calculation for years Max 11 The Chartered Institute of Management Accountants Page 4

5 Parts (a)(ii)- Explain suitability of each method used in part (a)(i) (6 marks) Comments (up to 3 marks each method) 6.0 Maximum part (a)(ii) Max 6 Part (i) - Evaluation of proposed initial offer price (11 marks) Viewpoint of NN s shareholders 3.0 Viewpoint of Aybe s shareholders Conclusion: overall offer price Maximum part (i) Calculation Comments Max 11 Part (ii) - Integration issues (7 marks) Discussing the potential problems and issues arising from the integration of NN into the SC Division of Aybe. Continuity of management Successful realisation of additional growth for NN in first 3 years Integration of management and IT systems Merging corporate culture Harmonisation of corporate culture Risk of new entrants with similar new product Impact on Aybe s financial performance (EpS etc) Impact on cash flow and loan covenants Disruption to production (Project 1) Maximum part (ii) up to 3 marks each 7 marks Part (iii) (12 marks) Issues affecting choice of debt finance, including: Liquidity of bond market/availability of credit from banks Flexibility of choice of terms (repayment terms etc) Credit standing of borrower (Aybe) Choice of currency EUR or C$ Impact of loan covenants Any security required Costs including underwriting costs for bond issue Impact on loan covenants Calculations Conclusion up to 2 marks each, max 6 marks 4 2 Maximum part (iii) Additional marks available for structure and presentation (1 for headings, 1 for purpose, 1 for labelled, tabulated, easy to follow DCF calculations) Total maximum for question 12 marks 3 marks 50 marks The Chartered Institute of Management Accountants Page 5

6 Examiner s Comments The calculations required in part (a)(i) to value the company were generally well answered, especially where candidates had managed to calculate the discount factor correctly. Discussion on integration issues was particularly strong. On the other hand, there were a large number of very disappointing answers on the choice of debt finance, revealing some serious misconceptions about the nature of bonds and bank debt. As already mentioned under general comments, competence in setting out calculations varied considerably between candidates. Some of the DCF calculations in particular were very difficult to follow. It was not uncommon to have a treasure trail of cell references over 3 or more stages. (For example, the first reference might say E23/B10 and then E23 and B10 would each refer to more cell references and so on.) This approach clearly also confused candidates because such trails often proved to give false results. It was much easier for candidate and marker alike if the calculation was set out in the relevant box (eg = E23*(1.03)/( ) for the calculation of the PV for years 4+). Common errors included: Using WACC rather than cost of equity to value the company. Incorrect calculation of net assets (where provided note that this information was not specifically required but was still useful information to include). Omitting advice on an appropriate price. Misconception that bonds are preferable to bank debt because they do not impact on gearing or do not need to be repaid as they could be converted into shares. The Chartered Institute of Management Accountants Page 6

7 Question Two Required: Assume you work in the Treasury Department of EM. (a) Describe the role of the Treasury Department in the management of funding for major investments, making specific reference to the three alternative financing methods under consideration. (7 marks) Advise the Finance Director on the appropriateness of each of the THREE proposed alternative methods of finance and recommend which, if any, should be chosen. In your answer, include a calculation of whether the outright purchase funded by bank borrowings or the finance lease is expected to be the cheaper source of debt funding. A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION (18 marks) (Total for Question Two = 25 marks) Rationale This question concerns a manufacturer of high-value electronic equipment based in Asia. It is proposing to invest in new machinery for a new product line in The company is all-equity financed and is considering 3 methods of funding the investment: a bond issue, a finance lease or a rights issue. The question examines learning outcomes in Section B of the syllabus. Suggested Approach (a) Firstly, describe the role of the Treasury Department in the management of funding for investments in the context of a company as a whole, covering general principles. No specific application to EM was required at this point. Secondly, consider the scenario presented and the role of treasury in arranging and managing the three alternative sources of finance being considered. Perform a standard lease versus buy/borrow calculation to determine which is the cheaper source of debt finance. Then consider the source of funds in turn, including the possible impact of the choice of finance on the original investment decision and the appropriateness of each method in the context of this scenario. The Chartered Institute of Management Accountants Page 7

8 Marking Guide Part (a) 7 marks Explanation of strategic funding management role - including advice on choice of appropriate funding structure Role in choice of lender and instrument Role in negotiating and arranging chosen finance Maximum part (a) Marks 1 to 2 marks per point 7.0 marks Part 18 marks Calculations Alt 1 Bank borrowing: TDAs and tax relief on TDAs 2.0 Purchase Cost 0.5 DCFs/NPV 1.0 Alt 2 - Lease: Accounting depreciation and tax relief on depreciation 1.5 Implied interest calculation and tax relief on implied interest 3.0 Lease payment (NO tax relief) 1.0 DCFs/NPV 1.0 (only if use 5% DF) 10.0 Discussion key points: Relative cost of finance over the life of the project. Importance of matching maturity with life of equipment. Impact on financial ratios and shareholder return/risk etc. Cost/ease/availability of funds using each method. Recommendation Max 8 Maximum part 18.0 marks Total maximum marks 25 marks The Chartered Institute of Management Accountants Page 8

9 Examiner s Comments There was a marked improvement in candidates understanding of the role of the treasury function over recent diets where questions about the role of the treasury function in other areas had been less successfully answered. However, knowledge of finance issues raised in part was generally poor. The appraisal of the finance lease versus buy/borrow was disappointing, despite a very similar question appearing in the specimen paper. As this was a major focus of Question 2, it inevitably had a major impact on the average mark achieved in this question. Common errors included: Including debt interest cash flows in the DCF calculations. Including loan repayment cash flows each year in the DCF calculations. Inability to calculate implied interest in the lease evaluation. Calculating implied interest on the lease payments but then including this interest rather than the tax relief on the interest in the DCF calculations. Incorrect discount rate. A misconception that introducing debt somehow reduces risk. Note that a T.E.R.P. calculation is not required in this instance. The Chartered Institute of Management Accountants Page 9

10 Question 3 Required: (a) (i) (ii) Calculate the net present value (NPV), internal rate of return (IRR) and (approximate) modified internal rate of return (MIRR) as at 01 January 2011 for the proposed project. Discuss the advantages and limitations of MIRR in comparison with NPV and IRR. (13 marks) (6 marks) Evaluate the likely impact of the project on MR s ability to meet its financial objectives assuming the project goes ahead. (6 marks) (Total for Question Three = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question Three concerns a large up-market chain of clothing stores operating in the USA. It is evaluating the introduction of a lower-priced range of clothes aimed at the middle-income market and also the possibility of expanding to countries outside the US. The question requires calculation of NPV, IRR and MIRR and a discussion about how the proposed investment might help the company meet its financial objectives. The question examines learning outcomes in Section C of the syllabus. The Chartered Institute of Management Accountants Page 10

11 Suggested Approach (a)(i) NPV calculation: First calculate the tax depreciation allowances. Then identify relevant project cash flows for the NPV calculation and tabulate them according to relevant time period. (Ignore sunk costs the US$100,000 consultancy cost.) Adjust for tax cash flows. Discount the cash flows at the risk-adjusted discount rate of 9%. IRR calculation: Re-perform the NPV calculation on the net project cash flows calculated above using a higher discount rate. Use interpolation of the two NPV results to obtain the IRR. Alternatively, apply the EXCEL IRR function to the net project cash flows. MIRR calculation: Compound net project cash flows at 9% per annum. Divide the aggregated future value of the cash flows by the 3 year 9% annuity factor. Look up this value in annuity tables to obtain the MIRR. Alternatively, apply the EXCEL MIRR function to the net project cash flows. (a)(ii) Identify and discuss each important advantage or limitation of MIRR in turn. Compare MIRR to NPV and/or IRR in each case. Calculate estimated gearing levels both with and without the proposed project. Compare the financial performance of the project against the company s financial objectives. The Chartered Institute of Management Accountants Page 11

12 Marking Guide Marks Part (a)(i) calculations of NPV, IRR and MIRR 13 marks Initial Investment 1.0 Residual Value Non Current Assets 0.5 Residual value - Net Current Assets % 1.0 Tax relief on TDAs 2.0 DCFs and NPV 1.0 IRR 3.0 MIRR 4.0 Maximum part (a)(i) 13 marks Part (a)(ii) advantages and limitations of MIRR in comparison with NPV and IRR 6 marks Up to 2 marks for each issue raised. Maximum part (a)(ii) 6 marks Part Evaluate project performance against financial objectives for MR 6 marks Key points How project meets financial objectives 2.0 Assessment against target gearing ratio 4.0 (both include calculations) Maximum part 6 marks Total maximum marks 25 Examiner s comments This question included the calculation of an IRR and MIRR, both of which are easily calculated using EXCEL functions but are quite complicated to set out correctly free hand. The better candidates sailed through with full marks but only a small minority of candidates used the EXCEL functions to full advantage. Others struggled to set out effective workings in EXCEL and took wrong turnings along the way. Competence in EXCEL had a major impact on the results for this question. Common errors included: Omitting residual value of non-current assets. Including the costs of the initial investigation (note that this is a sunk cost). Including depreciation rather than tax relief on depreciation in the DCF calculation. Errors in the MIRR calculation many candidates calculated a present value rather than a future value, others used an initial investment of 30 rather than 46. Inability to either describe or attempt to calculate MIRR. The Chartered Institute of Management Accountants Page 12

13 Question 4 Required: (a) (c) Discuss the rationale behind both Blue and Green s dividend policies and why a listed company such as Blue can be expected to have a different dividend policy to that of a private company such as Green. (9 marks) Explain Modigliani & Miller s dividend irrelevancy theory and its practical relevance to both Blue and Green in seeking to maximise shareholder value. (8 marks) Advise the Directors of Blue and the Directors of Green on an appropriate response to each of Mr B and Mr G s requests. (8 marks) (Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question Four concerns dividend decisions and how they differ between private and publicly listed companies. It also tests the understanding and application of Modigliani & Miller s Dividend Irrelevancy Theory. The question tests learning outcomes in Section A of the syllabus. Suggested Approach (a) Firstly discuss the rationale behind Blue s dividend policy, then do the same for Green s dividend policy. Describe how the financial objectives of a private company can be expected to differ from those of a listed company and how this is likely to impact their dividend policies. Explain the relevant Modigliani and Miller theory firstly stating the theory itself and then explaining the rationale behind the theory and the implications for setting dividend levels and determining dividend policies. Discuss to what extent this is relevant to either or both of companies Blue and Green. (c) Identify the three main methods for returning cash to shareholders or enabling shareholders to realise their investment in a private company: special one-off dividend, share repurchase or private sale of shares between individual shareholders and which, if any, might be appropriate for each of companies Blue and Green. In the light of your conclusions, compose a suitable response to Mr B and Mr G. Give full reasons for your suggestions. The Chartered Institute of Management Accountants Page 13

14 Marking Guide Up to 3 marks for each valid point (unless otherwise stated) Marks (a) Rationale behind Blue and Green s dividend policies and why they are different (9 marks) Blue: Market expects certain level of dividend. Signalling effect of dividends => stable, steady growth. Market does not like uncertainty. Share price will react to changing dividend levels. Financial institutions require steady returns to meet obligations. Small private investors also expect regular payouts. Green: No market pressures, no signalling effect. Can apply residual method, paying out dividends if no better use in reinvestment in the business. Applies a minimum payout to satisfy income needs of shareholders. Max 9 marks Modigliani & Miller s theory of dividend irrelevancy (8 marks) (c) Explain theory Explain practical relevance for: Blue Green Appropriate response to Mr B and Mr G s requests (8 marks) Mr B whether it might be appropriate to return cash to shareholders and, if so, how best to achieve this. Mr G how best to meet his cash need (dividend v arranging private purchase of his shares) Max 8 marks Max 8 marks Total maximum marks 25 Examiner s Comments This was the least popular question. There was a wide disparity of marks. Candidates with good knowledge of this subject scored well but there were also a number of very poor answers. Common errors: Inability to explain why a private company might be expected to have a different dividend policy from a publicly quoted company. Lack of knowledge of the basic premise of Modigliani and Miller s theory of Dividend Irrelevancy. Inappropriate responses to Mr B and Mr G. The Chartered Institute of Management Accountants Page 14

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.

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