The overall performance in this exam was comparable with May and September 2010 although there was a noticeable improvement in some overseas centres.

Transcription

1 F3 FINANCIAL STRATEGY Examiner s general comments The overall performance in this exam was comparable with May and September 2010 although there was a noticeable improvement in some overseas centres. The compulsory question one was generally answered well, especially the calculations for part (a), although many candidates provided a profit and loss statement not a cash flow forecast and/or failed to provide a statement of cash and cash equivalents. As in May and September, relatively few candidates were able to incorporate any of the pre-seen information into their answers. In the discussion sections many candidates provided comprehensive answers that would have been improved by greater focus on the scenario. The most popular of the optional questions was question 3 and this question gained the highest average mark. Question 4 was the most poorly answered. None of the optional questions was noticeably avoided by candidates. A summary of candidates performance on each of the optional questions is given below. Question 2 Overall, this question was poorly attempted. Part (ai), calculation of cost of equity, was often not attempted at all. Part (aii) was generally answered satisfactorily although candidates frequently did not include the conversion premium. Many answers to part (b) failed to recognise the specific issues raised by the scenario and provided a discussion of everything the candidate knew about raising new debt and equity Question 3 This question was generally answered very well by most candidates who attempted it, especially the calculations for part (ai), although a minority of candidates did not calculate profitability indices. Part (b) was frequently ignored or misunderstood. In Part (c) many answers discussed all types of key factors whereas the question required a focus on financial factors. Question 4 This question tended to be answered very well indeed, or very poorly. In part (ai) few candidates gained more than token marks for the MM graphs. Answers to part (bi) frequently multiplied the share price by number of shares in issue rather than using the DCF approach. Part (bii) required the use of MM s model with taxes. Many candidates attempted valuation of ADS s equity using a variety of other methods. However, on the own answer principle, most candidates gained marks for the WACC calculation. Part (c) was particularly poorly attempted and most candidates failed to address the question asked. 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. The Chartered Institute of Management Accountants Page 1

2 SECTION A 50 MARKS Question One Required: (a) Construct, for each of the financial years ending 30 June 2012 and 30 June 2013: A forecast of the net cash flow for the year; A statement of opening and closing balances for cash and cash equivalents and long term borrowings. (13 marks) (b) Assume you are an external consultant engaged by the Board to prepare a report on the factors that need to be considered should a takeover bid be received from TUV Airport. Write a report addressed to the Board in which you: (i) Calculate a range of values for DEF Airport as at 1 July Discuss your results and advise on an appropriate valuation for use in negotiations with TUV Airport. (Up to 7 marks are available for calculations) (14 marks) (ii) Explain the main differences in the financial objectives of public and private sector organisations, illustrating your answer by reference to the stated financial objectives of both DEF Airport and TUV Airport. (8 marks) (iii) Discuss the strategic implications of the proposed sale of the business for the LSGs and also for each of the other major stakeholder groups. Advise the LSGs whether or not to negotiate a sale of the business to TUV Airport. (12 marks) Additional marks available for structure and presentation: (3 marks) (Total for Question One = 50 marks) Rationale To test the ability to use modelling techniques to assess impact of changes in economic conditions on future cash flows of the airport. Also evaluate the value of the airport on different bases by a competitor airport that is interested in making a bid for the airport. Consider the financial and strategic implications of the proposed disposal on the local state governments and other stakeholders. This question examines learning outcomes from Sections A and C of the syllabus. The Chartered Institute of Management Accountants Page 2

3 Suggested Approach (a) The first stage is to calculate the income for the years ending 30 June 2012 and 30 June 2013 by multiplying the year to 30 June 2011 figures by (1 + % increase in passenger numbers) for aviation and car park income and then (1 + relevant inflation figure) for all income categories. Depreciation needs to be deducted from costs to obtain cash flows relating to costs and this net figure uplifted for inflation. Next include interest paid and received, calculated on the basis of the closing cash and borrowings as at 30 June Tax can then be calculated and included in the forecast, as can tax depreciation allowances, to arrive at the net cash flow for the year ended 30 June The net cash flow figure for the year ended 30 June 2012 can be used to obtain the closing balances for borrowings and cash/cash equivalents for that year. These figures form the basis of the interest calculations for the year ended 30 June A cash flow forecast can now be drawn up for the year ended 30 June 2013 in a similar manner. (b)(i) The figures calculated in (a) provide the income cash flows for the years ended 30 June 2012 and 30 June 2013 and the figures for the next 3 years are provided in the question. The only calculation required is therefore a cash flow figure for the year ended 30 June 2017 onwards and an appropriate discount rate calculated using the growing perpetuity formula. (b)(ii) In part (b)(ii), key financial objectives of public and private sector organisations need to be presented and compared and reference made to the given case for each main objective discussed. Finally, in part (b)(iii), discuss strategic implications. Also identify each stakeholder group and then consider the impact of the proposed sale on each one in turn, ending with a conclusion on the advisability of the sale of the airport. Marking Guide Marks Part (a) - Cash flow statements and cash balances for 30 June 2012 & 30 June 2013 (13 marks) Cash flows Uplift of income (1 mark per business segment) 3.0 Costs (including depreciation adjustment 1 mark) 2.0 Interest paid and received (1 mark each) 2.0 Tax at 30% Tax depreciation allowances 3.0 Proforma of cash flow Reconciliation of cash and cash equivalents Maximum part (a) marks The Chartered Institute of Management Accountants Page 3

4 Part (b)(i) - Calculate a value for DEF Airport and discussion/advice (14 marks) DCF calculation Net asset valuations Discussion and advice Maximum part (b)(i) For 30 June 2012 and June 2013 use figs from part (a)1.0 Add figures for year to 30 June 2014 to Year to 30 June 2017 onwards including discounting 2.0 Discounting and NPV 1.0 Calculation/recognition of synergistic benefits 1.0 Net asset calculation Range Explanation of NA value being larger than DCF 1.0 Dependency of result on assumptions made 2-3 marks each Likely acceptable price max 7.0 max marks Part (b)(ii) - Explain differences in financial objectives of public and private sector organisations with reference to DEF and TUV Airports (8 marks) Key points up to 3 marks each Typical financial objectives for public and private sector organisations Key differences between them Reference to both DEF and TUV Airport objectives Maximum part (b)(ii) 8 marks Part (b)(iii) - Discuss strategic implications of proposed sale for the LSGs and each major stakeholder group. (12 marks) Key points up to 2 marks each (but up to 3 marks for the conclusion) LSGs Employees Passengers Local residents Airlines Conclusion Return on investment calculation Comment on level of return Comment on cash flow risk arising on the investment Reduced influence on transport links Possible reduced headcount Impact on services and prices Priority given to noise levels Increases TUV s influence Summarise reasons for advising sale by LSGs Maximum part (b)(iii) Additional marks available for structure and presentation (1 for headings, 1 for purpose, 1 for tabulated calculations where appropriate) Total maximum for question 12 marks 3 marks 50 marks The Chartered Institute of Management Accountants Page 4

5 Examiner s Comments Part (a) of this question was generally well attempted. Common errors were: Ignoring other income in the forecast net cash flow Incorrect uplift of other income (that is, using a percentage other than 7%) Not deducting depreciation from operating costs Not including interest receivable Providing a Profit & Loss not a Cash Flow Forecast Incorrect treatment/calculation of tax depreciation allowances Not providing a statement of cash and cash equivalents as required by the question Poor layout of figures Part (bi) was less well attempted. Many candidates used total assets not Net Current Assets. Other common errors were: Incorrect perpetuity calculation in the discounted cash flow Ignoring synergistic benefits, or discounting them incorrectly Parts (bii) and (biii) were generally well attempted although many candidates appeared short of time and did not answer either or both these questions. Answers to part (biii) were sometimes wide of the mark and did not adequately address the scenario. The Chartered Institute of Management Accountants Page 5

6 Question Two Required: (a) Calculate: (i) (ii) GUC s current cost of equity The gross yield to maturity of the convertible bond up to and including conversion, assuming the convertible bond is issued on 25 November State any assumptions made. (10 marks) (b) Evaluate the THREE alternative methods of finance being considered by GUC and advise which method might be most appropriate. (15 marks) (Total for Question Two = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION Rationale Question 2 concerns a large gas utility company in the USA that is reviewing three alternative methods of raising finance: equity via a rights, straight bonds or convertible debt. The question requires some basic calculations to support the discussion of the features, advantages and disadvantages of the three methods. The question tests learning outcomes in syllabus section B. Suggested Approach For part (ai) calculate cost of equity using either EPS/current market price per share, or the dividend valuation model based on any reasonable assumptions. In part (aii) firstly calculate the premium on conversion which, added to the redemption of the principal, is the expected share price in year 5. Then discount the cash flows (capex, annual interest and capital redemption) at two appropriate rates. Calculate the YTM by interpolating between these two rates. In part (b) identify and evaluate the factors to consider in the three methods of finance under discussion, which are new equity via a rights issue, a 5 year straight bond and a convertible bond. Key factors are summarised in the marking scheme below. End your evaluation with a conclusion. The Chartered Institute of Management Accountants Page 6

7 Marking Guide Part (a) Calculations 10 marks Marks Cost of equity Yield to maturity Cost of equity (EpS/share price or DVM approach) 2.0 Future share price 2.0 Discounted cash flows 6.0 TOTAL for part (a) Part (b) Evaluation 15 marks 10.0 Key points up to 3 marks each Rights issue 5 Explanation Comparison of P/E with industry average Discount required Effect on gearing Effect on ownership/eps Need for signals to the market Need for dividends to be paid on increased number of shares. Bonds 5 Explanation Coupon rate Dilution of ownership/eps in long term Gearing Convertible bonds 5 Explanation Coupon rate: cheap finance versus yield to maturity Dilution of ownership/eps in long term Gearing Conclusion 3 TOTAL for part (b) Max 15 from 18 Total maximum marks 25 Examiner s Comments Part (ai) was often not attempted. In part (aii), candidates frequently did not include the conversion premium in the Yield to Maturity calculation. Many answers to part (b) failed to recognise the specific issues raised by the scenario and provided a discussion of everything the candidate knew about raising new debt and equity. The Chartered Institute of Management Accountants Page 7

8 Question Three Required: (a) (i) (ii) Calculate the NPV and PI of each of the THREE projects based on the GBP cash flows. (8 marks) Evaluate your results and advise PEI which project or combination of projects to accept. (7 marks) (b) (c) Explain the alternative method of evaluating Project C using an A$ discount rate, illustrating your answer with a calculation of an appropriate A$ discount rate. (4 marks) Discuss the key financial factors, other than the NPV decision, that should be considered before investing in a project located in a foreign country rather than the home country. (6 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION (Total for Question Three = 25 marks) Rationale This question concerns a UK-based private educational institution that is evaluating three investment opportunities that would allow it to expand its operations within the UK and to target new markets overseas. It does not have sufficient funds available to invest in all three projects and does not wish to borrow at this time. The question requires an evaluation of the investments when capital is rationed and also the calculation of a suitable discount rate for one of the projects. The question examines learning outcomes in Syllabus Section C. Suggested Approach In part (a) discount the cash flows and calculate an NPV for each project. Projects A and B should be discounted at 8% and project C at 9% to reflect the additional risk. For project B note there is a residual value. For project C, calculate exchange rates to convert the operating cash flows into GBP sterling from A$. Profitability indices should be calculated for each project by dividing the NPV by the initial investment. Part (aii) requires recognition that capital is limited to 25 million. It is therefore useful to rank the projects in order of NPV and profitability index (PI) and then look at the combination of any two projects. The discussion should focus on which combination gives the highest NPV and PI without breaking the investment limit. Some discussion should be provided about the limitations of PI when all projects are not of equal duration and risk. Finish your answer with advice on which projects to accept. In part (b) explain that the alternative method involves working with A$ cash flows and an A$ discount rate. Then calculate the A$ discount rate. In part (c) discuss key financial factors. The Chartered Institute of Management Accountants Page 8

9 Marking Guide Marks Part (ai) 8 marks Calculations Project A 2.0 Project B 3.0 Project C 3.0 Total for part (a)(i) 8.0 Part (aii) 7 marks Discussion Key points Capital rationing 1.0 Rankings by NPV and PI individual projects 1.0 Ranking by combination of projects 1.0 Evaluation and advice (advice on combination) 4.0 Total for part (a)(ii) 7.0 Part (b) 4 marks Calculation of discount rate 1.5 Explanation of alternative methods 2.5 Total for part (b) 4.0 Part (c ) 6 marks Key points: up to 2 marks per point Type of finance/hedging/matching if loan Risk appetite of shareholders Political risk Tax implications Choice of discount rate Total for part (c) Max 6 marks Total maximum marks 25 Examiner s comments Part (a) was very well answered by most candidates who attempted this question. Common errors were: Ignoring Residual Value in Project B Getting the exchange rates the wrong way round in Project C Not calculating profitability indexes (PIs) Part (b) was frequently ignored or misunderstood. The requirement for a calculation of the A$ discount rate should have been the clue as to what approach was required. In Part (c) many answers discussed all types of key factors whereas the question required a focus on financial factors. The Chartered Institute of Management Accountants Page 9

10 Question Four Required: (a) Discuss: How the MM models, both with and without corporate taxes, differ from the traditional view of the relationship between gearing and cost of capital. Accompany your discussion with appropriate graphical illustrations. The limitations of MM models in real world situations. (10 marks) (b) (i) Calculate the value of ADS s equity using discounted cash flow techniques, assuming that the new stores are financed by equity. (2 marks) (ii) Calculate, assuming that the new stores are financed by the undated bond and using the MM model with corporate taxes, the following: The value of ADS s equity; The expected cost of equity; The weighted average cost of capital (WACC). (6 marks) (c) Explain your results in (b) above and advise the directors whether their concern about lowering the value of equity is valid. (7 marks) (Total for Question Four = 25 marks) A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION The Chartered Institute of Management Accountants Page 10

11 Rationale Question 4 concerns a large, listed retail entity in Asia. It is currently all-equity financed but is considering issuing an undated bond to finance investment in new stores. The question requires discussion of how Modigliani and Miller s theories differ from traditional models and calculations of company value and cost of capital. The question examines learning outcomes in syllabus section B. Suggested Approach In part (a) introduce your answer by recognising the similarities between the Modigliani & Miller (MM) and traditional approaches. Then discuss how they differ. Up to 3 graphs should be provided to accompany your discussion; one of the traditional model, one of MM without taxes and one of MM with taxes. It is important to remember to label the axes on your graphs and clearly indicate which graph is which. Conclude with a discussion of the limitations of MM to real world situations. In part (bi) calculate the value of equity by dividing the forecast earnings of ADS by the cost of equity minus expected growth rate. In part (bii) calculate: The value of equity assuming Vg = Vug +TB The cost of equity using MM s formula with taxes, as shown in the formulae sheet The WACC using the cost of equity just calculated. In part (c) explain the impact of taxes on lowering the cost of capital and that when cost of capital decreases the value of the company will increase. Advise the directors why the apparent fall in the value of equity is not of long term concern when new finance is raised by debt. Marking Guide Marks Part (a) 10 marks How MM differs from traditional view 4.0 Graphical illustrations 4.0 Limitations in real world (WACC and MM to get maximum) 3.0 Total for part (a) Max 10 from 11 Part (b)(i) 2 marks Value of ADS s equity if ungeared 2.0 Total for (b)(i) Max 2 Part (b)(ii) 6 marks Value of ADS s equity if geared - Starting with V u Tax shield V g 1.0 Expected cost of equity (geared) 2.0 WACC 2.0 Total for part (b)(ii) Max 6 from 6.5 The Chartered Institute of Management Accountants Page 11

12 Part (c) 7 marks Key points 7.0 Explain difference in value of equity Explain difference in WACC Distinguish value of equity and shareholder wealth Conclude that, under MM, the Directors are wrong to be concerned as shareholder wealth is HIGHER if the bond is issued V e will fall by V d (1-ts) Explain traditional viewpoint depends on current capital structure and position on U -shaped WACC curve Total for part (c) Max 7 Total maximum marks 25 marks Examiner s Comments This question tended to be answered very well indeed, or very poorly. Some overseas centres provided very good answers to part (a) in particular. Few candidates gained more than token marks for the MM graphs, which were generally very poorly reproduced e.g. showing curves going in the wrong direction and not labelling (or mis-labelling) the axes. Some candidates discussed MM s theory of dividend-irrelevancy instead of gearing. Answers to (bi) frequently simply multiplied the share price by number of shares in issue rather than using the DCF approach as required. Part (bii) required the use of MM s model with taxes. Many candidates attempted valuation of ADS s equity using a variety of other methods. On the own answer principle, most candidates gained marks for the WACC calculation. Part (c) was particularly poorly attempted and most candidates failed to address the question asked. The Chartered Institute of Management Accountants Page 12