# Diploma in Financial Management Examination Module B Paper DB1 incorporating subject areas: Financial Strategy; Risk Management

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3 Diploma in Financial Management Examination Module B Paper DB1 incorporating subject areas: Financial Strategy; Risk Management June 2005 Answers 1 D Items 2, 3 and 4 are correct. Item 1 relates to economic exposure. 2 D The expected return is: 5% (8% 5%) = 8 6% The predicted value of a share is: Po = D/r = 0 60/0 086 = 6 98 Option A uses the rate of return in the dividend formula incorrectly: Po = 0 60/0 86 = 0 70 Option B uses the CAPM formula incorrectly: 5% x 1 2 (8% 5%) = 18% Po = 0 60/0 18 = 3 33 Option C also uses the CAPM formula incorrectly; 5% (8%) = 14 6% Po = 0 60/0 146 = C Statement 2 is correct. Statement 1 is incorrect. Futures contracts are standardised. 4 A The cash settlement is [ 10m x {( )/100} x (183/365)] = 1 25,068 Option B includes the 1% cost of the cap = 125,068 Option C uses the strike rate only. [ 10m x (6 0/100) x (183/365)] = 300,822 Option D uses the LIBOR rate of 6 5% but does not deduct the strike rate. [ 10m x (6 5/100) x (183/365)] = 325,890 5 A (1) The investor can buy the shares at 860p compared to a market price of 880p. The option should therefore be exercised. (2) The investor can sell the 600,000 for 900,000 compared to 870,000 on the spot market. The option should therefore be exercised. 6 C The overall cost is calculated as follows: % Fixed rate (6 0) Net receipts ( ) 0 4 Total cost 5 6 Option A takes the LIBOR rate of 5 1% Option B takes the bank s rate of 5 5% Option D adds the net receipts to the 6 0% fixed rate: % Fixed rate 6 0 Net receipts ( ) 0 4 Total cost A Both statements are correct. Both types of report are required under the Combined Code. 8 C Gain per contract = \$1 80 \$1 65 = 0 15 \$600,000/1 80 = 333,333 No. of contracts = 333,333/ 62,500 = 5 (to nearest whole number) Total gain = 5 x 1,500 ticks x \$6 25 = \$46,875 Option A calculates on the basis of a gain of 150 ticks per contract = \$4,687 Option B calculates on the basis of 150 ticks per contract and treats the gain as a loss. Option D treats the gain as a loss. 17

4 9 B Expected return = [3 0% + 1 1( ) = 7 4% Actual return (7 4% + 1 4%) = 8 8% Option A deducts the alpha factor from the expected return (7 4% 1 4%) = 6 0% Option C adds the alpha factor to 1 1( ) = 12 4% Option D uses the incorrect CAPM formula Expected return = [3 0% + 1 1( )] = 14 0% Actual return (14 0% + 1 4%) = 15 4% 10 B The correct answer is B. The graph shows that the writer of the call option runs the risk of unlimited losses. 11 C C refers to an opportunity cost that should be taken into account. The other costs should be ignored. A is a committed cost, B refers to costs that do not vary with the decision, D refers to a non-cash charge. 12 A The correct answer is A. The distractors are a re-arrangement of the correct equation. 13 C Cash flow Disc. Rate PV 10% Yr 1 Interest Yr 1 Redemption value (25 x 5) Yr 1 Market value Yr 1 Option A includes the nominal value of the debentures in the calculations. Cash flow Disc. Rate PV 10% Yr 1 Interest Yr 1 Redemption value Yr 1 Market value Yr 1 Option B ignores the interest that is due for payment and takes the discounted value of the shares. Yr 1 Option D ignores the interest that is due and takes the undiscounted value of the shares as the appropriate figure. 14 A 5 0 = X (8 X) X = 3 0 Y = ( ) Y = 10 5 Option B is (1 5/0 4) x ( ) = 11 3% Option C is 3 0 x risk premium ( ) = 15 0% Option D is (1 5/0 4) x 5 0 = 18 8% 15 C The first statement is incorrect. Participating preference shares do not give the holder the right to participate at the AGM. The second statement is correct. Cumulative preference shares give the right to arrears of dividends. 16 B Share price = P/E ratio x EPS = 20 x 0 50 = Dividend = 2% x = 0 20 Dividend cover ratio = 0 50/ 0 20 = 2 5 times Option A transposes the dividend cover ratio figures ( 0 20/ 0 50) = 0 4 times. Option C calculates the dividend yield by reference to the par value of the shares = 2% x 1 00 = Hence dividend cover = 25 times. Option D calculates the dividend per share by reference to the EPS figure = 2% x 0 50 = Hence dividend cover = 50 times. 17 B Initial outlay ( 40m/4 0) = 10m Cash inflows (20% x 10m) = 2m Option A calculates the initial outlays as (20% x 40m) = 8m The cash inflows are 20% x 8m = 1 6m Option C calculates the cash inflows as ( 10m/0 20) = 50m Option D calculates the initial outlay as (4 0 x 40m) = 160m The cash inflows are (20% x 160m) = 32m 18

5 18 B Dividends = ( 60m/10)/2 = 3m r = D1/Po = (3 0/60 0) = 5 0% Option A uses the par value of the shares in the calculation of dividends Dividends = ( 10m/10)/2 = 0 5m r = D1/Po = (0 5/60 0) = 0 8% Option C uses the dividend cover ratio incorrectly Dividends = ( 60m/10) x 2 = 12m r = D1/Po = (12 0/60 0) = 20 0% Option D expresses the dividend paid of 3 million as a percentage of the issued share capital ( 3m/ 10m) = 30% 19 D Total CE = 30m/3 = 10m Debt = 0 4 x 10m = 4m Equity = 10m 4m = 6m NPAT = 30m/20 = 1 5m ROSF = 1 5m/ 6m = 25% Option A calculates total capital employed incorrectly: Total CE = 30m x 3 = 90m Debt = 0 4 x 90m = 36m Equity = 90m 36m = 54m NPAT = 30m/20 = 1 5m ROSF = 1 5m/ 54m = 2 8% Option B adds the debt to the capital employed figure. Total CE = 30m/3 = 10m Debt = 0 4 x 10m = 4m Equity = 10m + 4m = 14m NPAT = 30m/20 = 1 5m ROSF = 1 5m/ 14m = 10 7% Option C expresses the net profit as a % of total CE. ROSF = 1 5m/ 10m = 15% 20 A Both statements are correct. 19

7 2 (a) The effect on profit can be calculated as follows: 000s 000s 000s Increase in sales Category A customers (20% x 4m) Category B customers (30% x 4m) 1,200 0 Category C customers (50% x 4m) 2, ,000 0 Increase in variable costs Materials [ 4m/ 50) x 10] Overheads [( 4m/ 50) x 5) ,200 0 Increase in marketing costs 1,500 0 Increase in bad debts Category A customers (1 0% x 800) 8 0 Category B customers (3 0% x 1,200) 36 0 Category C customers (5 0% x 2,000) Increase in financing costs* Category A customers 6 6 Category B customers 13 2 Category C customers ,891 2 Net profit 1,108 8 *The financing costs are calculated as follows: Customer category A B C 000s 000s 000s Increase in sales , ,000 0 Additional debtors ( 800 x 30/365) 65 8 ( 1,200 x 40/365) ( 2,000 x 50/365) Interest charges (10%) (b) (c) The calculations in (a) above show that profits will increase by approximately 1 1m as a result of a 4m increase in sales. This return on sales, of approximately 28%, is achieved despite a marketing campaign which adds a further 1 5m to the total expenses of the company. This relatively high return on sales can be explained by the fact that most of the costs of producing the device are fixed. The contribution per device is 35 per unit (that is, 50 selling price less 15 variable costs) which gives a contribution-to-sales ratio of 70%. Hence, any additional output will make a significant contribution to profit. A number of policies can be adopted to ensure that credit customers pay on time. These include the following: Issue invoices promptly and ensure that the payment terms are specified on the invoice; Send out regular monthly statements and issue reminders when payment is overdue; Monitor debtors by producing an ageing analysis of debtors; Deal with outstanding queries quickly and efficiently; Chase slow payers by letter, and telephone; Ensure that no further credit is given to delinquent debtors. Offer financial incentives, such as discounts, to encourage prompt payment. (Examiner s note: Other answers to this part of the question would have been acceptable). 21

9 4 (a) The cost of capital is the discount rate, which when used to discount the future cash flows of a company, will not result in a change in the value of the company. It represents the minimum required return from investors and has an important role in investment decision making. The NPV method, which has been adopted by Selwyn plc, uses the cost of capital as the appropriate rate for discounting future cash flows in order to derive the net present value (NPV) of an investment. For a company wishing to maximise shareholder wealth, projects that produce a positive NPV should be accepted and those with a negative NPV should be rejected. If the cost of capital is overstated, there is a risk that profitable projects will be rejected. If the cost of capital is understated there is a risk that unprofitable projects will be accepted. (b) (i) Gordon dividend growth model K e = (d 1 /P o ) + g Where: K e = expected return to equity d 1 = the dividend in Year 1 g = the annual growth rate in dividends P o = the current share price K e = (23 15/550) + 5% = 9 2% (ii) Capital asset pricing model The first step required is to ungear the beta of Cavendish plc: β a = β e [E/{E + D (1 t)}] Where: β a = asset beta β e = equity beta E = equity proportion within capital structure D = debt proportion within capital structure t = corporation tax rate = 1 4 [80/{ (1 0 25)}] = 1 18 Using CAPM, the cost of equity for Selwyn plc will be: K e = r f + [E(r m ) r f ] β j Where: K e = expected return to equity r f = risk-free rate of return E(rm) = the expected return from the market as a whole β j = the ungeared beta of Cavendish plc K e = ( ) 1 18 = 8 72% (c) We can see that the methods used in (b) above produced different figures for the cost of equity capital. Given the different approaches used and estimated made, however, this is not surprising. The Gordon dividend valuation model is a multi-period model that establishes the return from a share, based on information relating to actual dividends and market prices and estimates concerning future growth rates in dividends. The estimation of future growth rates is normally the most difficult item to derive, particularly for a young company such as Selwyn plc. CAPM is a single period model which derives a return that should be expected from the shares given the systematic risk associated with them. The CAPM approach also requires estimates to be made. Estimating the beta for a share, the market rate of return and the risk-free rate can all pose problems. In this case, the beta for Selwyn plc is not available. Instead, a beta for a similar business is used to help calculate the cost of equity. The reliability of the cost of equity figure derived is, therefore, dependent on the assumption that the two companies share the same risk characteristics. The CAPM approach has been criticised for considering just one factor when calculating equity return the return on the market portfolio. Critics point out, however, that other factors, such as the size of companies are important in determining return. 23

11 6 To: Board of Directors of Caius plc From: A. Candidate Directors pay and conditions When considering the pay and conditions of the directors of the company, the following principles and policies are recommended. Remuneration policy The guiding principle should be that the pay and conditions of directors must be sufficient to attract, retain and motivate individuals who have the qualities required to manage the company. Many companies use incentive schemes to help in motivating directors and in aligning the interests of directors with those of the shareholders. Where incentive schemes are used, the amounts paid under the schemes should be based on the directors either meeting or exceeding clearly defined targets. If incentive schemes are properly structured, there is no reason why payments made under an incentive scheme should not comprise a significant proportion of the total remuneration of the directors. However, incentive schemes must always be related to performance and should be geared to the long-term rather than the short-term. Service contracts and loss of office The service contracts of the directors must strike a fair balance between the needs of directors and those of the shareholders. These contracts should not contain excessive notice periods; normally the period should be one year or less. The existence of contracts does not mean that the Board should tolerate poor performance. It should be prepared to dismiss directors that do not achieve agreed targets. Any compensation for loss of office should be reasonable and should be spread over time. Furthermore, compensation payments should come to an end when the director begins another job. Remuneration committee An important principle to be followed is that no director should be allowed to determine his or her remuneration. Instead, a remuneration committee should be formed which has responsibility for setting the pay and conditions of the executive directors. This committee, which should consist entirely of independent non-executive directors, should be charged with developing appropriate remuneration policies and for establishing remuneration packages for individual directors. In carrying out their duties, the committee should enter into a dialogue with the chief executive officer as well as major shareholders concerning directors remuneration. Communicating directors pay and conditions to shareholders The annual report of the company should include a report on the remuneration policy and details of the remuneration of each director. In addition, the chairman of the remuneration committee should attend the AGM and should be available to answer any questions relating to directors remuneration that may arise. (Examiners s note: Other answers to this question may have been acceptable.) 25

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13 Diploma in Financial Management Examination Module B Paper DB1 incorporating subject areas: Financial Strategy; Risk Management June 2005 Marking Scheme Marks Section B 1 (a) 1 mark per point 4 (b) 3 marks per method 12 (c) 1 mark decision, 1 mark per point (max 4 marks) (a) 2 marks sales, 2 marks variable costs, 2 marks bad debts, 1 mark marketing costs, 4 marks financing cost, 1 mark profit calculation 12 (b) 1 mark per point 3 (c) 1 mark per point (a) 2 marks primary market, 2 marks secondary market 4 (b) 2 marks per point (max 16 marks) Section C 4 (a) 2 marks cost of capital, 3 marks reasons why important 5 (b) 4 marks dividend growth model, 6 marks CAPM 10 (c) 2 marks per point (max 5 marks) (a) 4 marks, option, 2 marks forward contracts, 2 marks do nothing 8 (b) 1 mark per point 4 (c) 3 marks characteristics, 5 marks advantages and disadvantages marks per point (max 20 marks) 20 27

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