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1 F3 FINANCIAL STRATEGY Examiner s general comments This was the first diet under the 2010 syllabus for F3, which replaces P9 under the old syllabus. The syllabus content is largely unchanged but a revised exam format has been introduced with three optional questions and all three strategic level papers using the same pre-seen case study for Question One. Overall, the compulsory Question One was answered well, especially the calculations for part (a). The discussions for parts (b) and (c) were less well attempted, especially by candidates in non-uk centres where there are also significant weaknesses in the structure and presentation of answers. Although the pre-seen information was made available well in advance of the exam, relatively few candidates were able to incorporate any of this information into their answers. In the discussion sections there was also a tendency for candidates to address the question that they had expected to see rather than the question set. The lowest average mark was for Question Two. Very few candidates could answer parts (ai) and (aii) satisfactorily. Part (aiii) was generally well attempted. Many candidates did not read the requirement for part (b) correctly and discussed working capital management rather than WC financing. This question was more popular in non-uk centres than in UK centres. Questions Three and Four were the most popular of the optional questions. In Question Three there were some good discussions about stakeholders for part (a) and economic and market factors for part (b). Part (c) was generally less well attempted and few candidates attempted many, if any, calculations to support their discussion. On the whole, all parts of Question Four were very well answered. Further comments are provided under Examiner s Comments for individual questions. 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: Assume you are an external consultant engaged by Aybe to evaluate the proposed projects. Write a report, suitable for presentation to the Directors of Aybe, in which you: (a) (b) (c) (d) Calculate the Net Present Value (NPV) of each of Project 1 and Project 2 as at 1 January 2011 for the 5 year planning horizon. State any assumptions made. (17 marks) Evaluate how other relevant factors such as changes to the planning horizon might affect the choice of project and advise Aybe how to proceed. Up to 6 marks are available for calculations. (14 marks) Advise on the choice of currency if long term borrowings should be required to finance the new USA subsidiary in Project Two. (5 marks) Advise the Directors on how to achieve efficient management and control of the implementation of the proposed projects. Your answer should include discussion of the different issues arising for each project. (11 marks) Additional marks available for structure and presentation. (3 marks) (Total for Question One = 50 marks) Rationale Candidates are required to demonstrate the ability to evaluate two different investment projects involving foreign currency, including consideration of the sensitivity of the investment appraisal results to changes in key underlying assumptions. Advice on implementation and control issues arising in the context of the scenario is also required. Suggested Approach In (a), candidates should prepare a schedule of cash flows arising under each project, grouped according to timing. Relevant discount factors can then be used to calculate the present value of each group of cash flows and the overall expected present value for each project. Separate calculations will be required for tax depreciation allowances and future exchange rates. In (b), candidates should discuss the impact of changes to key underlying assumptions and other important factors on the choice of project. Relevant factors include: planning horizon residual value key costs and revenues Calculations should be included where appropriate. In (c) and (d), candidates should identify key issues and then address each one in turn. As a rough guide, aim for at least as many key issues as indicated by a figure of half the maximum marks. The Chartered Institute of Management Accountants Page 2

3 Marking Guide Structure and Presentation Part (a) Preliminary workings Exchange rates 1.5 Tax depreciation allowances and relief 2.5 Project 1 Factory refit in Country C Cash inflows Loss of income on current products 0.5} Cash outflows 0.5} Cost of refit 0.5} Residual value 0.5} Timing of tax cash flows Discounting and NPV Project 2 New factory in the USA Net operating cash flow 0.5 Government grant 0.5 Cost of land 0.5 Cost of development 0.5 Residual value 0.5 Tax treatment Conversion to C$ Discounting Total for part (a) Part (b) Evaluation of relevant factors affecting the choice of project Introduction referring to calculations in (a) Planning horizon Disruption to production (Project 1) Cost of specialist consultants Residual values Exchange rates Any other valid point Marks up to 3 marks per issue plus up to 3 marks per calculation (max 6 marks overall for calculations) Total part (b) (including maximum of 6 marks for calculations) 14.0 Part (c) Advantages of C$ borrowings Advantages of US$ borrowings, such as hedging of: US$ assets by US$ borrowings US$ income by US$ interest payments Shareholder expectations Overall conclusion up to 2 marks each Total part (c) 5.0 The Chartered Institute of Management Accountants Page 3

4 Part (d) Prepare plan Carry out implementation according to plan Monitor events and performance against plan Carry out post-completion audit (Maximum 3 marks if answer focuses solely on PCA) Up to 3 marks each For Project 1: Minimise disruption to current production For Project 2: Issues arising from managing a project in a foreign country (distance, culture etc) Total part (d) 11.0 Total maximum of question 50.0 The Chartered Institute of Management Accountants Page 4

5 Examiner s Comments Overall, the performance in this question was good, especially in part (a). However, there was some evidence that candidates spent too long on this question to the detriment of their performance on the optional questions. The better candidates managed to make some references to the pre seen material but many failed to make any connection. Part (a) The performance in part (a) was generally good with most candidates gaining at least satisfactory marks. Common errors were: Incorrect calculation of forward exchange rates, showing a weakening instead of a strengthening US$. Incorrect tax calculations, typically ignoring the balancing allowance, or incorrect timing of tax relief cash flows. Ignoring tax relief on development in Project 2 Timing errors on cash flows in Project 2, especially the cost of land and development. A sizeable minority of candidates, especially in non-uk centres, could not set up their NPV calculations in the prescribed tabular/columnar format. This made marking difficult and the candidate failed to gain credit for the structure and presentation of figures. Part (b) In part (b) many candidates identified relevant factors but often failed to relate the points that were being made to the choice of project. Some candidates would, for example, correctly make a point about delays in starting the projects affecting the NPV, but were not specific enough about how the delays would directly affect each of the projects, and hence the impact that this could have on the choice of project. Weaker candidates frequently discussed the sensitivity of the NPV result to changes in individual inputs but with little effort made to discuss the implications. Part (c) The main weakness in this part of the question was misreading the question and discussing possible methods of financing rather than the choice of currency. Part (d) This part of the question was generally well attempted although many answers lacked focus on the question asked. For example focussing the answer exclusively on post-completion audits or on other issues not critical to project control/implementation The Chartered Institute of Management Accountants Page 5

6 Question Two Required: (a) (i) (ii) (iii) (b) (i) (ii) Calculate the short-term and long-term (permanent) financing requirements of PIC under the aggressive policy for financing net current assets that is currently being used and also under the proposed new conservative policy. (5 marks) Calculate the implied issue price per A$100 nominal of the bond being considered by the treasurer. (3 marks) Calculate the weighted average cost of capital (WACC) of PIC at present and discuss, briefly, the likely effect on WACC if PIC changes its policy for financing net current assets. (4 marks) Evaluate PIC s proposal to change from an aggressive to a conservative policy for financing net current assets. (9 marks) Advise PIC, briefly, on alternative approaches to financing net current assets that it should consider. (4 marks) (Total for Question Two = 25 marks) Rationale This question is designed to test an understanding of the issues and choices involved in financing working capital requirements. Part (b) of the question tests the ability to evaluate and discuss the suitability of the proposed change in financing policy and advise on alternative approaches to financing net current assets. Suggested Approach The Chartered Institute of Management Accountants Page 6

7 In part (ai) calculate the minimum and maximum total working capital requirements and from there the fluctuating element of net current assets. Short and long term financing requirements can then be calculated for both the aggressive and conservative approaches. The answer is best shown in tabular format as per the suggested solutions. In part (aii), recognise that this is, basically, the calculation of the present value of the bond s income stream using the opportunity cost of capital as the discount rate. In part (aiii) calculate the return to each class of security weighted by its value proportional to the total market value of the company. Overdraft should be included if overdraft is used as finance over the longer term. In part (b) discuss the key issues as shown in the marking guide and in the published solutions. Recognise that in part (bii) the discussion is about the financing of working capital, not the levels of working capital although clearly some connection can be made. Discussion of the methods of finance should be relevant to the company and the scenario. Marking Guide Marks Marks (ai) Calculations of short and long term financing requirements (5 marks) Total WC requirements 1.0 Correct approach to calculations 1.0 Aggressive 1.5 Conservative (aii) (aiii) (bi) (bii) Issue price (3 marks) Correct formula (interest + principal, 5 years, no adjustment for tax) 1.0 Use of 9% DR 1.0 Issue price 1.0 WACC (4 marks) Calculation of WACC 2.0 Comments 2.0 Advantages, disadvantages & factors (9 marks) Advantages of current policy 2.0 Disadvantages of current policy 2.0 Features of proposed policy 1.0 Main factors/other features up to 4.0 Other methods of finance (4 marks) Moderate policy } Factoring } 4.0 Long term debt } Total marks 25.0 Examiner s Comments The Chartered Institute of Management Accountants Page 7

8 In part (ai) the computation of short- and long-term financing requirements under aggressive and conservative approaches was generally very poorly attempted, or not attempted at all. The majority of candidates who did attempt it failed to appreciate that creditors represent negative working capital. Part (aii) was similarly poorly attempted, if attempted at all, and very few candidates were able to work out the correct value of the bond. The most common error was to use the annuity factor for 8% instead of 9% in calculating the value of interest stream. Part (aiii) was generally well attempted although many candidates ignored overdraft. This was not penalised in marking. In part (bi) a significant number of candidates misinterpreted the question as an evaluation of the level of working capital needed (i.e. levels of inventory or receivables) and made too few, if any, points about the financing of net current assets. Answers to part (bii) were often inappropriate e.g. recommending a rights issue The Chartered Institute of Management Accountants Page 8

9 Question 3 Required: (a) Evaluate the interests of the various stakeholder groups in both XK and its subsidiary Company Y, and how these might be affected by the divestment. (7 marks) (b) (c) Discuss the economic and market factors that might impact on the negotiations between XK and the various financiers of the divestment (the Executive Directors of Y, the investment bank and the venture capitalist). (7 marks) Evaluate the advantages and disadvantages of the proposed buyout structure, and recommend alternative financing structures for the buyout. Up to 5 marks are available for calculations (11 marks) (Total for Question Three = 25 marks) Rationale This question tests the understanding of the motivation and processes involved in demergers/divestments. It extends to consideration of stakeholder interests, reasons for divestment and possible exit strategies. Suggested Approach In part (a) choose 4 or 5 groups of stakeholders appropriate to the situation and provide brief discussion of each, In part (b) discuss economic and market factors that might affect negotiations. Recognise that this question is not about products and marketing but markets. In part (c) provide some basic calculations around which to hang discussion, for example the implied P/E ratio, the effect of debt on earnings and the return to the Venture Capitalist. Discuss the advantages and disadvantages of the proposed buyout structure from the perspective of the interested parties, especially noting the consequences of a high level of debt, and recommend alternative financing structures. The Chartered Institute of Management Accountants Page 9

10 Marking Guide Marks (a) (b) (c) Discussion of stakeholders (7 marks) Main groups: Shareholders of XK Directors and employees of XK Directors and other employees of subsidiary Y Creditors and bankers Customers Other Maximum 3 marks per group to overall Maximum of 7 Economic and market factors (7 marks) Interest rates and inflation Stock market movement/sentiment Alternative investment opportunities Regulatory controls Advantages and disadvantages of the buyout structure (11 marks) (up to 3 marks per issue) Venture capital Investment Bank Executive Directors Summary and Recommendation 6 Calculations up to Total maximum marks 25 Examiner s comments Overall, this question was answered satisfactorily although few managed to provide many, if any, calculations to support their answer to part (c). Common errors were: In part (a) discussing too few types of stakeholder. Conversely, some candidates wrote far too much for this part of the question and ran out of time to answer the other parts satisfactorily. Discussing the advantages and disadvantages of MBO in general, rather than the advantages and disadvantages of the MBO structure proposed in the scenario. Not understanding that Y is a wholly owned subsidiary and discussing the shareholders of Y as if they were individuals rather than recognising that Y is wholly owned by XK. Assuming a divestment was the subsidiary going out of business. The Chartered Institute of Management Accountants Page 10

11 Question 4 Required: (a) Discuss the meaning of the terms systematic and unsystematic risk and their relationship to a company s equity beta. Include in your answer an appropriate diagram to demonstrate the difference between the two types of risk. (6 marks) (b) Using the CAPM and the information given in the scenario about CIP and Companies A and B, calculate for each of CIP s proposed investments: An asset beta. An appropriate discount rate to be used in the evaluation of the investment. (6 marks) (c) Evaluate the benefits and limitations of using each of the following in CIP s appraisal of the two investments: CIP s WACC. An adjusted WACC as suggested by the Managing Director. CAPM-derived rates that use proxy (or surrogate) companies betas. (6 marks) (d) Discuss, briefly, how an asset beta differs from an equity beta and why the former is more appropriate to CIP s investment decision. Include in your discussion some reference to how the use of the CAPM can assist CIP to achieve its financial objective. (7 marks) (Total for Question Four = 25 marks) Rationale This question is designed to test understanding and application of CAPM, beta and systematic versus unsystematic risk. It also requires calculations to ungear and regear beta. Suggested Approach In part (a) discuss the meaning of systematic and unsystematic risk and its relationship to a company s equity beta. Provide a suitable diagram to accompany your discussion. It is important to provide labels for the two axes of the diagram. In part (b) Ungear the proxy companies equity betas Re-gear the ungeared betas for the proposed investments Use the re-geared betas in the CAPM formula to calculate a discount rate for each of the proposed investments and calculate WACC. In part (c) evaluate the key benefits and limitations of the three possible discount rates given in the question as they relate to CIP. In part (d): Discuss the differences between asset betas and equity betas Explain why asset betas might be more appropriate in CIP s investment decision Discuss how the use of the CAPM can assist CIP achieve its financial objectives. The Chartered Institute of Management Accountants Page 11

12 Marking Guide (a) Systematic and unsystematic Risk (6 marks) Comments 4 Diagram 2 Marks 6 (b) (c) (d) Calculations of beta and discount rates (6 marks) Calculation of betas 3.0 Calculate cost of equity using CAPM (using either B a or B g ) 1.0 Discount Rate of Investment Discount Rate of Investment Benefits and limitations of possible Discount Rates (6 marks) WACC 2 Adjusted WACC 1 CAPM derived rates 3 Equity and asset and betas and use of CAPM (7 marks) Equity and asset betas 4 CAPM and financial objectives Total maximum marks 25 Examiner s Comments This question was frequently the best answered by those who attempted it. Common errors were: Confusing the terms systematic risk and unsystematic risk. The same problem was noted for asset beta and equity beta. Providing a very poor attempt at the diagram. Many candidates provided a diagram of the security market line. The Chartered Institute of Management Accountants Page 12

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