The Institute of Chartered Accountants in England and Wales

Financial
Management

Question Bank
For exams in 2021

icaew.com
Financial Management
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-5097-3315-6
Previous ISBN: 978-1-5097-2782-7
eISBN: 978-1-5097-3270-8
First edition 2007
Fourteenth edition 2020
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system or transmitted in any form or by any means, graphic, electronic or
mechanical including photocopying, recording, scanning or otherwise, without the
prior written permission of the publisher.
The content of this publication is intended to prepare students for the ICAEW
examinations, and should not be used as professional advice.
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library.
Contains public sector information licensed under the Open Government Licence
v3.0.
Originally printed in the United Kingdom on paper obtained from traceable,
sustainable sources.

© ICAEW 2020
Contents
The following questions are exam-standard. They are not the original questions from the exams. The
marking guides provided with the answers are illustrative to help students understand how marks
may be allocated in the exam and to identify gaps in their answers.

Title Time Page

Marks allocation
(Mins) Question Answer

Objectives and investment appraisal

1 Stoane Gayte Sounds plc 35 52.5 1 135

2 Profitis plc 17 25.5 2 139

3 Horton plc 30 45 3 141

4 ProBuild plc 29 43.5 5 144

5 Frome Lee Electronics Ltd 26 39 6 148

6 Nuts and Bolts Ltd 24 36 8 150

7 Newmarket plc 35 52.5 9 154

8 Grimpen McColl International Ltd 30 45 10 158

9 Wicklow plc 35 52.5 12 161

10 Daniels Ltd 25 37.5 14 165

11 Hawke Appliances Ltd 35 52.5 15 168

12 Alliance plc 35 52.5 17 172

Finance and capital structure

13 Turners plc 35 52.5 21 177

14 Middleham plc 35 52.5 22 180

15 Better Deal plc 35 52.5 23 182

16 Puerto plc 35 52.5 24 185

17 Abydos plc 35 52.5 26 188

18 Biddaford Lundy plc 35 52.5 27 192

19 BBB Sports plc 35 52.5 28 196

Business valuations, plans, dividends and growth

20 Cern Ltd 31 46.5 31 201

21 Wexford plc 35 45 33 204

22 Loxwood 45 60 35 208

23 Sennen plc 35 52.5 37 212

24 Tower Brazil plc 35 52.5 38 216

25 Brennan plc 20 30 40 219

ICAEW 2021 Contents iii

 Title Time Page
Marks allocation
(Mins) Question Answer

Risk management

26 Fratton plc 30 45 43 221

27 Sunwin plc 26 39 44 223

28 Padd Shoes Ltd 30 45 45 226

29 Lambourn plc 35 45 46 229

30 Bridge Engineering plc 30 45 49 232

March 2016 exam questions

31 Aranheuston Pharma plc 35 52.5 51 237

32 Oliphant Williams plc 35 52.5 52 241

33 Tully Carlisle Ltd 30 45 53 245

June 2016 exam questions

34 Zeus plc 35 52.5 57 249

35 Ross Travel plc 35 52.5 58 252

36 Heaton Risk Management 30 45 59 256

September 2016 exam questions

37 Northern Energy Ltd 30 45 63 261

38 Roper Newey plc 35 52.5 64 264

39 Darlo Games Ltd 35 52.5 65 267

December 2016 exam questions

40 Ribble plc 35 52.5 69 273

41 Bristol Corporate Finance 35 52.5 70 276

42 Orion plc 30 45 72 280

March 2017 exam questions

43 Sentry Underwood plc 35 52.5 75 283

44 White Rock plc 35 52.5 76 286

45 ST Leonard Foods 30 45 79 292

June 2017 exam questions

46 Brighton plc 35 52.5 81 297

47 Easton plc 35 52.5 82 300

48 Lake Ltd 30 45 83 303

September 2017 exam questions

iv Financial Management ICAEW 2021

Title Time Page
Marks allocation
(Mins) Question Answer

49 Merikan Media plc 35 52.5 85 307

50 Ramsey Douglas Motors plc 35 52.5 86 309

51 Jenson Grosvenor plc 30 45 88 313

December 2017 exam questions

52 Innovative Alarms 35 52.5 91 317

53 Peel Kitchens plc 35 52.5 92 320

54 Jewel House Investments Ltd 30 45 94 324

March 2018 exam questions

55 Wells Bakers plc 35 52.5 97 329

56 Hunt Trading plc 30 45 98 332

57 Bishop Homes Ltd 35 52.5 100 335

June 2018 exam questions

58 Helvellyn Corporate Finance 35 52.5 103 341

59 Blackstar plc 35 52.5 105 344

60 Tarbena plc 30 45 107 347

September 2018 exam questions

61 Thomas Rumsey Group plc 35 52.5 109 351

62 Heath Care plc 35 52.5 110 355

63 Eddyson Cordless Ltd 30 45 112 359

September 2019 exam questions

64 Hodder Specialist Engineering Ltd 35 52.5 115 363

65 Jackett Clarke Travel plc 35 52.5 116 368

66 Barratt Waters Shine plc 30 45 118 373

December 2019 exam questions

67 Packaging Innovations plc 35 52.5 121 379

68 Wizard plc 35 52.5 122 383

69 Moon Sport Ltd 30 45 124 387

March 2020 exam questions

70 Engavon plc 30 45 127 393

71 AOS Energy plc 35 52.5 128 396

72 Greene & Banks plc 35 52.5 129 400

ICAEW 2021 Contents v

 Title Time Page
Marks allocation
(Mins) Question Answer

Appendices

Appendix: Formulae 409

Appendix: Discount tables 411

vi Financial Management ICAEW 2021

Question Bank topic finder
Set out below is a guide showing the Financial Management syllabus learning outcomes, topic areas,
and related questions in the Question Bank for each topic area. If you need to concentrate on certain
topic areas, or if you want to attempt all available questions that refer to a particular topic, you will
find this guide useful.

Topic area Syllabus Question number(s) Workbook

Learning chapter(s)
outcome(s)

Adjusted present value 1h 9,13,17,38,47,53,68,71 6

Business valuation methods 3i 11,20,22,23,25,34,39,49 8

Capital rationing 3g 3,10,12,44 2

CAPM 1i 13,14,15,16,19,35,38,41,47, 3, 6
53,55,68,71

Cryptocurrency 2d 26,29,69 10

Currency futures 2d 29,36,37,42,48,51,54,60,63 10

Currency options 2d 26,28,33,36,37,42,45,48,51, 10

54,56,60,63,66,69,70

Data analytics 3d 17,21 3

Debenture issues 1k 17,35,41,50,53,59 6

Dividend policy 1j 1,15,24,32,43,53,59 7

Economic risk 2f 42,51,63 10

EMH/behavioural effects 1d 13,14,16,17,44,50,53 4

Ethics 1c 19,22,23,24,32,34,39,40,43, 1, 4
46,50,52,55,59,61,65,67,72

Financial statements/ financing 1l 16,21,41,43 6

plans

Forward contracts 2d 26,28,29,33,36,37,42,45,48, 10

51,54,56,60,63,66,69,70

Forward rate agreements 2c 26,37,45 9

Gearing 1h 24,53,65,68 6

Gordon growth model 1g 13,19,62,68,71 5

Hedging advice 2a, 2b 28,42,45,48,51,54,56,60,63, 9, 10

66,69,70

Index options/futures 2c 27,36,54,63 9

Interest rate futures 2c 26,27,29,45,54,56,69 9

Interest rate options 2c 27,30,37,45,56,66 9

Interest rate parity 2c 42,60 9

Interest rate swaps 2c 33,37,54 9

Loan covenants 1e 16 4

ICAEW 2021 Introduction vii

 Topic area Syllabus Question number(s) Workbook
Learning chapter(s)
outcome(s)

Management buy outs 3i 23,34,41,49 8

Money market hedges 2d 26,28,29,33,37,45,48,51,56, 10

63,66,69,70

NPV – assumptions/strategic 3e 7,8 2

factors

NPV calculations – inflation 3b 4,5,6,8,8,64,70 2

NPV calculations – relevant cash 3b 1,4,5,6,7,8,9,10,11,12,44,52, 2

flows 57,58,61,72

Overseas trading 2f, 3f 8,19,28,48,51,63 2, 10

Real options 3e 4,7,40,46,52,57,61,64,67,72 2

Replacement decision/cycle 3h 2,10,20,52 2

Rights issues 1k 18,24,41,44,53,59,65 7

Risk 3d 4,7,8,19,47,64,70 2, 3

Sensitivity analysis 3c 9,11,12,31,40,46,52,57,64,6 3

7,72

Share buy back 1j 59 7

Share for share exchange 3i 23 8

Share options 2e 30,36 9

Shareholder value analysis (SVA) 3a 22,25,31,39,46,49,58,61 2, 8

Sources of finance/capital 1f, 1g 16,18,24,32,47,53,59,62 4, 5, 6

structure

Stakeholder objectives and 1a, 1b 31,32,41,43,46,47,53,59,67 1

conflict

Weighted average cost of capital 1g 13,14,15,16,19,35,38,47,50, 5

(WACC) 53,55,62,68,71

viii Financial Management ICAEW 2021

Exam
Your exam will consist of:
• 3 questions – 100 marks
• Pass mark – 55
• Exam length – 2.5 hours
The ACA student area of our website includes the latest information, guidance and exclusive
resources to help you progress through the ACA. Find everything you need, from exam webinars,
past exams, marks plans, errata sheets and the syllabus to examiner and tutor-written articles at
icaew.com/examresources.

ICAEW 2021 Introduction ix

Professional skills
Professional skills are essential to accountancy and your development of them is embedded
throughout the ACA qualification. The level of competency in each of the professional skills areas
required to pass each module exam increases as ACA trainees progress upwards through each Level
of the ACA qualification.
The professional skills embedded throughout this Question Bank provide the opportunity to develop
the knowledge and professional skills required to successfully pass the exam for this module.
During your question practice, remain mindful that you should be demonstrating each of the four
professional skills within your answers. You are advised to familiarise yourself with the full ACA
professional skills development grids which can be found at icaew.com/examresources.
The following advice will help you demonstrate each of the professional skills when completing your
answers to questions in this Question Bank.

Approach to ACA Professional Skills

Questions in the Financial Management exam will focus on the three main syllabus areas: financing
options, managing financial risk and investment decisions and valuation. Each question will be
broken down into a number of different requirements or tasks covering many different areas of the
syllabus. Below are the key skills required in the Financial Management module exam that you will
need to master to be able to answer each requirement correctly.

The Financial Management exam requires you to attempt three questions (one from each syllabus
area) in 2.5 hours. Managing financial risk will be assessed as a discrete topic. The other two
questions will assess financing options and investment decisions and valuation either as discrete or
integrated topics. Being disciplined, reading both the scenario and the requirement carefully, and
keeping track of time will mean that you work effectively within time constraints, which will offer you
the best chance of passing. It is important that you use your time efficiently to make sure you
understand the business or situation presented in the question and identify the information that is
relevant to each of the individual requirements.
A key aspect to this skill is in ensuring that you have an accurate understanding of the precise
meaning of each requirement within a question, and do not make the common mistake of
reproducing answers to previous exam questions that were similar, but different, to the question
being answered. This is especially important in discussion questions.

Each scenario will be different, so you need to practise a wide variety of questions in order to be able
to identify and accurately apply relevant technical knowledge and skills to analyse a specific
problem. This will help you to demonstrate the skill of being able to structure information from
various sources into suitable formats for analysis and provide pragmatic solutions in a business
environment.
Often the required technique will be specified but questions may also require you to identify the
technique that needs to be applied.

Applying judgement to financial management problems may involve consideration of broader

factors beyond the immediate scope of a specific technique, for example:
• the impact of an investment on other stakeholders, including possible ethical issues;
• the impact of a dividend decision on investment or financing plans;

x Financial Management ICAEW 2021

• application of professional scepticism and critical thinking by showing awareness of the
drawbacks to the techniques that have been used; and
• assessing contradictory information (for example different valuations of a business using different
techniques).
Where you are applying your judgement, you will need to concisely explain your logic as part of your
answer, so if, for example, you think that a calculation needs to be adjusted (for example a P/E ratio in
a business valuation), you will need to accompany this adjustment with a brief explanation of why
you are making it.

In the Financial Management exam, you are often asked to provide advice to the board. To be able to
do this successfully you need to demonstrate that you can apply your technical knowledge, skills and
experience to support reason-based conclusions and formulate advice based on valid evidence.
Examples of this include:
• ensuring that advice relates to the question scenario wherever possible; and
• demonstrating an understanding of the meaning and relevance of any financial calculations on
which the recommendations are based.
The ability to communicate clearly in a manner suitable for the recipient is also important.

ICAEW 2021 Introduction xi

xii Financial Management ICAEW 2021
Question Bank
xiv Financial Management ICAEW 2021
 Objectives and investment appraisal
1 Stoane Gayte Sounds plc
Stoane Gayte Sounds plc (SGS) manufactures audio equipment and has a financial year end of 31
March. Its directors are considering making use of SGS’s cash reserves to finance an investment of
£4.9 million in a new range of high specification audio speakers for cars, to be marketed under the
brand name of Inca. However, two of SGS’s directors are of the opinion that this money should be
used for an ordinary dividend payment instead, as they feel that this would help to increase the
company’s share price. They are therefore considering the use of peer-to-peer (P2P) lending to raise
new finance to fund the investment.
You work in SGS’s finance team and have been asked to advise the SGS board. You have been given
the following information:
Sales
£80,000 of market research work for SGS has been done by Etchingham Tyce Marketing Ltd (ETM) in
the past two months and the payment for this work has yet to be made. The results of the research
suggest that, although it is a very competitive market, Inca speakers would be popular amongst
young drivers for at least three years. ETM’s estimated figures for Inca sales over the next four years,
based on a selling price of £190 per unit (at 31 March 20X3 prices), are shown below:

Units
Year to 31 March 20X4 65,000
Year to 31 March 20X5 110,000
Year to 31 March 20X6 55,000
Year to 31 March 20X7 15,000

As a result of these estimates SGS’s directors are concerned about the riskiness of the proposal and
so wish to appraise the investment in Inca speakers over a three-year period only (ie, to 31 March
20X6).
Costs
The estimated variable costs (at 31 March 20X3 prices) of manufacturing one Inca unit are:

£
Raw materials 43
Variable overheads 45
Skilled labour (£9/hour) 18

Because of a lack of skilled labour, SGS will have to transfer all of the skilled production hours
required to manufacture the Inca away from the manufacture of another, lower specification speaker,
the Boom-Boom. Thus a proportion of the Boom-Boom production would have to cease. Current
production details for the Boom-Boom (at 31 March 20X3 prices) are shown below:

Per unit
£
Selling price 99
Raw materials 28
Variable overheads 35
Skilled labour (£9/hour) 9

SGS’s directors estimate that the company’s total fixed overheads are unlikely to change as a result of
manufacturing the Inca, but will nonetheless apportion a share of SGS’s existing fixed costs at a rate
of £27 per Inca unit (at 31 March 20X3 prices). However this does not include the depreciation

ICAEW 2021 Objectives and investment appraisal 1

 charge (to be spread evenly over the three financial years ending 31 March 20X6) that will be
incurred as a result of the capital expenditure for the Inca (see details below).
Capital expenditure
In order to manufacture the Inca speakers, new machinery costing £4.9 million would be purchased
on 31 March 20X3. SGS’s production director estimates that this could be sold on 31 March 20X6 for
£980,000 (at 31 March 20X6 prices).
This machinery will attract 18% (reducing balance) capital allowances in the year of expenditure and
in every subsequent year of ownership by the company, except the final year. In the final year, the
difference between the machinery’s written down value for tax purposes and its disposal proceeds
will be treated by the company either:
• as a balancing allowance, if the disposal proceeds are less than the tax written down value; or
• as a balancing charge, if the disposal proceeds are more than the tax written down value.
Working capital
SGS’s directors estimate that a net investment of £750,000 for additional working capital to support
the Inca will be required on 31 March 20X3 and that this will be fully recoverable on 31 March 20X6.
Inflation
Revenues, costs and working capital are all expected to increase in line with the general rate of
inflation, which is estimated at 3% pa.
Taxation
SGS’s directors wish to assume that the corporation tax rate will be 17% pa for the foreseeable future
and that tax flows arise in the same year as the cash flows which gave rise to them.
Cost of capital
For investment appraisal purposes SGS uses a money cost of capital of 11% pa.
Other information
• SGS’s ordinary dividends have been rising steadily over the past five years and in the financial
year to 31 March 20X2 they totalled £3.4 million.
• Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
Requirements
1.1 Calculate the net present value of the Inca proposal at 31 March 20X3 and, based on this
calculation alone, advise SGS’s directors whether they should proceed with it.
(17 marks)
1.2 Calculate the internal rate of return of the Inca proposal at 31 March 20X3 and advise SGS’s
directors as to the usefulness of this figure.
(6 marks)
1.3 Discuss, with reference to relevant theories, the view that SGS should, as an alternative to the
Inca proposal, pay an ordinary dividend in order to increase the company’s share price.
(6 marks)
1.4 Explain what is meant by peer-to-peer lending and outline the advantages and disadvantages
to SGS of using this type of finance to fund the new investment.
(Ignore any impact on SGS’s gearing ratio)
(6 marks)
Total: 35 marks

2 Profitis plc
Profitis plc has a continuing need for a machine. At the level of intensity of use by the company, after
four years from new the machine is not capable of efficient working. It has been the company’s
practice to replace it every four years. The production manager has pointed out that in the fourth
year the machine needs additional maintenance to keep it working at normal efficiency. The question
has therefore arisen as to whether to replace it after three years instead of the usual four years.

2 Financial Management ICAEW 2021

 Relevant information is as follows.
(1) The machine costs £80,000 to buy new. If it is retained for four years, it will have a zero scrap
value at the end of the period. If it is retained for three years, it will have an estimated disposal
value of £10,000.
The machine will attract capital allowances. For the purposes of this analysis assume that it will
be excluded from the general pool. This means that it will attract a 18% (reducing balance) tax
allowance in the year of acquisition and in every subsequent year of being owned by the
company, except the last year. In the final year, the difference between the machine’s written
down value for tax purposes and its disposal proceeds will be treated by the company either as
a balancing allowance, if the disposal proceeds are less than the tax written down value; or a
balancing charge, if the disposal proceeds are more than the tax written down value.
Assume that the machine will be bought and disposed of on the last day of the company’s
accounting year.
(2) The company’s corporation tax rate is 17%. Tax is payable on the last day of the accounting year
concerned.
(3) During the first year of ownership the supplier takes responsibility for any necessary
maintenance work. In the second and third years maintenance costs average £10,000 a year.
During the fourth year these rise to £20,000. Maintenance charges are payable on the first day of
the company’s accounting year and are allowable for tax.
(4) The company’s cost of capital is estimated at 15%.
Requirements
2.1 Prepare calculations to show whether it would economically be more desirable to replace the
machine after three years or four years.
(13 marks)
2.2 Discuss any other issues that could influence the company’s replacement decision. This should
include any weaknesses in the approach taken in 2.1.
(4 marks)
Total: 17 marks

3 Horton plc
3.1 The objective of the directors of Horton plc (Horton) is the maximisation of shareholder wealth.
The directors are currently considering Horton’s capital investment strategy for 20Y0. Five
potential investment projects have been identified, each one having an expected life of four
years. However, at this stage the directors are uncertain of the precise financial situation the
company will be in on 31 December 20X9 when it will actually make its chosen investments.
The company accountant has already undertaken net present value calculations for each of the
five potential investment projects as follows:

Initial Investment (31.12.X9) Net Present Value (31.12.X9)

£ £
Project 1 (2,400,000) 2,676,600
Project 2 (2,250,000) (461,700)
Project 3 (3,000,000) 4,111,500
Project 4 (2,630,000) 2,016,250
Project 5 (3,750,000) (45,250)

Whilst these net present value calculations include the impact of corporation tax, which the
company pays at 17%, they do not include the effect of capital allowances. Project 3 is the only
project that will attract capital allowances and these allowances will apply just to the initial £3
million investment. The allowances will be at a rate of 18% per annum on a reducing balance
basis, commencing in the year of initial investment, with either a balancing charge or

ICAEW 2021 Objectives and investment appraisal 3

 allowance arising in the final year of the project. The directors are confident that the company
will be able to use all capital allowances in full.
The company’s cost of capital is 10%. The cashflows used by the company accountant to
calculate the original net present values of the projects were as follows:

T0 T1 T2 T3 T4
Project 1 (2,400,000) (750,000) 300,000 4,200,000 3,450,000
Project 2 (2,250,000) (750,000) 1,800,000 900,000 450,000
Project 3 (3,000,000) (1,500,000) 3,750,000 3,750,000 3,750,000
Project 4 (2,630,000) 750,000 1,650,000 2,100,000 1,500,000
Project 5 (3,750,000) 1,050,000 1,350,000 1,950,000 250,000

Project 3’s T4 cashflow of £3.75 million includes disposal proceeds of £1 million relating to the
assets originally purchased on 31 December 20X9 for £3 million.
To reflect the uncertainty regarding Horton’s financial position at the end of 20X9, four
potential scenarios have been identified for consideration:
Scenario 1: Horton will face no capital rationing and the five projects will be independent and
divisible.
Scenario 2: Horton’s available capital for investment at T0 will be limited to £4.5 million; the five
projects will be independent and divisible and none of the projects can be delayed.
Scenario 3: Horton’s available capital for investment at T0 will not be limited, but its available
capital for investment at T1 will be limited to £0.3 million; the five projects will be independent
and divisible and none of the projects can be delayed.
Scenario 4: Horton’s available capital for investment at T0 will be limited to £5.25 million, and
whilst the five projects will be independent and none of the projects can be delayed, they will
be indivisible.
One director has indicated that he wishes to discuss the possibility of leasing some of the
assets that would be required as a result of these investment projects in preference to outright
purchase of the assets.
Requirement
(a) Calculate the revised net present value of Project 3 at 31.12.X9 taking account of the
capital allowances attributable to that project.
(4 marks)

(b) For each of the four scenarios, prepare calculations which show the proportion of each
project that should be undertaken.
(12 marks)

(c) Discuss the potential attractions of lease finance over outright purchase of an asset.
(3 marks)
3.2 The managing director of one of Horton’s subsidiary companies has approached Horton’s
finance director for advice. On 31 December 20X9 the subsidiary company will be replacing its
three existing company cars with brand new vehicles. The managing director wishes to know
whether to replace these new vehicles every one, two or three years from now on. He has
provided the following background information:
(1) Each new car will cost £11,000.
(2) Resale values for each car (assumed to be received in cash on the last day of the year to
which they relate) are estimated to be £7,000 after one year, £4,200 after two years and
£1,800 after three years.
(3) Annual running costs for each car (assumed to be paid on the last day of the year to which
they relate) are estimated at £6,600 in the first year of ownership, £7,600 in the second
year and £9,200 in the third year.

4 Financial Management ICAEW 2021

 (4) The subsidiary company uses a discount rate of 10% in its appraisal of such investments.
(5) For the purposes of the advice to be given to the managing director, taxation and inflation
can be ignored.
Requirement
(a) Using appropriate calculations, advise the managing director of the optimal replacement
policy for these new company cars.
(5 marks)

(b) Outline the limitations of the method used in answering 3.2(a) above.
(6 marks)

Total: 30 marks

4 ProBuild plc
ProBuild plc (ProBuild) runs a network of builders’ merchants in northern England. The company has
a small subsidiary, Cabin Ltd (Cabin) that hires out various types of portable cabin used on building
sites. In recent years, Cabin’s performance (relative to that of ProBuild’s core business) has been
disappointing and the directors of ProBuild have decided that they should focus resources on their
core operations and dispose of Cabin.
Having advertised the business for sale, ProBuild has now been approached by the directors of
Brixham plc (Brixham) with an offer to buy Cabin on 31 December 20X3. Brixham has agreed, in
principle, to pay ProBuild the net present value (as at 31 December 20X3) of the projected
incremental net cash flows of Cabin over the four-year period to 31 December 20X7.
You have been asked by Brixham’s directors to calculate an appropriate purchase price using the
following information which has been provided by ProBuild and verified by independent
accountants:
(1) All cash flows can be assumed to occur at the end of the relevant year unless otherwise stated.
(2) Inflation is expected to average 2% pa for all costs and revenues.
(3) The real discount rates applicable to the appraisal of this investment are:
20X4: 5%
20X5: 6%
20X6: 7%
20X7: 7%
(4) During the past five years, Cabin’s annual revenue (at 31 December 20X3 prices) has been
extremely volatile, having peaked at £2 million in one year, whilst falling to a low of £1.2 million
in another year.
(5) During the past five years, Cabin’s variable costs have been similarly volatile, being as low as
25% of annual revenue in one year, whilst having been as high as 30% of annual revenue in
another year. There has been no direct correlation between annual revenue and variable costs
during the past five years.
(6) It has been estimated that under Brixham’s ownership, annual fixed costs will be £0.6 million (at
31 December 20X3 prices), including a share of Brixham’s existing head office costs equal to
£0.25 million.
(7) Working capital equal to 8% of Cabin’s annual revenue for that year must be in place by the start
of the year concerned and, for the purposes of the calculation of a purchase price, it can be
assumed to be released in full on 31 December 20X7.
(8) Cabin has an existing commitment (which Brixham would have to honour as a condition of its
purchase of Cabin) to make a substantial investment of £1.5 million in new plant and equipment
on 31 December 20X3. This equipment is expected to have a useful working life of four years, at
which time it is estimated that it will be disposed of for a sum of £100,000 (at 31 December 20X7
prices).

ICAEW 2021 Objectives and investment appraisal 5

 This new plant and equipment will attract capital allowances of 18% pa on a reducing balance basis
commencing in the year of purchase and continuing throughout Brixham’s ownership of the
equipment. A balancing charge or allowance will arise on disposal of the equipment on 31
December 20X7.
It can be assumed that sufficient profits would be available for Brixham to claim all such tax
allowances in the year they arise. It can also be assumed that the corporation tax rate will be 17% for
the foreseeable future, and that tax payments will occur at the end of the accounting year to which
they relate.
Requirements
4.1 Using money cash flows, calculate the net present values at 31 December 20X3 of the Cabin
business for both the ‘worst case’ and ‘best case’ scenarios.
(17 marks)
4.2 Distinguish between the terms ‘uncertainty’ and ‘risk’ in the context of investment decision
making and describe how the directors of Brixham might adjust the calculations made in 4.1
from calculations made under conditions of uncertainty to calculations made under conditions
of risk.
(6 marks)
4.3 Explain what is meant by the term ‘real options’ and suggest two real options that might be
relevant to Brixham’s purchase of Cabin.
(6 marks)
Total: 29 marks

5 Frome Lee Electronics Ltd

Frome Lee Electronics Ltd (Frome Lee) makes small portable radios. Frome Lee’s board has been
considering the financial implications of launching a new radio, which it would call ‘The Pink ‘Un’. You
have recently been appointed on a short-term contract at Frome Lee following the sudden
resignation of the company’s chief accountant and have received this memo from the managing
director:

To: A Newman
From: Diana Marshall
Date: Friday, 5 September
As you are aware, our chief accountant, John Smith, left Frome Lee earlier this week following a
disagreement over company policy.
As a result we desperately need financial advice from you. We are considering the purchase of
capital equipment for the manufacture of a new radio, The Pink ‘Un. Our marketing team feels that
we would have a competitive advantage with this new radio for three years. Mr Smith had
prepared some estimated figures which we were going to consider at our next meeting on
Monday and he left some of them behind. You will find my summary of them (with some of my
notes) in the Appendix below. We would want to purchase the equipment at the end of our
financial year on 30 September, commence production very soon after and sell the equipment at
the end of September 20Y1.
The board would like to consider a complete set of figures and your recommendations over the
weekend so that we can reach a prompt decision on Monday. Apologies for giving you so little
time, but we don’t want to miss what could be a valuable investment opportunity for the company.
Diana Marshall

6 Financial Management ICAEW 2021

Appendix – summary of information available

Year to 30 September 20X8 20X9 20Y0 20Y1

£’000 £’000 £’000 £’000
Equipment cost (400.000)
Equipment scrap value 60.000
Working capital increment (32.000) (Note 1) (3.000) 40.000
Direct material costs (52.000) (64.000) (70.000)
Other variable costs (12.000) (14.000) (16.000)
Incremental fixed costs (11.000) (11.800) (12.700)
Sales (Note 1) Figures to be calculated
Direct labour costs (Note 2) Figures to be calculated

Notes
(1) As you can see, I don’t know the estimated sales figures, but we always make sure that we have
sufficient working capital, based on 10% of the annual sales, in place at the beginning of the
relevant year. All working capital will be recovered at the end of September 20Y1. We need to
know the missing figures for (a) annual sales (for 20X9–20Y1) and (b) working capital (for 20X9)
from this information.
(2) We always estimate labour costs at 50% of material costs.
(3) When discounting, we use a real cost of capital figure of 5% and make adjustments for inflation
when necessary. The figures in the appendix above are all in money terms and I’d like you to use
the following annual rates of general price inflation when working out the present values of the
estimated cash flows:

%
Year to 30 September 20X9 3
Year to 30 September 20Y0 3
Year to 30 September 20Y1 4

I’m not sure how accurate our cost of capital is, but I did read the other day that if a business uses the
wrong cost of capital figure ‘it destroys shareholder value’.
Capital allowances
The equipment would attract capital allowances, but would be excluded from the general pool.
Assume that this means that it attracts 18% (reducing balance) tax allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In the
final year, the difference between the equipment’s written down value for tax purposes and its
disposal proceeds will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down value; orb
• balancing charge, if the disposal proceeds are more than the tax written down value.
The corporation tax rate can be assumed to be 17% over the next three years.
Requirements
5.1 Calculate the net present value at 30 September 20X8 of proceeding with production of The
Pink ‘Un and advise the board as to whether it should purchase the equipment.
(15 marks)
5.2 Explain your approach to the effects of inflation in your calculation in 5.1 above.
(3 marks)
5.3 In response to Diana Marshall’s Note (3), discuss the view that a business, by using the wrong
cost of capital figure, ‘destroys shareholder value’.

ICAEW 2021 Objectives and investment appraisal 7

 (4 marks)
5.4 Explain, in the context of the proposed investment, the nature and importance of follow-on
and abandonment real investment options.
(4 marks)
Total: 26 marks

6 Nuts and Bolts Ltd

Nuts and Bolts Ltd (NBL) manufactures parts for motor cars and the majority of its customers are UK-
based. Its financial year end is 31 March. Its management team is considering the purchase of
machinery that would produce a new type of catalytic converter (model number NBL 1114).
However, NBL’s management team, mindful of the current weakness of the UK economy, is uncertain
as to the level of demand for NBL 1114. As a result it commissioned a market research report from
Ashford Hume Research and that report showed two alternative overall levels of demand for NBL
1114 – pessimistic throughout the project’s life or optimistic throughout the project’s life. The report
concluded that these alternative overall levels of demand were equally likely to occur.
For each of the overall levels of demand (pessimistic or optimistic), demand for NBL 1114 varies in
the first year of the project as shown here in Table 1:
TABLE 1

Pessimistic Optimistic
Annual demand
(units) Probability Annual demand (units) Probability
6,000 25% 10,000 25%
10,000 50% 14,000 37.5%
14,000 25% 20,000 37.5%

Demand in each subsequent year of the project’s life would remain at the first year’s expected level.
Financial information about the new machinery and NBL 1114 is shown here in Table 2:
Table 2

NBL 1114’s period of competitive advantage (1 April 20X1 to 31 March 20X4) 3 years
Maximum annual output of new machinery (units of NBL 1114) 12,800
Cost of new machinery (payable on 31 March 20X1) £480,000
Scrap value of new machinery (at end of three-year period, ie, 31 March 20X4) £nil
NBL 1114’s contribution per unit (based on a selling price per unit of £65) £33
Additional annual fixed costs incurred (including annual depreciation charge of
£160,000) £300,000
Extra working capital required at 31 March 20X1 (recoverable in full on 31 March
20X4) £50,000

Working capital
The working capital requirement for each year must be in place at the start of the relevant year.
Capital allowances
NBL’s machinery and equipment attracts capital allowances, but is and will be excluded from the
general pool. The equipment attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In the
final year, the difference between the equipment’s written down value for tax purposes and its
disposal proceeds will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down value; or
• balancing charge, if the disposal proceeds are more than the tax written down value.

8 Financial Management ICAEW 2021

 Inflation
All of the above figures are stated at 31 March 20X1 prices. NBL’s management is unsure of the rate
of inflation and would like to consider the impact of either 0% or 5% annual inflation.
Other relevant information:
(1) NBL’s directors would like to assume that the corporation tax rate will be 17% for the foreseeable
future and the tax will be payable in the same year as the cash flows to which it relates.
(2) Unless otherwise stated all cash flows occur at the end of the relevant trading year.
(3) NBL uses a real post-tax cost of capital of 10% for appraising its investments.
Requirements
6.1 Assuming that the annual rate of inflation is zero, calculate the expected net present value of
the NBL 1114 project at 31 March 20X1 and advise NBL’s management whether it should
purchase the new machinery.
(18 marks)
6.2 Assuming that the annual rate of inflation is 5%, explain, with supporting calculations, what the
impact will be on the expected net present value at 31 March 20X1 of this proposed
investment if the effects of inflation on pre-tax contribution and working capital are taken into
account.
(6 marks)
Total: 24 marks

7 Newmarket plc
Newmarket plc (Newmarket), a listed company, has recently developed a new lawnmower, the
NL500. Development of the NL500 was supported by market research which was undertaken by an
external agency who agreed that their £10,000 fee would only be payable if the NL500 was actually
launched, with payment due at the end of the NL500’s first year on the market.
Newmarket’s directors estimate that the market life of the NL500 will be five years but they would be
willing to launch the NL500 only if they were satisfied that the required investment would generate a
net present value of at least £300,000, using a discount factor of 10% pa.
Production and sale of the NL500 would commence on 1 July 20X3 and would require investment by
Newmarket in new production equipment costing £750,000, payable on 30 June 20X3. On 30 June
20X8 it is expected that this equipment could be sold back to the original vendor for £50,000.
Newmarket depreciates plant and equipment in equal annual instalments over its useful life.
The company’s directors would like to assume that the corporation tax rate will be 17% for the
foreseeable future, and it can be assumed that tax payments would occur at the end of the
accounting year to which they relate. The directors are also assuming that the new production
facilities would attract capital allowances of 18% pa on a reducing balance basis commencing in the
year of purchase and continuing throughout the company’s ownership of the equipment. A
balancing charge or allowance would arise on disposal of the equipment on 30 June 20X8. It can be
assumed that sufficient profits would be available for Newmarket to claim all such tax allowances in
the year they arise.
Purchase of the new production equipment would be financed by a five-year fixed rate bank loan
which will be drawn down on 30 June 20X3 at an interest rate of 6% pa. Interest on the loan would
be payable annually, with repayment of the capital being made in full on 30 June 20X8.
Newmarket’s marketing director has estimated annual demand for the NL500 to be 2,000 units and
on that basis the finance department has estimated the unit cost of the NL500 as follows:

ICAEW 2021 Objectives and investment appraisal 9

 £
Labour (4 hours @ £12 per hour) 48.00
Components 32.00
Loan interest 22.50
Depreciation 70.00
Variable energy costs 5.00
Share of Newmarket’s fixed costs 20.00
197.50

If the NL500 is launched, a manager already employed by Newmarket would be moved from his
present position to manage production and sale of the NL500. This existing manager’s position
would consequently have to be filled by a new recruit, specifically employed to replace him, on a
five-year contract at a fixed annual salary of £35,000. The launch of the NL500 would have a
negligible impact on both Newmarket’s working capital requirements and on its fixed costs.
Newmarket’s accounting year end is 30 June and it can be assumed that all cash flows would occur at
the end of the year to which they relate.
Requirements
7.1 Calculate (to the nearest £) the minimum price per unit that Newmarket should charge for the
NL500 if a net present value of at least £300,000 is to be achieved.
(15 marks)
7.2 Identify and describe two quantitative techniques that Newmarket could use to assess and
adjust for the various risks to which launching the NL500 would expose the company.
(6 marks)
7.3 Distinguish between systematic risk and non-systematic risk and explain, using examples, how
each of these types of risk might apply to the launch of the NL500.
(6 marks)
7.4 Identify and explain, in the context of the proposed investment in the NL500, the nature and
importance of the real options available to Newmarket.
(8 marks)
Total: 35 marks

8 Grimpen McColl International Ltd

Grimpen McColl International Ltd (GMI) specialises in the construction of hydroelectric dams. It has a
financial year end of 31 December. GMI is currently negotiating with the government of a South
American country regarding a new dam that the government plans to build on a tributary of the River
Amazon. You work for GMI and have been asked to advise its directors during the negotiations. The
following information has been collected:
Costs
GMI’s estimated costs of constructing the dam (all at 31 December 20X2 prices except where stated
otherwise) are shown below:

31 December
20X2 20X3 20X4 20X5
£’000 £’000 £’000 £’000
Specialist machinery (Note 1) 30,000
Working capital (Note 2) 5,000
Materials and labour costs 7,000 8,000 9,000

10 Financial Management ICAEW 2021

 31 December
20X2 20X3 20X4 20X5
£’000 £’000 £’000 £’000
Overheads (Note 3) 4,000 4,500 5,000
Lost contribution (Note 4) 4,000 4,000 4,000

Notes
1 GMI will need to purchase specialist machinery for the construction of the dam. This will have an
estimated resale value at the end of the construction period of £5 million (at 31 December 20X5
prices).
2 The initial working capital required will increase by £1 million pa (in 31 December 20X2 prices),
but will be fully recoverable on 31 December 20X5.
3 The overhead costs include a share of GMI head office costs which have been allocated to this
project at a rate of £1.5 million pa.
4 South America would be a new market for GMI and its directors are keen to win this contract. If
GMI were successful then it would be necessary to transfer resources from other projects –
typically service contracts for existing GMI dams in Europe and North America. The directors
estimate that this would result in a loss of contribution in each year of the construction period.
Inflation rates and cost of capital
GMI’s directors propose using the following inflation rates:
Materials, labour and overhead costs – 4% pa
Working capital – 4% pa
Lost contribution – 5% pa
GMI’s directors plan to use a money cost of capital of 8% when appraising this investment. However,
one of GMI’s directors has commented ‘I think that our hurdle rate may be wrong. Inflation rates may
actually be higher than those used in our estimates, which should be adjusted to take account of
this.’
Capital allowances
The specialist equipment attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In the
final year, the difference between the plant and equipment’s written down value for tax purposes and
its disposal proceeds will be treated by the company either:
• as a balancing allowance, if the disposal proceeds are less than the tax written down value; or
• as a balancing charge, if the disposal proceeds are more than the tax written down value.
Contract price
GMI’s board is keen that the contract price is not too high and has tendered a price of £95 million.
£10 million would be receivable on 31 December 20X2 when the specialist equipment is purchased.
The second instalment of £85 million (in 31 December 20X5 prices) would be receivable on
completion of the dam.
Taxation
GMI’s directors wish to assume that the corporation tax rate will be 17% for the foreseeable future
and that tax flows arise in the same year as the cash flows which gave rise to them.
Maintenance contract
The South American government has also proposed that, were GMI to build the dam, then GMI
should also provide annual maintenance in perpetuity from completion of the dam on 31 December
20X5. GMI’s directors estimate that this would cost GMI £3 million pa (in 31 December 20X5 prices)
and feel that it would be reasonable to charge a price of £5 million pa (in 31 December 20X5 prices).
Costs and revenues for the maintenance contract are expected to rise by 3% pa after 31 December
20X5. However, they are concerned about such a long-term commitment and would like to
investigate the price at which GMI could sell this maintenance contract to another company.

ICAEW 2021 Objectives and investment appraisal 11

 Other information
• Unless otherwise stated, all cash flows occur at the end of the relevant trading year.
• Ignore all foreign currency issues.
Requirements
8.1 Ignoring the maintenance contract, calculate the net present value of the dam project at 31
December 20X2 and advise GMI’s directors whether they should proceed with it.
(13 marks)
8.2 Calculate the minimum value of the second instalment of the contract price (receivable on 31
December 20X5) that would be acceptable to the GMI board, assuming that it wishes to
enhance shareholder value.
(3 marks)
8.3 With reference to the GMI director’s concerns about the rates of inflation being more than the
original estimates, discuss the potential effect of this on the project’s cash flows, cost of capital
and net present value.
(5 marks)
8.4 Advise the GMI board, showing supporting calculations, of the minimum selling price on 31
December 20X2 that it should set were it to sell the maintenance contract.
(4 marks)
8.5 Discuss the types of political risk that GMI may encounter were its proposed investment in
South America to proceed.
(5 marks)
Total: 30 marks

9 Wicklow plc
Wicklow plc (Wicklow) is a manufacturer of prestige cast iron cookers, having a long-standing
reputation for selling distinctive high price, high quality cookers to an increasingly global market. In
the face of growing competition from firms offering slightly more modern style cookers at much
lower prices, Wicklow’s recent strategy has been to introduce a ‘Heritage’ version of some of its
major product lines. The aim has been to emphasise the original design features of the brand and to
differentiate itself further from its competitors.
Wicklow is currently considering the introduction of a ‘Heritage’ version of its existing ‘Duo’ product,
a standard two-oven cooker. Wicklow has recently spent £375,000 developing the new version of the
product, to be known as the Duo Heritage (DH).
Production of the DH would require Wicklow to invest £2 million in new machinery and equipment
on 31 December 20X8. Based on past experience, the directors are assuming that this machinery
and equipment will have a disposal value on 31 December 20Y2 of £200,000.
Sales of the DH would be expected to commence during the year ending 31 December 20X9. Based
on a unit selling price of £7,000, Wicklow’s marketing director has estimated that unit sales in 20X9
will be either 1,500 (0.65 probability) or 2,000 (0.35 probability). In view of the uncertainty of unit
demand in the first year of production, the marketing director has also forecast that if 20X9 sales
were to be 1,500 units, then 20Y0 sales would be estimated at either 1,800 units (0.7 probability) or
2,000 units (0.3 probability). However, if 20X9 sales were to be 2,000 units, 20Y0 sales would be
estimated at either 2,200 units (0.6 probability) or 2,500 units (0.4 probability). In 20Y1 and 20Y2 unit
sales would be 110% of the expected unit sales in 20Y0. In each year production will equal sales,
which can be assumed to occur on the last day of each year.
As with other similar ‘Heritage’ product launches, the company invariably experiences a consequent
loss of sales on the original product line. In this particular case, the expectation is that for every two
DHs sold, the sale of one standard Duo oven will be lost. This effect would be expected to continue
throughout the four years over which the directors have decided to appraise this potential project.
As a result, it can be assumed that sales of both cookers will not continue beyond 20Y2.
The unit selling price and cost structure of the standard Duo product are as follows:

12 Financial Management ICAEW 2021

 £
Selling price 6,500
Materials 3,516
Labour (8 hours) 200
Fixed overheads (on a labour hour basis) 480

Launch of the DH is not expected to impact on the company’s total fixed overheads.
The material cost per unit of the DH will be £3,800. Production of each DH will require eight hours of
labour. The reduced levels of production on the Duo product line would mean that part of this labour
requirement will be met from labour transferred from that product, but to the extent that this would
provide insufficient hours, additional labour will be recruited at the company’s standard labour rate
of £25 per hour.
Each major product line within Wicklow is currently managed by a dedicated team of managers.
However, should the DH be launched, one additional manager would need to be recruited to the
Duo team. Wicklow has identified this new manager. He is currently employed by the company and
had recently accepted voluntary redundancy but would now be asked to stay on until 31 December
20Y2. He was due to leave Wicklow on 31 December 20X8 and to receive a lump sum of £35,000 at
that time. He will be paid an annual salary of £40,000 together with a lump sum bonus of £20,000
payable on 31 December 20Y2.
Working capital to support production of the DH would be expected to run at a rate of 15% of sales
value, although this would be off-set to some extent by reduced working capital commitments in
respect of the standard Duo product which also requires working capital equal to 15% of sales value.
The working capital would need to be in place by the beginning of each year and can be assumed to
be released in full on 31 December 20Y2. The working capital flows will have no tax effects.
Regarding tax, the directors are assuming that if Wicklow buys the new machinery and equipment it
will attract capital allowances of 18% per annum on a reducing balance basis, commencing in the
year of acquisition, with either a balancing charge or allowance arising at the end of the equipment’s
useful life. The company can be assumed to be in a position to claim all tax allowances in full as soon
as they become available and to pay corporation tax at a rate of 17% per annum over the life of the
DH project. All tax is payable at the end of the year to which it relates.
At the present time the company is financed entirely by equity and it has been decided that this will
continue even if the DH is launched, with internal funds being used to finance the investment. The
decision on whether or not to introduce the DH is to be based on the expected net present value of
the relevant cash flows, discounted at the company’s cost of equity capital of 8%.
However, the finance director had argued strongly that if Wicklow did decide to introduce the DH,
then the company should partly finance the project with a four-year loan of £2 million (at an interest
rate of 5% per annum), which would be well within Wicklow’s current debt capacity.
Requirement
9.1 Calculate the expected net present value at 31 December 20X8 of the introduction of the DH
product and advise the directors whether or not Wicklow should proceed with its introduction.
(18 marks)
9.2 Calculate the sensitivity of the decision to invest in DH to changes in:
Requirement
(a) The DH selling price (for the purpose of this calculation, assume working capital does not
change)
(4 marks)

(b) The cost of equity

(3 marks)

9.3 Calculate the adjusted present value of the introduction of the DH product if Wicklow had
decided to inject debt on the basis proposed by the finance director.

ICAEW 2021 Objectives and investment appraisal 13

 (4 marks)
9.4 Making reference to relevant theories, explain the weaknesses of the adjusted present value
methodology used in 9.3 above.
(6 marks)
Note: Ignore inflation.
Total: 35 marks

10 Daniels Ltd
Daniels Ltd (Daniels) is a large civil engineering company and it has a financial year end of 31 May.
Much of Daniels’ work involves long-term contracts for the railway industry. You work for Daniels and
have been asked for advice by the board on the following problems:
Problem 1
Daniels is considering a major investment involving five possible projects in the West of England and
South Wales which have been put out to tender. Daniels’ board of directors has prepared the
following estimated cash flows (and resultant net present values at 31 May 20X7) for the five projects:

Investment Year to Year to Year to

Project Location on 31/5/X7 31/5/X8 31/5/X9 31/5/Y0 NPV
£’000 £’000 £’000 £’000 £’000
B Bristol (4,150) (1,290) 530 7,270 577
C Cardiff (3,870) (1,310) 3,130 1,550 (1,309)
G Gloucester (6,400) 1,770 2,160 3,160 (632)
S Swansea (5,000) (2,610) 6,450 6,520 2,856
T Tiverton (4,600) 1,290 2,870 3,620 1,664

You can assume that the net present values shown in the table above are accurate.
Due to financial constraints, the company, if successful with its tenders, would be unable to take on
all five projects. The board is prepared to release £8 million for initial investment (on 31 May 20X7)
into one or more of the projects, but might increase this figure to £9 million if there are grounds for
doing so. An alternative scenario which has been considered would be to make available sufficient
funds to start all five projects in May 20X7, but this would limit the capital available in the year to 31
May 20X8 to a maximum of only £500,000.
Problem 2
Daniels runs a fleet of vans to support its operations. Currently it replaces those vans every three
years, but the board is not sure whether this is in the company’s best interests. Vans cost, on average,
£12,400 each. Daniels’ transport manager has prepared the following schedule of costs and resale
values for the vans:

Maintenance and
running costs Resale value
£ £
In first year of van’s life 4,300 After one year 9,800
In second year of van’s life 4,800 After two years 7,000
In third year of van’s life 5,100 After three years 5,000

Problem 3
About a year ago (March 20X6) Daniels completed construction of a factory for Kithill Ltd (Kithill).
This cost Daniels £720,000 to construct and Kithill is paying £190,000 a year for eight years. Daniels
will, therefore, ultimately make a profit of £800,000, which gives a return on the investment of over
100%. When Kithill sent its first annual instalment last week, it indicated that rather than make annual
payments it would prefer to settle the outstanding balance by making a one-off payment of

14 Financial Management ICAEW 2021

 £925,000 in a year’s time (March 20X8). One of Daniels’ directors is keen on this proposal stating, “I
know that this is less than we would receive over the full eight years, but my calculations show that
the internal rate of return would be much better”.
General information
(1) Daniels uses a cost of capital of 10% when appraising possible investments.
(2) You should assume that all cash flows take place at the end of the year in question.
(3) All projects are independent.
Requirements
10.1 For Problem 1, assuming that all of the projects are divisible and:
(a) Assuming that Daniels has no capital rationing, advise its directors as to which projects
should be accepted.
(2 marks)
(b) Assuming that the directors are prepared to spend a maximum of £8 million on 31 May
20X7, advise them as to which projects should be accepted.
(3 marks)

(c) Assuming that the directors are prepared to make available sufficient funds to start all five
projects on 31 May 20X7, but only £500,000 on 31 May 20X8, advise them as to which
projects should be accepted.
(5 marks)

10.2 For Problem 1, assuming that none of the projects are divisible and that the directors are
prepared to spend a maximum of £9 million on 31 May 20X7, advise them as to which projects
should be accepted.
(4 marks)
10.3 For Problem 2, advise the directors as to the optimal replacement period for Daniels’ vans and
comment on the limitations of the approach used.
(6 marks)
10.4 For Problem 3, advise the directors as to whether they should accept Kithill’s proposal.
(5 marks)
Note: Ignore taxation.
Total: 25 marks

11 Hawke Appliances Ltd

11.1 Hawke Appliances Ltd (Hawke) is a UK-based manufacturer of household appliances. It has a
financial year end of 31 December. You work for Hawke and have been asked to advise the
company’s board on the viability of a proposed new product.
The company is considering the development of a new vacuum cleaner, the JH143. This will be
more expensive than Hawke’s other vacuum cleaners but it contains a number of innovative
design features that Hawke’s board believes will be attractive in an increasingly competitive
market. Because of these market conditions, Hawke’s board wishes to evaluate the JH143 over
a three-year time horizon.
Selling price, materials and unskilled labour
You have obtained the following information on the budgeted price and costs per unit for the
JH143 (in 31 December 20X4 prices):

£
Selling price 155
Materials 53

ICAEW 2021 Objectives and investment appraisal 15

 £
Unskilled labour 28

Fixed costs are not expected to increase as a result of producing the JH143.
Skilled labour
Each JH143 will require one hour of skilled labour that is in short supply. Hawke will need to
transfer some of its skilled labour away from making another older vacuum cleaner (the
JH114), which requires half the skilled labour time per unit of the JH143. The current selling
price of the JH114 is £96 and its materials and unskilled labour costs total £74 per unit (in 31
December 20X4 prices). Hawke’s skilled labour is paid £8.80 per hour (in 31 December 20X4
prices).
Inflation
Revenues and costs are expected to inflate at a rate of 4% pa.
Sales volumes
Hawke commissioned market research at a cost of £55,000 for the JH143 project, half of which
remains unpaid and is due for settlement on 31 December 20X4. An extract from the results of
that market research is shown here:

20X5 20X6 20X7

Estimated annual sales of the JH143 (units) 50,000 95,000 45,000

Machinery
Specialised new production machinery will be required in order to make the new vacuum
cleaner. This machinery will cost £4.5 million to buy on 31 December 20X4 and will have an
estimated scrap value of £1 million on 31 December 20X7 (in 31 December 20X7 prices). If
production of the existing JH114 is reduced then some of Hawke’s older machinery could be
sold on 31 December 20X4. This machinery had a tax written down value of £80,000 on 1
January 20X4 and Hawke estimates that it could be sold for £220,000.
The machinery will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
In the final year, the difference between the machinery’s written down value for tax purposes
and its disposal proceeds will be treated by the company either:
• as a balancing allowance, if the disposal proceeds are less than the tax written down value;
or
• as a balancing charge, if the disposal proceeds are more than the tax written down value.
Corporation tax
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Working capital
Hawke will invest in working capital at a rate of 10% of the JH143’s annual sales revenue, to be
in place at the start of each year. It expects to recover the working capital in full on 31
December 20X7.
Cost of capital
Hawke uses a money cost of capital of 12% pa for investment appraisal purposes.
Requirement
(a) Using money cash flows, calculate the net present value on 31 December 20X4 of the
proposed development of the JH143 and advise the company’s board whether it should
proceed with the investment.
(16 marks)

16 Financial Management ICAEW 2021

 (b) Ignoring the effects on working capital, calculate the sensitivity of your advice in part (a)
to:
(1) changes in the selling price of the JH143
(2) changes in the volume of sales of the JH143
(7 marks)

11.2 Hawke’s board is also investigating the possibility of buying another company, Durram
Electricals Ltd (Durram) which is a successful retailer of electrical goods. The board has
obtained the following information about Durram:

Earnings and cash flows for the year ended

31 August 20X4 700,000
Expected growth of earnings and cash
flows 5% pa
Book value of equity at 31 August 20X4 £3,600,000
Average industry P/E ratio 11
Cost of capital 12% pa

Hawke’s board has no experience of buying another company and you have been invited to
the next board meeting to answer these questions:
(1) What range of values is reasonable for Durram on 31 August 20X4?
(2) Why do many acquisitions not benefit the bidding firm?
(3) Would it be better to pay for Durram in cash or with Hawke’s shares?
Requirement
Prepare calculations and notes that will enable you to answer these questions at the next board
meeting.
(12 marks)
Total: 35 marks

12 Alliance plc
You should assume that the current date is 31 December 20X5.
Alliance plc (Alliance) is a manufacturer of electronic devices. At a recent board meeting two agenda
items were discussed as follows:
(1) The possible development of an automatic watering system (Autowater) for indoor potted plants
in private houses and business premises. The sales director commented that there are similar
more expensive products on the market and it is likely that competitors will develop their
technology and bring down their prices in future. Therefore, it would be prudent to assume a life
cycle of four years for the Autowater.
(2) For other projects that have already been appraised using NPV analysis, the 20X6 capital
expenditure budget (excluding Autowater) should not exceed £350 million. The £350 million will
be allocated to projects, excluding Autowater, on the basis of maximising shareholder wealth.
The chairman of Alliance closed the meeting with the following statement:
“We will continue to see excellent opportunities to invest in profitable projects across our business
and we have no difficulty in raising finance. However we will be disciplined in our approach to
committing to capital expenditure. I would now like the finance director to evaluate the Autowater
project and to determine in which other projects the £350 million 20X6 capital expenditure budget is
going to be invested.”
The following information is available regarding the Autowater project:

ICAEW 2021 Objectives and investment appraisal 17

• The selling price will be £800 per unit for the year to 31 December 20X6 and will then increase by
5% pa. Contribution is 40% of the selling price.
• The number of units sold in the year to 31 December 20X6 is expected to be 9,000 per month.
For the year to 31 December 20X7 the number of units sold will increase by 15%. Because of
increased competition in the market it is anticipated that in the two years to 31 December 20X9
the number of units sold will decline by 10% pa.
• Incremental fixed production costs are expected to be £4 million pa and will increase after 31
December 20X6 by the general level of inflation.
• Alliance will rent a factory at an annual rent of £1.5 million, payable in advance on 31 December.
The rent is not subject to inflationary increases.
• Investment in working capital will be £2 million on 31 December 20X5 and will increase or
decrease at the start of each year in line with sales volumes and the unit selling price. Working
capital will be fully recoverable on 31 December 20X9.
• On 31 December 20X5 the project will require an investment in machinery and equipment of £60
million, which is expected to have a realisable value of £5 million (in 31 December 20X9 prices) at
the end of the project. The machinery and equipment will attract 18% (reducing balance) capital
allowances in the year of expenditure and in every subsequent year of ownership by the
company, except the final year.
In the final year, the difference between the machinery and equipment’s written down value for
tax purposes and its disposal proceeds will be treated by the company either:
(a) as a balancing allowance, if the disposal proceeds are less than the tax written down value;
or
(b) as a balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% pa for the foreseeable future and that tax
flows arise in the same year as the cash flows that gave rise to them.
• An appropriate real cost of capital for the Autowater project is 7% pa and the level of general
inflation is expected to be 3% pa.
The following information relates to the 20X6 capital expenditure budget of £350 million and
excludes the Autowater project.
The indivisible projects available for investment of the £350 million are:

Project Initial expenditure £ million NPV £ million

A 100 180
B 50 90
C 40 100
D 140 150
E 100 140

Requirements
12.1 Using money cash flows, calculate the net present value of the Autowater project on 31
December 20X5 and advise the board whether it should accept the project.
(16 marks)
12.2 Ignoring the effects on working capital, calculate the sensitivity of the Autowater project to
changes in sales revenue and indicate whether there is a sufficient margin of safety for the
project to go ahead.
(4 marks)
12.3 Discuss the disadvantages of sensitivity analysis and explain how simulation might be a better
way to assess the risk of the project.
(6 marks)
12.4 With regard to the 20X6 capital expenditure budget of £350 million:

18 Financial Management ICAEW 2021

 Requirement
(a) Discuss the differences between hard and soft capital rationing and comment on the form
of capital rationing that is being employed by Alliance.
(5 marks)

(b) Determine the combination of projects that will maximise shareholder wealth.
(4 marks)

Total: 35 marks

ICAEW 2021 Objectives and investment appraisal 19

20 Financial Management ICAEW 2021
 Finance and capital structure
13 Turners plc
Turners plc (Turners) is a listed company in the food retailing sector and has large stores in all the
major cities in the UK. Turners’ board is considering diversifying by opening holiday travel shops in
all of its stores.
At a recent board meeting the directors were discussing how the holiday travel shops project (‘the
project’) should be appraised. The sales director insisted that Turners’ current weighted average cost
of capital (WACC) should be used to appraise the project as the majority of its operations will still be
in food retailing. The finance director disagreed because the existing cost of equity does not take
into account the systematic risk of the new project. The finance director also said that the company’s
overall WACC, which reflects all of the company’s activities, would change as a result of the project’s
acceptance. The board were also concerned about the market’s reaction to their diversification plans.
A further board meeting was scheduled at which Turners’ advisors would be asked to make a
presentation on the project.
You work for Turners’ advisors and have been asked to prepare information for the presentation. You
have established the following:
Turners intends to raise the capital required for the project in such a way as to leave its existing
debt:equity ratio (by market values) unchanged following the diversification.
Extracts from Turners’ most recent management accounts are shown below:
Balance sheet at 31 May 20X4

£m
Ordinary share capital (10p shares) 233
Retained earnings 5,030
5,263
6% Redeemable debentures at nominal value (redeemable 20X8) 1,900
Long term bank loans (interest rate 4%) 635
7,798

On 31 May 20X4 Turners’ ordinary shares had a market value of 276p (ex-div) and an equity beta of
0.60. For the year ended 31 May 20X4 the dividend yield was 4.2% and the earnings per share were
25p. The return on the market is expected to be 8% pa and the risk-free rate 2% pa.
Turners’ debentures had a market value of £108 (ex-interest) per £100 nominal value on 31 May
20X4 and they are redeemable at par on 31 May 20X8.
Companies operating solely in the holiday travel industry have an average equity beta of 1.40 and an
average debt: equity ratio (by market values) of 3:5. It has been estimated that if the project goes
ahead the overall equity beta of Turners will be made up of 90% food retailing and 10% holiday
travel shops.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
13.1 Ignoring the project, calculate the current WACC of Turners using:
(a) The CAPM
(8 marks)

(b) The Gordon growth model

(6 marks)

ICAEW 2021 Finance and capital structure 21

 13.2 Using the CAPM, calculate the cost of equity that should be included in a WACC suitable for
appraising the project and explain your reasoning.
(6 marks)
13.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of
Turners assuming that the project goes ahead and comment upon the implications of a
permanent change in the overall WACC.
(6 marks)
13.4 Discuss whether Turners should diversify its operations and how the stock market might react
to the proposed project.
(5 marks)
13.5 Identify the appropriate project appraisal methodology that should be used when a project’s
financing results in a major increase in a company’s market gearing ratio and, using the data
relating to Turners, calculate the project discount rate that should be used in these
circumstances.
(4 marks)
Total: 35 marks

14 Middleham plc
Middleham plc (Middleham) is a company involved in the production of printing inks used in a wide
range of applications in the food packaging industry. The directors of Middleham are currently
considering a £2 million investment in new production facilities. At the present time, the company’s
finance director is seeking to establish an appropriate cost of capital figure for use in the appraisal of
the proposed investment. Extracts from Middleham’s most recent financial statements for the year
ended 31 March 20X3 are shown below:

£’000
Ordinary share capital (50p shares) 3,200
5% irredeemable preference share capital (50p shares) 1,400
Reserves 7,000
11,600
7% debentures (at nominal value) 1,500
13,100
Current liabilities 3,700
Total equity and liabilities 16,800

Profit before taxation 3,000

Taxation (510)
Preference share dividends (70)
Ordinary share dividends (1,088)

The market prices for the company’s shares and debentures on 31 March 20X3 were:
(1) Ordinary shares: £1.42 each (cum-div)
(2) 5% irredeemable preference shares: £0.20 each (ex-div)
(3) 7% debentures: £105.00 (per £100 nominal)
The ordinary dividend for the year ended 31 March 20X3 is due to be paid shortly. This is the first
dividend paid since the year ended 31 March 20W9, when the dividend payout ratio was 40% and
the earnings per share were £0.35. Middleham’s directors expect future dividends to grow at the

22 Financial Management ICAEW 2021

 annual growth rate implied by the dividends paid in 20W9 and 20X3. The number of ordinary shares
in issue has not changed since March 20W9.
The annual debenture interest has recently been paid. The 7% debentures are redeemable at par in
10 years’ time.
Shares in the industrial sector in which Middleham operates typically have an equity beta of 1.3 with
a debt to equity ratio of 1:1. The risk free rate is 6% pa and the return from the market portfolio is
14% pa.
The company’s finance director has proposed that, if the investment is undertaken, then an issue of
redeemable debentures is used to finance it. However, Middleham’s Chief Executive has expressed
concerns about the possible use of redeemable debentures. His view is that increasing the number
of debentures issued by the company will increase the company’s gearing dramatically and the
increased financial risk associated with this could easily lead to a fall in the company’s share price
and, therefore, its market value.
The directors wish to assume a rate of corporation tax of 17% for the foreseeable future.
Requirements
14.1 Calculate (using the dividend growth model) a weighted average cost of capital that could be
used to appraise Middleham’s proposed investment.
(13 marks)
14.2 Explain the underlying assumptions and any other relevant factors that may mean it is
inappropriate to use the cost of capital figure calculated in requirement 14.1 in the appraisal of
Middleham’s proposed investment.
(5 marks)
14.3
(a) Estimate Middleham’s cost of equity using the capital asset pricing model.
(5 marks)

(b) Explain two key assumptions that would underpin the use of this cost of equity in the
calculation of the weighted average cost of capital.
(2 marks)

14.4 Making reference to relevant theories, comment on the views expressed by Middleham’s chief
executive.
(5 marks)
14.5 Explain, with reference to the efficient market hypothesis, when news of the proposed
investment in the new production facilities would be reflected in Middleham’s share price on
the London Stock Exchange.
(5 marks)
Total: 35 marks

15 Better Deal plc

Better Deal plc (Better Deal) is a UK supermarket chain which has a financial year end of 28 February.
An extract from its balance sheet at 28 February 20Y0 is shown below:

£m
Ordinary shares (50p each) 82.5
Retained earnings 391.5
474.0
8% debentures (at nominal value; redeemable at par in 20Y4) 340.0
814.0

ICAEW 2021 Finance and capital structure 23

 Additional information about Better Deal:

Current market value of one ordinary share (ex div) £2.65

Current market value of one 8% debenture (ex int) £98

Dividends paid on 28 February 20Y0 £29.5m

Dividends paid on 28 February 20X6 £25.2m

Equity beta 1.1

Market return 11.4% pa

Risk free rate 5.2% pa

Notes
1 There have been no changes in the number of issued shares over the period 20X6–20Y0. Better
Deal’s annual dividend payments have risen steadily since 20X6.
2 Better Deal’s management is considering diversifying its product range and opening petrol
outlets at a number of its stores. The finance for this capital investment would be raised in such a
way as not to alter the current gearing ratio of Better Deal (measured by market values). The debt
element of the finance raised will come from a new issue at par of 9% irredeemable debentures.
3 Better Deal’s finance team has undertaken research into the company’s competitors in the UK
petroleum market and has calculated that the equity beta for this market is 1.5 and companies in
that market have, on average, long term funds in the ratio of 64:31 for equity:debt by market
value.
4 You should assume that the corporation tax rate is 17% pa and is payable in the same year as
profits are earned.
Requirements
15.1 Calculate Better Deal’s current weighted average cost of capital based on:
(a) The dividend growth model
(8 marks)

(b) The CAPM model

(2 marks)

15.2 Calculate the cost of capital that Better Deal should use when appraising the proposed
investment in petrol outlets and explain the reasoning for your approach.
(11 marks)
15.3 Compare and contrast multiple factor models with the CAPM model as a means of dealing
with risk.
(8 marks)
15.4 Making reference to relevant theories, advise Better Deal’s management as to what extent the
company’s dividend policy will affect the market value of its shares.
(6 marks)
Total: 35 marks

16 Puerto plc
You should assume that it is now 1 December 20X3.
Puerto plc (Puerto) is listed on the UK stock market and operates in the vehicle leasing industry.
During a period of expansion from 20W3 to 20W7 the company funded growth by way of

24 Financial Management ICAEW 2021

convertible loans obtained from an investment bank, SM Capital (SMC). As a result of the global
economic downturn Puerto has experienced a number of trading difficulties, and the company
ceased to pay dividends to its ordinary shareholders in 20W8. Since 20W9 Puerto has embarked on a
significant restructuring of its business. Although in the current year to 30 November 20X3 the
company has sustained losses, industry conditions have stabilised giving both the board of Puerto
and SMC confidence in the company’s future. This confidence is also shared by the UK stock market
as Puerto’s share price has been increasing over the last six months to 10p per ordinary share on 30
November 20X3.
Extracts from Puerto’s most recent management accounts are shown below:
Income statement for the year ended 30 November 20X3

£’000
Operating profit 2,280
Interest (2,460)
Profit/(loss) before tax (180)
Taxation 0
Profit/(loss) after tax (180)

The board of Puerto is now considering a further restructuring that includes the purchase on 1
December 20X3 of another vehicle leasing business that in the last financial year achieved a pre-tax
operating profit of £3 million. The purchase price for this business is £24 million. The board is
confident it will be able to raise the additional borrowings required for this purchase on 1 December
20X3, particularly as SMC, as part of the restructuring, has agreed to exercise its option to convert its
convertible loans into equity on that date in order to participate in Puerto’s future growth potential.
The board and SMC believe that Puerto’s share price will increase immediately on 1 December 20X3
by 35% as a result of the restructuring.
Additional information:
• The SMC convertible loans amount to £68 million and the rate of interest on these loans is 3% pa.
The market value of these loans, on 30 November 20X3, is equal to their nominal value of £68
million.
• SMC has the option to convert its loans into thirty ordinary shares for every £4 of loan.
• Puerto also has non-convertible secured bank loans amounting to £6 million that carry an interest
rate of 7% pa.
• On 30 November 20X3 Puerto had 492 million ordinary shares in issue.
• £24 million of new secured borrowings at an interest rate of 6% pa will be raised from Risky Bank
plc (Risky) to finance the purchase of the vehicle leasing business. A covenant attached to this
loan requires that the gearing (debt/equity by market values) immediately after the restructuring
is not more than the industry average of 25%.
• Corporation tax is 17% pa on current year profits.
• Puerto has an equity beta of 2.13 which reflects Puerto’s gearing on 30 November 20X3.
• The risk free rate is 2.8% pa.
• An appropriate market risk premium is 5% pa.
Requirements
16.1 Prepare Puerto’s forecast income statement for the year ended 30 November 20X4 assuming
that the restructuring goes ahead and that both the existing and newly-acquired leasing
businesses earn similar operating profits to those in the year to 30 November 20X3.
(3 marks)
16.2 Calculate Puerto’s gearing ratio (debt/equity) by market values on 30 November 20X3 and on
1 December 20X3 immediately after the restructuring.
(5 marks)

ICAEW 2021 Finance and capital structure 25

 16.3 Using your answer to 16.1 and 16.2, comment on the financial health of Puerto both before
and after the restructuring and whether the covenant imposed by Risky would be met if
Puerto’s share price remains at 10p on 1 December 20X3.
(5 marks)
16.4 Calculate (using the capital asset pricing model) the weighted average cost of capital of Puerto
on 30 November 20X3 and on 1 December 20X3 immediately after the restructuring.
(10 marks)
16.5 Discuss, with reference to relevant theories, whether the change in Puerto’s capital structure
following the restructuring on 1 December 20X3 will bring about a permanent change in its
weighted average cost of capital.
(6 marks)
16.6 Advise the board of Puerto on the likely reaction of the various stakeholders in the company to
the restructuring.
(6 marks)
Total: 35 marks

17 Abydos plc
Abydos plc is considering a large strategic investment in a significantly different line of business to its
existing operations. This will involve constructing its very first brewery that will focus on producing
and selling a new type of craft beer. The scale of the new venture is such that a significant injection of
£12.5 million of new capital will be required. There is some uncertainty over the expected operating
cash flows generated by the new brewery, therefore the directors of Abydos are keen to use data
analytics to help improve forecasting.
The current gearing of Abydos is 80% equity and 20% debt by market value.
The new project will require outlays immediately as follows:

£’000
Plant and equipment (purchased on first day of financial year) 10,000
Working capital 1,500
Equity issue costs (not tax allowable) 700
Debt issue costs (not tax allowable) 300
12,500

Other details are as follows:

• Estimates of relevant cash flows and other financial information associated with the possible new
investment. These are shown below.

Year 1 Year 2 Year 3 Year 4

£’000 £’000 £’000 £’000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300

• The directors have examined similar quoted companies operating in the same sector as the new
investment and have determined that a suitable equity beta is 1.4, using average industry gearing
of 60% equity, 40% debt by market values.
• The risk free rate is 5% and the market return 12%.
• £5 million of debt (an 8% fixed rate debenture) will be raised to fund part of the investment. The
remainder will be equity.
• Capital allowances are at 18% per year on a reducing balance basis.
• Tax is payable at 17% in the year that the taxable cash flow arises.

26 Financial Management ICAEW 2021

 • The after tax realisable value of the investment (including any balancing allowance/charge on the
equipment) as a continuing operation is estimated to be £4 million (including working capital) at
the end of Year 4.
• Working capital may be assumed to be constant during the four years.
The board of directors of Abydos plc is discussing how the company should appraise the new
investment. There is a difference of opinion between two directors.
The sales director believes that net present value at the current weighted average cost of capital
should be used as positive NPV investments should be quickly reflected in increases in the
company’s share price.
The finance director states that NPV is not good enough as it is only valid in potentially restrictive
conditions, and should be replaced by APV (adjusted present value).
The finance director is keen to use alternative finance platforms, such as crowdfunding and peer-to-
peer (P2P) lending to finance the new venture.
Requirements
17.1 Calculate the expected APV of the proposed investment.
(10 marks)
17.2 Discuss briefly the validity of the views of the two directors. Use your calculations in 17.1 to
illustrate and support the discussion.
(6 marks)
17.3 Explain what is meant by crowdfunding and peer-to-peer lending and how such alternative
finance platforms can be used to finance future growth and development for new ventures
such as the new brewery.
(8 marks)
17.4 Discuss how data analytics could be used by the senior management team to help improve
forecasting for the new brewery.
(6 marks)
17.5 Explain, with reference to the efficient market hypothesis, when news of the proposed
investment in the new brewery would be reflected in Abydos’s share price and how the
emergence of electronic share trading platforms has impacted on market efficiency.
(5 marks)
Total: 35 marks

18 Biddaford Lundy plc

Biddaford Lundy plc (BL) is a large UK engineering company. Its ordinary shares are quoted on the
London Stock Exchange.
BL’s board is concerned that the company’s gearing level is too high and that this is having a
detrimental impact on its market capitalisation. As a result the board is considering a restructuring of
BL’s long term funds, details of which are shown here as at 29 February 20X2:

Total par value Market value

£m

Ordinary share capital (50p) 67.5 £2.65/share ex-div

7% Preference share capital 60.0 £1.44/share ex-div

(£1)

4% Redeemable debentures 45.0 £90% ex-int

(£100)

The debentures are redeemable in 20X7. BL’s earnings for the year to 29 February 20X2 were £32.4
million and are expected to remain at this level for the foreseeable future. Retained earnings at 29
February 20X2 were £73.2 million.

ICAEW 2021 Finance and capital structure 27

 The board is considering a 1 for 9 rights issue of ordinary shares and this additional funding would
be used to redeem 60% of BL’s redeemable debentures at par. However, some of BL’s directors are
concerned that this issue of extra ordinary shares will cause the company’s ordinary share price and
its earnings per share (EPS) to fall by an excessive amount, to the detriment of BL’s shareholders.
Accordingly, they are arguing that the rights issue should be designed so that the EPS is not diluted
by more than 5%.
The directors wish to assume that the corporation tax rate will be 17% for the foreseeable future and
that tax will be payable in the same year as the cash flows to which it relates.
Requirements
18.1 Calculate BL’s gearing ratio using both book and market values and discuss, with reference to
relevant theories, why BL’s board might have concerns over the level of gearing and its impact
on BL’s market capitalisation.
(9 marks)
18.2 Assuming that a 1 for 9 rights issue goes ahead, calculate the theoretical ex-rights price of a BL
ordinary share and the value of a right.
(4 marks)
18.3 Discuss the directors’ view that the rights issue will cause the share price and the EPS to fall by
an excessive amount, to the detriment of BL’s ordinary shareholders. Your discussion should be
supported by relevant calculations.
(10 marks)
18.4 Calculate and comment on the rights issue price that would cause a 5% dilution in the current
EPS figure.
(6 marks)
18.5 Discuss the factors to be considered when making a rights issue.
(6 marks)
Total: 35 marks

19 BBB Sports plc

BBB Sports plc (BBB) operates gyms and health clubs in the UK and it is considering diversifying by
setting up a division called ‘Climbhigh’ which would operate indoor climbing walls in several cities in
other countries. Some of these countries have unstable governments and/or are countries where
health and safety laws are not as strict as those in the UK. The chairman of BBB is anxious that any
climbing walls that they operate overseas should be of the highest standard and meet the national
guidelines in the UK, which are available from the Association of British Climbing Walls (ABC).
The finance director of BBB, who is an ICAEW Chartered Accountant, has available the following
information regarding the Climbhigh project:
• The finance for Climbhigh can be raised in the UK in such a way as to leave the existing
debt:equity ratio (by market values) of BBB unchanged after the diversification.
• An appropriate equity beta for a company that operates climbing walls is 1.90 at a debt:equity
ratio (by market values) of 4:6.
• An email has been received from a contractor in one of the other countries. The contractor
intends to tender for the contract to build one of the climbing walls. Part of the email stated:
“The ABC guidelines are very strict and we can build a cheaper, but safe, wall by just ignoring
them. We do things differently here and can save you a lot of money by cutting corners!”
• If the Climbhigh project goes ahead, the overall equity beta of BBB will be made up of 80%
existing operations and 20% Climbhigh.

28 Financial Management ICAEW 2021

The following information relates to BBB without the Climbhigh project.
Extracts from the most recent management accounts:

Balance sheet at 30 November 20X5

£m
Ordinary share capital (20p shares) 365
Retained earnings 4,788
5,153
5% Redeemable debentures at nominal value 2,200
7,353

On 30 November 20X5 BBB’s ordinary shares each had a market value of 360p (cum-div) and an
equity beta of 1.10. For the year ended 30 November 20X5, the dividend declared was 10p per
ordinary share and the earnings yield (earnings per share divided by ex-div share price) was 7%.
BBB’s debentures had a market value at 30 November 20X5 of £99 (cum-interest) per £100 nominal
value and are redeemable at par on 30 November 20X9.
The market return is expected to be 7% pa and the risk free rate 2% pa.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
19.1 Ignoring the Climbhigh project, calculate the WACC of BBB at 30 November 20X5 using:
(a) The CAPM
(8 marks)

(b) The Gordon growth model

(6 marks)

19.2 Using the CAPM, calculate a WACC that is suitable for appraising the Climbhigh project and
explain the rationale for using this as the discount rate for the project.
(6 marks)
19.3 By calculating an overall equity beta and using the CAPM, estimate the overall WACC of BBB
assuming that the Climbhigh project goes ahead and comment upon the implications for the
value of BBB of any change from the WACC that you have calculated in 19.1(a) above.
(6 marks)
19.4 Advise BBB on how political risk could potentially affect the value of the Climbhigh project and
how it might limit its effects where such risk exists.
(6 marks)
19.5 Explain the ethical issues for the finance director in relation to the email received from the
contractor who wishes to tender for building one of the climbing walls, and briefly outline the
action that he should take.
(3 marks)
Total: 35 marks

ICAEW 2021 Finance and capital structure 29

30 Financial Management ICAEW 2021
 Business valuations, plans, dividends and
growth
20 Cern Ltd
20.1 Cern Ltd (Cern) is an unquoted company that manufactures a range of products used in the
construction industry. Extracts from the most recent management accounts of Cern are set out
below:
Income statement for the year ended 20 September 20X2

£
Profit before interest and tax 1,080,000
Interest (180,000)
Profit before tax 900,000
Tax (17%) (153,000)
Profit after tax 747,000

Dividends declared and paid:

Preference dividend 43,200
Ordinary dividend 180,000

Balance sheet at 30 September 20X2

£ £
Non-current assets
Intangibles 900,000
Freehold land and property 1,800,000
Plant and equipment 3,600,000
Investments 900,000
7,200,000
Current assets
Inventory 540,000
Receivables 1,080,000
Cash 180,000
1,800,000
Current liabilities (1,080,000)
720,000
7,920,000
Equity and non-current liabilities
Ordinary share capital (£1 shares) 3,600,000
6% Preference shares (£1 shares) 720,000
Retained earnings 1,800,000

ICAEW 2021 Business valuations, plans, dividends and growth 31

 £ £
6,120,000
10% Debentures 1,800,000
7,920,000

The following information is also available:

(1) In the two previous financial years the profit before interest and tax was:
– year ended 30 September 20X1: £440,000.
– year ended 30 September 20X0: £1,800,000.
(2) The current market value of the preference shares has been estimated at £0.90 per
preference share.
(3) The current market value of the debentures has been estimated at £110 per £100 of
debentures.
(4) The current rental value of the freehold land and property is £270,000 pa and this
represents a 6% return.
(5) The current market value of the investments is £1,350,000.
(6) The most recent P/E ratios of two comparable quoted companies operating in the same
sector as Cern are 9.6 and 7.0, and their most recent dividend yields are 4% and 3.4%
respectively.
(7) Cern’s directors assume that for the foreseeable future the corporation tax rate will be
17%.
The directors have recently received an approach from Fenton Holdings plc (Fenton), a
conglomerate company, whose directors have expressed an interest in making an offer to buy
the whole of Cern. Fenton’s directors have confirmed that if an acquisition goes ahead, they
will purchase the debentures at their market value and Fenton’s bank has agreed to buy the
preference shares at their market value. Cern’s directors have sought your advice as an
external consultant.
Requirements

(a) Using the available information, calculate the minimum price per ordinary share that the
shareholders of Cern should be willing to accept from Fenton using each of the following
methods of valuation:
• Net assets
• Dividend yield
• P/E ratio
(13 marks)

(b) Comment on the values you have calculated and any issues you think should be brought
to the attention of Cern’s directors.
(4 marks)

(c) Identify the motives that might lie behind Fenton’s possible acquisition of Cern.
(4 marks)

20.2 Cern has an annual cost of capital of 10%. One of its most successful products is Hadtone, a
mortar colouring agent. Hadtone is made using a single processing machine which mixes the
raw ingredients and dispenses the completed product into five-litre cartons.
A five-litre carton of Hadtone sells for £12.00 and estimated maximum annual demand at this
price is 300,000 cartons. At this level of demand, Cern can justify the operation of only one

32 Financial Management ICAEW 2021

 processing machine, which Cern currently replaces every three years, although the processing
machine has a productive life of four years.
In the first year of its life the processing machine has a productive capacity in line with the
maximum annual demand for the product, but each year thereafter this productive capacity
falls at a rate of 15,000 units pa. Annual maintenance costs in the first year of operating the
processing machine are estimated at £12,000. Thereafter, the directors expect the annual
maintenance costs to increase by £2,000 pa regardless of the actual number of five-litre
cartons produced. Cern incurs variable costs, excluding depreciation and maintenance costs,
of £8.00 in producing each five-litre carton. Cern provides for depreciation on all its non-
current assets using the straight-line method.
If Cern were to dispose of the processing machine after one year, the directors estimate sale
proceeds of £320,000, but these would fall by £120,000 pa in each of the following two years.
Once the machine has reached the end of its four-year productive life its residual value will be
£10,000.
Following a recent increase in the cost of a processing machine to £480,000, Cern’s directors
are reconsidering their current replacement policy with a view to maximising the present value
of the company’s cash-flows. It can be assumed that all revenues and costs are received or
paid in cash at the end of the year to which they relate, with the exception of the initial price of
the processing machine which is paid in full at the time of purchase.
Requirement
Assuming that the processing machine is used to maximum capacity, and showing all your
supporting calculations, advise Cern’s directors how often they should replace the processing
machine.
Note: Ignore inflation and taxation when answering 20.2.
(10 marks)
Total: 31 marks

21 Wexford plc
Wexford plc (Wexford) is a listed manufacturer of dairy products. In recent years the company has
experienced only modest levels of growth, but following the recent retirement of the chief executive,
his replacement is keen to expand Wexford’s operations and to improve Wexford’s approach to
investment appraisal.
It is currently December 20X8 and the board of directors has recently agreed to support a proposal
by the new chief executive that the company purchase new manufacturing equipment to enable it to
expand its range of yoghurt-based products. The new equipment will use artificial intelligence and
automated processes to reduce the need for human intervention. It will also provide management
with new information through the visualisation of data and key performance indicators that will help
to improve decision making in the future. The new equipment will cost £25 million and the company
is seeking to raise new finance to fund the expenditure in full. However, the board of directors is
undecided as to how the new finance is to be raised. The directors are considering either a 1 for 5
rights issue at a price of 250p per share or a floating rate loan of £25 million at an initial interest rate
of 8% per annum. The company’s bank has agreed to provide the £25 million loan. The loan would
be for a term of five years, with interest paid annually in arrears and with the capital being repaid in
full at maturity. The loan would be secured against the company’s freehold land and buildings.
You are employed by Wexford as a company accountant and have been able to obtain the following
additional information:
• As a result of the investment in the new machinery, the directors aim to increase the company’s
revenue by 15% per annum for the foreseeable future.
• It is expected that direct costs, other than depreciation, will, on average, increase by 18% during
the year ending 30 November 20X9 due to the ‘learning curve’ effects associated with the new
machinery.
• Indirect costs are expected to increase by £10 million in the year to 30 November 20X9.
• The ratios of receivables to sales and payables to direct costs (excluding depreciation) will remain
the same as in the year to 30 November 20X8.

ICAEW 2021 Business valuations, plans, dividends and growth 33

• Depreciation on assets existing at 30 November 20X8 is forecast to be £18 million in the year
ending 30 November 20X9.
• Depreciation on the new machinery will be 20% per annum on a straight line basis commencing
in the year of purchase.
• Capital allowances can be assumed to be equal to the depreciation charged in a particular year.
• The company’s inventory levels are expected to increase by £10 million as a result of the
increased levels of business.
• Tax is payable at a rate of 17% per annum in the year in which the liability arises.
• Dividends are payable the year following their declaration and the board of directors has
confirmed to the bank its intention to maintain the company’s current dividend payout ratio for
the foreseeable future.
A summary of Wexford’s most recent draft financial statements is shown below:
Income statement for the year ended 30 November 20X8

£’000
Revenue 270,000
Direct costs (Note) 171,000
Indirect costs 40,000
Operating profit 59,000
Interest 5,000
Profit before tax 54,000
Taxation 9,180
Profit after tax 44,820

Note: Includes depreciation of £19 million.

The company has declared a dividend that will cost £22,680,000.
Balance sheet at 30 November 20X8

£’000 £’000
Non-current assets (carrying amount) 152,590
Current assets
Inventory 35,000
Trade receivables 49,000
Cash at bank 10,500
94,500
247,090
Capital and reserves
£1 Ordinary shares 50,000
Retained earnings 81,410
131,410
Non-current liabilities
10% Debentures (repayable 20Y5) 50,000
Current liabilities
Trade payables 43,000

34 Financial Management ICAEW 2021

 £’000 £’000
Dividends payable 22,680
65,680
247,090

Requirements
21.1 For each of the financing alternatives being considered, prepare a forecast income statement
for the year ending 30 November 20X9 and a forecast Balance sheet at 30 November 20X9.
Note: Transaction costs on the issuing of new capital and returns on surplus cash invested in
the short term can both be ignored.
(16 marks)
21.2 Write a report (including appropriate calculations) to Wexford’s board of directors that fully
evaluates the two potential methods of financing the company’s expansion plans.
(14 marks)
21.3 Explain the advantages and disadvantages to Wexford of using prescriptive analytics in its
decision making.
(5 marks)
Total: 35 marks

22 Loxwood
Loxwood is a firm of ICAEW Chartered Accountants. You work in its Business Valuations Unit (BVU)
which advises clients wishing either (a) to sell their own business or (b) to purchase a new business.
You are currently advising three of Loxwood’s clients:
Client one
Walton plc (Walton) is considering making takeover bids for two of its competitors, Hampton plc
(Hampton) and Richmond Ltd (Richmond). Loxwood has been asked to advise Walton as to what
value it should place on these target companies. You have obtained the following financial data:

Walton Hampton Richmond

Profit before interest and tax(year ended 28
February 20X4) £36.2m £5.5m £4.8m
Depreciation charge (year ended 28 February 20X4) £6.5m £2.9m £0.9m
Average annual growth in profit after tax(years
ended 28 February 20X0-20X4) 5% 7.5% 9%
Average dividend pay-out ratio(years ended 28
February 20X0-20X4) 30% 35% 45%
P/E ratio (at 28 February 20X4) 16.5 15.2 Not available
Cost of equity (estimated) 5.0% 9% 10.5%

Statement of financial position

Extracts at 28 February 20X4

Walton Hampton Richmond

£m £m £m
Non-current assets (Note 1) 177.0 32.7 22.4
Current assets (Note 1) 146.5 22.8 33.3
Current liabilities (96.5) (11.3) (13.7)

ICAEW 2021 Business valuations, plans, dividends and growth 35

 Walton Hampton Richmond
£m £m £m
Non-current liabilities (Note 2) (70.0) (22.5) (19.3)
157.0 21.7 22.7
Ordinary share capital (£1 shares) 62.0 17.6 9.8
Retained earnings 95.0 4.1 12.9
157.0 21.7 22.7

Notes
1 These assets have been professionally valued on 28 February 20X4 as follows:

Hampton Richmond
£m £m
Non-current assets 45.2 24.1
Current assets 25.1 35.2

2 The non-current liabilities are all debentures, redeemable within the next six years, with
coupon rates as follows: Walton 7%, Hampton, 7%; Richmond, 8%. The debentures are currently
trading at: Walton £125, Hampton £110, Richmond £80.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Client Two
Jackie Wight has run a very successful fashion business, Regent Spark Ltd, for many years and is now
considering selling it and taking early retirement. She has read a recent article in the financial press
and is concerned that she won’t get a fair price for her company. As a result she has contacted
Loxwood for guidance. The following is an extract from the article:
‘Angel Ventures (AV) recently bid for biometrics company Praed Bio (PB), offering PB’s shareholders
£5.20 a share. Maida Money (MM), a hedge fund that owns PB shares, disliked the deal and sought a
court’s opinion on fair value. MM wanted £10.25 a share. AV countered with £5.10. In court, the
judge, using shareholder value analysis (SVA), settled on £5.80 but said there were problems in
estimating future cash flows and in calculating the value of the cash flows after the competitive
advantage period (the residual value).’
Client Three
Doug Williams owns 60 acres of agricultural land in south west England and is considering accepting
an offer from So Lah Energy Ltd (SLE) to install solar panels on his land. SLE would pay Doug £1,000
per acre pa (in 28 February 20X4 prices) at the end of each of the next 10 years for the use of his
land, after which time it would revert back to agricultural use. To take account of the general rate of
inflation, SLE will increase this payment by 3% pa (compound). One of Doug’s neighbours, Bill
Etheridge, is very unhappy at the prospect of this solar farm and is prepared to buy Doug’s land from
him for £500,000 in order to stop it being built. The land has a market value of £120,000 in
agricultural use on 28 February 20X4 and this is expected to rise in line with the general rate of
inflation, ie, 3% pa. Doug could invest Bill’s money in a bank account bearing interest at 4% pa, but
he is unsure whether he should accept Bill’s offer.
Client Four
Kaz Technologies (KT) is an intelligent software provider. KT combines artificial intelligence and
machine learning to create a smart platform which helps in data collection, processing, analysis and
monitoring. KT has developed unique business models which streamline the entire business data
management process and helps businesses to improve sales forecasting, interpret customer data
and predict customer needs. KT is currently loss-making but anticipates rapid sales growth in future
years.

36 Financial Management ICAEW 2021

 Requirements
22.1 For Client One, prepare a report for Walton’s board advising it of a range of suitable prices for
both Hampton and Richmond using asset, dividend, earnings and EBITDA multiple based
valuations. Your report should include your workings supported by a clear commentary as to
the strengths and weaknesses of each of the valuation methods used.
(25 marks)
22.2 For Client Two, explain how SVA works and why future cash flows and the residual value are
such problems.
(7 marks)
22.3 For Client Three, ignoring tax, advise Doug Williams as to whether he should accept Bill’s offer.
You should support your answer with workings and any assumptions that you make should be
clearly stated.
(5 marks)
22.4 For client four, explain the difficulties encountered in valuing a company like Kaz Technologies.
(5 marks)
22.5 Loxwood is planning a new marketing campaign for its BVU. Outline the key ethical issues that
Loxwood should consider when planning this campaign.
(3 marks)
Total: 45 marks

23 Sennen plc
You should assume that the current date is 31 May 20X4.
Sennen plc (Sennen) is a UK listed company in the chemical industry. Morgan plc (Morgan) is a UK
listed company that has a policy of expanding by way of acquisition. As a result of financing its
acquisitions with borrowings, Morgan’s gearing is high compared to its competitors.
Morgan has identified Sennen as a potential takeover target and intends to make an offer for all of
the ordinary shares of the company. The finance director of Morgan wishes to value Sennen’s
ordinary shares including any synergistic benefits that may arise following the acquisition. He is also
considering the advantages and disadvantages of the different methods that can be used to pay for
the ordinary shares. The intended offer for Sennen is not public knowledge.
The Finance Director of Morgan has asked North West Corporate Finance (NWCF) to give him advice
regarding the intended offer for the ordinary shares of Sennen. You work for NWCF and a partner in
the firm has asked you to prepare a report for a meeting that he is due to attend with the board of
Morgan. You have established the following data relating to Sennen:

Sales revenue for the year ended 31 May 20X4 £20 million
Competitive advantage period 3 years
Estimated sales revenue growth for the next three years 5% pa
Estimated sales revenue growth thereafter in perpetuity 2% pa
Operating profit margin 15%
Additional working capital investment at the start of each year 1% of that year’s sales revenue
Additional non-current asset investment at the end of each year 2% of that year’s sales revenue
2.5% of that year’s sales
After tax synergies at the end of each year revenue
Number of ordinary shares in issue 17,000,000
Current share price 160p
Appropriate weighted average cost of capital 7% pa

Price earnings (p/e) multiple used to value recent takeovers in 17

ICAEW 2021 Business valuations, plans, dividends and growth 37

 the chemical industry

You may assume that replacement non-current asset expenditure equals depreciation in each year.
On 31 May 20X4 Sennen had short-term investments with a market value of £2 million currently
yielding 3% pa and irredeemable debt with a market value of £10 million. The current gross yield on
Sennen’s debt is 5% pa.
Assume that corporation tax will be 17% of operating profits for the foreseeable future and that there
are no other tax issues that need to be considered.
The management team of Sennen, which includes a member of the ICAEW, has been preparing a
business plan to present to potential financial backers of a management buyout (MBO) that they
intend to launch for the ordinary shares of the company. The intended MBO is not public knowledge.
23.1 Prepare a report for the partner in NWCF which includes:
Requirements

(a) The estimated value of the ordinary shares of Sennen calculated using Shareholder Value
Analysis (SVA) and an explanation of the strengths and weaknesses of this valuation
method.
(13 marks)

(b) The sensitivity of the total value of Sennen (debt plus the value of equity calculated in (a)
above) to a change in the after tax synergies.
(3 marks)

(c) The value of the ordinary shares of Sennen using the p/e method and an explanation of
the strengths and weaknesses of this valuation method.
(5 marks)

(d) A discussion of whether Morgan should offer the shareholders of Sennen a premium over
its current share price given the valuations calculated in parts (a) and (c).
(3 marks)

(e) Advice on the suitability of each of the following methods that Morgan could use to pay
for the ordinary shares of Sennen:
• Cash
• A share for share exchange
• A loan stock for share exchange
• Part cash and part share for share exchange
(8 marks)

23.2 Identify and briefly discuss the ethical issues faced by the MBO team should Morgan make an
offer for the ordinary shares of Sennen.
(3 marks)
Total: 35 marks

24 Tower Brazil plc

You are an ICAEW Chartered Accountant and work in the finance team at Tower Brazil plc (Tower).
The company manufactures wallpaper and paint for major UK homeware retailers and has been
trading since 2001. It has a financial year end of 31 August. Extracts from its most recent
management accounts are shown below.

38 Financial Management ICAEW 2021

Income statement for the year ended 31 August 20X4
£’000
Profit before interest 9,356
Debenture interest (2,338)
Profit before tax 7,018
Tax at 17% (1,193)
Profit after tax 5,825
Dividends – preference shares (480)
Dividends – ordinary shares (4,509)
Retained profits 836

Balance sheet at 31 August 20X4

£’000
£1 ordinary share capital 16,500
Retained earnings 26,420
42,920
6% £1 preference shares 8,000
5% debentures at nominal value (redeemable 20X6) 46,750
97,670

The market values of Tower’s long-term finance on 31 August 20X4 are shown below:
£1 ordinary share capital £4.20/share
6% £1 preference shares £0.80/share
5% debentures £110%
Extracts from the minutes of Tower’s board meeting, 1 September 20X4
AB (Production Director) once again raised the issue of Tower’s ‘gearing problem’ and said that
gearing was now over 50%. DB (Marketing Director) and WR (Sales Director) concurred. All three felt
that gearing should be reduced as a matter of urgency, otherwise, according to AB, it’s very risky and
the company’s share price (and cost of capital) will be adversely affected which will make new
projects difficult to justify.
It was agreed to investigate the implications of using a rights issue to address the gearing problem.
The rights issue would enable ordinary shareholders to significantly increase their investment and so
reward them for their loyalty. It was proposed that a one for two rights issue would be made, but
concerns were raised that this would reduce the company’s earnings per share figure by more than
10%.
WR raised the point that dividends have increased 3% pa on average over the past five years. He
suggested that rather than raising more capital the company could change its dividend policy. As a
result it would retain more of its profits for re-investment. He thought this would not be popular with
shareholders, but that, if they did react badly to the change then Tower could always pay a one-off
special dividend to make up for any shortfall.
As a result of these discussions the board decided to explore the implications of making a 1 for 2
rights issue which would raise sufficient funds to purchase and cancel 60% of Tower’s debentures by
market value.
In advance of the next board meeting, you have been asked by your manager, Luke Cleeve, to
prepare calculations and advice for Tower’s directors. Luke pointed out to you that you should ‘be
careful with this information as it’s potentially price sensitive and not in the public domain.’
Assume that the corporation tax rate will be 17% pa for the foreseeable future.

ICAEW 2021 Business valuations, plans, dividends and growth 39

 Requirements
24.1 Calculate Tower’s theoretical ex-rights share price if a 1 for 2 rights issue were made on 1
September 20X4.
(3 marks)
24.2
(a) Calculate Tower’s earnings per share figure for the year ended 31 August 20X4 and for the
year ended 31 August 20X5 after the proposed rights issue (assuming no change in profit
before interest).
(5.5 marks)
(b) Calculate and comment on the terms of the rights issue required if the earnings per share
figure is not to worsen by more than 10% for the year ended 31 August 20X5.
(5.5 marks)
24.3 Calculate Tower’s gearing (debt/debt + equity) at 31 August 20X4 using both book and market
values and advise its board as to whether it has a ‘gearing problem’ and how its gearing level
could affect its share price. Where relevant, make reference to theories regarding the impact of
capital structure on share price.
(9 marks)
24.4 Advise Tower’s board as to whether the suggested change in dividend policy would have a
negative impact on the company’s share price. Where relevant, make reference to theories
regarding the impact of dividend policy on share price.
(9 marks)
24.5 Explain the ethical implications for an ICAEW Chartered Accountant of having access to ‘price-
sensitive information’.
(3 marks)
Total: 35 marks

25 Brennan plc
Brennan plc is a family run business, which obtained a stock market listing around three years ago.
The board is comprised of 75% of members of the founding family. Brennan plc has a current stock
market capitalisation of £250 million and the board owns 45% of the issued shares. The net book
value of assets held by Brennan plc is £300 million.
Brennan currently enjoys competitive advantage through being a low cost producer and the board
feels that this competitive advantage is likely to continue for the next six years. The following
information relating to Brennan and the period of competitive advantage is available.

Current sales revenue £200 million

Estimated sales growth 6%
Operating profit margin after depreciation 15%
Additional working capital investment 7% of sales increase
Additional non-current asset investment 12% of sales increase

Following the end of the period of competitive advantage, cash flows are expected to remain
constant for the foreseeable future.
Brennan plc currently has no long-term debt and holds short-term investments worth £2.5 million.
The corporation tax rate is expected to be 17% for the foreseeable future.
Brennan plc has an equity beta of 0.75, the risk free rate of interest is 3% and the return on the
market portfolio is 11%.
Brennan plc has a policy of paying out 10% of its post-tax earnings as dividends.

40 Financial Management ICAEW 2021

Requirements
25.1 Calculate the value of Brennan plc using SVA methodology and comment on the results.
(13 marks)
25.2 Discuss the reasons why Brennan plc has a market capitalisation lower than its net book value
of assets.
(7 marks)
Total: 20 marks

ICAEW 2021 Business valuations, plans, dividends and growth 41

42 Financial Management ICAEW 2021
 Risk management
26 Fratton plc
26.1 Fratton plc (Fratton) trades extensively in Europe. The firm is due to receive €2,960,000 in three
months’ time. The following information is available:
(1) The spot exchange rate is currently €1.1845 – 1.1856/£.
(2) The three-month forward rate of exchange is currently at a 0.79 – 0.59 cent premium.
(3) The prices of three-month sterling traded option contracts (premiums in cents per £ are
payable up front, with a standard contract size of £10,000) are as follows:

Exercise price Calls Puts

€1.18 2.40 1.20

(4) Annual interest rates at the present time are as follows:

Deposit Borrowing
UK 1.15% 2.40%
Eurozone 0.75% 1.60%

Requirement
(a) Calculate the net sterling receipt that Fratton can expect in three months’ time if it hedges
its foreign exchange exposure using:
• the forward market
• the money market
• the options market, assuming the spot exchange rate in three months is:
– €1.1185 – 1.1200/£
– €1.1985 – 1.2000/£
(10 marks)

(b) Discuss the advantages and disadvantages of using futures contracts as opposed to
forward contracts when hedging foreign currency exposure.
(7 marks)

26.2 You should assume that the current date is 31 January 20X1
One of Fratton’s customers is suggesting the use of Bitcoin to make a payment in 2 months’
time and has proposed a payment of 50 Bitcoins on 31st March 20X1.
The directors are worried about the volatility of the Bitcoin price and are considering using a
forward contract to hedge the risk.
The following rates are relevant:
Spot rate: 1 Bitcoin = £7,500 - £7,600
Forward rate: 1 Bitcoin = £7,550 - £7,650
Requirement
(a) Calculate the sterling receipt that Fratton can expect in two months’ time if it hedges its
Bitcoin exposure using the forward market.
(1 mark)
(b) Discuss the key problems associated with using cryptocurrencies to settle international
transactions.
(3 marks)

ICAEW 2021 Risk management 43

 26.3 In addition, in three months’ time Fratton will be drawing down a three-month £2.5 million loan
facility which is granted each year by its bank to see the firm through its peak borrowing
period. The following information is available:
(1) The quotation for a ‘3–6’ forward rate agreement is currently 2.60 – 1.35.
(2) The spot rate of interest today is 2.40% pa and the relevant three-month sterling interest
rate futures contract (standard contract size £500,000) is currently trading at 97.20.
Requirement
(a) Explain how Fratton could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months’ time, the
spot rate of interest is 3% pa.
(4 marks)

(b) Explain how Fratton could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months’ time, the spot rate of interest is 3%
pa and the price of the interest rate futures contract has fallen to 97.
(5 marks)

Total: 30 marks

27 Sunwin plc
27.1 The finance director of Sunwin plc (Sunwin) is a trustee of the firm’s employee pension fund.
The vast majority of the fund’s assets are currently invested in a portfolio of FTSE 100 shares. It
is 1 December 20X2 and the trustees are concerned that FTSE 100 share prices will fall over
the next month and they wish to hedge against this possibility by using FTSE index options.
The current market value of the pension fund’s portfolio of shares is £5.6 million. The FTSE 100
index stands at 5,000 on 1 December 20X2 and the directors wish to protect the current value
of the portfolio. The trustees have obtained the following information as at 1 December 20X2:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)

4,900 4,950 5,000 5,050 5,100

Call Put Call Put Call Put Call Put Call Put

December 139 34 104 48 74 70 49 99 34 134

January 214 94 184 114 154 134 124 159 104 189

February 275 135 245 155 220 180 190 200 165 225

Requirements
Demonstrate how FTSE 100 index options can be used by the trustees to hedge the pension
fund’s exposure to falling share prices and show the outcome if, on 31 December 20X2, the
portfolio’s value:
(a) Rises to £6.608 million and the FTSE index rises to 5,900
(4 marks)

(b) Falls to £4.592 million and the FTSE index falls to 4,100
(4 marks)

27.2 It is 1 December 20X2 and Sunwin’s board of directors has recently agreed to purchase
machinery from a UK supplier on 28 February 20X3. The firm’s cash flow forecasts reveal that
the firm will need to borrow £4 million on 28 February 20X3 for a period of nine months. The
directors are concerned that short-term sterling interest rates may rise between now and the
end of February and are considering the use of either sterling short-term interest rate futures

44 Financial Management ICAEW 2021

 or traded interest rate options on futures to hedge against the firm’s exposure to interest rate
rises.
The spot rate of interest on 1 December is 3% pa and March three-month sterling interest rate
futures with a contract size of £500,000 are trading at 96. Information regarding traded interest
options on futures on 1 December 20X2 is as follows:

Calls Puts

Strike Price March June September March June September

96.25 0.20 0.23 0.25 0.18 0.96 1.66

96.50 0.09 0.10 0.11 0.32 1.19 1.89

96.75 0.05 0.06 0.07 0.53 1.43 2.14

Premiums are in annual % terms.

Requirement
(a) Demonstrate how sterling short-term interest rate futures can be used by Sunwin to hedge
against interest rate rises, and show the effective loan rate achieved and the hedge
efficiency if, on 28 February 20X3, the spot rate of interest is 4.5% pa and the March
interest rate futures price has fallen to 95.
(6 marks)

(b) Demonstrate how traded interest rate options on futures can be used by Sunwin to hedge
against the interest rate rising above 3.75% pa and show the effective loan rate achieved
if, on 28 February 20X3:
(1) The spot price is 4.4% pa and the futures price is 95.31.
(2) The spot price is 2.1% pa and the futures price is 97.75.
(9 marks)

(c) Identify three factors that will affect the time value of an option.
(3 marks)

Total: 26 marks

28 Padd Shoes Ltd

You should assume that the current date is 31 March 20X4.
You work in the finance team at Padd Shoes Ltd (Padd), a footwear manufacturer and retailer based in
the UK. You have been given two tasks to deal with:
Task 1
Padd’s chief executive has been contacted by the managing director of a large Indian retailer, DS,
who feels that Padd’s footwear would sell well in India because, in her words, “Padd’s styles are
attractive to our consumers, UK brands are generally highly regarded here in India and our country
has a growing middle class with enhanced spending power”.
It has been agreed that, to test the market, Padd will send a large consignment of footwear to DS for
sale in its shops across India. The price for this consignment is 200 million Indian rupees (INR), which
will be payable by DS on 30 June 20X4.
Padd’s board is aware that the Indian rupee has weakened against sterling by almost 2% in the past
six months and so it wishes to explore whether to hedge this sale to DS. In addition, because Padd
has not traded outside of the UK before, its board has some more general concerns about trading
abroad.
You have been asked to prepare advice for the board and have obtained the following information at
the close of business on 31 March 20X4:

ICAEW 2021 Risk management 45

 Spot rate (INR/£) 94.0625 – 95.4930
Sterling interest rate (lending) 3.2% pa
Sterling interest rate (borrowing) 4.0% pa
INR interest rate (lending) 4.2% pa
INR interest rate (borrowing) 4.8% pa
Three-month OTC currency call option on INR – exercise price INR 94.7500/£
Three-month OTC currency put option on INR – exercise price INR 95.5500/£
Three-month forward rate discount (INR/£) 0.0195 – 0.2265
Cost of relevant OTC currency option £8,000
Cost of forward contract £4,500

Task 2
On 1 April 20X3 Padd borrowed £8.5 million over a four-year period at LIBOR + 1% pa to finance an
expansion of its production capacity and the refurbishment of a number of its larger stores. Padd’s
board is now investigating whether it should hedge against adverse interest rate movements over
the next 12 months. Its bank has offered either (a) an option at 4% pa plus a premium of 0.75% of the
sum borrowed or (b) a Forward Rate Agreement (FRA) at 4.5% pa.
Requirements
28.1 Calculate Padd’s sterling receipt from the sale to DS if it:
(a) Does not hedge the receipt and the Indian rupee weakens by 1% by 30 June 20X4
(2 marks)
(b) Uses an OTC currency option
(2.5 marks)
(c) Uses a forward contract
(2.5 marks)
(d) Uses a money market hedge
(3 marks)
28.2 With reference to your calculations in 28.1 above, advise Padd’s board whether it is worth
hedging the DS receipt.
(8 marks)
28.3 Advise Padd’s board as to the risks, other than currency risk, that should be considered if the
company is to continue to trade abroad in future.
(5 marks)
28.4 By preparing suitable interest payment calculations, recommend to Padd’s board whether it is
worth hedging against interest rate movements over the next 12 months if LIBOR is either (a)
3% pa or (b) 6% pa.
(7 marks)
Total: 30 marks

29 Lambourn plc
Throughout all parts of this question you should assume that today’s date is 30 June 20X2.
29.1 Lambourn plc (Lambourn) is a UK company that trades in a range of pharmaceutical products.
It buys and sells these products in the UK and also in the USA, where it trades with three
companies – Biotron Inc., Hope Inc. and USMed Inc.
In the past, the relatively low level of trading with US companies has meant that Lambourn has
not hedged its foreign currency exposure. However, due to increases in the level of trade

46 Financial Management ICAEW 2021

 conducted in the USA, Lambourn’s finance director is now considering the use of a variety of
hedging instruments.
Receipts and payments in respect of the following exports and imports (designated in the
currencies shown) are due in six months’ time:
Receipts due from exports to:

Biotron Inc. $600,000

Hope Inc. £400,000
USMed Inc. $200,000

Payments due on imports from:

Biotron Inc. $1,100,000

Hope Inc. £900,000
USMed Inc. $1,250,000

Exchange rates at the present time are as follows:

Spot $1.6666 – 1.6720/£

3-month forward premium 0.90c – 0.98c
6-month forward premium 2.49c – 2.65c

Sterling currency options (standard contract size £10,000) are currently priced as follows (with
premiums, payable up front, quoted in cents per £):

Calls Puts

Strike Price September December September December

$1.63 3.67 4.59 0.06 1.69

$1.65 2.35 3.07 1.63 3.43

$1.67 1.82 2.65 2.04 5.55

Sterling currency futures (standard contract size £62,500) are currently priced as follows:

September $1.6555/£
December $1.6496/£

Annual borrowing and deposit interest rates at the present time are as follows:

Sterling 3.00% – 1.70%

Dollar 1.50% – 0.50%

Requirements
Assuming the spot rate in six months’ time will be $1.6400 – 1.6454/£, calculate Lambourn’s
net foreign currency exposure, and the outcome achieved, using:
(a) A forward market hedge
(4 marks)

(b) Exchange-traded currency options (hedging to the nearest whole number of contracts) so
as to guarantee no worse an exchange rate than the current spot rate
(6 marks)

(c) Currency futures contracts (hedging to the nearest whole number of contracts) and
assuming the relevant futures contract is trading at $1.6400 in six months’ time

ICAEW 2021 Risk management 47

 (4 marks)

(d) A money market hedge

(3 marks)

29.2 As an additional transaction to those noted in 29.1 above, Lambourn has sold a new range of
pharmaceutical products to US Med Inc and is expecting to receive payment in 2 months’ time.
US Med Inc has stated that it will be making the payment using Bitcoin and has agreed to pay
50 Bitcoins on 30th August 20X2.
The directors are worried about the volatility of the Bitcoin price and are considering using the
futures market to hedge the risk.
The current (spot) value of a Bitcoin is £8,500 and Bitcoin futures (standard contract size 5
Bitcoins) are currently priced as follows:
July £8,450
August £8,344
September £8,100
Requirement
Assuming that the market value (and futures value) for Bitcoin on 30th August is £6,500, explain
how Bitcoin futures could be used to manage the price risk of Bitcoins and calculate the
outcome from the Bitcoin futures hedge.
(5 marks)
29.3 In six months’ time (ie, in December 20X2), Lambourn will need to borrow £1.5 million for a
period of six months at a fixed rate of interest. The company’s finance director is keen to
ensure that the interest rate on the loan does not exceed 3.75% pa. The spot rate of interest is
currently 3% pa. The finance director intends to use three-month sterling traded interest rate
options on futures to hedge the company’s interest rate exposure.
The current schedule of prices (premiums are in annual % terms) for these contracts (standard
contract size £500,000) is as follows:

Calls Puts

Strike Price Sept Dec Mar Sept Dec Mar

96.25 0.20 0.23 0.25 0.19 0.96 1.66

96.50 0.09 0.10 0.11 0.32 1.19 1.89

96.75 0.05 0.06 0.07 0.53 1.43 2.14

Requirement
(a) Calculate the outcome of the hedge and the effective annual rate of interest achieved if
prices in December 20X2, when Lambourn negotiates the six-month fixed rate loan with
its bank, are either:
• a spot interest rate of 4.4% pa and a futures price of 95.31; or
• a spot interest rate of 2.1% pa and a futures price of 97.75.
(10 marks)

(b) Explain why a hedge using futures contracts may be less than 100% efficient.
(3 marks)

Total: 35 marks

48 Financial Management ICAEW 2021

30 Bridge Engineering plc
You should assume that the current date is 31 December 20X5.
David Mann (David) is the finance director of Bridge Engineering plc (BE). David has approached
your firm to give a presentation to the board of BE on the characteristics and use of options in the
following two situations:
(1) BE has been expanding in recent years by acquisition. David would like to know how his
company might use traded options to protect itself against a fall in the value of the small
shareholdings that it holds in potential acquisitions. One such potential acquisition is Stickle plc
(Stickle) in which BE has a holding on 31 December 20X5.
The following information is available:
On 31 December 20X5 the share price of Stickle is 287 pence (ex div) and traded options on its
shares are available as follows (all figures in pence):

Calls Puts

Exercise price January March January March

280 8.5 16 1.5 10.5

290 2.5 11 5.5 16

(2) BE currently uses forward rate agreements (FRAs) and interest rate futures to hedge its interest
rate risk. David is now considering the use of traded interest rate options. BE needs to take out a
loan of £20 million on 31 July 20X6 for a period of seven months and David has agreed with BE’s
bank that the loan will have an interest rate of LIBOR + 4% pa.
LIBOR on 31 December 20X5 is 0.62% pa and David wishes to hedge against any increase in this
rate between 31 December 20X5 and 31 July 20X6.
The following information is available:
At 31 December 20X5 the following traded interest rate options on three month interest rate
futures with a contract size of £500,000 are available (option premiums are in annual % terms):

Calls Puts

Exercise March June Septembe March June Septembe

price r r

99.13 0.05 0.09 0.13 0.26 0.31 0.35

99.38 0.02 0.03 0.05 0.48 0.50 0.52

99.63 0.01 0.02 0.03 0.71 0.73 0.74

Assume that the options in (1) and (2) above expire at the end of the relevant month and that
premiums are payable on 31 December 20X5. The interest implications of paying the premium on 31
December 20X5 can be ignored.
You have been asked to prepare briefing notes for the presentation on options to be given to the
board of BE.

Prepare the briefing notes for the presentation that include:

Requirements
30.1 A calculation of the intrinsic value and time value of each of the options on Stickle’s shares at
31 December 20X5.
(4 marks)
30.2 A brief explanation of the three factors that affect the time value of the options on Stickle’s
shares.
(3 marks)

ICAEW 2021 Risk management 49

30.3 A brief explanation of the two factors that affect the intrinsic value of the options on Stickle’s
shares.
(2 marks)
30.4 A demonstration, using options, of how BE can protect itself against a fall in the Stickle share
price in the period up to 31 March 20X6 when it will decide whether to make an offer for the
whole of Stickle. Assume Stickle’s share price will be 250p on 31 March 20X6.
(4 marks)
30.5 A demonstration of how traded interest rate options on interest rate futures can be used by BE
to hedge against LIBOR rising above 0.62% pa, showing the effective interest rate on the loan,
if on 31 July 20X6:
(10 marks)
(a) LIBOR is 0.80% pa and the futures price is 99.15
(b) LIBOR is 0.40% pa and the futures price is 99.66
30.6 An explanation of the comparative advantages and disadvantages of using traded interest rate
options, rather than FRAs and interest rate futures, to hedge BE’s interest rate risk.
(7 marks)
Total: 30 marks

50 Financial Management ICAEW 2021

 March 2016 exam questions
31 Aranheuston Pharma plc
Aranheuston Pharma plc (AP) is a large listed UK pharmaceuticals company and its financial year end
is 31 March. Its directors have decided to invest in new products on a regular basis in order to keep
pace with the global trading environment. In order to help grow the company more quickly, AP’s
directors are also investigating the possible takeover of a competitor.
Considerable development time is required for the production of new pharmaceutical products and
so net cash inflows from sales often lag well behind the development costs required.
Forecast life-cycle data for a new product (AP525) that is under consideration are provided below:

Year to Year to Year to Year to

31/3/16 31/3/17 31/3/18 31/3/19
£’000 £’000 £’000 £’000
Depreciation (Note 1) (350) (350) (350) –
Rent (Note 2) – (80) (80) (80)
Fixed costs (Notes 3 & 5) – (290) (290) (290)
Interest (Note 4) – (60) (60) (60)
Sales (Note 5) – 0 2,600 700
Variable costs (Note 5) – 0 (1,180) (220)
Profit/(loss) (350) (780) 640 50
Total working capital required (Note 5) 0 260 70 0

Notes
(1) New equipment required for the production of AP525 will cost £1,150,000 on 31 March 20X6
and will be sold on 31 March 20X9 for an agreed price of £100,000 (in 31 March 20X9 prices).
AP depreciates its equipment on a straight-line basis. A full year’s depreciation is charged in the
year of purchase and none in the year of sale.
If this new equipment is purchased, existing equipment, which originally cost £120,000 many
years ago and has a tax written down value of zero, will be sold on 31 March 20X6 for £70,000.
The new equipment will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year. In
the final year, the difference between the equipment’s written down value for tax purposes and
its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down value; or
– balancing charge, if the disposal proceeds are more than the tax written down value.
(2) The new equipment will take up extra space, which will have to be rented for three years. The
rent would be at a fixed annual amount of £80,000, payable in advance, with the first payment
due on 31 March 20X6.
(3) £130,000 of these fixed costs per annum are existing head office costs that will be allocated to
the project.
(4) The purchase of the new equipment would be funded from an issue of debt and this represents
the interest cost on that debt.
(5) Unless otherwise stated, all of the above figures are in 31 March 20X6 prices. The following
inflation rates are expected for the years ended 31 March 20X7–20X9:
– Sales: 2% pa
– Variable and fixed costs and working capital: 3% pa

ICAEW 2021 March 2016 exam questions 51

 Other information
Corporation tax will be payable at the rate of 17% pa for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
An appropriate money cost of capital for the project is 8% pa.
Requirements
31.1 Using money cash flows, calculate the net present value of the AP525 product at 31 March
20X6 and advise AP’s directors whether the company should proceed with it.
(18 marks)
31.2 Calculate the sensitivity of your advice in 31.1 to changes in the variable costs of the AP525
product and comment on your result.
(5 marks)
31.3 For the purposes of the possible takeover of a competitor, outline the Shareholder Value
Analysis (SVA) approach to company valuation for AP’s directors, identifying its advantages
and disadvantages.
(6 marks)
31.4 Agency theory highlights the potential conflicts that may occur between a company’s
shareholders and its directors.
(a) Explain how these conflicts might arise in AP in relation to the potential takeover of a
competitor.
(3 marks)

(b) Assuming that the AP525 product goes ahead, explain how these conflicts might arise in
AP in relation to:
• debt levels
• short-term versus long-term performance appraisal
(3 marks)

Total: 35 marks

32 Oliphant Williams plc

You should assume that the current date is 1 March 20X6.
Oliphant Williams plc (OW) is a large UK design company that has traded since 1994. Its capital
structure at 29 February 20X6 is shown below:

Total market
Par Value Market Value value
£m (ex-div/ex-int) £m
Ordinary share capital 96 £1.70/share 326.4
Preference share capital 28 £1.80/share 50.4
3.5% debentures (redeemable at par in 20X9) 160 £105% 168.0

Notes
(1) OW’s retained earnings at 29 February 20X6 were £43.8 million.
(2) OW’s earnings for the year to 29 February 20X6 were £21.12 million. Earnings are not expected
to change significantly in the next two years.
(3) OW’s ordinary dividend for the year to 29 February 20X6 was £0.09 per share.
You are an ICAEW Chartered Accountant and the managing director of OW. The following comments
were made at OW’s most recent board meeting:

52 Financial Management ICAEW 2021

 Finance director
“The company’s level of debt is too high and its balance sheet needs restructuring. Why don’t we
raise more equity and pay off some of the debt? This would reduce gearing and have a positive
impact on the price of ordinary shares. A reasonably priced rights issue is probably the best way
forward and should not dilute OW’s earnings per share excessively.”
Marketing director
“Our dividend is similar, in terms of the payout ratio, to previous years, but I think that this policy of
paying high dividends is an unnecessary drain on our resources. I think that our shareholders would
react positively if we reduce the dividend in future.”
Production director
“Whilst we don’t expect our earnings to change much in the next two years, surely it would be better
for our share price if we predict some growth when we communicate with our shareholders?”
In response to the finance director’s concerns, OW’s board is considering the redemption of one half
of its debentures. The debentures would be redeemed at an agreed price of £110.40%. The
redemption would be funded by a 2 for 5 rights issue.
Assume that the corporation tax rate will be 17% pa for the foreseeable future.
Requirements
32.1 Calculate OW’s gearing ratio (debt / debt + equity) at 29 February 20X6, using both book and
market values.
(3 marks)
32.2 Discuss, with reference to relevant theories and your calculations in 32.1 above, the finance
director’s view that a reduction in OW’s gearing would have a positive impact on the
company’s share price.
(6 marks)
32.3 Assuming that the debenture redemption and rights issue goes ahead on 1 March 20X6 as
outlined above, calculate the theoretical ex-rights price of one OW ordinary share. Show the
financial impact of the proposed rights issue on an OW shareholder who owns 10,000 ordinary
shares and who:
(9 marks)
(a) Takes up all of the rights

(b) Sells all of the rights

(c) Does nothing

32.4 Calculate, and comment upon, the actual price of an ordinary OW share after the rights issue is
made, assuming that OW’s current P/E (price/earnings) ratio remains unchanged.
(7 marks)
32.5 Making reference to relevant theories, discuss whether the marketing director is correct that a
reduction in OW’s ordinary dividend would affect the price of its ordinary shares.
(7 marks)
32.6 Comment on the ethical implications of the production director’s suggestion for you as an
ICAEW Chartered Accountant.
(3 marks)
Total: 35 marks

33 Tully Carlisle Ltd

You should assume that the current date is 29 February 20X6.
33.1 Tully Carlisle Ltd (TC) is a UK construction firm. Most of its suppliers are UK-based. However,
since 20X4 it has been purchasing steel girders from a Russian company, GSL.

ICAEW 2021 March 2016 exam questions 53

 At a recent board meeting one of TC’s directors commented:
“With our GSL purchases, we’ve never hedged against adverse exchange rate movements. I
think that we should as we’re now buying a lot of steel from GSL. The orders are made three
months ahead of delivery and payment. A lot could happen to the exchange rate in those
three months.”
TC’s next order from GSL, at a price of R145.6 million (R = roubles, the Russian currency) will be
paid for in three months’ time on 31 May 20X6. You are a member of TC’s finance team and
have been asked to advise the board of the implications of hedging this purchase. You have
collected the following information:

Spot exchange rate at 31 December 20X4 (R/£) 79.45 – 91.34

Spot exchange rate at 31 December 20X5 (R/£) 76.51 – 87.95
Spot exchange rate at 29 February 20X6 (R/£) 78.81 – 90.62
Three-month forward contract discount (R/£) 0.55 – 0.63
Forward contract arrangement fee (per one million roubles converted) £40
Three-month over the counter (OTC) put option on roubles, exercise price
(R/£) 91.83
Three-month OTC call option on roubles, exercise price (R/£) 79.85
Relevant OTC option premium (per one million roubles converted) £90
Sterling interest rate (borrowing) 3.6% pa
Rouble interest rate (borrowing) 6.6% pa
Sterling interest rate (lending) 2.9% pa
Rouble interest rate (lending) 5.6% pa

Requirement
(a) Calculate the sterling cost of TC’s payment to GSL on 31 May 20X6 if it uses the following
to hedge its exchange rate risk:
• A forward contract
• A money market hedge
• An OTC currency option
(8 marks)

(b) With reference to your calculations in (a) above and the spot exchange rates provided,
advise TC’s board whether to hedge the payment to GSL.
(9 marks)

(c) Explain, with relevant workings, why the three-month forward rate is expressed at a
discount to the spot rate on 29 February 20X6.
(5 marks)

33.2 TC borrowed £18.5 million last year at a fixed rate of 5.2% pa and this loan is repayable in
March 20X9. Anticipating a fall in interest rates, TC’s board has asked its finance team to
investigate the possibility of arranging an interest rate swap. TC’s bank has offered the
company a variable rate loan at LIBOR plus 1.2% pa.
Saunders Southgate Media (SSM), a company with a similar sized loan to TC (at a variable rate
of LIBOR plus 1.6% pa), is keen to swap its loan for one at a fixed rate. SSM has been offered a
fixed rate of 6.4% pa by its bank. LIBOR is currently 3.5% pa.

54 Financial Management ICAEW 2021

 Requirement
Prepare workings for TC’s board that show how an interest rate swap that is equally beneficial
to both companies could be set up. The variable leg of the swap should be set at LIBOR. Your
workings should include a calculation of the total annual interest payable by each company
once the swap has been made.
(8 marks)
Total: 30 marks

ICAEW 2021 March 2016 exam questions 55

56 Financial Management ICAEW 2021
 June 2016 exam questions
34 Zeus plc
You should assume that the current date is 30 June 20X6.
Zeus plc (Zeus) is a large clothing retailer. Over the past five years it has built up an internet-based
division, Venus, which specialises in selling to 16–24-year old female customers.
At a recent board meeting the Chief Executive Officer (CEO) of Zeus stated that:
“Venus has been successful, but we have not been able to get the value out of it that we initially
expected, and the management time involved in running Venus is damaging the financial
performance of the group as a whole. Because internet-based companies have very high values
compared to non-internet companies with similar earnings, I feel that there could be more value in
Venus if it operated outside of our group. I think that we should divest ourselves of Venus and
appoint a financial advisor to assist us in the process. I wonder whether an Initial Public Offering
(IPO), where the shares are brought to the stock market for the first time is a possibility. I’ve also
heard about an Initial Coin Offering (ICO), would this be a possibility for the divestment of Venus?”
The board agreed with the CEO and voted in favour of the divestment of Venus. Starr Accountants
(SA), a firm of ICAEW Chartered Accountants, has been appointed to give advice to Zeus regarding
the value of Venus and the potential IPO. In their valuation SA would like to use net present value
analysis and also a multiple of earnings. In addition to general corporate finance work, SA also has a
team that specialises in giving investment advice to clients who buy shares in IPOs.
Extracts from Venus’s most recent management accounts are shown below:
Balance sheet value of net assets at 30 June 20X6: £39 million.

Income statement for the year ended 30 June 20X6 £m

Sales 140.0
Cost of sales (56.0)
Gross profit 84.0
Selling and administration costs (72.0)
Operating profit 12.0
Taxation 17% (2.0)
Profit after tax 10.0

Note: Selling and administration costs include depreciation of £2 million.

Additional information relating to Venus:
(1) An analyst has estimated that, for the four years to 30 June 20Y0, the volume of sales will grow
by 18% pa and selling prices will increase by 2% pa. Because of volume discounts, the gross
profit percentage will increase to 66%.
(2) Selling and administration costs, excluding depreciation, are estimated to increase by 5% pa for
the four years to 30 June 20Y0.
(3) Venus will require an additional investment in working capital on 1 July 20X6 of £26 million. This
will increase at the start of each subsequent year in line with sales volume growth and selling
price increases. Working capital will be fully recoverable on 30 June 20Y0.
(4) On 30 June 20X6 Venus will need to invest in a new warehouse management system that will
cost £10 million and will not have any scrap value on 30 June 20Y0. The warehouse
management system will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.
At 30 June 20Y0, the difference between the warehouse management system’s written down
value for tax purposes and its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down value; or

ICAEW 2021 June 2016 exam questions 57

 – balancing charge, if the disposal proceeds are more than the tax written down value.
(5) SA intends to include in the net present value analysis a continuing value at the end of four years
that will represent the value of the net cash flows after tax beyond the fourth year. This will be
calculated by treating the after-tax operating cash flows for the year ended 30 June 20Y0 as a
growing perpetuity with a growth rate of 1% pa.
(6) An appropriate money discount rate to reflect the risk of Venus is 10% pa.
(7) SA would like to assume that the rate of corporation tax will be 17% for the foreseeable future
and that tax flows arise in the same year as the cash flows that gave rise to them.
(8) The average price earnings (P/E) ratio of companies similar to Venus is 55.
(9) Unless otherwise stated assume that all cash flows arise at the end of the year to which they
relate.
Requirements
34.1 Using money cash flows, calculate the value of Venus on 30 June 20X6 using net present value
analysis.
(15 marks)
34.2 Calculate the value of Venus on 30 June 20X6 using a multiple of current earnings.
(2 marks)
34.3 Summarise the advantages and disadvantages of the two valuation methods used in parts 34.1
and 34.2 and identify any concerns you have in respect of using them to value Venus.
(5 marks)
34.4 In relation to the potential IPO, explain the difference between an offer for sale and an offer for
subscription (also known as a direct offer).
(2 marks)
34.5 Outline the advantages and disadvantages of underwriting and advise the board of Zeus as to
whether the potential IPO should be underwritten.
(4 marks)
34.6 Compare an ICO to an IPO and discuss whether an ICO is appropriate for the divestment of
Venus.
(4 marks)
34.7 Identify any ethical issues that SA may have in relation to the potential Venus IPO and state
how they might be resolved.
(3 marks)
Total: 35 marks

35 Ross Travel plc

Ross Travel plc (Ross) provides public transport services in the UK. Ross is planning to set up a new
division called ‘Happytours’ and to expand into a different sector of the transportation industry by
operating holiday and sightseeing tours. The Chief Executive Officer (CEO) of Ross believes that the
expansion will cost £500 million and that the finance can be raised in such a way as to leave the
existing debt:equity ratio, by market values, of the company unchanged after the expansion.
The CEO of Ross would like the finance director of the company to advise him of how the company’s
current weighted average cost of capital (WACC) can be adjusted to take into account the risk of
expanding into the new sector. The debt proportion of the new finance will be raised in the form of
redeemable debentures. However, the CEO would also like to know the advantages and
disadvantages of Ross issuing convertible debentures.
The finance director has established the following:
• The debt proportion of the £500 million finance to be raised on 1 June 20X6 will be in the form of
new 4% coupon debentures, which will be redeemed on 31 May 20Y1 at par. The redemption
yield of the new debentures will be equal to the redemption yield of Ross’s existing debentures.

58 Financial Management ICAEW 2021

 • An appropriate equity beta for a company that operates in the holiday and sightseeing tour
sector is 1.3 at a debt:equity ratio, by market values, of 1:1.
• The market risk premium is expected to be 5% pa and the risk free rate 2% pa.
• The corporation tax rate will be 17% for the foreseeable future.
The following information relates to Ross without the Happytours project.
Extracts from Ross’s most recent management accounts are as follows:

Balance sheet at 31 May 20X6 £m

Ordinary share capital (5p shares) 32
Retained earnings 3,072
3,104
6% Redeemable debentures at nominal value 608
3,712

On 31 May 20X6 Ross’s ordinary shares each had a market value of 576p (cum-div) and an equity
beta of 0.65. For the year ended 31 May 20X6, the dividend declared was 11p per ordinary share
and the earnings yield (earnings per share divided by the ex-div share price) was 6%.
Ross’s 6% coupon debentures had a market value on 31 May 20X6 of £111 (cum-interest) per £100
nominal value and are redeemable at par on 31 May 20Y0.
Requirements
35.1 Ignoring the Happytours project, calculate the WACC of Ross at 31 May 20X6 using:
(a) The Gordon growth model
(12 marks)
(b) The CAPM
(2 marks)
35.2 Explain the limitations of the Gordon growth model.
(3 marks)
35.3 Using the CAPM, calculate a WACC that is suitable for appraising the Happytours project and
explain your rationale.
(6 marks)
35.4 Assuming that £75 million is raised from the new 4% coupon debentures issued on 1 June
20X6, calculate the issue price per £100 nominal value and the total nominal value that will
have to be issued. Comment on the issue terms for these new debentures.
(7 marks)
35.5 Explain what is meant by a convertible debenture and outline the advantages and
disadvantages for Ross in raising finance using this type of debt.
(5 marks)
Total: 35 marks

36 Heaton Risk Management

You should assume that the current date is 31 May 20X6.
36.1 Heaton Risk Management (HRM) is an authorised financial advisor and provides investment
and risk management advice. You work for HRM and currently you are advising two clients,
Orchid Cars Ltd (Orchid) and Sheldon Investments (Sheldon).
Orchid is a UK company that manufactures sports cars. Orchid’s main market is the UK but it
also exports cars to the USA.
Currently Orchid uses forward contracts to hedge its foreign exchange rate risk. However,
Orchid’s managing director has recently been considering using foreign currency futures and

ICAEW 2021 June 2016 exam questions 59

 over-the-counter foreign currency options. You have been asked to make a comparison of the
results of hedging using the three different techniques.
Orchid is due to receive $2,500,000 on 30 September 20X6.
The following data is available to you at the close of business on 31 May 20X6:
Exchange rates:
Spot exchange rate ($/£) 1.5398 – 1.5402
Four-month forward premium ($/£) 0.0015 – 0.0010
September currency futures price (standard contract size £62,500): $1.5379/£
Four-month over-the-counter currency options:
Call options to buy £ have an exercise price of $1.5300/£. The premium is £0.03 per $ to be
converted and is payable on 31 May 20X6.
Put options to sell £ have an exercise price of $1.5200/£. The premium is £0.01 per $ to be
converted and is payable on 31 May 20X6.
Orchid has surplus cash funds on which it receives interest at 3.60% pa.
Requirements

(a) Assuming that the spot exchange rate on 30 September 20X6 will be $/£1.5315 – 1.5325
and that the sterling currency futures price will be $1.5320/£, calculate Orchid’s net
sterling receipt if it uses the following to hedge its foreign exchange rate risk:
• A forward contract
• Currency futures contracts
• An over-the-counter currency option
(11 marks)

(b) Discuss the relative advantages and disadvantages of each hedging technique and advise
Orchid on which would be most beneficial for hedging its foreign exchange rate risk.
(9 marks)

36.2 Sheldon holds a portfolio of FTSE 100 shares and the current market value on 31 May 20X6 is
£9,657,000. The managers at Sheldon are worried that over the next three months the FTSE
100 will fall in value due to economic uncertainty in Europe and Asia. The managers at Sheldon
do not want to sell the company’s portfolio and wish to protect its current value against a
potential fall in the FTSE 100.
The FTSE 100 index is 6,525 on 31 May 20X6 and you have the following information available
to you regarding traded index option premiums:
FTSE 100 INDEX OPTIONS: £10 per full index point (points per contract)

6,450 6,525 6,600

Calls Puts Calls Puts Calls Puts

July 155 51 87 85 70 135

August 215 120 171 159 120 213

Option contracts expire at the end of the month.

Requirements
Demonstrate how FTSE 100 index options can be used by Sheldon to hedge its portfolio of
shares against a fall in the FTSE 100 and show the outcome if, on 31 August 20X6, the
portfolio’s value:
(7 marks)
(a) Rises to £10,471,000 and the FTSE 100 index rises to 7,075

60 Financial Management ICAEW 2021

 (b) Falls to £8,695,000 and the FTSE 100 index falls to 5,875

36.3 Sheldon’s managers would like an explanation regarding the time value of the FTSE 100 index
options.
Requirement
Explain the three factors that will affect the time value of the FTSE 100 index options in 36.2
above.
(3 marks)
Total: 30 marks

ICAEW 2021 June 2016 exam questions 61

62 Financial Management ICAEW 2021
 September 2016 exam questions
37 Northern Energy Ltd
You should assume that the current date is 30 September 20X6.
Northern Energy Ltd (Northern) is a UK electricity generator. On 31 March 20X7 it has contracted to
borrow £9.5 million for a year at an interest rate of LIBOR + 2% pa. The loan will be used to finance
the construction of a new rail terminal at one of its power stations. Northern’s board is now worried
that interest rates may well increase over the next six months and would like to investigate how it
might hedge against any adverse movements. Northern’s bank has offered the company either a
Forward Rate Agreement (FRA) at 7.25% pa or an option at 6.5% pa plus a premium of 1% of the sum
borrowed. The board would also like to consider the possibility of an interest rate swap.
Northern’s three power stations are coal-fired and the company has for many years imported coal
from China and India, with payment made to suppliers at the time of the order. Northern’s board is
concerned that in recent months the Indian and Chinese exchange rates have become more volatile.
As a result Northern’s board is considering buying coal from the USA.
Earlier this month Northern’s purchasing team started discussions with ACT Inc (ACT), an American
coal mining company. ACT has informed Northern that, because of the logistical issues involved, the
first consignment of coal would arrive in three months’ time on 31 December 20X6. Northern has
agreed to pay for the coal one month later on 31 January 20X7. Northern’s board is keen to establish
whether it is worth hedging its dollar exchange rate risk.
ACT has quoted Northern a price of $4.8 million for this first consignment. You work in Northern’s
finance team and have been asked to prepare workings to help Northern’s board to decide on a
hedging strategy. You have collected the following data at the close of business on 30 September
20X6:

Spot rate ($/£) 1.5150 – 1.5260

Relevant currency futures contract price (standard contract size £62,500) $1.5095/£
OTC currency option:
Four-month put option on dollars ($/£) 1.5110
Four-month call option on dollars ($/£) 1.5020
Premium (per $ converted) £0.011
Forward contract:
Four month forward premium ($/£) 0.0112 – 0.0094
Arrangement fee (per $ converted) £0.004
Interest rates:
US dollar interest rate (lending) 3.6% pa
US dollar interest rate (borrowing) 4.5% pa
Sterling interest rate (lending) 5.4% pa
Sterling interest rate (borrowing) 6.9% pa

Requirements
37.1 Assuming that on 31 March 20X7 LIBOR will be:
• 5% pa
• 7% pa
prepare suitable interest payment calculations for each eventuality and recommend to
Northern’s board whether it should hedge against interest rate movements using a FRA, an
option or an interest rate swap.
(9 marks)

ICAEW 2021 September 2016 exam questions 63

 37.2 Calculate Northern’s sterling cost of the ACT consignment if it uses the following to hedge its
exchange rate risk.
You should assume that on 31 January 20X7 the spot exchange rate will be $1.4895 – 1.4956/£
and that the sterling currency futures price will be $1.4945/£.
(a) Currency futures contracts
(5 marks)

(b) An OTC currency option

(3 marks)

(c) A forward contract

(2 marks)

(d) A money market hedge

(3 marks)

37.3 With reference to your calculations in 37.2 above, explain to Northern’s board the implications
of hedging or not hedging the payment to ACT.
(8 marks)
Total: 30 marks

38 Roper Newey plc

Roper Newey plc (Roper) is a UK engineering company that operates in the oil industry providing
support services on oil rigs and at oil terminals. It started trading nearly 20 years ago and it has a
financial year end of 31 August.
For a number of years Roper has used a weighted average cost of capital (WACC) figure of 7% pa as
its hurdle rate when appraising large-scale investments. At Roper’s most recent board meeting it was
decided to investigate the possibility of the company diversifying into the UK fracking industry.
Fracking involves extracting oil and gas from beneath the ground via the high pressure injection of
water and sand. It is a very controversial industry in the UK, not least because of concerns about its
impact on the natural environment.
Roper’s board is considering supplying services to the fracking industry. The finance for this
investment would be raised in such a way so as not to alter Roper’s current gearing ratio (measured
by market values). The debt element of the finance will come from a new issue of 6% irredeemable
debentures at par.
Roper’s directors are aware that many American companies have been very successful financially
when investing in fracking, but are concerned that such a diversification by Roper in the UK would be
excessively risky. As a result Becky Challoner, Roper’s finance director, has agreed to present relevant
figures and advice at the next board meeting. Becky has asked you, as a member of Roper’s finance
team, to work with her on this.
Details of Roper’s capital structure at 31 August 20X6 are shown below:

Total nominal value Market value

£m
Ordinary share capital (£1 shares) 15.5 £5.20/share (ex-div)
Preference share capital (£1 shares) 9.0 £1.08/share (ex-div)
4% redeemable debentures (Note 1) 6.5 £107% (cum-int)
5% irredeemable debentures 10.0 £101% (cum-int)

Roper’s most recent dividend payments and the interest payments due in the near future are shown
below:

64 Financial Management ICAEW 2021

 Ordinary dividends (Note 2) £3,797,500 Paid in August 20X6
Preference dividends (Note 2 £540,000 Paid in August 20X6
4% redeemable debentures
interest £260,000 To be paid in September 20X6
5% irredeemable debentures
interest £500,000 To be paid in September 20X6

Notes
(1) These are redeemable at par on 31 August 20X9.
(2) Ordinary and preference dividends are paid once a year. Ordinary dividend payments have
increased at a steady annual rate since August 20X2 at which time the ordinary dividend per
share was £0.201. There have been no issues of ordinary shares since August 20X2.
Additional information at 31 August 20X6
Roper equity beta – 1.2
Risk free rate (pa) – 1.9%
Market return (pa) – 9.5%
Fracking industry – market data at 31 August 20X6
Average equity beta – 1.9
Ratio of long–term funds (equity:debt) by market values – 90:25
Assume that corporation tax will be payable at the rate of 17% for the foreseeable future and tax will
be payable in the same year as the cash flows to which it relates.
Requirements
38.1 Ignoring the investment in fracking services, calculate Roper’s WACC at 31 August 20X6 using:
(a) The dividend growth model; and
(11 marks)

(b) The CAPM

(2 marks)

38.2 Ignoring the investment in fracking services, advise Roper’s board, giving reasons, whether it
should continue using 7% as its hurdle rate when appraising large-scale investments.
(3 marks)
38.3 Explain the underlying logic for using the CAPM when calculating a company’s WACC.
(5 marks)
38.4 Calculate the WACC that Roper should use when appraising its proposed investment in
fracking and explain the reasoning behind your approach.
(10 marks)
38.5 With reference to the information provided, explain the circumstances in which it would be
appropriate to use the adjusted present value approach to investment appraisal.
(4 marks)
Total: 35 marks

39 Darlo Games Ltd

Darlo Games Ltd (Darlo) is a UK company which was formed in 20W5 by Michelle Cartmel and Rob
Orton. Darlo develops and produces games for use on computers and mobile devices such as
phones. Its financial year end is 31 August. Michelle and Rob own 70% of Darlo’s issued share capital
and are part of its executive management team. The remainder of Darlo’s share capital is owned by
Michelle and Rob’s friends and family. Darlo has been particularly successful in the past three years

ICAEW 2021 September 2016 exam questions 65

as two of its games introduced in late 20X3 have generated very high levels of sales. A game has a
typical lifespan of three to five years.
NSL plc (NSL) is a listed software development company based in the UK and is actively seeking to
invest in other companies. You are an ICAEW Chartered Accountant and work in Darlo’s finance
team. You have received an email from your manager, Jackie Tann, an extract from which is shown
below:

From: Jackie Tann

Date: 1 September 20X6
A member of the board has told me, in confidence, that NSL is considering buying shares in Darlo.
I’m not sure at this stage if they want to buy all of them or just a minority holding. We need some
guidance on what a reasonable share price might be. I’ve extracted the key figures from our most
recent management accounts in the document attached to this email. I’ve also provided you with
some working assumptions.
Could you please prepare a range of prices for the Darlo board to consider? Also I’m keen to
know if we could value Darlo using Shareholder Value Analysis (SVA).

Email attachment:
Income statement for the year ended 31 August 20X6

£’000
Revenue 9,390

Profit before interest and tax 2,849

Interest (30)
Profit before taxation 2,819
Corporation tax at 17% (479)
Profit after taxation 2,340
Dividends paid (740)
Retained profit 1,600

Balance sheet at 31 August 20X6

£’000
Freehold land and buildings (original cost £2.8 million) 2,400
Equipment (original cost £4.5 million) 3,200
5,600
Working capital 148
5,748
4% debentures (redeemable in 20Y3) at nominal value (750)
4,998

Ordinary shares of £1 each 500

Retained earnings 4,498
4,998

Working assumptions

66 Financial Management ICAEW 2021

(1) Darlo’s fixed assets were revalued at 31 August 20X6 as follows:

£’000
Freehold land and buildings 3,150
Equipment 3,370

These revalued amounts have not been recognised in the balance sheet at 31 August 20X6.
(2) The average price/earnings ratio for listed businesses in Darlo’s industrial sector is 10 and the
average dividend yield is 8%.
(3) A discount rate of 12% pa appropriately reflects the risk of Darlo’s cash flows.
(4) Darlo’s pre-tax net cash inflows (after interest) for the next three years are estimated to be:

£’000
Year to 31 August 20X7 2,900
Year to 31 August 20X8 3,000
Year to 31 August 20X9 3,100

Projecting forward from 31 August 20X9 and taking a prudent view, our estimated net cash inflows
(after interest, capital asset replacement and all necessary tax adjustments) will be £2 million pa.
(5) On 31 August 20X6 Darlo’s equipment had a tax written down value of £920,000. Assume that
we will scrap it (ie, dispose of it for zero income) on 31 August 20X9. The equipment attracts 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent year of
ownership by the company, except the final year. In the final year, the difference between the
equipment’s written down value for tax purposes and its disposal proceeds will be treated by the
company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down value; or
– balancing charge, if the disposal proceeds are more than the tax written down value
(6) Corporation tax will be payable at the rate of 17% for the foreseeable future and that tax will be
payable in the same year as the cash flows to which it relates.
Requirements
39.1 Prepare a report for Darlo’s board which:
(a) Calculates the value of one share in Darlo based on each of these methods:
• Net asset basis (historic cost)
• Net asset basis (revalued)
• Price/earnings ratio
• Dividend yield
• Present value of future cash flows
(10 marks)

(b) Explains, with reference to your calculations and the information provided, the advantages
and disadvantages of using each of the five valuation methods in (a) above.
(10 marks)

39.2 Explain how the SVA approach works and whether the information provided by Jackie Tann is
sufficient to value Darlo using SVA (calculations are not required).
(8 marks)

ICAEW 2021 September 2016 exam questions 67

39.3 Discuss the challenges of adapting traditional valuation models to value a company like Darlo.
(4 marks)
39.4 Explain the ethical issues that you should consider as an ICAEW Chartered Accountant arising
from Jackie Tann’s email.
(3 marks)
Total: 35 marks

68 Financial Management ICAEW 2021

 December 2016 exam questions
40 Ribble plc
You should assume that the current date is 31 December 20X6.
Ribble plc (Ribble), a UK company, manufactures hoverboards and other products. Hoverboards are
a form of self-balancing scooter powered by rechargeable batteries. In the last two years total UK
sales of hoverboards have increased rapidly but major concerns have arisen over their safety and,
even though they are still in high demand, some retailers have stopped selling them.
At a recent directors’ meeting of Ribble the chief executive officer (CEO), who is an ICAEW Chartered
Accountant, presented a research and development report (that had cost £100,000) on a new and
safer hoverboard; the Ribbleboard. The CEO stated that he believed the new Ribbleboard could be
successfully marketed for a period of four years and would replace the company’s existing
hoverboard, the Ribflyer. The directors decided that a project appraisal should be undertaken to
ascertain whether the Ribbleboard should be marketed. Some directors felt that as there is a
continuing demand for the Ribflyer, even though there are concerns about its safety, it should still be
manufactured and sold rather than taking the risk of marketing the Ribbleboard. There was also
concern that a rival company was known to be developing a new safer hoverboard and it is likely to
launch it onto the market on 31 December 20X7.
The following information is available regarding the Ribbleboard project:
• The selling price will be £299 per unit in the year to 31 December 20X7 and will remain fixed in
each subsequent year of the product’s life. The contribution for the year to 31 December 20X7 is
expected to be 45% of the selling price. The variable cost of producing the Ribbleboard is
expected to increase by 5% pa in the three years to 31 December 20Y0.
• The number of units sold in the year to 31 December 20X7 is expected to be 8,000 per month.
For the year to 31 December 20X8 the number of units sold is expected to increase by 20%. For
the remaining two years to 31 December 20Y0, the number of units sold is expected to decline by
15% pa.
• The new specialist equipment required to manufacture the Ribbleboard requires more space than
Ribble currently has available. Therefore, Ribble will use factory space that it currently owns and
rents out for storage to another company for a fixed rent of £1 million pa payable in advance on
31 December. The space will be re-let for £1 million pa at the end of the project on 31 December
20Y0.
• If the project goes ahead, two managers who had already accepted voluntary redundancy would
be asked to remain employed until 31 December 20Y0 and manage the project at a salary of
£60,000 pa each. These managers were due to leave on 31 December 20X6 and receive lump
sum payments of £50,000 each at that time. They will now receive lump sum payments of £60,000
each on 31 December 20Y0 when their services will no longer be required. The managers were
also due to receive consultancy fees of £25,000 pa each for the two years ended 31 December
20X7 and 20X8. These consultancy fees would not be paid to them if they remained employed to
manage the project. All of the above salaries, lump sums and fees are stated in money terms.
• It is estimated that for every 10 Ribbleboards sold there will be a loss of sales of one unit of the
Ribflyer, which Ribble expects to sell at a fixed selling price of £100 and a contribution of 25%, in
each of the four years to 31 December 20Y0.
• The project will incur fixed overhead costs of £500,000 in the year to 31 December 20X7 of which
40% is centrally allocated overheads. The fixed overhead costs will increase after 31 December
20X7 by 3% pa.
• Investment in working capital will be £1 million on 1 January 20X7 and will increase or decrease at
the start of each year in line with sales volumes. Working capital will be fully recoverable on 31
December 20Y0.
• On 31 December 20X6 the project will require an investment in machinery and equipment of £24
million, which is expected to have a realisable value of £4 million (in 31 December 20Y0 prices) at
the end of the project. The machinery and equipment will attract 18% (reducing balance) capital
allowances in the year of expenditure and in every subsequent year of ownership by the
company, except the final year.

ICAEW 2021 December 2016 exam questions 69

 In the final year, the difference between the machinery and equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down value; or
– balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax flows
arise in the same year as the cash flows that give rise to them
• An appropriate money cost of capital for the Ribbleboard project is 10% pa.
Requirements
40.1 Using money cash flows calculate the net present value of the Ribbleboard project at 31
December 20X6 and advise Ribble’s directors whether it should be accepted.
(20 marks)
40.2 Advise Ribble’s directors as to the sensitivity of the NPV of the Ribbleboard project to:
(a) Changes in sales revenue (ignoring the effects on working capital)
(4 marks)

(b) Changes in the realisable value of the machinery and equipment

(3 marks)

40.3 Identify and discuss two real options available to Ribble in relation to the Ribbleboard project.
(5 marks)
40.4 Discuss the ethical issues that the CEO should consider regarding the suggestion by some
directors that only the Ribflyer hoverboard should continue to be manufactured.
(3 marks)
Total: 35 marks

41 Bristol Corporate Finance

You should assume that the current date is 31 December 20X6.
You work for Bristol Corporate Finance (BCF). Two of the clients for whom you are responsible are
Middleton plc (Middleton) and the management team of Oldham Ltd (Oldham).
41.1 Middleton
Middleton is a listed company and is seeking to raise £70 million to invest in new projects
during 20X7. Currently Middleton is financed only by equity. However, at a recent board
meeting the finance director stated that, since other companies in Middleton’s industry sector
have average gearing ratios (measured as debt/equity by market value) of 30% (with a
maximum of 40%) and an average interest cover of six times (with a minimum of five times),
perhaps the company should access the debt markets. The finance director presented the
board with two alternative sources of finance to raise the £70 million.
Equity issue: The £70 million would be raised by a 1 for 2 rights issue, priced at a discount on
the current market value of Middleton’s shares.
Debt issue: The £70 million would be raised by an issue of 7% coupon debentures,
redeemable at par on 31 December 20Y6. The yield to redemption of the debentures would
be equal to the yield to redemption of the debentures of Wood plc (Wood), another listed
company in Middleton’s market sector. Wood has a similar risk profile to Middleton and has
recently issued its debentures. Wood’s debentures have a coupon of 7%, will be redeemed in
four years at par and their current cum-interest market price is £110 per £100 nominal value.
There were concerns expressed by a number of board members regarding the debt issue
since it has been the long-standing policy of the company not to borrow. Their concerns were
how Middleton’s shareholders and the stock market would react and that the company’s cost
of capital would increase as a result of borrowing, leading to a fall in the company’s value.
An extract from Middleton’s most recent management accounts is shown below:

70 Financial Management ICAEW 2021

 Income statement for the year ended 31 December 20X6

£m
Operating profit 25.00
Taxation at 17% (4.25)
Profit after tax 20.75

Additional information:
• Middleton has an equity beta of 1.1
• The risk free rate is expected to be 3% pa
• The market return is expected to be 8% pa
• Middleton’s current share price is £5 per share ex-div
• Middleton has 40 million ordinary shares in issue
Requirements

(a) Calculate, using the CAPM, Middleton’s cost of capital on 31 December 20X6.
(1 mark)

(b) Assuming a 1 for 2 rights issue is made on 1 January 20X7:

• Calculate the discount the rights price represents on Middleton’s current share price
• Calculate the theoretical ex-rights price per share
• Discuss whether the actual share price is likely to be equal to the theoretical ex-rights
price.
(5 marks)

(c) Alternatively, assuming debt is issued on 1 January 20X7:

• Calculate the issue price and total nominal value of the debentures that will have to be
issued to give a yield to redemption equal to that of Wood’s debentures.
• Discuss the validity of the use of the yield to redemption of Wood’s debentures in the
above calculation.
(7 marks)

(d) Outline the advantages and disadvantages of the two alternative sources for raising the
£70 million, discuss the concerns of the board regarding the debenture issue (using the
gearing and interest cover information provided by the finance director) and advise
Middleton’s board on which source of finance should be used.
(12 marks)

41.2 The management team of Oldham

You have been asked to make a presentation to the management team of Oldham, an unlisted
company, who are considering a management buyout (MBO) of the company. Your
presentation will cover certain aspects of the MBO process and the contents of the financial
information section of the business plan that will need to be prepared for potential financiers.
Prepare notes for your presentation which include:
Requirement
(a) An outline of the sources and forms of finance that the management team is likely to need.
(3 marks)

(b) The possible exit routes for the financiers that contribute to the funding of the MBO.

ICAEW 2021 December 2016 exam questions 71

 (2 marks)

(c) The content of the financial information section of the business plan.
(5 marks)

Total: 35 marks

42 Orion plc
You should assume that the current date is 30 November 20X6.
Orion plc (Orion) is a UK company that manufactures nutrition products which it exports to the USA
and receives payment in dollars. Orion imports raw materials from a number of countries located in
Europe and makes payments to suppliers in euros.
At a recent board meeting of Orion concern was expressed about several aspects of the company’s
foreign exchange rate risk (forex) hedging strategy. Below is an extract from the minutes of the
meeting:
Managing director: “We have always hedged our forex and we should continue to do so. But I am
worried that because we import our raw materials and export our finished products, we are subject
to economic risk.”
Production director: “We use derivative instruments to hedge forex and I think they are too
complicated. How do the banks calculate forward rates for example? Also can someone explain to
me what economic risk is?”
It was decided that at the next board meeting the finance director should make a presentation to the
board on the subject of forex. The finance director has asked you to prepare some information for his
presentation including an example of how receipts are hedged using different hedging techniques.
You have the following information available to you at the close of business on 30 November 20X6:
Orion currently has substantial sterling funds on deposit.
Receipts due from USA customers on 31 March 20X7 are $5,000,000.
Exchange rates:
Spot rate ($/£) 1.4336 – 1.4340
Four month forward discount ($/£) 0.0086 – 0.0090
March currency futures price (standard contract size £62,500) $1.4410/£
Over-the-counter (OTC) currency option
A March put option to sell $ is available with an exercise price of $1.4390/£. The premium is £0.03
per $ and is payable on 30 November 20X6.
Annual borrowing and depositing interest rates (%)
Dollar 5.20 – 4.80
Sterling 3.30 – 3.00

Provide the following information for the finance director of Orion:

Requirements
42.1 A calculation of Orion’s sterling receipt using:
(a) A forward contract
(2 marks)

(b) Currency futures

(5 marks)

(c) An OTC currency option:

72 Financial Management ICAEW 2021

 assuming that the spot price on 31 March 20X7 is $/£ 1.4484 – 1.4490 and the March
futures price is $1.4487/£.
(4 marks)

42.2 An explanation of the advantages and disadvantages of the three hedging techniques used in
42.1 above and, using your results from 42.1 above, advice on which hedging technique Orion
should use.
(8 marks)
42.3 A demonstration, with reference to theories and relevant workings, of why the forward rate is at
a discount to the spot rate at 30 November 20X6.
(5 marks)
42.4 An explanation of what economic risk is, a discussion of how it affects Orion and an outline of
how economic risk can be mitigated.
(6 marks)
Total: 30 marks

ICAEW 2021 December 2016 exam questions 73

74 Financial Management ICAEW 2021
 March 2017 exam questions
43 Sentry Underwood plc
You should assume that the current date is 28 February 20X7.
Sentry Underwood plc (Sentry) is a large, listed UK drinks manufacturer. Sentry’s recent profitability
has deteriorated because of increased competition and a volatile consumer market. As a result,
Sentry’s board is considering a major change in the company’s trading strategy which will cost £20
million to implement. The board has decided that this investment will be funded either via a rights
issue or an issue of debentures. Jenna Helier is Sentry’s finance director and she is an ICAEW
Chartered Accountant. Sentry’s other directors have asked her to provide information to help them
decide on the source of funding for the new investment.
Extracts from Sentry’s most recent management accounts are shown below:
Income statement for the year to 28 February 20X7

£’000
Sales 78,500
Variable costs (56,520)
Fixed costs (13,850)
Profit before interest 8,130
Debenture interest (1,421)
Profit before tax 6,709
Taxation at 17% (1,141)
Profit after tax 5,568
Dividends proposed (3,000)
Retained profit 2,568

Balance sheet at 28 February 20X7

£’000
Ordinary share capital (£1 shares) 12,500
Retained profits 11,286
23,786
7% debentures (redeemable July 20X9 to December 20Y0) 20,300
44,086

The market values of Sentry’s ordinary shares and debentures on 28 February 20X7 are:

Ordinary shares £3.44 (cum div)

7% debentures £111% (cum int)

The £20 million required would be raised on 1 March 20X7 by either:

(1) A rights issue at £2.50 per ordinary share; or
(2) An issue of 8% debentures at par, redeemable in 20Y3.
You have been asked by the directors to assume the following for the year to 28 February 20X8:
• Sales will increase by 20%
• The contribution to sales ratio will remain unchanged
• Fixed costs will increase by £2 million pa

ICAEW 2021 March 2017 exam questions 75

 • The current level of dividends per share will be maintained
• Corporation tax will remain at 17%
At last week’s board meeting the following comments were made by two of Sentry’s other directors:

Matthew Girvan: “We could decrease the amount of new capital

that we have to raise by reducing the annual
dividend. Our payout ratio has been excessive
for a number of years now. Why not halve it?”

Roger Smyth: “We need to be very careful with this issue of

shares or debentures. There’s a danger that our
earnings per share (EPS) figure will be diluted,
which could cause a fall in our share price. To
avoid any problem with our share price, I
suggest it would be better to tell our
shareholders that we expect sales to increase
by 30%–35% next year, rather than the 20% we
are forecasting.”

Requirements
43.1 For both the rights issue and the debenture issue, prepare forecast income statements for
Sentry for the year to 28 February 20X8.
(6 marks)
43.2 For both the rights issue and the debenture issue, calculate Sentry’s forecast:
• EPS figure for the year to 28 February 20X8; and
• gearing ratio (book value of long-term borrowings/long-term funds) as at 28 February
20X8.
(6 marks)
43.3 For the rights issue only, calculate the increase in annual sales required for the year to 28
February 20X8 in order that Sentry’s EPS figure remains the same as in the current year.
(6 marks)
43.4 Making reference to your calculations in 43.1, 43.2 and 43.3 above, discuss the implications for
Sentry’s shareholders of the company using a rights issue or a debenture issue to fund its
proposed £20 million investment.
(8 marks)
43.5 Discuss Matthew Girvan’s proposal that dividends should be cut, making reference to relevant
theories.
(6 marks)
43.6 Discuss the ethical issues for Jenna Helier that would be caused by Roger Smyth’s suggestion.
(3 marks)
Total: 35 marks

44 White Rock plc

White Rock plc (White), a UK listed company, manufactures a range of cosmetics at three factories:
lipsticks (London), mascara (Newcastle) and foundation products (Manchester). White’s financial year
end is 31 March.
At its most recent board meeting the following matters were discussed:
(1) Closure of the London factory
(2) Investment priorities at the Manchester factory
(3) The impact of (1) and (2) above on White’s share price

76 Financial Management ICAEW 2021

44.1 Closure of the London factory
The cosmetics industry is very competitive and products can quickly become unfashionable.
Falling demand for White’s lipsticks and the high costs of operating in London have meant that
the company’s directors have decided to close the London factory. Instead, White will
manufacture a smaller range of lipsticks at its Newcastle factory which currently only makes
mascara, but does have spare capacity. Manufacture of this smaller range of lipsticks would
commence in Newcastle as soon as the London factory is closed. White’s directors are unsure
whether to close the London factory on 31 March 20X7 or on 31 March 20X9, when its lease
expires.
You work in White’s finance team and have been asked to provide information to aid the
directors’ decision on the date of the factory closure. Information to support your task is shown
below:
Sales and contribution

London Newcastle
factory factory
Estimated lipstick sales (all at 31 March 20X7 prices)
Year to 31 March 20X8 £7.2m £1.3m
Year to 31 March 20X9 £5.5m £1.5m
Contribution to sales ratio 60% 65%

Leases
The London factory lease costs £1.8 million pa and expires on 31 March 20X9. The annual
lease cost is fixed and is payable on 1 April. If the factory is closed on 31 March 20X7 then
White would pay a tax allowable cancellation charge of £3 million on that date to cancel the
lease. The Newcastle factory lease costs a fixed £0.8 million pa which is payable on 1 April.
Other fixed costs

London Newcastle
factory factory
Factory-wide fixed costs pa (at 31 March 20X7 prices) £1.4m £1.2m
Allocated head office costs pa (at 31 March 20X7 prices) £1.6m £1.3m

Working capital
The London factory has a working capital balance on 31 March 20X7 of £0.8 million. White’s
policy is that at the start of each financial year, there should be working capital in place that is
equivalent to 10% of the estimated sales for that year.

Tax allowable London factory closure payments

Closure payments if closure is on 31 March 20X7 £1.6m
Closure payments if closure is on 31 March 20X9 (at 31 March 20X9 prices) £2.3m

London factory machinery

Machinery tax written down value at 1 April 20X6 £3.1m
Resale value of machinery at 31 March 20X7 £1.7m
Resale value of machinery at 31 March 20X9 (at 31 March 20X9 prices) £0.6m

The factory machinery attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final year.

ICAEW 2021 March 2017 exam questions 77

 In the final year, the difference between the machinery’s written down value for tax purposes
and its disposal proceeds will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down value; or
• balancing charge, if the disposal proceeds are more than the tax written down value.
Inflation rates (applicable to all sales and costs unless otherwise indicated)
Year to 31 March 20X8 2%
Year to 31 March 20X9 3%
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant year.
White uses a money cost of capital of 11% for investment appraisal purposes.
Requirements

(a) Calculate the relevant money cash flows associated with closing the London factory on:
(1) 31 March 20X7
(2) 31 March 20X9
and use these to calculate the net present value at 31 March 20X7 of each of these
possible closure dates.
In both of these calculations you should ignore any opportunity cash flows associated with
the alternative closure date
(21 marks)

(b) Advise White’s directors as to the preferred closure date of the London factory.
(1 mark)

44.2 Investment priorities at the Manchester factory

The Manchester factory has a capital expenditure budget of £15 million for the financial year to
31 March 20X8. White’s board needs to choose which of the available projects would
maximise shareholder wealth. Details of the four projects available are shown below:

Project 1 2 3 4
£’000 £’000 £’000 £’000
Investment required 6,000 4,500 4,700 3,850
Net Present Value 621 563 869 622

Requirement
Prepare calculations showing the combination of projects that will maximise White’s
shareholders’ wealth if the four projects are assumed to be either (1) divisible or (2) indivisible.
(6 marks)
44.3 White’s managing director has stated that once the London closure date and the Manchester
investment plans are announced to the stock market, White’s share price will adjust to reflect
this information accurately. However, the finance director has pointed out that there are
behavioural factors that may mean that this is not the case.
Requirement
Explain the key principles underlying the Efficient Market Hypothesis and how behavioural
factors question the validity of that hypothesis.
(7 marks)
Total: 35 marks

78 Financial Management ICAEW 2021

45 ST Leonard Foods
You should assume that the current date is 31 March 20X7.
ST Leonard Foods (STL) is a UK frozen food company. It buys raw vegetables and fish from its
suppliers and, following processing and freezing, sells them to its customers.
You work in STL’s finance team and have been asked to prepare calculations that will help STL’s
management decide on the best strategy with regard to these two issues:
Issue 1 – foreign exchange rate hedging
Earlier this year STL’s management signed a contract worth €1,750,000 with one of its Spanish
suppliers and the goods arrived at STL last week. In addition, it has agreed to sell €600,000 worth of
frozen goods to a new customer, a French hypermarket, and these goods will be despatched to
France in 10 days’ time.
Both of these contracts are due to be settled in three months’ time on 30 June 20X7. STL’s
management is keen to explore whether it is worth hedging against movements in the value of the
euro between now and then. Four possible strategies are under consideration by the board:
• Do not hedge
• Use an over-the-counter (OTC) currency option
• Use a money market hedge
• Use a forward contract
The following data has been collected at the close of business on 31 March 20X7:

Spot rate (€/£) 1.2652 – 1.2744

Euro interest rate (lending) 2.2% pa
Euro interest rate (borrowing) 3.4% pa
Sterling interest rate (lending) 4.2% pa
Sterling interest rate (borrowing) 4.6% pa
Three-month OTC call option on € – exercise price 1.2540/£
Three-month OTC put option on € – exercise price 1.2650/£
Three month forward contract premium (€/£) 0.0058 – 0.0042
Cost of relevant OTC option £0.70 per €100 converted
Arrangement fee for forward contract £5,500

Issue 2 – interest rate hedging

STL has recently signed a contract with its bank to borrow £4.2 million on 1 July 20X7 to help fund
the construction of a new factory. The loan is for three years at an interest rate of LIBOR + 1% pa.
STL’s management is concerned that interest rates will rise before 1 July and wishes to explore
whether it should hedge its borrowing cost. Its bank has offered STL a Forward Rate Agreement
(FRA) at 5.8% pa, or an option at 5.2% pa plus a premium of 0.5% of the sum borrowed.
Requirements
45.1 For Issue 1, show the net sterling payment for the four possible strategies under consideration,
assuming that on 30 June 20X7 the spot exchange rate will be:
(1) €1.1875 – 1.1960/£
(2) €1.2745 – 1.2860/£
(11 marks)
45.2 For Issue 1, with reference to your calculations in 45.1 above, advise STL’s board whether it
should hedge against movements in the value of the euro.
(8 marks)
45.3 For Issue 2, assuming that on 1 July 20X7 LIBOR will be:

ICAEW 2021 March 2017 exam questions 79

 (1) 4% pa
(2) 6% pa
(7 marks)
45.4 Explain briefly how FRAs differ from interest rate futures.
(4 marks)
Total: 30 marks

80 Financial Management ICAEW 2021

 June 2017 exam questions
46 Brighton plc
Brighton plc (Brighton) manufactures and sells various types of lock. After undertaking market
research that cost £50,000, Brighton is considering manufacturing and selling a new type of lock for
bikes. For the purposes of the initial project appraisal it can be assumed that the locks would be
manufactured in the UK. However, the board of Brighton are considering manufacturing them
overseas where labour costs and associated safety standards for employees are much lower than in
the UK. The bike lock market is highly competitive with companies entering and leaving the market
on a regular basis.
The decision on whether to introduce the new lock will be based on net present value analysis. At a
recent board meeting one of Brighton’s directors quoted from a recent financial newspaper article
that he had read:
“Shareholder wealth maximisation is the generally accepted corporate objective. Net present value
analysis is the most logical way to achieve this when used in conjunction with Shareholder Value
Analysis.”
The director felt that Brighton should be concerned with more than just the shareholders since there
are other stakeholders who also contribute to the business. However, some of the other directors felt
that if shareholder wealth is maximised they had fulfilled their obligations and that the company
should not be concerned about these other stakeholders.
The following data relates to the new bike lock
• The bike lock’s product life-cycle is estimated to be four years and the sales volume is expected to
be 5,500 units per month in the year to 30 June 20X8. The sales volume is expected to increase
by 5% in the year to 30 June 20X9 and then decrease at the rate of 10% pa (compound) in the two
years to 30 June 20Y1.
• The selling price will be £100 per lock in the year to 30 June 20X8 and will increase at 2% pa for
the three years to 30 June 20Y1. The contribution per unit is expected to be 45% of the selling
price.
• Fixed production overhead costs are estimated to be £0.2 million in the year to 30 June 20X8.
50% of these fixed production overheads are centrally allocated. The fixed production overheads
are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Selling and administration costs are estimated to be £0.5 million in the year to 30 June 20X8 and
are expected to increase by 3% pa in the three years to 30 June 20Y1.
• Warehousing and office space that Brighton currently owns and lets to third parties for an annual
fixed rent of £0.4 million pa, payable in advance on 30 June, will be used for the bike lock project.
The rent will not increase with inflation. At the end of the project the warehousing and office
space will be re-let to third parties.
• An investment in working capital of £1 million will be required on 1 July 20X7. This will increase at
the start of each subsequent year in line with sales volume growth and selling price increases.
Working capital will be fully recoverable on 30 June 20Y1
• An investment in plant and machinery costing £8 million will be required on 30 June 20X7 and
this will not have any scrap value on 30 June 20Y1. The plant and machinery will attract 18%
(reducing balance) capital allowances in the year of expenditure and in every subsequent year of
ownership by the company, except the final year.
At 30 June 20Y1, the difference between the plant and machinery’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as a:
(1) balancing allowance, if the disposal proceeds are less than the tax written down value; or
(2) balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax flows
arise in the same year as the cash flows that gave rise to them.
• A suitable real cost of capital to appraise the project is 7% pa and the general level of inflation is
expected to be 2.5% pa.

ICAEW 2021 June 2017 exam questions 81

 Note: Ignore any issues relating to foreign exchange throughout this question.
Requirements
46.1 Using money cash flows, calculate the net present value of the bike lock project on 30 June
20X7 and advise Brighton as to whether it should proceed with the project.
(15 marks)
46.2 Ignoring the effects on working capital, calculate and comment upon the sensitivity of the
project to changes in sales revenue.
(4 marks)
46.3 Outline what is meant by Shareholder Value Analysis and identify how it might be specifically
applied to the bike lock project.
(6 marks)
46.4 Identify and explain two real options associated with the proposed bike lock project.
(4 marks)
46.5 Giving two examples, illustrate how conflicts may arise between the shareholders and the
other stakeholders in Brighton.
(3 marks)
46.6 Outline the main elements of an ethical employment policy that Brighton could adopt if it were
to manufacture the bike locks overseas.
(3 marks)
Total: 35 marks

47 Easton plc
Easton plc (Easton) is a listed company and a specialist retailer of pet-related products and operates
stores throughout the UK. The company is considering diversifying by opening veterinary practices
(‘the project’), which will operate from dedicated space in all of its stores.
At a board meeting of Easton it was agreed to appraise the project using net present value analysis.
However, considerable debate took place regarding the discount factor to use and whether the
company should be diversifying at all. At the meeting the finance director said:
“I will have to calculate a weighted average cost of capital (WACC) that reflects the systematic risk of
the project. I also intend to raise the capital required for the project in such a way as to leave our
existing debt: equity ratio (by market values) unchanged following the diversification”.
Various comments made by the other attendees at the meeting were as follows:
“Why can’t we just use our current WACC?”
“I have read that the shareholders of listed companies should diversify away unsystematic risk. But I
am confused as to what systematic and unsystematic risks are.”
“I think that we should stick to what we know and not attempt to diversify. I am worried about the
stock market’s reaction to this diversification.”
“What happens if we can’t maintain our existing capital structure? How do we then appraise the
project?”
Extracts from Easton’s most recent management accounts are shown below:
Balance sheet at 31 May 20X7

£m
Ordinary share capital (1p shares) 5
Retained earnings 1,098
1,103
4% Redeemable debentures at nominal value (redeemable 20Y5) 200
1,303

82 Financial Management ICAEW 2021

 On 31 May 20X7 Easton’s ordinary shares had a market value of 252p each (cum-div). The company
declared a dividend of 10p per ordinary share during the year to 31 May 20X7 and it is expected to
be paid shortly. The equity beta of Easton is 0.45. The return on the market is expected to be 9% pa
and the risk free rate 2% pa.
On 31 May 20X7 Easton’s 4% redeemable debentures had a market value of £109 (cum-interest) per
£100 nominal value. The debentures are due to be redeemed at par on 31 May 20Y5.
A listed company operating solely in the veterinary practices market had an equity beta of 0.80 and a
debt: equity ratio by market values of 3:7 on 31 May 20X7. It has been estimated by the finance
director that if the project goes ahead the overall equity beta of Easton will be made up of 75% pet-
related products and 25% veterinary practices.
Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
47.1 Ignoring the project, calculate the current WACC of Easton on 31 May 20X7 using the CAPM.
(8 marks)
47.2 Using the CAPM, calculate a cost of equity that reflects the systematic risk of the project and
explain your reasoning.
(6 marks)
47.3 Assuming that the project goes ahead, estimate, using the CAPM, the overall WACC of Easton
and comment upon the implications of any permanent change in the overall WACC.
(6 marks)
47.4 Explain what is meant by systematic and unsystematic risk and give two examples of each for
Easton.
(6 marks)
47.5 Discuss whether Easton should diversify its operations and how its shareholders and the stock
market might react to the proposed project.
(4 marks)
47.6 Identify and describe the appropriate project appraisal methodology that should be used if, as
a result of financing the project, the current capital structure of Easton is not maintained. Using
the data relating to Easton, calculate the project discount rate that should be used in these
circumstances.
(5 marks)
Total: 35 marks

48 Lake Ltd
Lake Ltd (Lake) is a UK company that has recently started exporting leather goods to the USA. Lake is
fully aware of its exposure to foreign exchange rate risk (‘forex risk’) and the need to hedge it.
However, Lake is concerned that there may be other overseas trading risks that it should be
protecting itself against.
You work for Lake and have been asked to advise the board on how to hedge the forex risk
associated with its US trading activities. You have the following information available to you at the
close of business on 30 June 20X7:
Lake is due to receive payments from its US customers in three months’ time totalling $1,300,000.
Lake currently has an overdraft.

Exchange rates

Spot rate ($/£) 1.3086 – 1.3092

Three-month forward contract discount ($/£) 0.0014 – 0.0018

September currency futures price (standard contract size £62,500): $1.3105/£

ICAEW 2021 June 2017 exam questions 83

 Annual borrowing and depositing interest rates

Sterling 3.20% – 3.10%

Dollar 3.70% – 3.60%

Three-month over-the-counter currency options

Call options to buy £ have an exercise price of $/£1.3200 and premium of £0.02 per $ converted.
Put options to sell £ have an exercise price of $/£1.3100 and a premium of £0.03 per $ converted.
Requirements
48.1 Assuming that the spot exchange rate on 30 September 20X7 will be $/£1.3210 – 1.3250 and
that the sterling currency futures price will be $1.3230/£, calculate Lake’s sterling receipt if it
uses the following to hedge its forex risk:
• A forward contract
• A money market hedge
• Currency futures contracts
• An over-the-counter currency option
(14 marks)
48.2 Describe the relative advantages and disadvantages of each of the hedging techniques in 48.1
above and advise Lake on which would be most beneficial for hedging its forex risk.
(10 marks)
48.3 Identify and explain two overseas trading risks (other than forex risk) that Lake is exposed to
and discuss how they might be mitigated.
(6 marks)
Total: 30 marks

84 Financial Management ICAEW 2021

 September 2017 exam questions
49 Merikan Media plc
Merikan Media plc (Merikan) is a large listed media group based in the UK. It currently owns a
controlling interest in 35 companies worldwide. Merikan’s board is considering altering its UK
investment portfolio via:
(1) the purchase of all of the shares in a commercial radio company; and
(2) the disposal of all of its shares in a newspaper company.
You work in Merikan’s finance team and have been asked to prepare valuations and supporting notes
for the board. Details of the two proposed transactions are shown below.
49.1 Purchase of all of the shares in a commercial radio company
Coastal Radio Ltd (Coastal) was formed nearly 15 years ago and has been a very successful
radio station. Its listener numbers have increased steadily, as have advertising revenue and
annual profits. Extracts from Coastal’s most recent management accounts (together with
supporting notes) are shown here:

Income statement for the year ended 31

August 20X7 Balance sheet at 31 August 20X7
£’000 £’000
Sales 28,400 Non-current assets 36,310
Operating costs (15,600) Current assets 4,316
Depreciation (3,500) 40,626
Amortisation (1,200)
Profit before interest 8,100 £1 ordinary shares 3,500
Debenture interest (400) Retained earnings 27,206
Profit before tax 7,700 5% debentures 8,000
Taxation (at 17%) (1,309) Current liabilities 1,920
Profit after taxation 6,391 40,626
Dividends paid (1,750)
Retained profit 4,641

Notes
1 Coastal’s non-current assets originally cost £52.8 million. They were valued at £37.8 million
on 31 August 20X7 and its current assets were valued at £4.2 million on the same date.
Neither of these valuations is reflected in the balance sheet at 31 August 20X7.
2 Coastal’s debentures were trading at £110% on 31 August 20X7
3 Average figures for listed UK commercial radio companies:

P/E ratio 8.5

Dividend yield 5%

Enterprise value multiple 6.5

Requirement
(a) Calculate the value of one Coastal share based on each of the following methods:
• Price earnings ratio
• Dividend yield

ICAEW 2021 September 2017 exam questions 85

 • Enterprise value
• Net assets basis (historic cost)
• Net assets basis (revalued)
(12 marks)

(b) Justify and advise the board of the price range within which it should make an offer for
Coastal’s shares. Refer to your calculations in part (a) above.
(8 marks)

49.2 Disposal of all of its shares in a newspaper company

Merikan has owned all of the share capital of Albion Newspaper Group Ltd (Albion) since
2005. Recently Albion’s directors have informed Merikan’s board that they are willing to make a
management buy-out (MBO) of Albion. Accordingly, Merikan’s board wishes to value Albion
using the shareholder value analysis method (SVA). Merikan’s board estimates that Albion has
a three-year competitive advantage over its competitors (to 31 August 20Y0) and the following
data regarding Albion’s value drivers and additional financial information has been collected:

Sales for the current year (to 31 August 20X7) £70.0 million
Annual depreciation
(equal to annual replacement non-current asset expenditure) £1.5 million
Par value of 6% debentures in issue (current market value £95%) £10.0 million
Short-term investments held £0.7 million
Corporation tax rate 17%
Current WACC 8%

Beyond
Year to 31 August (budgeted) 20X8 20X9 20Y0 20Y0
Sales growth 5% 3% 2% 0%
Operating profit margin 8% 9% 9% 9%
Incremental non-current asset investment (as
a % of sales increase) 6% 5% 2% 0%
Incremental working capital investment (as a
% of sales increase) 5% 5% 4% 0%

Requirement
(a) Calculate the value of Albion’s equity using SVA.
(12 marks)

(b) Outline the methods by which Albion’s directors might raise the funds necessary for the
proposed MBO of the company.
(3 marks)

Total: 35 marks

50 Ramsey Douglas Motors plc

You should assume that the current date is 31 August 20X7.
Ramsey Douglas Motors plc (Ramsey) is a UK-listed, UK-based motor car manufacturer which was
formed nearly 40 years ago. Ramsey’s financial year end is 31 August.

86 Financial Management ICAEW 2021

Details of Ramsey’s long term-finance at 31 August 20X7 and its total dividend and interest payments
for the year to 31 August 20X7 are shown in the following table:

Dividends paid Interest paid in

Market value Nominal value in year to year to
at 31/8/X7 at31/8/X7 31/8/X7 31/8/X7
£’000 £’000 £’000 £’000
£1 ordinary shares (Note 1) 65,600 32,000 5,440
£0.50 preference shares 10,800 2,000 640
£100 irredeemable
debentures 6,000 5,000 275
£100 redeemable
debentures (Note 2) 4,200 4,000 240
Notes
1 Ordinary share dividends have been growing at 3% pa for the past four years.
2 The redeemable debentures are redeemable at par on 31 August 20Y0.
3 All dividends and interest for the year to 31 August 20X7 have been paid in full.

You are Ramsey’s finance director and an ICAEW Chartered Accountant. At its 22 August 20X7
meeting, the board considered two proposed new investments. You were asked to prepare workings
and recommendations in advance of the next meeting regarding those two investments, details of
which are shown below:
Investment 1
Ramsey wishes to invest £9.5 million in a new computerised manufacturing system, making use of
robotic techniques. Half of this investment would be funded from Ramsey’s retained earnings and
the balance via a bank loan at an agreed rate of 7.5% pa. A report was presented by the production
director at the 22 August board meeting. It concluded that this new system would generate
efficiencies that would increase manufacturing profit by 6–8% pa. At the same meeting, one of
Ramsey’s other directors, Michael Bateman, said that “because the company should be striving for a
higher share price, any press releases regarding the new system should state that profits are
expected to increase by at least 15% pa.”
Investment 2
Ramsey’s board is considering a major change in strategy by investing in the development of
driverless cars. A driverless car is a vehicle that is capable of sensing its environment and navigating
without human input. The finance for this investment would be raised in such a way so as not to alter
Ramsey’s current gearing ratio (measured as debt: equity by market values). The debt element of the
finance will come from a new issue of 9% irredeemable debentures at par.
Ramsey’s directors want to establish a cost of capital that could be used to appraise the investment in
driverless cars. They are aware that such a diversification would be very risky and is likely to increase
Ramsey’s equity beta which is currently 1.25.
The following data, collected at 31 August 20X7, should be used when preparing your workings for
the next board meeting:
Driverless cars industry sector

Equity beta 2.10

Ratio of long-term funds (debt: equity) by 16:72

market values

Expected risk free rate 2.25% pa

Expected return on the market 9.15% pa

ICAEW 2021 September 2017 exam questions 87

 The board also discussed the possible negative impact of this risky investment on Ramsey’s share
price. One director, Laura Young, commented “It’s okay. Markets are efficient. Even if it does fall, the
share price will soon adjust to its normal level.”
Other information
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable future
and tax will be payable in the same year as the cash flows to which it relates.
Requirements
50.1 Using the information in the table, calculate Ramsey’s WACC at 31 August 20X7.
(10 marks)
50.2 Calculate, and briefly comment upon, the impact on the market value of Ramsey’s redeemable
debentures of a rise in their gross redemption yield to 5% pa.
(3 marks)
50.3 Advise, with reasons, whether Ramsey should use the WACC figure calculated in part 50.1
above when appraising Investment 1.
(5 marks)
50.4 Explain the ethical implications for you, as an ICAEW Chartered Accountant, arising from
Michael Bateman’s suggestion regarding the press releases for Investment 1.
(3 marks)
50.5 Calculate an appropriate WACC that Ramsey could use when appraising Investment 2 and
explain the reasoning behind your approach.
(10 marks)
50.6 Evaluate briefly Laura Young’s comments regarding Investment 2’s effect on Ramsey’s share
price.
(4 marks)
Total: 35 marks

51 Jenson Grosvenor plc

You should assume that the current date is 31 August 20X7.
Jenson Grosvenor plc (Jenson) is a UK-based manufacturer of industrial pumps. The majority of the
raw materials and component parts used in the manufacture of Jenson’s pumps are imported from
EU countries and are invoiced in euros.
You work in Jenson’s finance team and have been asked to provide guidance on two issues to be
discussed at the next board meeting.
Issue 1 – AZS Oil contract
Jenson’s directors recently signed a contract with a Canadian oil company, AZS Oil (AZS). This
contract is for the supply of a large consignment of specialised oil pumps for use by AZS at its
oilfields in northern Canada. The contract is valued at 5.2 million Canadian dollars (C$). The pumps
will be dispatched on 31 October 20X7 and Jenson will receive the C$5.2 million from AZS on 30
November 20X7.
You have been given the following information at the close of business on 31 August 20X7:

Spot rate (C$/£) 1.6305 – 1.6385

Three-month forward contract discount (C$/£) 0.0045 – 0.0085
Arrangement fee for forward contract £0.35 per C$100 converted
Canadian dollar interest rate (lending) 4.4% pa
Sterling interest rate (lending) 2.8% pa
Canadian dollar interest rate (borrowing) 5.2% pa
Sterling interest rate (borrowing) 3.6% pa

88 Financial Management ICAEW 2021

Three-month OTC call option on C$ – exercise price 1.6090/£
Three-month OTC put option on C$ – exercise price 1.6245/£
Cost of relevant OTC option £0.75 per C$100 converted

In relation to the AZS contract, you are aware that at the next board meeting Jenson’s directors will
discuss (a) the implications of an increase in the value of sterling and (b) the foreign exchange
hedging techniques that Jenson might employ.
Issue 2 – Shareholding in Callella plc
Jenson owns 50,000 shares in Callella plc (Callella). The company has never used any hedging
techniques to protect it from a fall in the value of this investment and the board now wishes to
remedy that. As a first step, the directors will consider how traded options work at the next board
meeting.
The market price of one Callella share at 31 August 20X7 is 365p. Traded options on Callella shares
at the same date are available as follows (all figures are in pence):

Calls Puts
Exercise price September October September October
355 11.0 21.0 2.0 13.5
370 3.5 14.0 9.0 20.5

Requirements
51.1 For Issue 1, calculate Jenson’s sterling receipt from the AZS contract if it:
(a) Uses an OTC currency option
(3 marks)

(b) Uses a forward contract

(2 marks)

(c) Uses a money market hedge

(3 marks)

(d) Does not hedge the Canadian dollar receipt and sterling strengthens by 5% by 30
November 20X7
(1 mark)

51.2 With reference to your calculations in part 51.1, advise Jenson’s board whether or not it should
hedge its Canadian dollar receipt from the AZS contract.
(7 marks)
51.3 Explain why Jenson’s imports and exports might expose the company to economic risk.
(3 marks)
51.4 Explain the advantages and disadvantages of using currency futures rather than a forward
contract to manage foreign exchange risk.
(4 marks)
51.5 For Issue 2, calculate the intrinsic value and the time value of each of the options on Callella’s
shares at 31 August 20X7.
(4 marks)
51.6 For Issue 2, explain briefly the three factors that affect the time value of the options on
Callella’s shares.
(3 marks)
Total: 30 marks

ICAEW 2021 September 2017 exam questions 89

90 Financial Management ICAEW 2021
 December 2017 exam questions
52 Innovative Alarms
Assume that the current date is 31 December 20X7.
Innovative Alarms (Innovative) is a division of a major quoted company and manufactures and sells a
single alarm system to private houses and commercial premises. The financial management
department of Innovative is considering two separate issues:
Issue One: Whether to launch onto the market a new type of alarm system, the Defender, which
when triggered will not only ring a bell but also play a realistic recording of dogs barking.
Issue Two: How often the division’s fleet of delivery vans should be replaced.
You are asked to provide advice on both of these issues and report to the head of the financial
management department.
52.1 Issue One: The Defender Project
The Defender is to be evaluated over a planning horizon of three years from 31 December
20X7. It has been agreed that on 31 December 20Y0 the rights to manufacture the Defender
will be sold to a team made up of the current management of Innovative (‘the team’) as by that
date the Defender is expected to be Innovative’s only product. The finance director of
Innovative, who is an ICAEW Chartered Accountant, will be a member of the team and is
responsible for calculating the value of the rights to manufacture the Defender.
The following information is available regarding the Defender project:
• The selling price will be £399 per unit in the year to 31 December 20X8 and the
contribution per unit is expected to be 40% of the selling price. The selling price and
variable costs per unit are expected to increase by 3% pa in the two years to 31 December
20Y0.
• The number of units sold in the year to 31 December 20X8 is estimated to be 30,000 and is
expected to increase by 6% pa in the two years to 31 December 20Y0.
• On 31 December 20X7 the project will require an investment in working capital of £2
million, which will increase at the start of each subsequent year in line with sales volume
growth and sales price increases. Working capital will be fully recoverable on 31 December
20Y0.
• Incremental fixed costs for the year ended 31 December 20X8 are expected to be £0.5
million and are expected to increase by 5% pa in the two years to 31 December 20Y0.
• The Defender will require two hours of skilled labour per unit. Skilled labour is expected to
be in short supply over the next three years. Innovative will need to transfer skilled labour
from its existing product, which requires half the skilled labour time per unit of the
Defender. The existing product has a selling price of £175 and an expected material and
skilled labour cost of £150 in the year to 31 December 20X8. The selling price and variable
costs are expected to increase by 3% pa in the two years to 31 December 20Y0, the end of
the existing product’s life cycle. Innovative’s skilled labour is paid at the rate of £15 per hour
(in 31 December 20X8 prices). Any working capital adjustments associated with the existing
product can be ignored.
New equipment will be required to manufacture the Defender, which will cost £8 million on
31 December 20X7 and will have an estimated scrap value of £2 million on 31 December
20Y0 (in 31 December 20Y0 prices). The new equipment will attract 18% (reducing balance)
capital allowances in the year of expenditure, except in the final year.
At 31 December 20Y0, the difference between the equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company as a:
1. balancing allowance, if the disposal proceeds are less than the tax written down value; or
2. balancing charge, if the disposal proceeds are more than the tax written down value.
– Assume that the rate of corporation tax will be 17% for the foreseeable future and that
tax flows arise in the same year as the cash flows that gave rise to them.

ICAEW 2021 December 2017 exam questions 91

 – The finance director calculated the value of the rights to manufacture the Defender as
three times the net contribution after tax for the year to 31 December 20Y0.
– A suitable money cost of capital to appraise the project is 10% pa.
Requirement
(a) Using money cash flows, calculate the net present value of the Defender project on 31
December 20X7 and advise whether Innovative should proceed with the project.
(16 marks)

(b) Outline the disadvantages of sensitivity analysis for the head of the financial management
department and how simulation might be a better way to assess the risk of the Defender
project.
(4 marks)

(c) Describe two real options that are available at the end of the project on 31 December
20Y0 as an alternative to selling the rights to manufacture the Defender.
(4 marks)

(d) Identify and discuss the ethical issues in relation to the sale of the rights to manufacture
the Defender.
(3 marks)

52.2 Issue Two: Replacing the fleet of delivery vans

Innovative would like to decide upon a policy for replacing its fleet of delivery vans, since no
formal policy exists at the present time. A new delivery van costs £30,000. The following
information is available:

Interval between replacement Maintenance cost

(years) Trade-in value (paid at the end of the year)
£ £
1 22,500 500
2 17,000 2,500
3 12,000 3,500

A suitable cost of capital for evaluating the replacement policy is 15% pa.
Requirement
Calculate the optimal replacement policy for the delivery vans and advise the head of the
financial management department of the limitations of the approach used.
Note: Ignore inflation and taxation when determining the optimal replacement policy.
(8 marks)
Total: 35 marks

53 Peel Kitchens plc

Assume that the current date is 1 December 20X7.
Peel Kitchens plc (Peel) is a quoted wholesaler of kitchen cabinets and worktops and has a financial
year end of 30 November.
The board of Peel is considering diversifying into the supply of domestic appliances and would need
to raise finance of £200 million during 20X8 should the diversification go ahead. The finance director
of Peel, Debbie Harris (Debbie), needs to calculate the weighted average cost of capital (WACC) that
will be used to appraise the potential diversification. She is also considering whether the finance
required should be raised by debt in the form of 6% debentures issued at par or by equity in the

92 Financial Management ICAEW 2021

form of an issue of 100 million ordinary shares. Debbie is particularly concerned about how the
financial markets and the company’s shareholders might react to the impact the additional £200
million finance may have on the company’s capital structure.
The board of Peel is also contemplating its dividend policy beyond 20X7. Extracts from Peel’s
management accounts are produced below:

Year ended 30 November

20X3 20X4 20X5 20X6 20X7
£m £m £m £m £m
Profits before interest
and tax 81.03 78.86 87.54 85.37 94.04
Interest (33.32) (33.32) (33.32) (33.32) (33.32)
47.71 45.54 54.22 52.05 60.72
Taxation (8.11) (7.74) (9.22) (8.85) (10.32)
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividends 19.80 18.90 22.50 21.60 25.20
Special dividend – – – – 9.00
Total dividends 19.80 18.90 22.50 1.60 34.20

Capital at 30 November 20X7 £m

Ordinary shares (50p nominal value) 90.00
Retained earnings 256.50
346.50
7% Debentures at nominal value (redeemable at par on 30 November 20Y2) 476.00
822.50

The number of shares in issue has not changed during the period from 1 December 20X2 to 30
November 20X7.
Additional information:
• The cum-div share price on 1 December 20X7 is £2.92 per ordinary share. The special dividend
was paid in June 20X7.
• The 7% debentures have a cum-interest market value of £111 per £100 nominal value.
• Peel has an equity beta of 1.3.
• A company that supplies domestic appliances has an equity beta of 1.1 and a debt:equity ratio of
40:60 by market values.
• The risk free rate is expected to be 3% pa.
• The market risk premium is expected to be 6% pa.
• Assume that the rate of corporation tax will be 17% for the foreseeable future.
• An analyst has calculated the gearing ratios (measured as debt/equity by market values) and
interest cover for companies that operate in Peel’s market sector as follows:

Maximum Minimum Average

Gearing ratio 135% 80% 100%

Interest cover 3 2 2.4

ICAEW 2021 December 2017 exam questions 93

 Debbie has asked you to provide her with certain information so that she can prepare a report for the
board of Peel.
Requirements
53.1 Calculate Peel’s WACC on 1 December 20X7 using:
(a) The dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information provided)
(9 marks)

(b) The CAPM

(1 mark)

53.2 Explain and evaluate whether either of the WACC figures calculated in 53.1 above would be
appropriate for appraising Peel’s diversification into supplying domestic appliances.
(5 marks)
53.3 Determine whether the £200 million finance required should be raised from either debt or
equity sources. You should discuss the likely reaction of both shareholders and the financial
markets, and make reference to the gearing and interest cover data provided and give advice
to Debbie on which source of finance should be used.
(12 marks)
53.4 Assuming that Peel raises the £200 million finance required wholly from debt, identify the most
appropriate project appraisal methodology that could be used to appraise the diversification.
Also determine the project discount rate that should be used in these circumstances.
(3 marks)
53.5 Discuss whether Peel’s dividend policy over the last five years is appropriate for a listed
company.
(5 marks)
Total: 35 marks

54 Jewel House Investments Ltd

Assume that the current date is 30 November 20X7.
Jewel House Investments Ltd (Jewel) is an investment company based in the UK. You work for Jewel
and at a recent meeting with the company’s finance director it was agreed that you would work on
three specific tasks:
Task One: Hedging foreign exchange rate risk for receipts from foreign investors.
Task Two: Hedging a portfolio of investments.
Task Three: Arranging an interest rate swap for a loan that the company has recently taken out.
54.1 Task One: Jewel is due to receive an investment of $8 million from a client in the USA on 31
March 20X8. It was agreed with the client that Jewel would hedge the foreign exchange rate
risk associated with the $ receipt and invest the sterling equivalent of the $8 million on behalf
of the client.
You have the following information available to you on 30 November 20X7:
Exchange rates:

Spot rate ($/£) 1.2490 – 1.2492

Four-month forward contract discount ($/£) 0.0031 – 0.0034

Over-the-counter (OTC) currency option

A put option to sell $ is available with an exercise price of $1.2400. The premium is £0.02 per $
and is payable on 30 November 20X7.
Jewel has funds on deposit which earns interest of 3% pa.

94 Financial Management ICAEW 2021

 Requirement
(a) Calculate the amount of sterling to be invested on behalf of the US client using:
• a forward contract
• an OTC currency option
assuming that the spot price on 31 March 20X8 is $/£ 1.2697 – 1.2700.
(6 marks)
(b) Using your results from 54.1 (a) above, explain the advantages and disadvantages of the
two hedging techniques used and advise which hedging technique would be the more
beneficial for Jewel’s client
(4 marks)
(c) Outline whether currency futures would have been more advantageous than using a
forward contract to hedge the foreign exchange rate risk associated with the $8 million
receipt.
(2 marks)
54.2 Task Two: One of Jewel’s investments is a portfolio of UK FTSE 100 shares, which is worth £100
million on 30 November 20X7. The finance director of Jewel is concerned about a potential fall
in value of the portfolio over the next four months.
You have the following information available to you on 30 November 20X7:
• The FTSE 100 index is 7,261
• The price for a March 20X8 FTSE 100 index future is 7,195
• The face value of a FTSE 100 index futures contract is £10 per index point
Requirement
(a) Calculate the outcome of hedging Jewel’s £100 million portfolio using March 20X8 FTSE
100 index futures. Assume that on 31 March 20X8 both the FTSE 100 index and the FTSE
100 index futures price are 7,010 and that the portfolio value changes exactly in line with
the change in the FTSE 100 index.
(6 marks)

(b) Explain why the hedge in 54.2 (a) above will not be 100% efficient.
(2 marks)

54.3 Task Three: Jewel recently bought new premises and borrowed £50 million for a period of 10
years. The loan is at a floating rate of LIBOR + 4% pa. LIBOR is currently 0.36% pa. The finance
director of Jewel believes that interest rates are going to rise and he would like to protect the
company against interest rate risk.
The finance director of Jewel identified Nevis plc (Nevis), which is a company that would like to
swap £50 million of its 5% pa fixed rate loans to a floating rate. Jewel and Nevis agreed to
enter into an interest rate swap with any benefits from the swap being shared equally between
the two companies. Jewel can borrow at a fixed rate of 6.5% pa and Nevis can borrow at a
floating rate of LIBOR + 3.5% pa.
Requirement
(a) Demonstrate how the interest rate swap between Jewel and Nevis would be
implemented, with the floating rate leg of the swap set at LIBOR.
(4 marks)

(b) Calculate:
• the initial difference in annual interest rates for Jewel if it enters into the interest rate
swap with Nevis.
• the amount to which LIBOR would have to rise for the cost of Jewel’s floating rate
borrowing to equal the fixed rate achieved through the interest rate swap.
(2 marks)

ICAEW 2021 December 2017 exam questions 95

 (c) Identify four advantages for Jewel of entering into an interest rate swap with Nevis.
(4 marks)

Total: 30 marks

96 Financial Management ICAEW 2021

 March 2018 exam questions
55 Wells Bakers plc
Assume that the current date is 31 March 20X8.
Wells Bakers plc (Wells) is a UK bakery firm that has been trading since 1983. It manufactures and
sells its own branded products to UK supermarkets and its financial year end is 31 March.
Wells’ board is considering a change in the company’s strategy with the opening of a number of
retail bakery outlets across the UK. This would be a major investment for the company. The £17
million required for this investment would be raised in such a way as not to alter the company’s
existing gearing ratio (equity:debt by market values). Wells’ bank, London & Edinburgh plc (L&E), is
aware of the company’s plans and has stated that it is prepared to provide the debt element of the
£17 million at an interest rate of 8.5% pa, with repayment due in 10 years’ time.
Wells has always used a discount rate of 7% when assessing potential investments. The following
comments made by directors regarding the planned £17 million investment were recorded in the
minutes of the board meeting held on 27 February 20X8:
Phil Turner: “Let’s carry on using 7% as the discount rate. We’re being prudent here, as7% represents
the most costly source of finance that we have, ie, preference shares. At least that’s a fixed cost, unlike
the ordinary shares.”
Alana Clarke: “I don’t think we can ignore the ordinary shares. Can’t we average out the costs of the
various types of capital and use that?”
Alison Hughes: “We should use 8.5% as our discount rate as that’s what L&E would charge us for
funding the retail expansion.”
The board wants to determine the appropriate discount rate to use when assessing the investment in
retail bakery outlets. You work in Wells’ finance team and are an ICAEW Chartered Accountant. You
have been asked to provide workings for the board to consider when it meets next month. You have
collected the following data as at 31 March 20X8:

Balance sheet extract Nominal value Market value

(£’000)
£1 ordinary shares (Note 1) 6,600 £3.46/share cum-div
7% £1 preference shares 1,000 £1.35/share ex-div
6% Irredeemable debentures 1,200 £106% ex-int
4% Redeemable debentures (Note 2) 1,800 £100% cum-int

Notes
1 Wells will pay its ordinary dividend (£1.716 million) for the year to 31 March 20X8 in early April
20X8. Its annual dividend has been growing steadily every year since April 20X5, at which time
the dividend totalled £1.570 million.
2 The 4% debentures are redeemable at par in 20Y1.

CAPM data
Wells’ equity beta 1.25
Expected risk-free return 2.4% pa
Expected return on the market portfolio 10.8% pa
Average equity beta for bakery retailers 1.80
Ratio of long-term funds (equity:debt by market
values) for bakery retailers 77:23

Two days ago, Alison Hughes sent you an email about Wells’ proposed investment. An extract from
her email is shown below:

ICAEW 2021 March 2018 exam questions 97

 Email extract
.........The board has managed to keep our expansion plans very quiet so far. Do be very careful
who you share this information with as the proposals are likely to have an impact on the Wells
share price.........

Assume that the corporation tax rate will be 17% for the foreseeable future.
Requirements
55.1 Ignoring the investment in retail bakery outlets, calculate Wells’ weighted average cost of
capital (WACC) at 31 March 20X8 using:
(a) The dividend growth model and
(14 marks)

(b) The CAPM

(2 marks)

55.2 Discuss the points raised by the three directors at the 27 February 20X8 board meeting.
(6 marks)
55.3 Calculate an appropriate WACC that Wells could use when appraising the £17 million
investment in retail bakery outlets and explain the reasoning behind your approach.
(10 marks)
55.4 Identify and explain the ethical implications of Alison Hughes’ email for you, as an ICAEW
Chartered Accountant.
(3 marks)
Total: 35 marks

56 Hunt Trading plc

Assume that the current date is 31 March 20X8.
Hunt Trading plc (Hunt) is a UK supplier of timber products. It imports timber in large quantities and
manufactures a range of products for sale to builders’ merchants and garden centres in the UK. You
work in Hunt’s finance team and have been asked to provide advice on two issues.
56.1 Issue one: interest rate risk
The company has been very successful recently with demand for its products growing steadily.
At its March meeting, Hunt’s board identified a need for £4.5 million of short term finance to
fund additional machinery and increasing levels of working capital. A £4.5 million bank loan
would be required for a six-month period from 1 June 20X8 until 30 November 20X8. The
board is concerned that the current cost of borrowing, 6.4% pa, will increase before 1 June
and would like to investigate how it might hedge this risk using either traded sterling interest
rate futures or over-the-counter (OTC) interest rate options.
You have collected the following information on 31 March 20X8:

Traded sterling interest rate futures OTC interest rate options

June 3-month futures price = 93.2 Strike rate = 7.3% pa plus
Standard contact size = £500,000 A premium of 0.2% of the sum borrowed

Requirement
(a) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses traded sterling
interest rate futures to hedge its interest rate risk and if by 1 June 20X8:
• interest rates increase to 7.5% pa and the futures price moves to 92.2
• interest rates increase to 8.0% pa and the futures price moves to 91.8

98 Financial Management ICAEW 2021

 • interest rates decrease to 5.5% pa and the futures price moves to 94.1
(8 marks)

(b) Calculate the cost to Hunt of borrowing £4.5 million for six months if it uses OTC interest
rate options to hedge its interest rate risk and if by 1 June 20X8:
• interest rates increase to 7.5% pa
• interest rates increase to 8.0% pa
• interest rates decrease to 5.5% pa
(3 marks)

(c) Based on your calculations in (a) and (b) above, advise Hunt’s board as to the preferred
method of hedging its interest rate risk.
(2 marks)

56.2 Issue two: foreign exchange rate risk

The majority of Hunt’s timber suppliers are based in Scotland and Wales. However, Hunt’s
board is concerned that those suppliers’ delivery lead times are lengthening as they struggle
to keep pace with increasing demand. The board has a contract with a Finnish supplier for a
very large consignment of timber costing €1.7 million. This is due to arrive at Hunt’s factory on
31 May 20X8, with payment due on 30 June 20X8. There is concern amongst board members
that sterling might weaken against the euro before the end of June and they would like to
explore the implications of hedging the foreign exchange risk of the Finnish purchase.
You have been asked to advise Hunt’s board and have collected the following information at
the close of business on 31 March 20X8:

Spot rate (€/£)

Three-month forward contract discount (€/£) 0.0059 – 0.0081
Arrangement fee for forward contract £4,600
Sterling interest rate (lending) 5.8% pa
Sterling interest rate (borrowing) 6.6% pa
Euro interest rate (lending) 8.0% pa
Euro interest rate (borrowing) 9.2% pa

Requirement
(a) Calculate Hunt’s sterling payment if it:
• does not hedge the euro payment and sterling weakens by 5% by 30 June 20X8
• uses a forward contract
• uses a money market hedge
(7 marks)

(b) With reference to your calculations in (a) above, advise Hunt’s board whether it should
hedge its euro payment.
(7 marks)

(c) Identify the differences between traded currency options and OTC currency options.
(3 marks)

Total: 30 marks

ICAEW 2021 March 2018 exam questions 99

57 Bishop Homes Ltd
Bishop Homes Ltd (Bishop) is a UK property company that started trading in 20W8. It has a financial
year-end of 31 March. Bishop builds low-cost houses for sale and for rent. It currently owns and
collects rent from 12,500 rental properties.
Bishop has the opportunity to invest in a new development of 500 identical low-energy houses on
one of its vacant sites called Garthwick. Once the land has been cleared then Bishop will employ
Piper Hardwick plc (Piper), a UK house-building firm, to construct the houses over a two year period.
You work in Bishop’s finance department and have been asked to provide information on the viability
of the Garthwick development for Bishop’s board. You have been provided with the following details:
Land clearance
This will cost £1.4 million, payable on 31 March 20X8.
Construction cost
The total contract price for the 500 houses is £57 million, which will be payable to Piper in three
equal annual instalments starting on 31 March 20X8. Only the construction costs relating to the
houses for sale are an allowable expense for tax purposes. Those construction costs are allowable for
tax in the year of sale (see building schedule below).
Building schedule
Of the 500 houses built, 150 will be sold and 350 will be rented. Houses built for sale are sold in the
year of construction whereas houses built for rent are not rented out until the year after construction.

Year to 31 March
20X9 20Y0 20Y1
Houses constructed in year 250 250 0
Houses sold in year 75 75 0
Houses rented in year 0 175 350

Houses for rent

The rent per property will be £5,940 pa. Bishop estimates that bad debts amount to 1.5% of rental
income.
Houses for sale
The selling price of a house will be £340,000.
New staff
Bishop will need to employ two new full-time employees to manage the additional rented houses in
the year to 31 March 20Y0 and then two more employees will be employed in the year to 31 March
20Y1. The average salary per employee will be £23,000 pa.
Other costs
In addition to the new employees, it is estimated that the new houses for rent will lead to an increase
in general costs equal to 3% of their rental income before bad debts.
New machinery
Bishop will need to purchase specialist equipment to check the low-energy specifications of the new
houses. This will be purchased on 31 March 20X9 at a cost of £1.2 million. Because this equipment
has a high rate of obsolescence, Bishop estimates that it will be sold on 31 March 20Y1 for £100,000.
The equipment attracts 18% (reducing balance) capital allowances in the year of expenditure and in
every subsequent year of ownership by the company, except the final year. In the final year, the
difference between the equipment’s written down value for tax purposes and its disposal proceeds
will be treated by the company either as a:
• balancing allowance, if the disposal proceeds are less than the tax written down value; or
• balancing charge, if the disposal proceeds are more than the tax written down value.
Assumptions to be used in calculations
• Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be
payable in the same year as the cash flows to which it relates.

100 Financial Management ICAEW 2021

• All income will be liable to corporation tax.
• Unless indicated otherwise, all costs will be allowable for corporation tax.
• Inflation can be ignored throughout.
• A suitable cost of capital is 6%.
• All cash flows occur at the end of the relevant financial year.
Investment appraisal
Bishop appraises its capital investments using the net present value approach. For new
developments Bishop discounts its future income and costs over a 20-year period.
6% annuity factors
Year 3 = 2.673
Year 17 = 10.477
Year 20 = 11.470
Requirements
57.1 Calculate the net present value of the Garthwick development at 31 March 20X8 and advise
Bishop’s board whether the company should proceed with it.
(18 marks)
57.2 Calculate the sensitivity of the decision in 57.1 above to changes in the selling price per house
sold and hence the minimum selling price per house sold that Bishop should accept for the
Garthwick development to proceed.
(4 marks)
57.3 Determine the impact on your advice in 57.1 above if Piper offers to accept a revised contract
price of £54 million payable in full on 31 March 20X8.
(5 marks)
57.4 Compare the strengths and weaknesses of sensitivity analysis with those of simulation.
(4 marks)
57.5 Explain what is meant by the term ‘real options’ and identify two real options that could apply
to the Garthwick development.
(4 marks)
Total: 35 marks

ICAEW 2021 March 2018 exam questions 101

102 Financial Management ICAEW 2021
 June 2018 exam questions
58 Helvellyn Corporate Finance
You work for Helvellyn Corporate Finance (HCF) and you are currently working on two tasks:
Task 1: Evans Stores Ltd (Evans) is an independent food retailer. Evans is considering an initial public
offering (IPO) of its ordinary shares on 30 June 20X8 and you have been asked to advise on a value
for these shares.
Task 2: Huzzey plc (Huzzey) is a quoted conglomerate that is considering divesting itself of one of its
divisions. You have been asked to value the division.
58.1 Task 1: Valuation of Evans’s ordinary shares
Extracts from Evans’s most recent management accounts are as follows:

Income statement
for the year ended Balance sheet
31 May 20X8 as at 31 May 20X8
£’000 £’000
Sales 280,000 Non-current assets 53,000
Operating costs (270,000) Current assets 31,000
Depreciation (6,000) 84,000
Amortisation (500)
Share capital (£1 ordinary
Profit before interest 3,500 shares) 3,000
Interest (950) Retained earnings 12,000
Profit before tax 2,550 15,000
Taxation (at 17%) (434) Long term loans 41,000
Profit after tax 2,116 Current liabilities 28,000
84,000

Additional information:
(1) Evans’s current assets include cash balances and short-term investments, which total £7
million.
(2) The market value of Evans’s non-current assets at 31 May 20X8 was estimated to be £59
million.
(3) Average multiples for a sample of listed companies in the same market sector as Evans at
31 May 20X8 are:
– Enterprise value – 6.5
– Price earnings (P/E) ratio – 12.1
Requirement
(a) Calculate the value of one Evans ordinary share at 31 May 20X8 based on each of the
following methods:
• Enterprise value
• P/E ratio
• Net assets basis (historic)
• Net assets basis (re-valued)
(8 marks)

ICAEW 2021 June 2018 exam questions 103

 (b) Recommend and justify to the board of Evans an issue price per share on 30 June 20X8
for the company’s ordinary shares. Refer to the range of values calculated in part (a)
above.
(4 marks)

(c) Discuss whether Shareholder Value Analysis (SVA) might be a useful additional method, to
those in part (a) above, of valuing Evans’s ordinary shares.
(3 marks)

58.2 Task 2: Divestment of the Huzzey division

Assume that the current date is 30 June 20X8.
At a recent board meeting of Huzzey it was decided that the company should divest itself of its
paint-manufacturing subsidiary, Supercover Ltd (Supercover). The board discussed the
following three proposed ways of carrying out the divestment:
• Proposal 1 – To reduce Supercover’s operations over a period of three years and then close
it down.
• Proposal 2 – To sell Supercover to another company.
• Proposal 3 – To sell Supercover to a team made up of its current management.
It was decided at the board meeting that one of the criteria for choosing the best method of
divestment would be the present value of the cash flows associated with each proposal.
A suitable discount rate to assess the present value of the cash flows of all three proposals is
10%.
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable
future and tax will be payable in the same year as the cash flows to which it relates.
Financial information for each proposal is as follows:
Proposal 1:
• Sales revenue for the year to 30 June 20X8 was £25 million. For the three years to 30 June
20Y1 sales volumes are expected to decrease by 10% pa compound. Selling prices will not
change and contribution is expected to be 60% of the selling price.
• The amount invested in working capital on 30 June 20X8 was £2 million. This amount will
reduce at the end of each year in line with the reduction in sales volumes. On 30 June 20Y1
all remaining working capital will be recovered in full.
• On 30 June 20X8 Supercover’s plant and equipment has a tax written down value of £3
million.
• On 30 June 20Y1 Supercover’s plant and equipment will be sold for an estimated £9 million
(at 30 June 20Y1 prices).
• The plant and equipment attracts 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the plant and equipment’s written down value
for tax purposes and its disposal proceeds will be treated by the company either as a:
– balancing allowance, if the disposal proceeds are less than the tax written down value; or
– balancing charge, if the disposal proceeds are more than the tax written down value.
• Redundancy payments on 30 June 20Y1 will amount to £0.50 million (at 30 June 20Y1
prices). This amount is fully allowable for tax.
Proposal 2:
All the shares in Supercover will be sold for £38 million before taxation on 30 June 20X8.
Assume that this amount is fully taxable.
Proposal 3:
The management team will buy the shares of Supercover for £41 million. The £41 million will
be received in three instalments as follows:

104 Financial Management ICAEW 2021

 • On 30 June 20X8 £15 million
• On 30 June 20X9 £13 million
• On 30 June 20Y0 £13 million
Assume that all these instalments are fully taxable in the year that they are received.
Requirement
(a) Calculate the present value at 30 June 20X8 of each of the three proposed ways in which
Huzzey could divest itself of Supercover.
(10 marks)

(b) Identify one advantage and one disadvantage for each of the three divestment proposals.
(6 marks)

(c) Advise the board of Huzzey as to which of the three divestment proposals should be
chosen
(4 marks)

Total: 35 marks

59 Blackstar plc
Assume that the current date is 30 June 20X8.
Mitchells is a firm of ICAEW Chartered Accountants. Mitchells has been asked to advise a listed
client, Blackstar plc (Blackstar), on the following two issues:
Issue 1: Blackstar intends to raise additional funds of £150 million to fund an expansion of its existing
operations.
Issue 2: Blackstar is concerned about its existing dividend policy.
59.1 Issue 1: Raising additional funds of £150 million
Blackstar has always maintained a policy of no gearing. Other companies in Blackstar’s market
sector have average gearing ratios (measured as debt/equity by market values) of 25%, with a
maximum of 35%, and an average interest cover of eight times, with a minimum of six. The
finance director of Blackstar is considering raising the £150 million by either a rights issue or
by the company now borrowing and issuing debentures.
The details of the alternative sources of finance are as follows:
Rights Issue: The £150 million would be raised by a 2 for 3 rights issue, priced at a discount on
the current market value of Blackstar’s ordinary shares.
Debt issue: The £150 million would be raised by an issue of 6% coupon debentures,
redeemable at par on 30 June 20Y5. The gross redemption yield would be based on the
current gross redemption yield of other debentures issued by companies in Blackstar’s market
sector. One such company is Blue plc (Blue). Details for Blue’s debentures are as follows:
• Coupon 5%
• The current market price on 30 June 20X8 is £109 cum interest
• Redemption at par on 30 June 20Y3
Further information regarding Blackstar:
• The forecast pre-tax operating profit for the year ending 30 June 20X8 is £50 million
• The corporation tax rate is 17%
• The current share price at 30 June 20X8 is £7.50 ex-div
• The number of ordinary shares in issue is 60 million

ICAEW 2021 June 2018 exam questions 105

 Requirements

(a) Assuming a 2 for 3 rights issue is made on 1 July 20X8:

• Calculate the discount the rights price represents on Blackstar’s current share price.
• Calculate the theoretical ex-rights price per share.
• Discuss whether the actual share price is likely to be equal to the theoretical ex-rights
price.
(5 marks)

(b) Alternatively, assuming debt is issued on 1 July 20X8:

• Calculate the issue price per debenture and total nominal value of the debentures that
will have to be issued to give a yield to redemption equal to that of Blue’s debentures.
• Discuss the validity of using the yield to redemption of Blue’s debentures in the above
calculation.
(7 marks)

(c) Advise Blackstar’s finance director of the advantages and disadvantages of raising the
£150 million by debt or equity or a combination of the two.
You should also discuss the likely reaction of Blackstar’s shareholders and the stock market
(you should refer to the gearing and interest cover information provided).
(12 marks)

59.2 Issue 2: Blackstar’s dividend policy

Blackstar is reviewing its dividend policy, which has been to maintain a constant payout ratio of
30% of profits after tax. The following views were expressed by two directors at the most recent
board meeting:
Director A: “We should have a constant dividend growth policy with some growth irrespective
of whether profits after tax rise or fall. If we have surplus cash after reinvestment we can leave it
in the bank.”
Director B: “I agree with Director A, but instead of leaving surplus cash in the bank we can pay
a special dividend or repurchase some shares.”
Requirement
(a) Describe what is meant by:
• a special dividend
• a share repurchase
(4 marks)

(b) Discuss whether Blackstar’s current dividend policy is appropriate for a listed company
and critically evaluate the alternatives suggested by Directors A and B.
(4 marks)

59.3 Mitchells is also advising Goldwing plc, which is considering making a takeover bid for
Blackstar.
Requirement
Identify the ethical issues for Mitchells regarding giving advice to both Goldwing plc and
Blackstar. Also advise Mitchells on what safeguards might be put in place.
(3 marks)
Total: 35 marks

106 Financial Management ICAEW 2021

60 Tarbena plc
Assume that the current date is 30 June 20X8.
Tarbena plc (Tarbena) is a UK company that has a subsidiary company in Germany and also has
customers and suppliers in the USA.
At a recent board meeting of Tarbena there was a discussion about the company’s exposure to
foreign exchange rate risk (forex). In particular the following points were discussed:
• How the company’s dollar receipts and payments are hedged
• The role that interest rate parity and purchasing power parity play in relation to forex
• The likely effect on the company’s share price if it shows exchange rate losses when translating
the German subsidiary’s financial statements into sterling
It was decided at the meeting that the finance director would make a presentation to the board and
he has asked you to prepare some notes for his presentation, including numerical examples where
appropriate.
You have the following information available to you at the close of business on 30 June 20X8:
Receipts and payments
Receipts due from customers on 30 September 20X8 are $6,000,000.
Payments due to suppliers on 30 September 20X8 are $10,000,000.
Exchange rates

Spot rate ($/£) 1.3078 - 1.3080

Three month forward discount ($/£) 0.0088 - 0.0092

September currency futures price

Standard contract size £62,500 $1.3096/£
Over-the-counter (OTC) currency options
September put options to sell $ are available with an exercise price of $1.3190. The premium is
£0.03 per $ and is payable on 30 June 20X8.
September call options to buy $ are available with an exercise price of $1.3170. The premium is
£0.04 per $ and is payable on 30 June 20X8
Annual borrowing and depositing interest rates (%)

Dollar 6.00 - 5.80

Sterling 3.28 - 2.98

Tarbena currently has an overdraft.

Prepare notes for the finance director of Tarbena, which should include:
Requirements
60.1 A calculation of Tarbena’s net sterling payment if it uses the following to hedge its forex:
(1) A forward contract
(2) Currency futures
(3) An OTC currency option
assuming that the spot rate on 30 September 20X8 will be $/£1.3167 – 1.3175 and the
September futures price will be $/£1.3171.
(12 marks)

ICAEW 2021 June 2018 exam questions 107

60.2 A discussion of the advantages and disadvantages of the three hedging techniques used in
60.1 above and, using your results from 60.1 above, advice on which hedging technique is the
most advantageous for Tarbena.
(7 marks)
60.3 An explanation of interest rate parity together with calculations which show why the forward
rate is at a discount to the spot rate on 30 June 20X8.
(5 marks)
60.4 An explanation, without calculations, of purchasing power parity.
(3 marks)
60.5 The likely effect on Tarbena’s share price if there are exchange rate losses when translating the
German subsidiary’s financial statements into sterling.
(3 marks)
Total: 30 marks

108 Financial Management ICAEW 2021

 September 2018 exam questions
61 Thomas Rumsey Group plc
Note: Assume that the current date is 31 August 20X8.
The Thomas Rumsey Group plc (Rumsey) is a UK company which was founded in 20W1 and has a
financial year end of 31 August. Rumsey manufactures computer hardware and also supplies
information technology (IT) support services. Since its formation the group has expanded via organic
growth and the acquisition of other companies.
Snowdog Printers Ltd (Snowdog) is a UK company that manufactures computer printers. Rumsey has
owned 100% of Snowdog’s ordinary shares since 20W9.
Snowdog’s sales and profits have fallen in each of the last two years. Rumsey’s board met in July
20X8 and decided to wind down Snowdog’s operations and that Snowdog will cease trading in three
years’ time, on 31 August 20Y1.
Following the July 20X8 meeting, Snowdog’s directors informed the Rumsey board that they would
like to investigate a management buy-out (MBO) of 100% of Snowdog’s share capital. You are an
ICAEW Chartered Accountant and you work in Rumsey’s finance team. You have been asked to
provide guidance on the MBO for Rumsey’s board.
The Snowdog MBO was discussed at the Rumsey board meeting on 15 August 20X8. Three key
issues discussed at that meeting are summarised below:
• It was agreed that the buy-out price for Snowdog would be its economic value to Rumsey,
assuming that it remained in the group until 31 August 20Y1. The economic value would be the
expected net present value of Snowdog’s projected cash flows over the next three years,
discounted at Rumsey’s WACC. The forecast data for this calculation is shown below.
• One of Rumsey’s directors asked “Couldn’t we add a premium to the MBO price? The cash flows
are only estimates after all. I’m sure that we could inflate the cash inflows or alter the WACC figure
in our favour. Snowdog’s directors would be unaware of this and they seem very keen to buy the
company.”
• Another director asked whether Shareholder Value Analysis (SVA) could be used as an alternative
to the expected NPV to calculate the value of Snowdog.
Forecast data
(1) Sales in the year to 31 August 20Y0 will be dependent on the level of sales in the year to 31
August 20X9 as shown in the table below:

y/e August 20X9 y/e 31 August 20Y0

Sales (£m) Probability Sales (£m) Probability

7.0 0.7 5.0 0.6

4.0 0.4

4.5 0.3 4.0 0.4

3.0 0.6

Sales in the year to 31 August 20Y1 will be £2.5 million. The expected value of annual sales is to be
used in the NPV calculation.
(2) Variable costs will be 30% of sales.
(3) Fixed costs (including depreciation of £600,000 pa) will be £1.7 million pa.
(4) Closure costs on 31 August 20Y1 will be £600,000.
(5) All of the figures in (1)–(4) above are in 31 August 20X8 prices. The inflation rate for sales and
costs is 2% pa.
(6) The tax written down value at 31 August 20X8 of Snowdog’s plant and machinery is £3.3 million.
It is estimated that this will have a scrap value of £1.5 million (in 31 August 20Y1 prices) on 31

ICAEW 2021 September 2018 exam questions 109

 August 20Y1. The plant and machinery attracts 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company, except the final
year. In the final year, the difference between the equipment’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as:
– a balancing allowance, if the disposal proceeds are less than the tax written down value, or
– a balancing charge, if the disposal proceeds are more than the tax written down value
(7) Snowdog’s working capital on 31 August 20X8 totalled £1.8 million. It is planned to reduce this
by £0.2 million on 31 August 20X9 and £0.3 million on 31 August 20Y0. The outstanding
balance will be released on 31 August 20Y1. All working capital figures are given in money
terms.
Other information
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be payable
in the same year as the cash flows to which it relates.
Rumsey’s money WACC is 11% pa.
Requirements
61.1 Calculate the expected NPV of Snowdog’s money cash flows at 31 August 20X8.
(18 marks)
61.2 Calculate the effect on this expected NPV if the scrap value of Snowdog’s plant and machinery
on 31 August 20Y1 is £1 million.
(4 marks)
61.3 Comment on the ethical implications for you as an ICAEW Chartered Accountant of the
Rumsey director’s suggestion regarding the MBO premium.
(3 marks)
61.4 Explain what is meant by the term ‘real options’ and identify for Rumsey’s board two real
options that could apply to Snowdog as alternatives to the MBO.
(5 marks)
61.5 Outline the Shareholder Value Analysis (SVA) approach to company valuation, identifying its
advantages and disadvantages.
(5 marks)
Total: 35 marks

62 Heath Care plc

Note: Assume that the current date is 1 September 20X8.
Heath Care plc (Heath) is a listed UK company that sells baby products. The company was founded in
almost thirty years ago and it has a financial year end of 31 August.
All of Heath’s customers are based in the UK. They order goods online and these are then delivered
by a national courier company from Heath’s central warehouse. Despite not having any physical
shops, Heath was initially very successful. However, in the past two years the market for baby
products has become much more competitive and the company’s market share has fallen as a result.
This has led to a 15% decline in the price of its ordinary shares.
You work in Heath’s finance team and have been asked to provide guidance for the company’s board
following its most recent meeting. At that meeting the following suggestions were made by two of
Heath’s directors:
Janine Barrowland – “We could establish a number of Heath shops across the UK. This would give
more visibility to our brand. I estimate it would cost us £10 million for 10 shops. I can see from the
management accounts that we’ve not got sufficient cash to make that sort of investment, but I see no
reason why we shouldn’t borrow the £10 million. Interest rates are still very low and we could
probably borrow it from our bank at a maximum cost of 4% pa. Our WACC wouldn’t alter by much,
which would make any investment decision very straightforward.”

110 Financial Management ICAEW 2021

Chris Sinnott – “Why not invest in a completely different type of business? We know that people in
the UK are living longer and I know of an established care home business that is for sale and it may
well be a good investment for us.
There’s a steady net cash inflow and we’d own a number of valuable properties. Yes, it’s risky, but
diversification like this would be good for our investors as we’d be making positive use of the
portfolio effect.”
An extract from Heath’s balance sheet at 31 August 20X8 is shown below:

£’000
Ordinary share capital (£1 shares) 6,300
Retained earnings (Note 1) 2,520
9% Preference share capital (£1 shares) 750
4% Redeemable debentures (Note 2) 680
5% Irredeemable debentures 1,240
11,490

Notes
1 Earnings for the year to 31 August 20X8 were £1,050,000 and an ordinary dividend of £630,000
for the year to 31 August 20X8 has been proposed.
2 These debentures are redeemable at par on 1 September 20Y1.
The market prices of Heath’s long-term finance on 1 September 20X8 are:
Ordinary shares – £3.45/share (cum div)
Preference shares – £1.62/share (cum div)
Redeemable debentures – £103% (cum interest)
Irredeemable debentures – £94% (ex interest)
Additional information
Heath’s equity beta – 1.4
Expected risk free rate – 3.35% pa
Expected return on the market – 8.25% pa
You should assume that corporation tax will be payable at the rate of 17% for the foreseeable future
and tax will be payable in the same year as the cash flows to which it relates.

Note: In the earnings retention model g = rb.

Requirements
62.1 Calculate Heath’s WACC on 1 September 20X8 using:
(a) Gordon’s growth model (earnings retention model)
(17 marks)

(b) CAPM
(3 marks)

62.2 Compare and contrast Gordon’s growth model with the CAPM as alternative means of
calculating the cost of equity.
(5 marks)
62.3 Advise Heath’s directors whether they should use the existing WACC figure calculated in part
62.1 above when appraising the investment suggested by Janine Barrowland. Your advice

ICAEW 2021 September 2018 exam questions 111

 should include specific reference to the use of the APV technique and the circumstances under
which it is applicable.
(6 marks)
62.4 From the point of view of a shareholder, explain the portfolio effect and discuss the validity of
Chris Sinnott’s proposal that Heath should purchase a care home business.
(4 marks)
Total: 35 marks

63 Eddyson Cordless Ltd

Note: Assume that the current date is 1 September 20X8.
Eddyson Cordless Ltd (Eddyson) is a UK-based company that designs and manufactures battery-
powered home and garden appliances. It was formed in 20X0 and an analysis of its sales and
purchases, by value, over the past 12 months shows the following:

UK Eurozone
Sales 96% 4%
Purchases of raw materials 74% 26%

Recently, a very large US electrical wholesale company, Timba Inc (Timba), placed an order with
Eddyson worth $2.3 million. The goods will be exported to the US next week and Timba will pay for
them on 30 November 20X8.
Eddyson’s board is considering whether it is worth hedging the foreign exchange rate risk associated
with the sale to Timba. Four possible strategies have been proposed:
• Do not hedge
• Use a forward contract
• Use a money market hedge
• Use sterling traded currency options
You work in Eddyson’s finance team and have been asked to provide calculations and guidance for
the board. You have collected the following information at the close of business on 1 September
20X8:

Spot exchange rate ($/£) 1.3655 – 1.3775

Three-month forward contract premium ($/£) 0.0060 – 0.0044
Arrangement fee for forward contract £0.30 per $100 converted
Sterling interest rate (borrowing) 5.6% pa
Sterling interest rate (lending) 4.6% pa
US dollar interest rate (borrowing) 4.0% pa
US dollar interest rate (lending) 3.2% pa

Sterling traded currency options (standard contract size £10,000) are priced as follows on 1
September 20X8 (premiums are quoted in cents per £):

September 20X8 November 20X8

contracts contracts

Exercise price ($/£) Calls Puts Calls Puts

1.38 1.08 2.36 1.99 3.70

112 Financial Management ICAEW 2021

Requirements
63.1 Calculate Eddyson’s net sterling receipt for each of the four proposed strategies under
consideration, assuming that on 30 November 20X8 the spot exchange rate will be:
(1) $/£ 1.3240 – 1.3350
(2) $/£ 1.3935 – 1.4050
Note: Interest on option premiums should be ignored
(16 marks)
63.2 With reference to your calculations in 63.1 above, advise Eddyson’s board whether it should
hedge against movements in the value of the US dollar.
(6 marks)
63.3 Explain, with relevant workings, why the three-month forward rate is expressed at a premium to
the spot rate on 1 September 20X8.
(5 marks)
63.4 Briefly discuss whether any future sales to Timba might expose Eddyson to economic risk.
(3 marks)
Total: 30 marks

ICAEW 2021 September 2018 exam questions 113

114 Financial Management ICAEW 2021
 September 2019 exam questions
64 Hodder Specialist Engineering Ltd
Hodder Specialist Engineering Ltd (Hodder) is a UK company with a financial year end of 31 October.
Hodder provides a powder-coating service for its UK-based customers that require a protective finish
on their products. Powder coating is applied as a free-flowing, dry powder producing thicker
coatings than conventional liquid coatings such as paint. At present, all of Hodder’s customers
operate in the consumer goods sector of the UK market.
Diamond Cars Ltd (DC) is a UK manufacturer of sports vehicles. DC’s board has approached Hodder
and asked it to provide a powder coating service for DC’s vehicles over a three-year period.
The majority of Hodder’s board members want to accept the contract as DC is a well-established and
very profitable company. However, two of Hodder’s directors feel that this diversification carries
excessive risk. At Hodder’s most recent board meeting they proposed that the company would be
better served by expanding its existing operations overseas, citing India and China as two mass
markets for consumer goods.
You work in Hodder’s finance team and have been asked to advise Hodder’s board on the DC
proposal and overseas expansion.
You have been given these estimates with regard to the DC proposal:

Year to 31 October 20X9 20Y0 20Y1 20Y2

£’000 £’000 £’000 £’000
Purchase of new machinery (Note 1) (1,200)
Trade-in value of new machinery (Note 2) 140
Depreciation of new machinery (265) (265) (265) (265)
Interest costs (Note 3) (54) (54) (54) (54)
Additional fixed costs (Note 4) (35) (35) (35)
Additional direct labour and materials
(Note 4) (162) (162) (162)
Additional working capital (Note 4) (50) (5) (5) 60

Notes
1 The new machinery would be purchased on 31 October 20X9. Hodder charges a full years’
depreciation in the year of acquisition and disposal.
The machinery attracts 18% (reducing balance) capital allowances in the year of expenditure and
in every subsequent year of ownership by the company, except the final year. In the final year, the
difference between the machinery’s written down value for tax purposes and its disposal
proceeds will be treated by the company either as:
• a balancing allowance, if the disposal proceeds are less than the tax written down value, or
• a balancing charge, if the disposal proceeds are more than the tax written down value.
2 The trade-in value of the new machinery on 31 October 20Y2 is expressed in 31 October 20Y2
prices.
3 This represents the interest cost on a loan to part-finance the purchase of the new machinery.
4 The figures for fixed costs, direct labour, materials and working capital are stated in 31 October
20X9 prices. The inflation rate applicable to these flows is 2% pa. The outstanding working capital
balance will be released on 31 October 20Y2.
Other information
DC has offered Hodder the choice of two contract prices:
• £550,000 pa on 31 October in each of the three years 20Y0–20Y2; or

ICAEW 2021 September 2019 exam questions 115

 • a lump sum of £1.9 million receivable on 31 October 20Y2.
These amounts are expressed in money terms.
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant financial year.
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be payable
in the same year as the cash flows to which it relates.
Hodder’s money weighted average cost of capital is 9% pa.
Requirements
64.1 Using the NPV of money cash flows at 31 October 20X9, advise Hodder’s board whether it
should accept the DC proposal if the agreed price is:
(a) £550,000 pa receivable on 31 October in each of the years 20Y0–20Y2 or
(18 marks)

(b) £1.9 million receivable on 31 October 20Y2.

(4 marks)

64.2 Compare the strengths and weaknesses of sensitivity analysis and simulation as methods of
assessing the risk of the DC proposal.
(5 marks)
64.3 Explain what is meant by the term ‘real options’ and identify one real option that could apply to
the DC proposal.
(3 marks)
64.4 Outline the potential risks that Hodder could face were it to expand its operations into China
and India.
(5 marks)
Total: 35 marks

65 Jackett Clarke Travel plc

Assume that the current date is 30 September 2019
Jackett Clarke Travel plc (Jackett) is a UK-listed company, founded in 19W9. Jackett is a travel agency
and tour operator. It arranges flights and package holidays to destinations across Europe and North
America. You are an ICAEW Chartered Accountant and are a member of Jackett’s finance team.
Extracts from Jackett’s management accounts for the financial year to 30 September 20X9 are shown
below:
Income Statement for the year to 30 September 20X9

£’000
Sales 43,500
Variable costs (23,925)
Fixed costs (9,500)
Profit before interest and tax 10,075
Interest (805)
Profit before tax 9,270
Taxation (17%) (1,576)
Profit after tax 7,694
Dividends paid (2,400)

Retained profit

116 Financial Management ICAEW 2021

 £’000
5,294

Balance Sheet at 30 September 20X9

£’000
£1 ordinary shares 16,000
Retained earnings 8,750
24,750
7% Debentures (redeemable in 20Y1) 11,500
36,250

Jackett’s board is keen to explore the implications of expanding the company’s operations into South
East Asia and Australia. The demand for package holidays to these areas has grown steadily in the
past five years and this is expected to continue, but at a slower rate, for at least another five years.
The board commissioned market research and the key financial implications noted in the research
report are shown below:
Table
Initial cost of investment – £7 million
Impact on sales and variable costs – 20% increase pa
Impact on fixed costs – Increase by £1.5 million pa
Other information
Jackett’s board plans to maintain the dividend per share payout for at least another 12 months.
Corporation tax will be payable at the rate of 17% for the foreseeable future.
The board has decided that, were this investment to proceed, it would commence on 1 October
20X9 when the £7 million required for the initial investment would be raised via:
• a 1 for 4 rights issue of ordinary shares; or
• an issue of 5% debentures (redeemable in 20Y8) at par.
The current market values of Jackett’s shares and debentures are:
Ordinary shares – £2.58 (ex-div)
7% debentures – £105% (ex-int)
Emails
You have recently received emails from Jackett’s sales director, Michael Ayres and a colleague in the
finance team, Ann Baker. An extract from each email is shown below:
Michael Ayres:
“I’m an amateur investor and have been tracking the Jackett share price for about four years. Past
patterns suggest that it will decrease by about 25% in the next quarter, so we need to make sure that
we don’t overprice any rights issue.”
Ann Baker:
“I’m worried that Jackett’s share price will fall if debt is used to finance the expansion. Please let me
know what the board decide so I can sell my Jackett shares if necessary before the market finds out.”
Requirements
65.1 For both the 1 for 4 rights issue and the 5% debenture issue, prepare forecast income
statements for Jackett for the year to 30 September 20Y0.
(9 marks)
65.2 For both the 1 for 4 rights issue and the 5% debenture issue, calculate Jackett’s:
• Earnings per share for the year to 30 September 20Y0.

ICAEW 2021 September 2019 exam questions 117

 • Gearing ratio (long-term borrowings/total long-term funds at book value) as at 30
September 20Y0.
(5 marks)
65.3 Discuss the implications for Jackett’s shareholders of the company choosing equity or debt to
raise the £7 million required for the investment. You should make reference to your
calculations in 74.1 and 74.2 above.
(7 marks)
65.4 Assuming that Jackett chooses the rights issue, calculate the theoretical ex-rights price of one
ordinary share and explain why this may be different to the actual ex-rights price.
(6 marks)
65.5 Discuss Michael Ayres’ views on the Jackett share price making reference to relevant theory on
efficient markets.
(5 marks)
65.6 Identify the legal and ethical issues arising for you as an ICAEW Chartered Accountant as a
result of Ann Baker’s email request.
(3 marks)
Total: 35 marks

66 Barratt Waters Shine plc

Assume that the current date is 31 August 20X9.
Barratt Waters Shine plc (Barratt) is a UK-listed manufacturer of pharmaceuticals. It has traded since
19W4 and it sells its products worldwide. You are a member of Barratt’s finance team and are
currently working on three tasks.
66.1 Task 1
Barratt has agreed to sell a large consignment of pharmaceuticals to DMBJ, an Argentine
wholesaler. The agreed price is 22.4 million Argentine pesos (AP). The consignment will leave
the UK on 31 October 20X9 and DMBJ will pay for the goods on 30 November 20X9. Barratt’s
board has to decide whether to hedge this transaction and you have been asked to provide
advice. You have collected the following data at the close of business on 31 August 20X9:

Spot rate (AP/£) 46.22 – 46.85

AP interest rate (lending) 4.4% pa

AP interest rate (borrowing) 6.0% pa

Sterling interest rate (lending) 3.6% pa

Sterling interest rate (borrowing) 4.8% pa

Three-month forward contract discount 0.10 – 0.13

(AP/£)

Forward contract arrangement fee £260

(per one million pesos converted)

Three-month OTC call option on pesos 44.30

– exercise price (AP/£)

Three-month OTC put option on pesos 46.05

– exercise price (AP/£)

Relevant OTC option premium £740

(per one million pesos converted)

118 Financial Management ICAEW 2021

 Requirement
(a) Calculate Barratt’s sterling receipt for the DMBJ consignment if it uses the following to
hedge its foreign exchange rate risk:
• A forward contract
• A money market hedge
• An OTC currency option
(8 marks)
(b) With reference to your calculations in 75.1(a), advise Barratt’s board whether it should
hedge against movements in the value of the Argentine peso.
(6 marks)
(c) Identify the key differences between forwards and futures as a means of hedging foreign
exchange rate risk.
(3 marks)

66.2 Task 2
Barratt has built up a portfolio of UK FTSE100 shares over a number of years. The portfolio is
worth £8,350,000 on 31 August 20X9. The company’s board is considering using FTSE100
index futures to hedge against a fall in the value of the portfolio over the next four months.
You have the following information available to you on 31 August 20X9:
• The FTSE100 index is 7,130
• The price for December 20X9 FTSE100 index futures is 7,115
• The face value of a FTSE100 index futures contract is £10 per index point
Requirement
(a) Calculate the outcome of hedging the portfolio using December 20X9 FTSE100 index
futures. Assume that on 31 December 20X9 both the FTSE100 index and the FTSE100
index futures price will be 7,055 and that the portfolio value changes exactly in line with
the change in the FTSE100 index.
(6 marks)

(b) Explain why the hedge will not be 100% efficient.

(2 marks)

66.3 Task 3
Barratt is expanding its manufacturing and warehousing capacity and needs a bank loan to
finance this. Construction work will start in January 20Y0 and Barratt’s bank has agreed to lend
the company £12.5 million for a five-year period, commencing on 1 March 20Y0. The bank will
charge interest at LIBOR + 1.5% pa. The board wishes to explore whether it would be worth
taking out an interest rate option to hedge against increases in LIBOR. Barratt’s bank has
offered it an option at 5.3% pa plus a premium of 1% of the sum borrowed.
Requirement
Calculate the annual interest payment if Barratt takes out the interest rate option and advise
the board whether it should hedge against increases in LIBOR.
For your calculations, assume that on 1 March 20Y0 LIBOR will be:
3.5% pa; or
5.5% pa
(5 marks)
Total: 30 marks

ICAEW 2021 September 2019 exam questions 119

120 Financial Management ICAEW 2021
 December 2019 exam questions
67 Packaging Innovations plc
Assume that the current date is 31 December 20X9.
Packaging Innovations plc (PI) is listed on the London Stock Exchange and is a manufacturer of
packaging products. One of PI’s objectives is to become more eco-friendly. The board of PI feels that
by entering the sustainable packaging market it will meet this objective, by showing due regard for
the environment and its wider stakeholders.
PI has carried out research and development, at a cost of £90,000, into the production of a new eco-
friendly range of food packaging products to be called ‘Ecopacks’. The board asked the finance
director, Chan Lee (Lee), who is an ICAEW Chartered Accountant, to carry out an NPV analysis of the
Ecopacks project assuming a three-year time horizon to 31 December 20Y2.
At the end of three years the Ecopacks project could sold to a management team made up of current
PI employees led by Lee. He feels, however, that the management team might struggle to raise the
necessary funds. Some members of PI’s board think that there might be alternatives available, at or
after 31 December 20Y2, instead of selling the project to the management team.
The sales director of PI is concerned about the production of Ecopacks as they are expensive and he
feels that it will be difficult to sell them to food producers. He would rather continue with the
production of less eco-friendly packaging, which is cheaper and easier to sell.
Information relating to the Ecopacks project:
• In the year to 31 December 20Y0 it is estimated that 3,000 batches of Ecopacks per month will be
sold and then increase by 10% pa in the two years to 31 December 20Y2.
• The selling price will be £266 per batch in the year to 31 December 20Y0 and then increase by
3% pa in the two years to 31 December 20Y2. Contribution is expected to be 30% of the selling
price.
• Selling and administration expenses for the year to 31 December 20Y0 are estimated to be £1.5
million and are expected to increase by 4% pa in the two years to 31 December 20Y2.
• Fixed production costs, 50% of which are centrally allocated, are estimated to be £0.60 million for
the year to 31 December 20Y0. These costs are expected to remain constant in the two years to
31 December 20Y2.
• PI will rent factory space on 31 December 20X9 for three years to manufacture Ecopacks at a cost
of £0.2 million pa. This will be payable in advance on 31 December and will increase by 3% pa.
• Lee has estimated that the price the management team could afford to pay to PI for the Ecopacks
project on 31 December 20Y2 is two times the pre-tax contribution for the year to 31 December
20Y2. PI would pay corporation tax on the sum received.
• On 31 December 20X9 the project requires an investment in working capital of £1.9 million. This
will increase at the start of each year in line with sales volume growth and sales price increases.
Working capital will be fully recoverable on 31 December 20Y2.
• The Ecopacks project will require an investment of £2 million in plant and machinery on 31
December 20X9. The plant and machinery has a life of three years and the estimated scrap value
is £0.25 million on 31 December 20Y2 (in 31 December 20Y2 prices).
• The plant and machinery will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except in the final year.
At 31 December 20Y2, the difference between the plant and machinery’s written down value for
tax purposes and its disposal proceeds will be treated by the company as either a:
(a) balancing allowance, if the disposal proceeds are less than the tax written down value, or
(b) balancing charge, if the disposal proceeds are more than the tax written down value.
• Assume that the rate of corporation tax will be 17% for the foreseeable future and that tax flows
arise in the same year as the cash flows that gave rise to them.
• A suitable real cost of capital to appraise the Ecopacks project is 7% pa. The general level of
inflation is expected to be 2.4% pa.

ICAEW 2021 December 2019 exam questions 121

 Requirements
67.1 Using money cash flows and assuming that the Ecopacks project is sold to the management
team, calculate the project’s NPV on 31 December 20X9 and advise PI’s board whether it
should proceed with the project.
(19 marks)
67.2 Ignoring the effects on working capital, calculate and comment upon the sensitivity of the
project’s NPV in part 67.1 above to changes in sales volume.
(5 marks)
67.3 Using the NPV in your answer to 67.1 above and assuming now that the Ecopacks project is
not sold to the management team, calculate the project’s revised NPV on 31 December 20X9.
(2 marks)
67.4 Explain what is meant by ‘real options’ and, using your answer to 67.3 above, their relevance to
the Ecopacks project. Identify and discuss one real option that PI has as an alternative to selling
the Ecopacks project to the management team.
(4 marks)
67.5 Briefly evaluate the sales director’s comments regarding the production of Ecopacks in relation
to the board’s sustainability objective.
(2 marks)
67.6 Identify the ethical issues for Lee regarding his involvement in setting the price at which the
Ecopacks project would be sold to the management team.
(3 marks)
Total: 35 marks

68 Wizard plc
Assume that the current date is 31 December 20X9.
Wizard plc (Wizard) is listed on the London Stock Exchange and is an entertainments company
operating in the UK. The board of Wizard is considering diversifying by purchasing Merlin Ltd
(Merlin) which runs a chain of hotels. The cost of purchasing Merlin is estimated to be £735 million
and this will be financed entirely by new 5% coupon debentures issued at par.
Wizard’s board has asked you, the finance director, to make a presentation at the next board meeting
on:
• Why the purchase of Merlin should be evaluated using the Adjusted Present Value (APV)
technique.
• How the new debt finance raised would affect certain key financial ratios and the likely reaction of
shareholders and the capital markets.
• Wizard’s current dividend policy and whether this should be continued in future.
Extracts from Wizard’s most recent management accounts are shown below:
Income statement for the year ended 31 December 20X9

£m
Profit before interest and tax 395
Interest 55
340
Taxation @ 17% 58
Profit after tax 282

122 Financial Management ICAEW 2021

Balance Sheet at 31 December 20X9

£m
Ordinary share capital (10p nominal value) 140
Retained earnings 2,100
2,240
4% Redeemable debentures at nominal value 1,375
3,615

On 31 December 20X9 Wizard’s ordinary shares each have a market value of £4.79 (ex-div). The 4%
debentures are redeemable at par (£100) in four years’ time and their current market price is £93 (ex-
interest).
Profit after tax and dividends for the 5 years to 31 December 20X9 are shown below:

Year 20X5 20X6 20X7 20X8 20X9

£m £m £m £m £m
Profit after tax 238 236 226 240 282
Dividends 119 118 113 120 141

Other information and assumptions

• Wizard’s equity beta on 31 December 20X9 is 0.79.
• Listed companies operating in similar areas to Merlin:

Company Main activity Equity Market Market

beta value of value of
equity debt

£m £m

Spell Hotels plc Operating hotels 0.92 1,950 1,050

Magic Resorts plc Operating hotels and

entertainment venues 1.10 610 152

Cauldron Travel Operating travel companies and

plc hotels 0.66 806 269

• The risk free rate is expected to be 2% pa.

• The market risk premium is expected to be 7% pa.
• Assume that corporation tax will be at the rate of 17% for the foreseeable future.
• The number of ordinary shares has not changed in the last 5 years.
• Data regarding gearing ratios (measured as debt/equity by market values) and interest cover in
Wizard’s current industry (ie entertainments) are as follows:

Maximum Minimum Average

Gearing ratio 30% 15% 18%
Interest cover 9 times 4 times 7 times

Requirements
68.1 Calculate Wizard’s compound annual dividend growth rate for the following periods and
discuss which of the rates is most appropriate for calculating the cost of equity in the dividend
valuation model:

ICAEW 2021 December 2019 exam questions 123

 (1) 31 December 20X5 to 31 December 20X9
(2) 31 December 20X7 to 31 December 20X9
(3 marks)
68.2 Ignoring the Merlin purchase, calculate:
(a) Wizard’s WACC at 31 December 20X19 using the CAPM.
(7 marks)
(b) Wizard’s cost of equity at 31 December 20X9 using the dividend valuation model and the
growth rate that you have chosen in 2.1 above.
(2 marks)
68.3 Explain why APV should be used to appraise the purchase of Merlin and outline the main
elements of the technique.
(4 marks)
68.4 Calculate the cost of equity that should be used in an APV appraisal of the Merlin purchase.
Explain, and give two examples of, the type of risk this cost of equity reflects.
(5 marks)
68.5 Calculate Wizard’s gearing ratio (measured as debt/equity by market values) and interest cover
before and after the purchase of Merlin.
(3 marks)
68.6 Discuss the likely reactions of both the shareholders and the capital markets to the purchase of
Merlin being financed entirely by debt. You should refer to your answer to 2.5 above and the
industry data provided.
(6 marks)
68.7 Discuss, with reference to both theory and practical factors, whether Wizard’s dividend policy
over the last five years is appropriate for a listed company.
(5 marks)
Total: 35 marks

69 Moon Sport Ltd

Assume that the current date is 31 December 20X9.
Your firm advises Moon Sport Ltd (Sport) and you are working on three tasks.
69.1 Task 1 Foreign exchange rate risk
Sport imports rock climbing equipment from the USA and uses forward contracts to hedge its
foreign exchange rate (forex) risk. The board of Sport would like to investigate using money
market hedges and over the counter (OTC) currency options as alternatives. Sport is due to
make a payment of $1,550,000 in four months’ time on 30 April 20Y0.
You have the following information available to you at the close of business on 31 December
20X9:
Spot exchange rate ($/£): 1.3156 – 1.3160
4-month forward contract premium ($/£):0.0059 – 0.0053
Annual borrowing and depositing interest rates:
Dollar 3.20% – 2.70%
Sterling 4.10% – 3.70%
4-month OTC currency options:
• Call options to buy $ have an exercise price of $/£1.3200 and a premium of £0.03 per $
converted.
• Put options to sell $ have an exercise price of $/£1.3050 and a premium of £0.05 per $
converted.
The option premium is payable on 31 December 20X9. Sport has an overdraft.

124 Financial Management ICAEW 2021

 Requirements

(a) Calculate Sport’s sterling cost of the $1,550,000 payment using:

• a forward contract
• a money market hedge
• an OTC currency option
Assume that the spot rate on 30 April 20Y0 will be $/£ 1.3080 – 1.3090.
(9 marks)

(b) Explain the relative advantages and disadvantages of each of the hedging techniques in
78.1 (a) above and advise Sport’s board as to which technique would be the most
beneficial for hedging its forex risk.
(8 marks)

69.2 Task 2 Bitcoin price risk

Sport is intending to sell one of its surplus buildings for £0.5 million in the near future and the
purchaser would like to make payment in a cryptocurrency such as Bitcoins instead of sterling.
The Sport board is worried about the volatility of the Bitcoin price between the time that the
sale proceeds are received and the time that the Bitcoins are subsequently sold.
Using Bitcoin prices on 31 December 20X9 you have been asked to illustrate for the Sport
board the potential losses that could occur if the value of Bitcoins decreases before they are
sold for sterling.
You have the following information available to you on 31 December 20X9:

31 December 20X9 £ equivalent of one Bitcoin

Time
09.00 £2,733.29
10.00 £2,740.30
11.00 £2,698.44

Requirements

(a) Calculate the gains or losses if the purchaser had paid in Bitcoins at 09.00 on 31
December 20X9 and those Bitcoins had then been sold for sterling at either 10.00 or
11.00.
(2 marks)

(b) Advise Sport on whether to accept the payment for the building in sterling or Bitcoins.
(2 marks)

69.3 Task 3 Interest rate risk

Sport is buying new factory premises and arranged to borrow £1,240,000 on 31 March 20Y0.
The loan will be for an 18 month period at an interest rate of LIBOR + 4% pa. The Sport board
is concerned about potential increases in LIBOR over the next three months, to 31 March 20Y0,
from its current level of 0.90% pa.
You have the following information available to you on 31 December 20X9:
Traded sterling interest rate futures: March three-month futures price = 98.80
Standard contract size = £500,000

ICAEW 2021 December 2019 exam questions 125

 Requirement

(a) Calculate the interest cost of Sport borrowing £1,240,000 for 18 months if it does not
hedge its interest rate risk and LIBOR remains at 0.90% pa.
(1 mark)

(b) Calculate the interest cost of Sport borrowing £1,240,000 for 18 months if it uses traded
sterling interest rate futures to hedge its interest rate risk, if by 31 March 20Y0:
• LIBOR increases to 1.50% pa and the futures price moves to 98.30
• LIBOR decreases to 0.75% pa and the futures price moves to 99.00
(6 marks)

(c) Explain why the interest rate risk of Sport borrowing the £1,240,000 is not perfectly
hedged by the futures contracts in 3.3 (b) above.
(2 marks)

Total: 30 marks

126 Financial Management ICAEW 2021

 March 2020 exam questions
70 Engavon plc
Assume that the current date is 1 April 20Y0.
Engavon plc (Engavon) is a UK engineering company which has been trading since 1992. It has a
financial year end of 31 March. Engavon’s main source of income is the manufacture and sale of
emergency vehicles. Its major customers are the British and European governments. 90% of its
vehicle components are imported from EU suppliers and paid for in euro.
You are a member of the company’s finance team. Two days ago, you received an email from the
finance director. Below is an extract from her email:
“I agreed to make a brief presentation on risk management to the board at next week’s meeting.
However, I must now visit two of our key European customers and so I won’t be able to attend. I need
you to present for me. The directors’ particular concern was the possible hedging of the foreign
exchange rate risk on the dollar income from a contract with the Australian government. Please
explain to the board the financial implications of using the following hedging methods:
(1) Forward contract
(2) Money market hedge
(3) Sterling traded currency options”
Since receiving the email, you have researched the Australian contract and have established that
Engavon’s board is actively seeking to expand the company’s operations into the Asia Pacific market.
In October 20X9 it signed a contract to supply the Australian government with a consignment of
emergency vehicles. This contract is worth A$2.9 million.
The vehicles will be shipped to Australia in late April 20Y0 and Engavon will receive settlement on 30
June 20Y0. You have collected the following information at close of business on 1 April 20Y0:

Spot rate (A$/£): 1.8495 – 1.8585

Three-month forward contract discount (A$/£): 0.0102 – 0.0117
Sterling interest rate (lending): 3.0% pa
Sterling interest rate (borrowing): 4.0% pa
Australian dollar interest rate (lending): 5.2% pa
Australian dollar interest rate (borrowing): 6.6% pa
Arrangement fee for forward contract: £10 per A$1,000 converted

Sterling traded currency options (standard contract size £10,000) are priced as follows on 1 April
20Y0 (premiums are quoted in cents per £ and are payable in advance):

April 20Y0 contracts June 20Y0 contracts

Exercise price (A$/£)
Calls Puts Calls Puts
1.862 1.49 3.26 2.74 5.09

Requirements
70.1 Calculate Engavon’s net sterling receipt for each of the three hedging methods listed in the
finance director’s email, assuming that on 30 June 20Y0 the spot exchange rate will be:
(1) A$/£ 1.8270 – 1.8345
(2) A$/£ 1.8730 – 1.8810
Note: Interest on option premiums should be ignored.
(14 marks)

ICAEW 2021 March 2020 exam questions 127

 70.2 With reference to your calculations in 70.1, advise Engavon’s board whether it should hedge
the receipt from the Australian government contract.
(7 marks)
70.3 Explain, with relevant workings, why the three-month forward rate is expressed at a discount to
the spot rate on 1 April 20Y0.
(5 marks)
70.4 Explain whether the board’s plans to expand the company’s operations into the Asia Pacific
market will expose Engavon to economic risk.
(4 marks)
Total: 30 marks

71 AOS Energy plc

Assume that the current date is 1 April 20Y0.
AOS Energy plc (AOS) manufactures and erects wind turbines. The company has traded since 2002,
is listed in the UK and its financial year end is 31 March. AOS is involved in energy projects across the
world, but most of its work is within Europe.
To date the company has increased in size and value by organic growth. AOS’s board is now
investigating the acquisition of 100% of the share capital of Pentmarine Power Ltd (Pentmarine), a
manufacturer of wave energy converters.
You are a member of AOS’s finance team and the company’s finance director has sent an email to
you, extracts from which are shown below:
“I’m really busy with year-end work and would value your input regarding the Pentmarine acquisition.
This would be a big investment for us and owning Pentmarine would mean that AOS was operating
in a different technology sector. One of our board members is keen for AOS to develop a portfolio of
investments in order to reduce our shareholders’ risk. However, two others are worried about this
and need some reassurance as they feel that buying Pentmarine is too risky.
Were AOS to buy Pentmarine it would cost in the region of £30 million, which we would need to
borrow. Our bankers are willing to lend us that sum, but at an interest rate of 10.5% pa. I want to
explain to the board the implications of the investment, based primarily on its estimated NPV. Can
you calculate an up to date cost of capital figure for me?
Also, we’ve never used the CAPM method, so I’d be interested to see if this would show much of a
difference.”
AOS’s management accounts at 31 March 20Y0 included the following:

£’000
£1 ordinary shares 20,500
6% £1 preference shares 4,300
4% irredeemable debentures 5,100
3% redeemable debentures (note 1) 6,800

Note 1
These debentures are redeemable at par on 31 March 20Y3.
The market values of AOS’s capital at 31 March 20Y0 are:

Ordinary shares (note 2) £4.20/share (cum-div)

Preference shares £1.33/share (ex-div)
Irredeemable debentures £102% (ex-interest)
Redeemable debentures £101% (cum-interest)

128 Financial Management ICAEW 2021

 Note 2
AOS’s ordinary dividend for the year to 31 March 20Y0 totals £5,125,000 and this is due to be paid in
full on 14 April 20Y0. AOS’s ordinary dividends have been increasing at a steady annual rate since
the year ended 31 March 20X5 when they totalled £4,428,000. AOS’s issued ordinary share capital
has not changed since 20X4
Additional information at 31 March 20Y0:

AOS’s equity beta 1.30

Expected risk-free return 2.6% pa
Expected return on the market 8.7% pa

You should assume that corporation tax will be payable at the rate of 17% for the foreseeable future
and tax will be payable in the same year as the cash flows to which it relates.
Requirements
71.1 Calculate AOS’s WACC on 31 March 20Y0 using:
(a) The dividend valuation model
(16 marks)
(b) The CAPM
(2 marks)
71.2 Compare and contrast the dividend valuation model with the CAPM as alternative means of
calculating the cost of equity.
(5 marks)
71.3 Advise AOS’s directors whether they should use the WACC figure calculated in 71.1 when
appraising the Pentmarine purchase.
(4 marks)
71.4 Explain the adjusted present value (APV) technique and indicate whether it is applicable to the
Pentmarine purchase.
(4 marks)
71.5 Explain the portfolio effect and discuss the board member’s contention that AOS’s
development of a portfolio of investments would reduce the risks to its shareholders.
(4 marks)
Total: 35 marks

72 Greene & Banks plc

Assume that the current date is 31 March 20Y0.
Greene & Banks plc (Greene) is a listed UK producer of dairy products. Its headquarters are in Bristol
and its financial year end is 31 March. You are an ICAEW Chartered Accountant and are employed in
Greene’s finance team.
Currently Greene has four regional factories which produce and sell milk, yoghurt and cheese within
their region. Greene’s board has decided to rationalise its operations. Production and retailing will be
moved into one factory in Bristol, whilst the other three factories will be closed. The Bristol factory
output will be expanded via the use of sophisticated technological developments. It will then make
sales to the three regions once their own factories have closed. It is forecast that the company’s total
sales will increase following the rationalisation. These plans have not yet been made public.
The factory in Hawten is one of those that will close and its factory will be sold to Sharpe
Manufacturing Ltd (Sharpe). However, Greene’s board is unsure whether to close it in one year’s time
on 31 March 20Y1 or in three years’ time on 31 March 20Y3. Sharpe would prefer to purchase the
factory on 31 March 20Y3 and is prepared to pay an additional £500,000 if Greene agrees to that
date.
You have been asked to prepare calculations to enable Greene’s board to make a decision on the
preferred closure date for Hawten and have been given the following estimates:

ICAEW 2021 March 2020 exam questions 129

 Year to 31 March
20Y1 20Y2 20Y3
Hawten factory
Sales (£’000) £1,200 £1,220 £1,250
Variable costs as a % of sales 55% 55% 55%
Fixed costs (£’000) £200 £200 £200
Bristol factory
Sales to Hawten’s region after closure (£’000) £1,280 £1,360
Variable costs as a % of sales 45% 45%
Incremental fixed costs (£’000) £320 £320

All figures in this table are in 31 March 20Y0 prices. Sales will not increase with inflation. The inflation
rate applicable to all costs in this table is 2% pa.
Additional estimates at 31 March

20Y1 20Y3
£’000 £’000
Factory selling price (note 1) 7,700 8,200
Plant and machinery disposal proceeds
(note 2) 900 780
Redundancy payments (note 3) 2,000 2,150

Note 1
The factory selling prices are stated in money terms. Greene’s board wishes to provide for a
corporation tax charge of 17% on the agreed selling price of the factory.
Note 2
The plant and machinery disposal proceeds are stated in money terms. The plant and machinery will
have a tax written down value of £740,000 on 1 April 20Y0. It attracts 18% (reducing balance) capital
allowances in the year of expenditure and in every subsequent year of ownership by the company,
except the final year.
In the final year, the difference between the plant and machinery’s written down value for tax
purposes and its disposal proceeds will be treated by the company either as:
• a balancing allowance, if the disposal proceeds are less than the tax written down value; or
• a balancing charge, if the disposal proceeds are more than the tax written down value.
Note 3
The redundancy payments are stated in money terms.
Other information
Unless indicated otherwise, assume that all cash flows occur at the end of the relevant financial year.
Corporation tax will be payable at the rate of 17% for the foreseeable future and tax will be payable
in the same year as the cash flows to which it relates.
Greene’s money cost of capital is 8% pa.
Requirements
72.1
(a) Calculate the relevant money cash flows associated with closing Hawten on:
(1) 31 March 20Y1

130 Financial Management ICAEW 2021

 (2) 31 March 20Y3
and use these to calculate the NPV at 31 March 20Y0 for each of these possible closure
dates.
In both of these calculations you should ignore any opportunity cash flows associated with
the alternative closure date.
(17 marks)
(b) Advise Greene’s board as to the preferred closure date for Hawten.
(1 mark)
72.2 Calculate the selling price of the factory on 31 March 20Y3 that would make Greene’s board
indifferent to which of the two possible closure dates to choose.
(5 marks)
72.3 Explain what is meant by the term ‘real options’ and identify one real option that could apply to
Greene’s board’s plans.
(4 marks)
72.4 Compare the strengths and weaknesses of sensitivity analysis and simulation as means of
assessing the risk of a project.
(5 marks)
72.5 Explain the ethical implications for you, as an ICAEW Chartered Accountant, of having
knowledge of potentially price-sensitive information about Greene’s plans.
(3 marks)
Total: 35 marks

ICAEW 2021 March 2020 exam questions 131

132 Financial Management ICAEW 2021
Answer Bank
134 Financial Management ICAEW 2021
 Objectives and investment appraisal
1 Stoane Gayte Sounds plc

Marking guide Marks

1.1 Machinery 1
Tax saving 2
Tax on income 1
Working capital investment 2
Discounting and NPV 1
Recommendation 1
No market research costs 1
No fixed costs 1
Selling price 1
Raw materials 1
Variable overheads 1
Loss of contribution 3
Labour costs ignored 1
Maximum 17
1.2 NPV 1
IRR 1
Advice on usefulness 4
Maximum 6
1.3 Relevant discussion 6
Maximum 6
1.4 Relevant discussion 6
Maximum 6
Total 35

March 20X3 March 20X4 March 20X5 March 20X6

£’000 £’000 £’000 £’000
Machinery (4,900.000) 980.000
Tax saving (W1) 149.940 122.951 100.820 292.690
Income (W2) 2,008.500 3,500.970 1,803.000
Tax on income (W2) (341.445) (595.165) (306.510)
Working capital investment
(W3) (750.000) (22.500) (23.175) 795.675

Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855

11% factor 1.000 0.901 0.812 0.731
PV (5,500.060) 1,592.523 2,422.561 2,605.909
NPV 1,120.933

As the NPV is positive SGS should proceed with the investment as this will enhance
shareholder wealth.

ICAEW 2021 Objectives and investment appraisal 135

 No market research costs.
No fixed costs.

WORKINGS
(1)

March 20X3 March 20X4 March 20X5 March 20X6

£’000 £’000 £’000 £’000
Cost/WDV 4,900.000 4,018.000 3,294.760 2,701.703
WDA (18%) (882.000) (723.240) (593.057) (1,721.703)
WDV/disposal 4,018.000 3,294.760 2,701.703 980.000

Tax saved (17% × WDA) 149.940 122.951 100.820 292.690

(2)

March
20X3
Contribution/unit £
Selling price 190
Less: Raw materials (43)
Variable overheads (45)
Loss of Boom-Boom contribution ([£99 – £28 – £35] × 2) (72)
Contribution/unit 30

Labour costs ignored

Contribution adjusted for inflation

March March March

20X4 20X5 20X6
Contribution/unit (real terms) £30.00 £30.00 £30.00
× × ×
Sales volume (units) 65,000 110,000 55,000
= = =
Total contribution £1,950,000 £3,300,000 £1,650,000
× × ×
Inflation adjustment 1.03 (1.03) 2
(1.03)3
= = =
Total contribution (money terms) £2,008,500 £3,500,970 £1,803,000
Corporation tax on contribution (@ 17%) £341,445 £595,165 £306,510

136 Financial Management ICAEW 2021

 (3) Working capital investment

March March March

March 20X3 20X4 20X5 20X6
Working capital £750,000 × 1.03
£772,500 × 1.03
£795,675
Increment (£750,000) (£22,500) (£23,175) £795,675

1.1 IRR calculation

Rework total cash flows at (say) 15%:

Total cash flows (5,500.060) 1,767.506 2,983.450 3,564.855

15% factor 1.000 0.870 0.756 0.658
PV (5,500.060) 1,537.730 2,255.488 2,345.675
NPV 638.833

IRR = 15% + [4% × (638,833/(1,120.933 – 638.833))] = 20.3%

The IRR is approximately 20.3%, which exceeds SGS’s cost of capital (11%) and so the
investment will enhance shareholder wealth. If, however, the IRR had been less than the cost of
capital then shareholder wealth would decline.
IRR and NPV normally give the same result as to whether investment should take place or not.
As a percentage return, IRR may be easier to understand for managers and employees.
However, IRR does not calculate the change in absolute shareholder wealth. As a
consequence, it may provide the wrong result when alternative projects are being ranked. Also
non-conventional cash flows can create more than one IRR.
1.2
1.3 The traditional school of thought regarding dividends states:
Shareholders would prefer dividends today rather than dividends or capital gains in the future.
This is because cash now is more certain than cash in the future.
However, this implies that future payments would be discounted at a higher rate to take
account of the uncertainty, but does risk really increase over time?
Risk is however related to the activities and operations of the business, and so the discount
rates applied to dividends should reflect this.
Modigliani and Miller (MM)
MM argued that share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities and any loss in dividend income
will be offset by gains in share price.
Shareholders can create home-made dividends and do not have to rely on the company’s
dividend policy; if cash is needed, they can sell some shares instead.
Taxes, share transaction costs and share issue costs will have an effect.
Other issues
Informational content – dividends mean that management is confident of the future. The
signalling view.
Clientele effect – investors have a preferred habitat. That is, they seek a company with a
particular dividend policy that suits them. If shares are unpopular because of inconsistent
policy, then the share price will suffer.

ICAEW 2021 Objectives and investment appraisal 137

 Agency – separation of ownership from management of a firm can lead to sub-optimal
decisions being made. Agency costs are borne by shareholders. Managers may often make
investments that do not increase shareholder wealth, and dividends worsen as a result.
Dividend commitments can reduce agency costs. A high dividend payout and low retentions
leads to greater scrutiny of the firm’s investment decisions by outsiders (due to the need for
external funds).
Tax – some shareholders may prefer income to capital gains.
Overall
Evidence seems to support MM – valuation not closely related to levels of dividends.
Clientele effect seems to operate.
Dividends do not affect the value of shares, provided the shareholders know the dividend
policy of the company. It is important to establish a consistent policy and stick to it.
Lack of consistency means that shareholders will leave, and as a result the share price is likely
to fall.
1.4 Peer-to-peer (or P2P) lending connects established businesses looking to borrow with
investors who want to lend, via a specialised online platform.
P2P lending is potentially available for any type of lending, whether short or long-term or
secured or unsecured. However, most loans in P2P lending are unsecured personal loans.
Platforms usually require borrowers to have a trading track record, to submit financial
accounts, and will perform credit checks as part of the credit assessment.
P2P would therefore be an appropriate source of finance for SGS to use to finance the
investment in the new range of high-tech audio speakers as SGS is an established
manufacturer of audio equipment and would be able to offer security to potential investors.
P2P lending also allows customers and family or friends to share in the returns of the business.
Investors can lend small parts of individual loans, which encourages a wide range of lenders to
participate. However, P2P loans can also be for large loans of several million pounds. SGS is
looking to raise £4.9 million to finance the new investment, but this would only be possible if
they are able to access a large enough group of lenders willing to invest in the company.
Advantages of P2P lending
P2P lending can be cheaper than using a traditional bank loan, the greater competition
between lenders results in a lower interest rate and lower organisation fees. Access to this type
of finance could therefore reduce the overall cost of capital of SGS.
As P2P lending platforms are typically entirely online, the application process is quick and
convenient. Given that SGS operate in a competitive environment, securing the funds quickly
to commence the investment could be a valuable option.
Most P2P platforms have a waiting list of investors to provide loans to borrowers which, when
combined with an automated matching process, means turnaround time on accessing finance
can also be very quick.
Using external finance, such as P2P lending, would allow SGS to proceed with the investment
while also paying out the cash dividend financed from internal funds.
Disadvantages of P2P lending
SGS will still need to pass a credit check and other internal checks to acquire the loan.
Borrowers who apply for P2P loans usually have low credit ratings that prevent them from
obtaining conventional sources of finance. However, SGS is a listed company with an
established trading history and is therefore likely to pass the credit checks and be able to
access the required amount of finance.
The loan is still likely to include an arrangement fee payable to the P2P firm, however this is
likely to be cheaper than the fee attached to traditional bank borrowings.

Examiner’s comments
This question was generally done very well and had the highest average mark on the paper.

138 Financial Management ICAEW 2021

 This was a three-part question that tested the candidates’ understanding of the investment decisions
and valuations element of the syllabus. In addition, it tested candidates’ understanding of IRR and
dividend theory.
In the scenario a company was considering whether or not to proceed with the development of a
new range of audio speakers for cars. Part one, for 17 marks was a fairly traditional NPV calculation
and required candidates to deal with lost contribution, inflation, working capital and capital
allowances. Part two, for six marks, asked candidates to calculate the IRR of the proposed investment
and explain the usefulness of this figure to the company’s directors. In the third part, also for six
marks, candidates had to discuss whether the company should use company funds to pay a dividend
instead of investing in the audio speakers project.
In the first requirement, the majority of candidates scored high marks. The most common errors were
made with regard to the lost contribution and the non-relevance of skilled labour costs. Also a fair
number of candidates were unable to deal correctly with (a) the working capital requirements and/or
(b) the correct discount rate.
Most answers to the second part were disappointing. Too few candidates were able to calculate the
project’s IRR correctly, even allowing for errors made in the NPV calculation in part one. It was also
clear that far too few candidates understood the meaning of the IRR figure and its usefulness to
management.
The third part was answered far better and most candidates demonstrated a good understanding of
the theory underpinning dividend policy and thus scored high marks.

2 Profitis plc

Marking guide Marks

2.1 Calculations:
Time 0 1
Time 1 1
Time 2 1.5
Time 3 2.5
Time 4 1
PV 2
Equivalent annual cost 3
Conclusion 1
Maximum 13
2.2 1.5 marks per point 4
Maximum 4
Total 17

2.1 Derivation of the equivalent annual cost: Net present value

3 years 4 years
Time PV @ 15% PV @ 15%
£ £ £ £
0 Cost (80,000) (80,000)
Capital allowance (w) 2,448 2,448
(77,552) (77,552) (77,552) (77,552)
1 Capital allowance 2,007 2,007

ICAEW 2021 Objectives and investment appraisal 139

 3 years 4 years
Time PV @ 15% PV @ 15%
£ £ £ £
Maintenance (10,000) (10,000)
(7,993) (6,954) (7,993) (6,954)
2 Capital allowance 1,646 1,646
Maintenance (10,000) (10,000)
Tax on maintenance 1,700 1,700
(6,654) (5,030) (6,654) (5,030)
3 Capital allowance 5,799 1,350
Maintenance – (20,000)
Tax on maintenance 1,700 1,700
Proceeds 10,000 –
17,499 11,514 (16,950) (11,153)
4 Capital allowance – 6,149
Tax on maintenance – 3,400
9,549 5,462
Present value (78,022) (95,227)
Annuity factor 2.283 2.855
Equivalent annual cost £34,175 £33,354

Therefore a four-year life is marginally more economic.

WORKING

Time @ 17%
£ £
0 Cost 80,000
Writing-down allowance (18%) (14,400) 2,448
65,600
1 Writing-down allowance (18%) (11,808) 2,007
53,792
2 Writing-down allowance (18%) (9,683) 1,646
44,109
3 Proceeds (10,000)
34,109 5,799
or

2 Written-down value 44,109

3 Writing-down allowance (18%) (7,940) 1,350

140 Financial Management ICAEW 2021

 Time @ 17%
36,169
4 Proceeds Nil
36,169 6,149

2.2 Discussion of other issues

Relevant issues include the following.
(1) The analysis in 2.1 ignores price changes of all descriptions. A change in the price of a
new machine, for example, could easily alter the conclusion. The same would be true for
all of the input factors.
(2) The approach taken assumes that replacement will take place with an identical machine.
The machine may be technologically superseded. The company may conclude that it no
longer has a need for such a machine. In practice it seems unlikely that many such assets
are replaced with identical models on a continuing basis.
(3) The timing of the cash outflows on new machines could be an issue in practice, ie, making
payments every fourth year may cause less of a cash flow problem than every third year.

3 Horton plc

Marking guide Marks

3.1 (a) Calculation of capital allowances 3

Calculation of NPV 1
Maximum 4
(b) Scenario 1 1
Scenario 2 4
Scenario 3 5
Scenario 4 2
Maximum 12
(c) Reasons why leasing might be a preferred source of finance (1 mark per
valid point) 3
Maximum 3
3.2 (a) Calculations for:
1 year cycle 1
2 year cycle 1
3 year cycle 1
Annual equivalent cost, 0.5 marks per cycle 1.5
Conclusion .5
Maximum 5
(b) 1.5 marks per valid issue discussed 6
Maximum 6
Total 30

3.1
(a) Project 3
Capital Allowances
Cost 3,000,000

ICAEW 2021 Objectives and investment appraisal 141

 Cash flow £ Tax relief @ 17%

Cost 3,000,000

540,000 91,800
20X9 WDA @ 18%

2,460,000

20Y0 WDA @18% 442,800 75,276

2,017,200

20Y1 WDA @18% 363,096 61,726

1,654,104

20Y2 WDA @18% 297,739

50,616

1,356,365

Proceeds 1,000,000

Bal. All. 356,365 60,582

Year 0 1 2 3 4
(2,908,200) (1,424,724) 3,811,726 3,800,616 3,810,582
1 0.909 0.826 0.751 0.683
PV (2,908,200) (1,295,074) 3,148,486 2,854,263 2,602,628
NPV £4,402,103

(b) Scenario 1:
With no capital rationing, all projects yielding a positive NPV should be accepted.
Therefore, accept 100% of Projects 1, 3 and 4.
Scenario 2:
With capital rationing of £4.5 million at T0 and divisible projects, the NPV per £ invested
needs to be calculated for each project:
Project 1: 2,676,600/2,400,000 = £1.12 (Rank 2)
Project 2: (461,700)/2,250,000 = Negative
Project 3: 4,402,103/3,000,000 = £1.47 (Rank 1)
Project 4: 2,016,250/2,630,000 = £0.77 (Rank 3)
Project 5: (45,250)/3,750,000 = Negative
So with £4.5 million to invest, accept 100% of Project 3 (£3m) and 62.5% of Project 1
(£1.5m).
Scenario 3:
Under this scenario, Project 2 will never be accepted as it yields a negative NPV and
consumes funds in the year of capital rationing. However, Project 4 will always be
accepted as it yields a positive NPV and generates funds in the year of capital rationing.
Of the remaining projects:
Project 1: 2,676,600/750,000 = £3.57 (Rank 1)
Project 3: 4,402,103/1,500,000 = £2.93 (Rank 2)
Project 5: Negative NPV

142 Financial Management ICAEW 2021

 However, although Project 5 has a negative NPV of £45,250 it does release £1,050,000 at
T1. The question that needs to be asked, therefore, is whether the negative NPV is
outweighed by the return on these released funds if Project 5 is undertaken.
Without Project 5, capital available = £300,000 + £750,000 (from Project 4) which means
Horton can accept 100% of Projects 1 and 4, and 20% of Project 3 to yield an overall NPV
of £5,573,271 (£2,676,600 + £2,016,250 + (0.2 × £4,402,103)).
If Project 5 is undertaken, capital available = £300,000 + £750,000 (from Project 4) +
£1,050,000 (from Project 5) which means Horton can accept 100% of Projects 1, 4, 5 and
90% of Project 3 (£1.35m) to yield an overall NPV of £8,609,493. So this latter solution
maximises shareholder wealth.
Scenario 4:

With indivisible projects, the potential portfolios of investments possible with capital of
£5.25 million are as follows: Project 1 or Project 3 or Project 4 or Projects 1 and 4.
The NPVs generated by these four possibilities are:
Project 1: 2,676,600
Project 3: 4,402,103
Project 4: 2,016,250
Projects 1 and 4: 4,692,850
Therefore, the projects that should be undertaken are Projects 1 and 4.
Note: 99.9% of candidates attempting this question proceeded on the basis set out
above, which takes account of the revised NPV for Project 3 calculated in part 3.1(a) –
£4,402,103 – but which retains the original Project 3 cash outlays as (£3m) in T0 and
(£1.5m) in T1, thereby reflecting the practical reality that Horton would have to spend these
sums before receiving the benefit of the capital allowances calculated in part 3.1(a).
Note: However, it should be noted that full credit was given to any candidate who used
the revised Project 3 cash outlays of £2,908,200in T0 and £1,424,724 in T1.
Note: Taking this approach would have the following impact on the calculations:
Note: In Scenario 1, no impact.
Note: In Scenario 2, Project 3 would now yield an NPV per £ invested of £1.51 (still Rank 1)
and 66.3% of Project 1 could now be undertaken (up from 62.5%).
Note: In Scenario 3, Project 3 would now yield an NPV per £ invested of £3.09 (still Rank
2); without Project 5, 21.1% of Project 3 could now be undertaken (up from 20%); and this
would now yield an overall NPV of £5,621,694; with Project 5, 94.8% of Project 3 could
now be undertaken and this would now yield an overall NPV of £8,820,794.
(c) The reasons why leasing might be a preferred source of finance are as follows:
(1) Tax: The tax effects of owning an asset compared to using one under a lease are
different and can lead to a preference for leasing as a source of finance.
(2) Capital rationing: Firms, in particular small firms, who may encounter difficulties
raising conventional loan finance, are effectively able to use the asset acquired as
security to overcome such potential funding problems.
(3) Cash flow: Leasing means avoiding the large cash outlay at the outset. Lease
payments will be predictable which aids business planning.
(4) Cost of capital: The implicit cost of borrowing in the lease can be lower than that in a
conventional bank loan.
(5) Flexibility: Examples such as ease of arrangement; lower payments in early stages;
combining other elements into overall package – service, insurance, secondary lease
terms.
(a) Calculation of NPVs of each potential replacement cycle:
1-year cycle:
(11,000) + {7,000 × 0.909} + {(6,600) × 0.909} = £(10,636)

ICAEW 2021 Objectives and investment appraisal 143

 2-year cycle:
(11,000) + {4,200 × 0.826} + {(6,600) × 0.909} + {(7,600) × 0.826} = £(19,808)
3-year cycle:
(11,000) + {1,800 × 0.751} + {(6,600) × 0.909} + {(7,600) × 0.826} + {(9,200) × 0.751} =
£(28,834)
The annual equivalent costs are:
1-year cycle: (10,636)/0.909 = £(11,701)
2-year cycle: (19,808)/1.736 = £(11,410)
3-year cycle: (28,834)/2.487 = £(11,594)
Therefore the advice to the managing director should be to replace the new company
cars after two years.
(b) Weaknesses of the method:
• The analysis in part 3.1(a) ignores price changes of all descriptions. A change in the
price of a new car, for example, could easily alter the conclusion. The same would be
true for all of the input factors.
• The approach taken assumes that replacement will take place with an identical car. The
car may be replaced with an improved model. Horton may conclude that it no longer
has a need for such a car. In practice it seems unlikely that cars are replaced with
identical models on a continuing basis.
• The timing of the cash outflows on new cars could be an issue in practice, ie, making
payments every fourth year may cause less of a cash flow problem than every third
year.
• The effects of taxation have been ignored in this analysis.

Examiner’s comments
Candidates generally coped well with the calculation of capital allowances in the opening section of
part 3.1 and it was a rare script that failed to pick up full marks (where this did happen, it was most
commonly due only to arithmetical slips of the pen). With the four capital rationing scenarios most
candidates were able to identify the correct projects to pursue in scenario 1. However, in scenario 2
there were weaker candidates who simply failed to use the ranking methodology based on NPV per
£ invested. Weaker candidates also found scenario 3 rather challenging, overlooking the need to
consider Project 5 in spite of its negative NPV in view of the cash released in the second period. Most
candidates coped well with scenario 4. Most candidates picked up high marks on the technical
knowledge part of the lease discussion, but scored less strongly on the whole in discussing the
relative merits of leasing over outright purchase. Another notable feature was that some candidates
tended to answer the question with their ‘financial reporting’ hat on rather than their ‘financial
management’ hat – the examination is a test of candidates’ knowledge of the financial management
learning materials.
Most candidates found little to trouble them in the standard replacement analysis question in part
3.2.

4 ProBuild plc

Marking guide Marks

4.1 Best case scenario:

Plant and equipment 2
Capital allowance 2
Operating cash flow 2
Tax 1
Working capital 2

144 Financial Management ICAEW 2021

 Marking guide Marks

Discount factor and NPV 2

Worst case scenario:
Capital allowance 2
Operating cash flow 1
Tax 2
NPV 1
Maximum 17
4.2 Discussion of uncertainty and risk 6
Maximum 6
4.3 Discussion of real options 6
Maximum 6
Total 29

4.1 Best case scenario

20X3 20X4 20X5 20X6 20X7

Plant & Equipment (1,500,000) 100,000
Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 1,173,000 1,196,460 1,220,389 1,244,797
Tax (17%) (199,410) (203,398) (207,466) (211,615)
Working Capital (W3) (163,200) (3,264) (3,329) (3,396) 173,189
(1,617,300) 1,007,964 1,020,596 1,034,835 1,404,662
Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250
(1,617,300) 941,136 881,387 818,658 1,018,380

NPV £2,042,260

Worst case scenario

20X3 20X4 20X5 20X6 20X7

Plant & Equipment (1,500,000) 100,000

Capital Allowance (W1) 45,900 37,638 30,863 25,308 98,291
Operating Cash Flow (W2) 499,800 509,796 519,992 530,392
Tax (17%) (84,966) (86,665) (88,399) (90,167)
Working Capital (W3) (97,920) (1,958) (1,998) (2,038) 103,914

(1,552,020) 450,514 451,996 454,863 742,430

Discount Factor (W4) 1 0.9337 0.8636 0.7911 0.7250

(1,552,020) 420,645 390,344 359,842 538,262

NPV £157,073

ICAEW 2021 Objectives and investment appraisal 145

 WORKINGS
(1) Capital Allowances (£)

20X3 Cost 1,500,000

WDA 18% 270,000 × 17% = 45,900
1,230,000
20X4 WDA 18% 221,400 × 17% = 37,638
1,008,600
20X5 WDA 18% 181,548 × 17% = 30,863
827,052
20X6 WDA 18% 148,869 × 17% = 25,308
678,183
20X7 Disposal 100,000
578,183 × 17% = 98,291

(2) Operating Cash Flows

Best Case Scenario: 2,000,000 – (500,000 + 350,000) = 1,150,000

1,173,00
20X4: 0 (1,150,000 × 1.02)
1,196,46
20X5: 0 (1,150,000 × 1.022)
1,220,38
20X6: 9 (1,150,000 × 1.023)
1,244,79
20X7: 7 (1,150,000 × 1.024)

Worst Case Scenario: 1,200,000 – (360,000 + 350,000) = 490,000

20X4: 499,800 (490,000 × 1.02)
20X5: 509,796 (490,000 × 1.022)
20X6: 519,992 (490,000 × 1.023)
20X7: 530,392 (490,000 × 1.024)

(3) Working Capital

Best Case Scenario:

20X3: (2,000,000 × 1.02 × 0.08) = (163,200)
20X4: (2,000,000 × 1.022 × 0.08) – 163,200 = (3,264)
20X5: (2,000,000 × 1.023 × 0.08) – 166,464 = (3,329)
20X6: (2,000,000 × 1.024 × 0.08) – 169,793 = (3,396)
20X7: 173,189

146 Financial Management ICAEW 2021

 Worst Case Scenario:
20X3: (1,200,000 ×1.02 × 0.08) = 97,920
20X4: (1,200,000 × 1.022 × 0.08) – 97,920 = (1,958)
20X5: (1,200,000 × 1.023 × 0.08) – 99,878 = (1,998)
20X6: (1,200,000 × 1.024 × 0.08) – 101,876 = (2,038)
20X7: 103,914

(4) Discount Factor

20X4: 1/(1 + 0.05) (1.02) = 0.9337

20X5: 1/(1 + 0.05) (1 + 0.06) (1.022) = 0.8636
20X6: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07) (1.023) = 0.7911
20X7: 1/(1 + 0.05) (1 + 0.06) (1 + 0.07)2(1.024) = 0.7250

4.2 Decisions are usually said to be subject to uncertainty if the possible outcomes of a decision
are known but the probabilities attaching to each possible outcome are unknown.
Decisions are usually said to be subject to risk if, although there are several possible outcomes
of a decision, these outcomes as well as the respective probabilities attaching to each of these
possible outcomes are known.
The calculations undertaken in part 4.1 have been made under conditions of uncertainty as the
directors do not have details of the probabilities attaching to the two scenarios. So they need
to establish such probabilities and then calculate expected values for each variable (the
arithmetic mean of possible outcomes weighted by the probability of each outcome).
4.3 The concept of ‘real options’ relates to the strategic implications attaching to undertaking a
particular project – the value of such ‘real options’ would not ordinarily be included in a
traditional NPV calculation.
Two obvious ‘real options’ applicable to Brixham’s acquisition of Cabin are as follows:
(1) Follow-on option: For example, the opportunity to add further acquisitions in due course
to gain the benefits of increased economies of scale/market share.
(2) Growth option: For example, the opportunity to broaden the range of services on offer in
due course.

Examiner’s comments
The first question on the paper was a standard investment appraisal question, supplemented by tests
of technical knowledge and its practical application. For the most part, candidates scored strongly on
the first part of the question, the majority clearly being well-drilled in the quantitative techniques
involved in this part of the question. Equally apparent was that the majority of candidates were ill-
equipped in terms of simple technical knowledge to pick up full or even high marks in the second
and third parts of the question, with many scripts scoring zero or at most very low marks on both
parts.
In the first part of the question, probably the most common error was inaccurate calculation of the
inflation-adjusted discount factors. However, there were many instances of full marks.
The second part of the question was a straightforward test of knowledge of elements from the
learning materials, but many candidates were completely unacquainted with them and consequently
there was much waffling and little accuracy and substance to many of the candidates’ responses. In
the final part of the question, many candidates were completely unaware of what a ‘real option’ was
in an investment decision-making context, with many candidates incorrectly interpreting ‘real’ as
meaning after taking account of the effects of inflation, thereby betraying their lack of study of the
learning materials. The last part of the question was of a different character to the second part in that
it was not merely looking for technical knowledge, but also the application of that knowledge to the

ICAEW 2021 Objectives and investment appraisal 147

 scenario in the question and weaker candidates too often simply presented theory rather than
practical application.

5 Frome Lee Electronics Ltd

Marking guide Marks

5.1 Net present value 15

Maximum 15
5.2 Inflation 4
Marks Available 4
Maximum 3
5.3 Diana Marshall note 5
Marks Available 5
Maximum 4
5.4 Real investment options 6
Marks Available 6
Maximum 4
Total 26

5.1 Net present value at 30 September 20X8

T0 T1 T2 T3
£’000 £’000 £’000 £’000
Plant (400.000) 60.000
Tax saved (W1) 12.240 10.037 8.230 27.293
Working capital (W2) (32.000) (5.000) (3.000) 40.000
Sales (W2) 320.000 370.000 400.000
Materials (52.000) (64.000) (70.000)
Labour (26.000) (32.000) (35.000)
Other variable costs (12.000) (14.000) (16.000)
Fixed overheads (11.000) (11.800) (12.700)
Tax on profit (W3) (37.230) (42.194) (45.271)
Total Cash Flows (419.760) 186.807 211.236 348.322
Discount factor (W4) 1.000 0.925 0.855 0.783
PV (419.760) 172.796 180.607 272.736
NPV 206.379

Comments:
The NPV is positive and so Frome should proceed with the investment as shareholder value is
enhanced.

148 Financial Management ICAEW 2021

 WORKINGS
(1)

Cost 400.000 328.000 268.960 220.547

WDA @ 18% (72.000) (59.040) (48.413) (160.547)
WDV 328.000 268.960 220.547 60.000

Tax saved @ 17% 12.240 0.037 8.230 27.293

(2)

Working capital increment 32,000 5,000 3,000 (40,000)

Working capital total 32,000 37,000 40,000
Sales (WC total × 10) 320,000 370,000 400,000

(3)

Sales (W2) 320,000 370,000 400,000

Total costs (101,000) (121,800) (133,700)
Taxable profits 219,000 248,200 266,300

Tax payable @ 17% (37,230) (42.194) (45.271)

(4)

Discount factor (1/1.05/1.03) 0.925

(1/1.05/1.03/1.05/1.03) 0.855
(1/1.05/1.03/1.05/1.03/1.05/1.04) 0.783

5.2 Inflation has to be taken properly into account so that the correct NPV is calculated. Inflation
will have a negative effect on the real value of money and an investor will need to be
compensated for that loss of value. As a result it is important to match real cash flows with real
interest/discount rate. This method can be problematic and so it is preferable, if possible, to
match money (nominal) cash flows, ie, actual cash flows, with an inflated discount rate. This
discount rate is calculated as follows: (1 + m) = (1 + r) × (1 + i), where m = money rate, r = real
rate and i = inflation rate.
5.3 The cost of capital is the cost of funds that a company raises and uses, and the return that
investors expect to be paid (commensurate with the risk exposure) for putting funds into the
company and therefore is the minimum return that a company must make on its own
investments, to earn the cash flows out of which investors can be paid their return.
If a company calculates its cost of capital at too high a figure then it is likely to reject
investment opportunities that it should be taking on (ie, would provide a positive NPV).
In contrast if it sets the cost of capital at too low a level then it is likely to take on investment
opportunities that it shouldn’t be taking on (ie, those with negative NPVs).
Both of these outcomes would be detrimental to shareholder value.
5.4 Follow-on

ICAEW 2021 Objectives and investment appraisal 149

 Launching the Pink ‘Un would give Frome an opportunity to launch further models at a later
date. By investing in this first model, Frome effectively has the right to ‘follow-on’. It is a call
option.
Abandonment
Frome has budgeted to sell the capital equipment for £60,000 in September 20Y1. It may be
that the three-year project does not go as well as hoped and the company might then wish to
abandon it and sell the assets earlier than anticipated. This would be a put option.
These two real options could be taken account of by Frome’s management and would affect
their decision regarding the project, which is otherwise only appraised by calculating its NPV.

Examiner’s comments
This question scored the highest average mark for the paper and was done very well.
The first part was relatively straightforward and most candidates scored high marks. The main errors
were candidates inflating the cash flows (unnecessarily) or getting the discount factor to t2 and t3
incorrect.
The second part was done reasonably well, but too few candidates were able to adequately explain
the reasons for their approach to inflation.
Most candidates failed to explain the meaning of the cost of capital in part 5.3. Otherwise it was
done well.
Part four was generally done well and those candidates who scored well here explained the real
options in the context of the question.

6 Nuts and Bolts Ltd

Marking guide Marks

6.1 Calculation of expected sales 2.5

Initial investment 1
Tax savings 3
Contribution 1
Fixed costs 1.5
Tax on extra profit 1.5
Working capital 2
Discount factor 1
Optimistic contribution 1
Optimistic tax on extra profit 1.5
Average NPV 1
Conclusion 1
Maximum 18
6.2 Calculation of money cost of capital 1
Calculation of difference in contribution 2
Calculation of difference in working capital 3
Maximum 6
Total 24

6.1 Net present value of the NBL 1114 project at 31 March 20X1

150 Financial Management ICAEW 2021

 Pessimistic Optimistic
Annual sales Annual sales
(units) p EV sales (units) p EV sales
6,000 25% 1,500 10,000 25.0 % 2,500
10,000 50% 5,000 12,800 37.5% 4,800
12,800 25% 3,200 12,800 37.5% 4,800
9,700 12,100

Expected sales 9,700 units Expected sales 12,100 units

EITHER
Pessimistic

t0
t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c (W1) 14,688 12,044 9,876 44,992
Contribution (W2) 320,100 320,100 320,100
Fixed costs (W3) (140,000) (140,000) (140,000)
Tax on extra profit (W4) (30,617) (30,617) (30,617)
Working capital (50,000) 50,000
Total cash flows (515,312) 161,527 159,359 244,475
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 146,828 131,631 183,601
NPV (53,252)

Optimistic

t1
t0 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on m/c 14,688 12,044 9,876 44,992
Contribution (W5) 399,300 399,300 399,300
Fixed costs (140,000) (140,000) (140,000)
Tax on extra profit (W6) (44,081) (44,081) (44,081)
Working capital (50,000) 50,000
Total cash flows (515,312) 227,263 225,095 310,4211
Discount factor 10% 1.000 0.909 0.826 0.751
PV (515,312) 206,582 185,928 232,968

ICAEW 2021 Objectives and investment appraisal 151

 t1
t0 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
NPV 110,166

Average NPV ((53,252) + 110,1660)/2 = £28,457

OR
Overall expected sales = (9,700 + 12,100)/2 = 10,900 units

t0 t1 t2 t3
20X1 20X2 20X3 20X4
£ £ £ £
Machine (480,000) 0
Tax saved on
m/c 14,688 12,044 9,876 44,992
Contribution
(@33) 359,700 359,700 359,700
Fixed costs (140,000) (140,000) (140,000)
Tax on extra
profit (W7) (37,349) (37,349) (37,349)
Working capital 50,000
Total cash flows 194,395 192,227 227,343
Discount factor
10% 1.000 0.909 0.826 0.751

PV (515,312) 176,705 158,780 208,285

NPV 28,458

Positive NPV and shareholder wealth increased; therefore, proceed.

WORKINGS
(1) WORKINGS

t0 t1 t2 t3
£ £ £ £
Cost/WDV 480,000 393,600 322,752 264,657
WDA @ 18% (86,400) (70,848) (58,095) (264,657)
WDV 393,600 322,752 264,657 0
Tax @ 17% 14,688 12,044 9,876 44,992

(2) Annual contribution

£33/unit × 9,700 units = £320,100
(3) Annual fixed costs
£300,000 – £160,000 = £140,000
(4) Annual tax on extra profit
(£320,100 – £140,000) × 17% = £30,617

152 Financial Management ICAEW 2021

 (5) Annual contribution
£33/unit × 12,100 units = £399,300
(6) Annual tax on extra profit
(£399,300 – £140,000) × 17% = £44,081
(7) Annual tax on extra profit
(£359,700 – £140,000) × 17% = £37,349
6.2 If inflation is taken into account then money (inflated) cash flows will be matched against NBL’s
money cost of capital, which is 15.5% (1.10 ×1.05).
(1) Contribution – there will be no effect on the NPV of the investment as both the cash
inflows (annual contribution) and the cost of capital will have been inflated by 5% per
annum, which will produce the same present value (allowing for small rounding
differences) in each relevant year.

t1 t2 t3 Total
‘Real’ cash flow (W2) £320,100 £320,100 £320,100
‘Real’ discount factor (10%) (1/1.10) (1/1.102) (1/1.103)
‘Real’ Present Value £291,000 £264,545 £240,496 £796,041

t1 t2 t3 Total
‘Money’ cash flow (inflated) £336,105 £352,910 £370,556
‘Money’ discount factor (1/1.155) (1/1.1552) (1/1.1553)
‘Money’ Present Value £291,000 £264,545 £240,496 £796,041
NPV difference 0

(2) Working capital – the NPV will be affected by the impact of inflation on the working capital
investment as there will be incremental increases to the working capital in the three years
of the project and there will be an inflated working capital figure at the end of the project.

t0 t1 t2 t3 Total
‘Real’ cash flow [see (a)] (50,000) 0 0 50,000 0

‘Real’ discount factor

(10%) 1.000 (1/1.10) (1/1.102) (1/1.103)

‘Real’ Present Value (50,000) 0 0 37,566 (12,434)

t0 t1 t2 t3 Total
‘Money’ cash flow (50,000) (2,500) (2,625) 55,125 0
‘Money’ discount
factor (15.5%) 1.000 (1/1.155) (1/1.1552) (1/1.1553)
‘Money’ Present Value (50,000) (2,164) (1,968) 35,777 (18,355)
NPV difference (5,921)

So the total impact of 5% annual inflation on contribution and working capital will be an NPV
figure that is £5,921 lower.

Examiner’s comments
This question had the highest average mark on the paper and most candidates scored high marks.

ICAEW 2021 Objectives and investment appraisal 153

 This question tested the investment decisions element of the syllabus. The scenario was that of a
manufacturer wishing to introduce a new product to the market and therefore needing to make a
major capital investment.
In the first part, for 18 marks candidates were presented with a lot of information, as in a typical NPV
setting, and were required to calculate the NPV of the proposal. The question was unusual in that
candidates had to calculate the level of customer demand by using expected values. In addition, this
demand was constrained by the fact that the new equipment had a maximum level of output.
Despite this intricacy, candidates could secure a good mark here if they followed the key elements of
an NPV calculation. In the second part, for six marks required candidates to explain the implications
for their NPV calculation in the first part if the contribution and working capital figures were adjusted
to take account of a 5% annual inflation rate.
In the first part most errors related to the expected values calculation with only a small minority of
candidates getting it right. Many candidates ignored the production constraint completely. Despite
these errors the majority of candidates scored high marks.
In the second part, the contribution figure was generally inflated accurately, but too many candidates
only adjusted the final working capital figure, without taking account of the incremental annual
changes. Also, too many candidates failed to make use of a money (inflated) discount rate, which
suggests a real lack of understanding of the impact of inflation on cash flows.

7 Newmarket plc

Marking guide Marks

7.1 Discount factor 1

Equipment cost 1
Incremental unit costs 2
Incremental salary 1
Market research fee 1
Tax 2
Writing down allowance 2
Sale proceeds 1
Price calculation – revenue 1
Price calculation – tax on revenue 1
Price calculation – equation 1
Price calculation – selling price 1
Maximum 15
7.2 1 mark per point 6
Maximum 6
7.3 1 mark per point 6
Maximum 6
7.4 Existence of real options 1
Follow on options 2
Abandonment options 2
Timing option 2
Growth option 2
Marks Available 9
Maximum 8
Total 35

154 Financial Management ICAEW 2021

7.1 The schedule of relevant cash-flows and present values (in £) would be as follows:

Year Item CF 10% df PV

0 Equipment purchase (750,000) 1.000 (750,000)
1–5 Incremental unit costs (W1) (170,000) 3.791 (644,470)
1–5 Tax re: unit costs 28,900 3.791 109,560
1–5 Incremental salary (35,000) 3.791 (132,685)
1–5 Tax re: incremental salary 5,950 3.791 22,556
1 Market research fee (10,000) 0.909 (9,090)
1 Tax re: market research fee 1,700 0.909 1,545
0 WDA (W2) 22,950 1.000 22,950
1 WDA 18,819 0.909 17,106
2 WDA 15,432 0.826 12,747
3 WDA 12,654 0.751 9,503
4 WDA 10,376 0.683 7,087
5 WDA 38,769 0.621 24,076
5 Sale proceeds 50,000 0.621 31,050
(1,278,065)

Alternative presentation (also in £)

0 1 2 3 4 5
Cost (750,000) 50,000
Fee (10,000)
Inc. Costs (170,000) (170,000) (170,000) (170,000) (170,000)
Salary (35,000) (35,000) (35,000) (35,000) (35,000)
Tax 36,550 34,850 34,850 34,850 34,850
WDA 22,950 18,819 15,432 12,654 10,376 38,769
Net (727,050) (159,631) (154,718) (157,496) (159,774) (81,381)
10% 1 0.909 0.826 0.751 0.683 0.621
PV (727,050) (145,105) (127,797) (118,279) (109,126) (50,538)

Total PV = (1,277,895) difference due to rounding discount factors.

If we set price equal to

P:
1–5 Revenue 2,000P 3.791 7,582P
1–5 Tax re: revenue (340)P 3.791 (1,289)P
6,293P

Therefore: 6,293P – 1,278,065 = 300,000

6,293P = 1,578,065
P = £250.77
To the nearest £, Newmarket would need to charge a minimum unit price of £251.

ICAEW 2021 Objectives and investment appraisal 155

 WORKINGS
(1) Incremental unit costs

Incremental unit cost: £

Labour (4 hours @ £12 per hour) 48.00 incremental
Components 32.00 incremental
Loan interest 0.00 dealt with via df
Depreciation 0.00 not a cash-flow
Energy costs 5.00 incremental
Share of Newmarket’s fixed costs 0.00 not incremental
85.00
£85.00 × 2,000 = £170,000

(2) Writing Down Allowances

Tax effect @
Year end 17% Year
£ £
30 June 20X2 Purchase 750,000
WDA @ 18% (135,000) 22,950 0
615,000
30 June 20X3 WDA @ 18% (110,700) 18,819 1
504,300
30 June 20X4 WDA @ 18% (90,774) 15,432 2
413,526
30 June 20X5 WDA @ 18% (74,435) 12,654 3
339,091
30 June 20X6 WDA @ 18% (61,036) 10,376 4
278,055
30 June 20X7 Sale proceeds 50,000
Balancing allowance 228,055 38,769 5

7.2
(1) Sensitivity analysis:
– A way of incorporating alternative forecasts into project evaluation
– Involves taking each uncertain forecast and calculating the change in the variable
necessary for the NPV of the project to fall to zero
– Formula: Sensitivity = NPV of project/PV of cash-flows subject to uncertainty × 100
(2) Simulation (scenario analysis):
– Allows the effect of more than one variable changing simultaneously to be assessed
– Monte Carlo simulation, for example, makes use of random numbers and probability
statistics to evaluate projects armed with a more detailed insight into the nature of risks
and returns
(Reference to expected values would also be rewarded with up to three marks.)
7.3 Systematic risk:

156 Financial Management ICAEW 2021

 Also known as market risk.
It is that element of risk which cannot be eliminated by diversification.
It affects all markets within the economy systematically.
Examples in this (or any such scenario) would be changes in macroeconomic variables, for
example, changes in interest rates, inflation rates, capital allowances or other tax rate changes.
Non-systematic (unsystematic) risk:
Also known as unique or specific risk.
It is that element of risk that can be eliminated by diversification.
It is related to factors that affect the return on individual investments in unique ways.
Examples in this scenario would be a decrease in demand for the product below projections,
unexpected actions of competitors or an increase in component costs.
7.4 NPV only considers the cash flows associated with the NL500 project. It is possible that the
project is worth more than the target NPV of £300,000 because of the existence of real options
associated with the project.
Follow on options
Launching the NL500 gives an opportunity to launch a second (and third and so on) version of
the lawnmower that could be very profitable (or not). The right to invest in later versions is a
call option.
Abandonment option
If the NL500 is a failure then management can terminate the project early and sell the
equipment, giving them a put option.
Timing option
It may be possible to delay the introduction of the NL500, particularly if the demand estimates
are uncertain, effectively a call option. The longer the possible delay the more valuable the
option. Newmarket would need to protect its position, eg, from a competitor establishing a
strong market position, by using patents.
Growth option
If the NL500 is more successful than envisaged, Newmarket have the (call) option to expand
production facilities ie, the opposite of the abandonment option.

Examiner’s comments
Rather surprisingly, this was the lowest scoring question on the paper, which is not something we
normally associate with the investment appraisal question, albeit on a paper with a relatively high
pass rate of 88%. The final stage of the first part of the question proved beyond many candidates,
who up until that point had generally coped well with the standard demands of the question. Parts
two and three proved relatively straightforward for well-prepared candidates, but the failure of many
weak candidates to complement their learning of technique with the acquisition of basic knowledge
led to many of them often sacrificing all 12 of the marks available on these parts of the question.
Overall, the performance in the first part of the question was strong, although where errors were
made the most common ones related to the inclusion and timing of the fee payment, the inclusion of
irrelevant costs and an inability to use the net present value calculation to accurately address the final
stage of the question.
For the most part, well-prepared candidates scored full marks in the second part, but there were still
a surprising number of scripts that missed the opportunity to score strongly, often veering off course
into other areas of the syllabus, notably derivatives, which were not relevant to the precise
requirements of the question.
Although the third part covers an element of the syllabus that is tested relatively infrequently, the
majority of candidates coped well with it, although there were still a significant number of weaker
scripts that displayed a complete misunderstanding of the terms and that were, consequently,
unable to apply them meaningfully to the scenario in the question.

ICAEW 2021 Objectives and investment appraisal 157

8 Grimpen McColl International Ltd

Marking guide Marks

8.1 Equipment cost and residual value .5

Tax saving 2
Income .5
Materials and labour 1
Overheads 2
Lost contribution 1
Tax on extra profit 2
Working capital 2
Discount factor 1
Conclusion 1
Maximum 13
8.2 Calculation of decrease 2
Minimum value of second instalment 1
Maximum 3
8.3 1 mark per point 5
Maximum 5
8.4 Annual surplus from year 4 1
Tax 1
Perpetuity factor 1
Discount to PV 1
Maximum 4
8.5 1 mark per point 5
Maximum 5
Total 30

8.1 Net present value of the dam project at 31 December 20X2

20X2 20X3 20X4 20X5

Year 0 Year 1 Year 2 Year 3
£’000 £’000 £’000 £’000
Machinery (30,000) 5,000
Tax saving (W1) 918 753 617 1,962
Income 10,000 85,000
Materials and labour (W2) (7,280) (8,653) (10,124)
Overheads (W3) (2,600) (3,245) (3,937)
Lost contribution (W4) (4,200) (4,410) (4,631)
Tax on extra profit (W5) (1,700) 2,394 2,772 (11,272)
Working capital (W6) (5,000) (1,240) (1,331) 7,571
Total Cash Flows (25,782) (12,173) (14,250) 69,569
8% factor 1.000 0.926 0.857 0.794

158 Financial Management ICAEW 2021

 20X2 20X3 20X4 20X5
Year 0 Year 1 Year 2 Year 3
£’000 £’000 £’000 £’000
PV (25,782) (11,272) (12,212) 55,238
NPV 5,972

As the NPV is positive GMI should proceed with the investment as this will enhance
shareholder wealth.

WORKINGS
(1)

Year 0 Year 1 Year 2 Year 3

£’000 £’000 £’000 £’000
Cost of machinery 30,000 24,600 20,172 16,541
WDA @ 18% (5,400) (4,428) (3,631) (11,541)
WDV/sale 24,600 20,172 16,541 5,000
Tax saving @ 17% 918 753 617 1,962

(2)

Year 0 Year 1 Year 2 Year 3

£’000 £’000 £’000 £’000
Materials and labour (7,000) (8,000) (9,000)
Inflation @ 4% pa × 1.04 × 1.042 × 1.043
(7,280) (8,653) (10,124)

(3)

Overheads (excluding Head office costs) (2,500) (3,000) (3,500)

Inflation @ 4% pa × 1.04 × 1.042 × 1.043
(2,600) (3,245) (3,937)

(4)

£’000 £’000 £’000

Lost contribution (4,000) (4,000) (4,000)
Inflation @ 5% pa × 1.05 × 1.052 × 1.053
(4,200) (4,410) (4,631)

(5)

Income 10,000 85,000

Materials and labour (7,280) (8,653) (10,124)
Overheads (2,600) (3,245) (3,937)
Lost contribution (4,200) (4,410) (4,631)

ICAEW 2021 Objectives and investment appraisal 159

 Profit/(loss) 10,000 (14,080) (16,308) 66,308
Tax @ 17% on profit/(loss) (1,700) 2,394 2,772 (11,272)

(6)

Year 0 Year 1 Year 2 Year 3

£’000 £’000 £’000 £’000
Total investment (money terms) 5,000
£6,000 × 1.04 (year 1) 6,240
£7,000 × 1.042 (year 2) 7,571 0
(Increase)/decrease in WC (5,000) (1,240) (1,331) 7,571

8.2 For NPV to fall to zero then the second instalment will need to fall by:

£
£5,972,000/0.794/0.83 = (9,061,940)
Estimated second instalment = 85,000,000
Minimum value of the second instalment 75,938,060

8.3 GMI’s money cost of capital already takes into account GMI’s estimated inflation rate. So if the
cash flows are inflated at the same rate then the correct NPV will be calculated.
If the South American inflation rates are higher than predicted then inflate further the money
cost of capital and the estimated cash flows. NPV will not be affected.
However, for the WDA, equipment resale and the second instalment, the NPV will fall as the
money discount rate rises. These are in money terms already.
8.4 Calculations:

£’000
Annual income from 20X6 (Year 4) 5,000
Annual costs from 20X6 (3,000)
Annual surplus from 20X6 2,000
Less tax @ 17% (340)
1,660
Perpetuity factor (1.08/1.03) 4.85%
PV of future cash flows at Year 3 [end 20X5] (£1,660/4.85%) 34,227
Discount to PV (from Year 3 [end 20X5]) × 0.794
PV of future cash flows (minimum selling price of the maintenance contract) 27,176

8.5 Political risk is the risk that political action will affect the position and value of a company.
Candidates’ discussion should be based on the following possible risks:
• Quotas/tariffs/barriers imposed by the overseas government
• Nationalisation of assets by the overseas government
• Stability of the overseas government
• Political and business ethics
• Economic stability/inflation
• Remittance restrictions

160 Financial Management ICAEW 2021

 • Special taxes
• Regulations on overseas investors

Examiner’s comments
This question was a good discriminator between those students who have learned the calculations
and underlying theory by rote and those who really understand the topic.
In general, in the first part, a fairly standard NPV calculation, most candidates scored high marks. The
most common errors were made with regard to working capital investment and the corporation tax
flows.
The second part was done reasonably, but a surprising number of candidates forgot to take taxation
into account in their calculations.
The discursive nature of the third part caught out many candidates – they failed to adequately explain
the impact of using an erroneous inflation rate and therefore to demonstrate that they fully
understood this part of the syllabus. A common error made by candidates was to forget that revenue
from the project was fixed.
The final part was done poorly and too few candidates were able to adequately deal with the
discounting techniques required.

9 Wicklow plc

Marking guide Marks

9.1 Capital allowances 3

Revenue 3
Material costs 2
Lost contribution 3
Labour 2
Working capital 4
Tax 1
NPV calculation 1
Marks Available 19
Maximum 18
9.2 (a) Calculation of selling price sensitivity 4
Maximum 4
(b) Calculation of cost of equity sensitivity 3
Maximum 3
9.3 PV of tax shield 2
APV calculation 2
Maximum 4
9.4 2 marks per valid point 6
Maximum 6
Total 35

9.1 Net present value at 31 December 20X8

20X8 20X9 20Y0 20Y1 20Y2

Investment (2,000,000) 200,000

ICAEW 2021 Objectives and investment appraisal 161

 20X8 20X9 20Y0 20Y1 20Y2
Capital allowances
(W1) 61,200 50,184 41,151 33,744 119,721

DH revenue (W2) 11,725,000 14,147,000 15,561,000 15,561,000

DH material costs
(W3) (6,365,000) (7,679,800) (8,447,400) (8,447,400)
Duo lost contribution
(W4) (2,500,592) (3,016,824) (3,318,208) (3,318,208)
Additional labour
(W5) (167,500) (202,100) (222,300) (222,300)
New manager 35,000 (40,000) (40,000) (40,000) (60,000)
Working capital (W6) (941,700) (194,625) (113,625) 1,249,950
Taxation (17%) (5,950) (450,824) (545,407) (600,626) (597,226)

NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537

df (8%) 1 0.926 0.857 0.794 0.735

DCF (2,851,450) 1,904,451 2,219,969 2,355,171 3,296,870

NPV £6,925,011
The recommendation to the directors should, therefore, be to proceed with the ‘Heritage’
version of the Duo cooker.

WORKINGS
(1) Capital Allowances

Cash flow £ Tax relief @ 17%

Cost 2,000,000
20X8 WDA @18% 360,000 61,200
1,640,000

20X9 WDA @18% 295,200 50,184

1,344,800
20Y0 WDA @18% 242,064 41,151
1,102,736
20Y1 WDA @ 18% 198,492 33,744
904,244
Proceeds 200,000
Bal. Allowance 704,244 119,721

(2) DH Revenue
20X9: 1,500 (0.65) + 2,000 (0.35) = 1,675 × £7,000 = £11,725,000
20Y0: 1,800 (0.65 × 0.7) + 2,000 (0.65 × 0.3) + 2,200 (0.35 × 0.6) + 2,500 (0.35 × 0.4) =
2,021 × £7,000 = £14,147,000
20Y1 and 20Y2: 110% × 2,021 = 2,223 × £7,000 = £15,561,000 pa

162 Financial Management ICAEW 2021

 (3) DH Material Costs
Unit sales × £3,800
20X9: 1,675 units = £6,365,000
20Y0: 2,021 units = £7,679,800
20Y1 and 20Y2: 2,223 units = £8,447,400 pa
(4) Duo Lost Contribution
The effective lost contribution on each Duo = £6,500 – £3,516 = £2,984 as the labour cost
and fixed overheads will still be incurred.
20X9: 838 × £2,984 = £2,500,592
20Y0: 1,011 × £2,984 = £3,016,824
20Y1 and 20Y2: 1,112 × £2,984 = £3,318,208 pa
(5) Additional Labour Costs
The standard Duo product will simply provide half of the labour required to manufacture
the ‘Heritage’ version of the product.
20X9: 1,675 units × 8 = 13,400/2 = 6,700 × £25 = £167,500
20Y0: 2,021 units × 8 = 16,168/2 = 8,084 × £25 = £202,100
20Y1 and 20Y2: 2,223 units × 8 = 17,784/2 = 8,892 × £25 = £222,300 pa
(6) Working Capital

Next year’s
sales value 15%
DH:
20X8 11,725,000 (1,758,750)
20X9 14,147,000 (2,122,050)
20Y0 15,561,000 (2,334,150)
20Y1 15,561,000 (2,334,150)
20Y2 0 0
Duo:
20X8 (5,447,000) 817,050
20X9 (6,571,500) 985,725
20Y0 (7,228,000) 1,084,200
20Y1 (7,228,000) 1,084,200
20Y2 0 0
Net effect:
20X8 (941,700)
20X9 (194,625)
20Y0 (113,625)
20Y1 0
20Y2 1,249,950

(a) To calculate the sensitivity of changes in sales price, it is assumed sales quantity is fixed
and then the relevant cash flows from part 9.1 are considered.

20X9 20Y0 20Y1 20Y2

DH revenue 11,725,000 14,147,000 15,561,000 15,561,000

ICAEW 2021 Objectives and investment appraisal 163

 20X9 20Y0 20Y1 20Y2
Tax on revenue (1,993,250) (2,404,990) (2,645,370) (2,645,370)
Cash flow 9,731,750 11,742,010 12,915,630 12,915,630
df (8%) 0.926 0.857 0.794 0.735
Present value 9,011,601 10,062,903 10,255,010 9,492,988

Total present value = £38,822,502

Sensitivity = 6,925,011/38,822,502 = 17.8%
This means selling price can fall by 17.8% to £5,754 before the decision to invest would
change.
(b) To calculate the sensitivity to the cost of equity, an IRR is required, using the net cash flows
from part 9.1.

NCF (2,851,450) 2,056,643 2,590,395 2,966,210 4,485,537

df (15%) 1 0.870 0.756 0.658 0.572

DCF (2,851,450) 1,789,279 1,958,339 1,951,766 2,565,727

NPV = £5,413,661
IRR for this project = 8 + (6,925,011/(6,925,011 – 5,413,661))(15 – 8) = 40.1%
The cost of equity would need to increase to 40.1% (an increase of almost 400% from its
current level) before the investment decision would change.
9.2 The NPV calculated in 10.1 at £6,925,011 is for an ungeared firm.
The PV of the tax shield (interest = £2m × 0.05 = £0.1m) is calculated as follows:

Time £ per annum df @ 5% PV (£)

1–4 0.1m × 0.17 = 0.017m 3.546 60,282

Therefore the adjusted present value = £6,925,011 + £60,282 = £6,985,293.

9.3 The APV technique is based upon the assumptions of Modigliani and Miller with tax.
That means that issues which may affect the attractiveness of debt finance are not reflected in
the technique:
• Direct and indirect costs of bankruptcy
• Agency costs and covenants
• Tax exhaustion
• Perfect market assumptions eg, risk-free debt
To the extent that any of these assumptions do not hold true, the APV methodology will not
take account of all the potential implications of increased debt within a firm’s capital structure.
There is also a question mark over the appropriate rate at which to discount the tax shield.

Examiner’s comments
Most candidates found the first part of the question to their liking. The initial calculation of expected
values proved largely unproblematic, but common errors among weaker candidates were incorrect
calculation of the lost contribution from the existing product and an inability to calculate accurately
the net working capital impact of the project. In this latter regard, a surprising number of candidates
correctly calculated the impact of the new product, but then failed to deduct the off-setting impact of
the existing product. It was also apparent that a significant number of candidates appear to believe
that it is an effective time-saving tactic not to bother with the calculation of discount factors and/or
the actual discounting of cash flows and simply to say that if the resultant NPV was positive their
recommendation would be to accept the project (or vice versa). Given that marks were explicitly

164 Financial Management ICAEW 2021

 available for both the discount factors and the discounting process itself, this was a potentially costly
omission.
Section 3 and 4, proved to be effective discriminators between stronger and weaker candidates.
Many weaker candidates were unable to make any meaningful attempt, some simply believing that
what was required was to discount the net cash flows calculated in the first section at a discount
factor of 5%. Common errors among candidates who were able to adopt the correct approach were
to use an incorrect annuity factor in the calculation or to use the post-tax cost of debt, but for well
prepared candidates this proved to be easy marks.
Section 4 polarised performance, although unlike in the third section it was the majority rather than
the minority of candidates who struggled. The question required candidates to think laterally across
the syllabus to establish the link to underlying theory. However, many candidates resorted simply to
listing all they knew about the limitations of issues such as WACC and CAPM.
Performance overall was relatively strong on this question with the majority of candidates scoring
well in the first section, although the adjusted present value sections of the question served to
polarise performance.

10 Daniels Ltd

Marking guide Marks

10.1 (a) Reasoning: 1 Figures: 1 2

Maximum 2
(b) Method and figures: 2 Ranking: 1 3
Maximum 3
(c) Method: 1 Calculations: 2 Conclusions and reasoning: 2 5
Maximum 5
10.2 Reasoning: 2 Conclusion: 1 NPV: 1 4
Maximum 4
10.3 Calculations: 4 Limitations: 2 6
Maximum 6
10.4 PV calculations: 3 Conclusion and reasoning: 2 5
Maximum 5
Total 25

10.1
(a) No capital rationing, so choose all projects with a positive NPV, ie:

NPV
£’000
Bristol 577
Swansea 2,856
Tiverton 1,664
Total 5,097

(b) Capital rationing of £8 million on 31/5/X7 (t0). Rank according to NPV/£ invested:

Bristol Cardiff Gloucester Swansea Tiverton

£’000 £’000 £’000 £’000 £’000
NPV (£’000) 577 (1,309) (632) 2,856 1,664

ICAEW 2021 Objectives and investment appraisal 165

 Bristol Cardiff Gloucester Swansea Tiverton
£’000 £’000 £’000 £’000 £’000
Investment t0 4,150 3,870 6,400 5,000 4,600
NPV/£ 0.139 n/a n/a 0.571 0.362
Rank 3 1 2

Therefore choose all of Swansea (£5m investment) and 65.2% (£3,000/£4,600) of Tiverton:

NPV
£’000
Swansea (100%) 2,856
Tiverton (65.2%) 1,085
Total 3,941

(c) No capital rationing at t0 but only £500,000 available at t1:

Bristol Positive NPV and negative funds in t1 So consider further

Cardiff Negative NPV and negative funds in t1 So ignore
Gloucester Negative NPV and positive funds in t1 So consider further
Swansea Positive NPV and negative funds in t1 So consider further
Tiverton Positive NPV and positive funds in t1 So accept unconditionally

If Gloucester is ignored, because it has a negative NPV, then there is £1,790,000 (£500,000
+ 1,290,000 [Tiverton]) available at t1.
Thus choose Swansea (higher ranking than Bristol) and do 68.6% (£1,790/£2,610) of it.
Thus the total NPV would be:

£’000
Tiverton 1,664
Swansea (68.6% × £2,856,000) 1,959
3,623

Alternatively, if Gloucester is considered and its positive t1 cash flow utilised then there is
£3,560,000 capital available (£1,790,000 + £1,770,000) at t1.
Based on the same ranking, for t1 choose 100% Swansea and use the balance (£950,000)
to fund Bristol, ie, (higher ranking than Bristol) and do 73.6% (£950/£1,290) of it. Thus the
total NPV would be:

£’000
Tiverton 1,664
Swansea (100%) 2,856
Bristol (73.6% × £577,000) 425
Gloucester (632)
4,313

Thus it is preferable if the Gloucester project is taken on as this produces the higher total
NPV.
10.2 Capital rationing of £9 million in t0, but projects not divisible:

166 Financial Management ICAEW 2021

 Only choose the projects with positive NPVs, ie, Bristol, Swansea or Tiverton. The highest NPV
is generated from Swansea (and is higher than Bristol and Tiverton added together). Thus the
NPV would be £2,856,000.
10.3 Optimal replacement period:

Eq. Ann
PV factor PV PV factor Cost
£ £ £ £
Replace vans after
one year
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300)
Resale value 9,800
5,500 0.909 5,000
(7,400) 0.909 (8,140)
Replace vans after
two years
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
t2 Maintenance costs (4,800)
Resale value 7,000
2,200 0.826 1,818
(14,491) 1.735 (8,352)
Replace vans after three years
t0 Cost of van (12,400) 1.000 (12,400)
t1 Maintenance costs (4,300) 0.909 (3,909)
t2 Maintenance costs (4,800) 0.826 (3,965)
t3 Maintenance costs (5,100)
Resale value 5,000
(100) 0.751 (75)
(20,349) 2.486 (8,185)

Thus the cheapest option for Daniels is to replace the vans every year as this produces the
lowest Equivalent Annual Cost (EAC). However it should be noted that this is by no means a
clear decision, as a three-year cycle produces only a slightly higher EAC.
Limitations
• Changing technology, leading to obsolescence, changes in design
• Inflation – affecting estimates and the replacement cycles
• How far ahead can estimates be made and with what certainty?
Note: A further limitation is the ignoring of taxation, which the candidates were told to do.
10.4 The PV of the two investments should be considered:

ICAEW 2021 Objectives and investment appraisal 167

 Original
situation Proposed change
Cash 10% Cash 10%
Flow factor PV Flow factor PV

840,82
Year 1–7 190,000 4.868 925,000 Year 1 925,000 0.909 5

The NPV is higher if Daniels maintains the current cash flow profile and so is better off not
accepting Kithill’s proposal. The IRR might be higher by accepting, but the NPV is the key
measure and should be followed.

Examiner’s comments
This question was based on (a) investment appraisal with capital rationing and (b) replacement
analysis. Both of these elements, whilst comprehensive and technical, were straightforward and most
candidates did well. In addition there was a small final part to the question which required
candidates to compare, in effect, net present value and internal rate of return.
As expected most candidates scored full marks for part (a) of the first requirement.
Part (b) of the first requirement was also done well, and most candidates demonstrated how to rank
the projects on the basis of NPV/£ invested.
Part (c) of the first requirement was answered satisfactorily and a good number of scripts
demonstrated how to deal with capital rationing in the second year of the projects.
The second part was answered well, and most students were able to make the right decision.
The third part was also answered well and a good number of students scored full marks for it.
In the final part of the question a majority of candidates gave the correct advice, although few were
able to produce the exact relevant cash flow.

11 Hawke Appliances Ltd

Marking guide Marks

11.1 (a) New machine 1

Tax relief 2
Old machine .5
Tax due 1
Sales, materials, unskilled labour, lost contribution 5.5
Tax on extra profits 1
Working capital 2
Discount factor .5
NPV .5
Advise to proceed as NPV is positive 1
State market research fee is not a relevant cash flow as it is sunk 1
Maximum 16
(b) Sensitivity of sales price 3
Sensitivity of sales volume 4
Maximum 7
11.2 Asset value 1
P/E with current earnings 1

168 Financial Management ICAEW 2021

 Marking guide Marks

P/E with one year of growth 1

Future cash flows/earnings 2
Dividend valuation 1
Reasons why acquisitions do not benefit bidding firm 4
Compare cash and shares 4
Marks Available 14
Maximum 12
Total 35

11.1
(a) Net present value on 31 December 20X4

Y0 Y1 Y2 Y3
£’000 £’000 £’000 £’000
New machine (4,500.000) 1,000.000
Tax relief (W1) 137.700 112.914 92.589 251.797
Old machine 220.000
Tax due (W2) (23.800)
Sales (W3) 8,060.000 15,926.560 7,845.926
Materials (W4) (2,756.000) (5,445.856) (2,682.801)
Unskilled labour (W5) (1,456.000) (2,877.056) (1,417.329)
Lost contribution (W6) (2,288.000) (4,521.088) (2,227.231)
Tax on extra profits (W7) (265.200) (524.035) (258.156)
Working capital (W8) (806.000) (786.656) 808.063 784.593
Total cash flows (4,972.1) 621.058 3,459.177 3,296.799
12% discount factor 1.000 0.893 0.797 0.712
PV (4,972.1) 554.605 2,756.964 2,347.321
NPV 686.790

The NPV is positive and so the investment should go ahead as it will enhance shareholder
wealth.
The market research fee is not a relevant cash flow as it is sunk/committed (candidates
needed to state this to get the mark and not just ignore).
(1)

£’000 £’000 £’000 £’000

Cost/WDV 4,500.000 3,690.000 3,025.800 2,481.156
WDA @ 18%/Bal.
allowance (810.000) (664.200) (544.644) (1,481.156)

WDV/sale 3,690.000 3,025.800 2,481.156 1,000.000

Tax on WDA @ 17% 137.700 112.914 92.589 251.797

(2)

ICAEW 2021 Objectives and investment appraisal 169

 WDV b/f 80.000
Balancing charge 140.000
Sale proceeds 220.000
Tax due on bal. charge @ 17% (23.800)

(3)

Sales units 50,000 95,000 45,000

Selling price/unit £155 ×1.04 £155 ×1.042 £155 ×1.043
Sales 8,060.000 15,926.560 7,845.926

(4)

Sales units 50,000 95,000 45,000

Material cost/unit £53 × 1.04 £53 × 1.042 £53 ×1.043
Materials 2,756.000 5,445.856 2,682.801

(5)

Sales units 50,000 95,000 45,000

Unskilled cost/unit £28 × 1.04 £28 × 1.042 £28 × 1.043
Unskilled costs 1,456.000 2,877.056 1,417.329

(6)

Sales units 50,000 95,000 45,000

Lost contribution/unit ([£96 – £74] × 2) £44 × 1.04 £44 × 1.042 £44 × 1.043
Variable costs 2,288.000 4,521.088 2,227.231

(7)

Extra profit (sales less materials,

unskilled labour, lost contribution) 1,560.000 3,082.560 1,518.565
Tax at 17% 265.200 524.035 258.156

(8)

Sales 8,060.000 15,926.560 7,845.926

Sales increment 8,060.000 7,866.560 (8,080.634)
Working capital at 10% (806.000) (786.656) 808.063 784.593

(b) Calculations:

Sales 8,060.000 15,926.560 7.845.926

Discount rate at 12% × 0.893 × 0.797 × 0.712

170 Financial Management ICAEW 2021

 PV of sales 7,197.580 12,693.468 5,586.299
Total PV of sales 25,477.347
less: Tax at 17% (4,331.149)
21,146.198

Sensitivity of sales price 686.79

21,146.198

= 3.25%

Sensitivity of sales volume

Contribution (£30 × 50 × 1.04) £1,560.000

Contribution (£30 × 95 × 1.04 × 1.04) £3,082.560
Contribution (£30 ×45 × 1.04 × 1.04 ×
1.04) £1,518.565
Discount rate at 12% × 0.893 × 0.797 × 0.712
PV of contribution 1,393.080 2,456.800 1,081.218
Total PV of contribution 4,931.098
less: Tax at 17% (838.287)
4,092.811
Sensitivity of sales volume 686.79
4,092.811
=16.8%

11.2 Calculations and notes:

(1) Possible values for Durram

Asset value (book value) = £3.6m

P/E – with current earnings – 11 × £0.7m = £7.7m
P/E – with one year of growth – 11 × (£0.7m × 1.05) = £8.1m
Future cash flows/earnings (12% discount rate) for PV of future cash flows
(£0.7m × 1.05)/(12% – 5%) = £10.5m
Dividend valuation (no growth) – £0.7m/12% = £5.8m

(2) Reasons why acquisitions do not benefit the bidding firm

The price paid is too high and synergies go to the target shareholders.
Lack of fit within the existing group of companies, so cost savings and synergies are not as
great as forecast.
Transaction costs – underwriting, legal fees etc – are expensive and reduce any gains
made.
Talented staff in the target company may leave.

ICAEW 2021 Objectives and investment appraisal 171

 The takeover/merger may be because of management hubris rather than an increase in
shareholder value.
The subsidiary is too small and does not warrant the management time required.
Conglomerate discount may exist, ie, the individual parts of the business are worth more
than the group as a whole.
(3) Is it better to pay with cash or shares?
Paying in cash
This is more attractive to the target shareholders as the value is certain, but there may be
personal tax implications.
This may cause liquidity problems for the bidding firm and so it may be necessary to
increase its gearing.
Lower transaction costs will arise with a cash purchase.
Paying with shares
There will be a dilution of ownership and any gains made will now be shared with the
target shareholders.

Examiner’s comments
This question had the highest average mark on the paper. Candidate performance was very good.
This was a four-part question that tested the candidates’ understanding of the investment decisions
and valuation element of the syllabus.
In the scenario a UK manufacturer of household appliances was planning (1) the development of a
new product and (2) the possible purchase of an electrical goods retailer. Part (a) of the first
requirement, for 16 marks, required candidates to advise the company’s board, based on an NPV
calculation, whether the proposed product manufacture should proceed. Candidates were required
to deal with relevant cash flows, tax allowances and costs, inflation and working capital. In part 1(b) of
the first requirement, for seven marks, they had to calculate the sensitivity of their calculations to
changes in the proposed selling price and estimated sales volumes. The second part was worth 12
marks and required candidates to calculate a range of values for the target retailer and then provide
guidance for the board on the inherent dangers of buying another company and the best method
with which to pay for it, ie, cash or shares.
In part (a) of requirement 1 most candidates scored well. The main weakness evident was the
opportunity cost calculation, which was either completely ignored (by the weakest candidates) or
halved instead of doubling the lost volume. Also many candidates included calculations regarding
skilled labour, which was not a relevant cost. A number of candidates failed to calculate the
balancing charge arising on the sale of the old machinery.
Part (b) of requirement 1 was generally done well, but a disappointing number of candidates used
contribution rather than sales revenue in their first set of sensitivity calculations.
In the second requirement candidates coped well, as expected, with the book value and P/E
methods of valuation, but many were unsure of themselves (as in previous papers) when valuing the
company based on discounted cash flows. A high proportion of candidates struggled with the
reasons for the failure of acquisitions, but in general the cohort was stronger when explaining the
implications of buying in cash or shares.

12 Alliance plc

Marking guide Marks

12.1 Calculation of net present value:

Contribution per unit 1
Annual sales units 1
Total contribution per year, Year 1 to Year 4 2

172 Financial Management ICAEW 2021

 Fixed costs 1
Annual rent 1
Machinery and equipment 1
Tax 1
Tax saved on capital allowances 2
Working capital flows 3
Use of correct discount rate 1
NPV and conclusion 2
Maximum 16
12.2 Correct contribution figure, after tax 2
Calculation of NPV 1
Correct sensitivity .5
Conclusion 1.5
Marks Available 5
Maximum 4
12.3 Disadvantages of sensitivity analysis – 1 mark per point 3
Disadvantages of sensitivity analysis – 1 mark per point 3
Maximum 6
12.4 (a) Explanation of hard capital rationing 1
Explanation of soft capital rationing 2
Form that is being adopted by Alliance 1
Use of evidence from the scenario 1
Maximum 5
(b) Allocation to combination that yields the highest NPV 1
Determination of best combination 2
Conclusion 1
Maximum 4
Total 35

12.1 Net present value of the Autowater project on 31 December 20X5

0 1 2 3 4
£m £m £m £m £m
Contribution 34.56 41.73 39.44 37.27

Fixed costs (4.00) (4.12) (4.24) (4.37)

Annual Rent (1.50) (1.50) (1.50) (1.50)
Operating cash flows (1.50) 29.06 36.11 33.70 32.90

Tax 17% 0.26 (4.94) (6.14) (5.73) (5.59)

Machinery and equipment (60.00) 5.00

Tax saved on CA’s 1.84 1.51 1.23 1.01 3.76
Working capital (2.00) (0.42) 0.13 0.13 2.16

ICAEW 2021 Objectives and investment appraisal 173

 0 1 2 3 4
£m £m £m £m £m
Net cash flows (61.40) 25.21 31.33 29.11 38.23
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value (61.40) 22.92 25.88 21.86 26.11

NPV 35.37

The project has a positive NPV, and therefore Alliance should accept it.
The contribution per unit = £800 × 0.40 = £320.
The annual sales in units in year one = 9,000 × 12 = 108,000 units.
The total contribution per year =
Year 1: 108,000 × £320 = £34.56m
Year 2: £34.56m × 1.15 × 1.05 = £41.73m
Year 3: £41.73m × 0.90 × 1.05 = £39.44m
Year 4: £39.44m × 0.90 × 1.05 = £37.27m
Working capital:
Year 1: 2.00 × 1.15 × 1.05 = £2.42m. Increment 2.00 – 2.42 = £(0.42)m
Year 2: 2.42 × 0.90 × 1.05 = £2.29m. Increment 2.42 – 2.29 = £0.13m
Year 3: 2.29 × 0.90 × 1.05 = £2.16m. Increment 2.29 – 2.16 = £0.13m
Year 4: Release of working capital £2.16m.
Capital allowances and the tax saved:

Cost/WDV CA Tax
0 60.00 10.80 1.84
1 49.20 8.86 1.51
2 40.34 7.26 1.23
3 33.08 5.95 1.01
4 27.13
Sale –5.00 22.13 3.76

Nominal cost of capital: (1.07 × 1.03) – 1 = 0.1021. 10.21% or 10%

12.2 Calculations:

Contribution X (1 – 0.17) 28.68 34.64 32.74 30.93

PV factors at 10% 0.909 0.826 0.751 0.683
Present Value 26.07 28.61 24.59 21.13
Total present value £100.40

Sensitivity: £35.37m/£100.40m = 35.2%

A 35.2% fall in sales would result in a zero NPV.
Alliance should consider its estimates of future sales, and decide whether it is likely that there
will be a 35.2% drop. This is especially pertinent when there are similar products on the
market, and Alliance’s market share may be eroded to a greater extent than predicted.
12.3 The disadvantages of sensitivity analysis are as follows:
• It assumes that changes to variables can be made independently.

174 Financial Management ICAEW 2021

 • It ignores probability. It identifies how far a variable needs to change to result in a zero NPV,
but it does not look at the probability of such a change.
• It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to addressing the weaknesses of sensitivity analysis.
The main advantage is that it allows the effect of more than one variable changing at the same
time to be assessed. This gives more information about the possible outcomes and their
relative probabilities.
It is also useful for problems that cannot be solved analytically.
However it should be noted that simulation also is not an optimising technique, and does not
point directly to a correct decision.
12.4
(a) There are two types of capital rationing:
Hard rationing is where the external capital markets limit the supply of funds.
Soft rationing is where the firm imposes its own internal constraints on the amount of
funds to be raised and invested in projects.
This investment limit may be used as a surrogate for other constraints, such as insufficient
managerial capacity to handle all positive NPV projects.
Soft rationing may also arise where it is impractical for the firm to go the market and raise
a small amount of finance.
Alliance’s chairman has stated that: “We will continue to see excellent opportunities to
invest in profitable projects across our business and we have no difficulty in raising
finance. However we will be disciplined in our approach to committing to capital
expenditure”. The board of Alliance has chosen to limit the capital expenditure budget
(excluding Autowater) to £350 million. It is therefore apparent that Alliance is employing
soft capital rationing.
(b) The £350 million will be allocated to the combination of projects that yields the highest
NPV by trial and error, since they are indivisible.
The possible combinations are:

Project Initial expenditure NPV

£m £m
A, B, C, D 330 520
A, B, C, E 290 510
B, C, D, E 330 480
A, D, E 340 470

The combination of projects that maximises shareholder wealth is A, B C, D.

Examiner’s comments
This was a four-part question, which tested the candidates’ understanding of the investment
decisions element of the syllabus. The scenario was that a UK company was considering launching a
new product on the market, and also planning additional investment into other projects.
The first part was well answered by many candidates; common errors that weaker candidates made
were failing to calculate annual demand from monthly data, inflating cash flows which had already
been inflated because of price increases, deducting contribution from sales, treating WDAs as
outflows rather than inflows, failing to put rent in advance and using real discount rate for money
flows. All easy things, where errors should have been avoided. The hardest part was WC flows (as
expected). The second part was not well answered by the majority of candidates, with weaker
candidates using sales instead of contribution. Responses to part 3 were mixed and often lacked
detail or included irrelevant material (eg, advantages of sensitivity). In the final part (a) was well
answered by many students; however weaker candidates thought that hard versus soft capital

ICAEW 2021 Objectives and investment appraisal 175

rationing meant the difference between indivisible and divisible projects. However, part (b) had very
mixed and unclear answers, with many candidates using NPV/£ invested, which applies to divisible
rather than indivisible projects. The question clearly stated that the projects were indivisible.

176 Financial Management ICAEW 2021

 Finance and capital structure
13 Turners plc

Marking guide Marks

13.1 (a) Ke 1
Kd 3
Loans 1
WACC 3
Marks Available 8
Maximum 8
(b) Retentions rate 2
Shareholders’ return 1.5
Growth .5
Ke 1
WACC 1
Marks Available 6
Maximum 6
13.2 Degearing equity beta 1.5
Regear asset beta 1.5
Ke 1
State discount rate should reflect systematic risk 1
State discount rate should reflect financial risk 1
Marks Available 6
Maximum 6
13.3 Weighted average beta of enlarged group 1
Ke 1
WACC of enlarged group 1
Implications 3
Capital structure theory 2
Marks Available 8
Maximum 6
13.4 Diversification plans 5
EMH 3
Marks Available 8
Maximum 5
13.5 Project appraisal methodology and discount rate 4
Marks Available 4
Maximum 4
Total 35

13.1
(a) The current WACC using CAPM is calculated as follows: Ke = 2 + 0.60 (8 – 2) = 5.6%
Calculation of Kd
The cost of the debentures – the cost can be calculated using linear interpolation

ICAEW 2021 Finance and capital structure 177

 5% 1%
T0 (108) 1 (108) 1 (108)
T1–4 6 3.546 21.276 3.902 23.412
T4 100 0.823 82.3 0.961 96.1
(4.424) 11.512

IRR = 1%+ (11.512/11.512 + 4.424)(5 – 1) = 3.89% × (1 – 0.17) = 3.23% after tax

Loans have an after-tax cost of 4(1 – 0.17) = 3.32%

Market values:

Equity 233m/0.10 × 276p = £6,431m

Debentures 1,900m × 108/100 = £2,052m
Loans £635m
Total market values £9,118m

WACC = (5.6% × 6,431 + 3.23% × 2,052 + 3.32% × 635)/ 9,118 = 4.91%

(b) The current WACC using the Gordon growth model is calculated as follows:
Calculating growth using the formula r × b.
Retentions rate:
Dividends = share price × dividend yield = 276p × 4.2% = 11.6p
Dividend payout ratio = dividend/ EPS = 11.6/25 = 46.4% ∴ Retentions = 1 – 0.464 = 0.536
or 53.6%
Shareholders return is calculated as follows:
Profit after tax (PAT) = EPS × number of shares in issue = 25p × 233/0.10 = £582.5m
Return = PAT/opg shareholders funds = 582.5/(5,263 – (2,330 × £0.134*)) = 11.77%
*EPS – Dividend: 25p – 11.6p = 13.4p
Growth = r × b = 0.1177 × 0.536 = 0.063 or 6.3%
Ke = (Do(1 + g)/Po) + g = (11.6(1 + 0.063)/276) + 0.063 = 10.77%
Kd and market values as in (a)
WACC = (10.77% ×6,431 + 3.23% × 2,052 + 3.32% × 635)/9,118 = 8.55%
13.2 The cost of equity should be adjusted to reflect the systematic risk of the new project. The beta
factor for the holiday travel industry should be adjusted for gearing. Degearing the equity
beta, ßa = 1.40/(1 + (3(1 – 0.17)/5) = 0.93
Gear up the asset beta to reflect Turners’ gearing:
ße = 0.93 × (1 + (2,687(1 – 0.17)/6,431) = 1.25
The Ke should be = 2 + 1.25 (8 – 2) = 9.5%
With regard to the WACC to be used for the project students should state that the discount
rate should reflect the systematic risk of the project and the financial risk of the company.
13.3 If the diversification goes ahead the cost of equity will reflect the systematic risk of both
divisions.
The weighted average beta of the enlarged group = 1.25 × 0.10 + 0.6 × 0.90 = 0.665
Ke = 2 + 0.665(8 – 2) = 5.99%
The WACC of the enlarged group will be:
(5.99% × 6,431 + 3.23% × 2,052 + 3.32% × 635)/9,118 = 5.18%

178 Financial Management ICAEW 2021

 The implications of a permanent change in the company’s WACC from 4.91% to 5.18% are less
clear. An increase in the WACC is usually associated with reductions in value, on the other
hand assuming that the new project has a positive net present value this could result in an
increase in the market capitalisation.
13.4 The diversification plans may not be welcomed by the market. Portfolio theory tells us that
rational shareholders would hold a well-diversified portfolio and that they might not welcome
the company diversifying. Conglomerate companies often trade at a discount.
13.5 Students should mention that if the gearing changes dramatically then it is not suitable to use
WACC/NPV to appraise the project. Instead APV should be used.
The discount rate will be that of an all equity company using the ßa of 0.93 to reflect the
systematic risk. The discount rate will be = 2 + 0.93(8 – 2) = 7.58%.
This will be used to calculate the base case NPV. This will then be adjusted for the benefits and
costs of the actual way that the project has been financed.

Examiner’s comments
This was a six-part question that tested the candidates’ understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying its activities. The diversification was to be financed in such a way that the gearing of the
company remained unchanged. The first part of the question required candidates to calculate the
current WACC of the company using CAPM and also the Gordon growth model. The second part of
the question required candidates to calculate, using CAPM, the cost of equity to be included in the
WACC that should have been used to appraise the new project. The third part of the question
required candidates to calculate the overall WACC of the company after the diversification. The
fourth part of the question required candidates to discuss whether the company should diversify its
operations. The fifth part of the question required candidates to discuss how the project should have
been appraised assuming that there was a major change in financial gearing of the company. Also
candidates were required to calculate a discount rate that should have been used in these
circumstances.
Part (a) of the first requirement was designed to give a basic eight marks to build on and was set at a
textbook level with no tricks or complications. However, weaker candidates lost many of these marks
by: completely ignoring the cost of a bank loan (two marks) or not deducting tax (one mark);
incorrect calculation of the cost of the redeemable debentures, incorrect interpolation calculations,
incorrect coupon and timing (three marks), correct interpolation but no tax adjustment (one mark);
incorrect equity beta or correct beta but error in computation (one mark).
Part (b) of the first requirement was a discriminator as expected, however many candidates
demonstrated poor knowledge of what a dividend yield is, many students multiplying earnings by
the dividend yield.
In the second part again many basic errors were made: eg, degearing using market values but
regearing using book values, even though the formulae sheet states market values on the key to the
formulae and despite the examiner’s comments regarding March 2014, omitting tax completely from
the computations and poor mathematical ability using beta equations. Also no explanation of what
candidates were doing threw away two marks in this part.
The third part was well answered by many candidates. However in the discursive part of their answers
some candidates mainly discussed capital structure theory.
The fourth part had very mixed responses but flexible marking allowed candidates to pick up two to
three marks.
In the fifth part most candidates mentioned APV but many did not calculate the discount rate
needed.

ICAEW 2021 Finance and capital structure 179

14 Middleham plc

Marking guide Marks

14.1 Earnings in 20W8 1

Dividend in 20W8 1
Dividend growth rate 1
Dividend per share in 20X2 1
Current ex-dividend share value 1
Cost of equity 1
Cost of preference shares 1
Cost of debentures – two present values calculated 2
Cost of debentures – IRR calculation 1
WACC calculation 3
Marks Available 13
Maximum 13
14.2 1 mark per point 5
Marks Available 5
Maximum 5
14.3 (a) Ungear industry beta 2
Regear using Middleham’s data 2
CAPM calculation 1
Marks Available 5
Maximum 5
(b) 1 mark per assumption 3
Marks Available 3
Maximum 2
14.4 1 mark per point 5
Marks Available 5
Maximum 5
14.5 Forms of efficiency (1.5 marks for each) 4.5
Stock exchange regarded as semi-strong form efficient 1
Market reacts to press announcement if semi-strong form 1.5
Market does not react to press announcement if strong form 1.5
Marks Available 8.5
Maximum 5
Total 35

14.1 Cost of equity capital:

Earnings in 20W9 = £0.35 × 6,400,000 = £2,240,000
Dividends in 20W9 = £2,240,000 × 40% = £896,000
Dividend growth rate: 896,000 × (1 + g)4 = £1,088,000
(1 + g)4 = 1,088,000/896,000 = 1.2143
1 + g = ∜1.2143 = 1.0497
g = 5%
Dividend per share in 20X3 (d0) = £1,088,000/6,400,000 = 17p

180 Financial Management ICAEW 2021

 Current ex-dividend share value = £1.42 – £0.17 = 125p
Using the dividend growth model: ke = d0 (1 + g)/p0 + g
= 17(1.05)/125 + 5%
= 19.3%
Cost of preference share capital: = 2.5p/20p
= 12.5%
Cost of debentures:

Year Cash Flow 10% df PV Cash Flow 1% df PV

0 (105) 1.000 (105.00) (105) 1.000 (105.00)
1–10 7 6.145 43.02 7 9.471 66.30
10 100 0.386 38.60 100 0.905 90.50
NPV (23.38) NPV 51.80

IRR = 1% + 51.8/75.18 × 9 = 7.20%

Post-tax = 7.20 × (1 – 0.17) = 5.98%
Weighted Average Cost of Capital:

Total market value

Cost (£’000) WACC
Equity 19.3% 8,000 15.2
Preference shares 12.5% 560 0.7
Debentures 5.98% 1,575 0.9
10,135 16.8

Thus the Weighted Average Cost of Capital = 16.8%

14.2 If this weighted average cost of capital of 16.8% is used in the appraisal of the proposed
investment then the following assumptions must be recognised and if these assumptions do
not hold then the WACC figure has serious limitations if used as a discount factor:
• Historical proportions of debt and equity are to remain unchanged.
• Business risk is to remain unchanged.
• The finance raised is not project specific.
• The project is small in size relative to the size of the company.
Other factors are as follows:
• Is the dividend growth rate sustainable given the lack of track record?
• There could be other sources of finance that have not been considered.
• Future tax rate changes will affect the cost of debt and so the WACC.
• Will the redeemable debentures be replaced by similar funds in 10 years?
14.3
(a) Ungear the equity beta of the industry
1.3= ßa(1 + (1(1 – 0.17)/1))
ßa=0.7104
regear using Middleham’s gearing from part 19.1 (prefs are treated as debt)
ße=0.7104(1 + (2,135(1 – 0.17)/8,000))
ße=0.868

ICAEW 2021 Finance and capital structure 181

 Cost of equity capital = Rf + ß(Rm – Rf) = 6 + 0.868 (14 – 6) = 12.94%
(b) Key assumptions comprise:
(1) The objective of the company is to maximise the wealth of shareholders.
(2) All shareholders hold the market portfolio (they are fully diversified).
(3) Shareholders are the only participants in the firm.
14.4 The increased risk created by issuing more debentures is a financial or gearing risk. The
traditional view of gearing is that at low levels of gearing a company’s WACC will decrease
(because debt is cheaper than equity) – this will cause the value of the company to rise.
However, as gearing becomes a greater proportion of total long term funds, the cost of debt
will start to increase and WACC will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company’s WACC, and therefore value, is not
affected by the level of gearing other than through the effects of tax relief and that this leads to
a fall in WACC and a corresponding increase in the value of the company.
However, at very high levels of gearing bankruptcy costs, tax exhaustion and agency costs can
all cause the cost of debt to increase and, as with the traditional theory, the WACC will start to
rise and the value of the company fall.
14.5 There are three levels of market efficiency:
• Weak form – Share prices reflect information about past price movements and future price
movements cannot be predicted from past movements (Chartism/technical analysis).
• Semi-strong form – Share prices incorporate all publicly available information rapidly and
accurately. The market cannot be beaten by analysing publicly available information.
• Strong-form – Share prices reflect all information whether published or not. Insider dealing
has no value.
• The London Stock Exchange is generally regarded as at least semi-strong efficient.
If the stock market is semi-strong efficient then Middleham’s share price should rise (+NPV
project) or fall (–NPV) when the project is announced to the market eg, in the newspaper, press
release.
If the stock market is Strong-form efficient then Middleham’s share price should remain
unaltered as the +NPV or –NPV will already be reflected in the share price ie, as soon as the
decision is made (unlikely).

Examiner’s comments
A generally very well answered question which was the second highest scoring question on the
paper.
A very common error on this relatively straightforward cost of capital question was a failure to follow
the instructions in the question – many candidates chose to use the Gordon growth model rather
than the dividend growth model – an easy way to lose marks. Other common errors were an inability
to accurately calculate the dividend growth rate from the data provided, errors in calculating market
values in the final WACC calculation and in calculating the cost of debt a number of candidates
betrayed basic misunderstanding by firstly applying one discount rate that produced a negative NPV
and then choosing a larger rather than smaller discount rate for their second choice.
The second to fifth parts were generally well answered.

15 Better Deal plc

Marking guide Marks

15.1 (a) Dividend growth rate 1

Cost of equity 1
IRR 3

182 Financial Management ICAEW 2021

 Market value of equity 1
Market value of debt 1
WACC 1
Marks Available 8
Maximum 8
(b) Cost of equity 1
WACC 1
Marks Available 2
Maximum 2
15.2 New market ungeared beta 2
Better Deal’s geared beta 2
Cost of equity 1
Cost of debt 1
WACC 1
Reasoning for approach – 1 mark per point 4
Marks Available 11
Maximum 11
15.3 1–2 marks per relevant point 8
Marks Available 8
Maximum 8
15.4 Key theories regarding dividend policy 3
Additional comments 3
Relating theory to the scenario 3
Marks Available 9
Maximum 6
Total 35

15.1 WACC based on:

(a) Dividend per share 20Y0 (29.5m/165m) = 17.9 pence
Dividend growth rate = ∜(29.5/25.2) – 1 = 4% p.a.
Cost of equity = d1/MV + g [(£0.79 × 1.04)/£2.65] + 4% = 11%
Cost of debt

Year Cash Flow 5% factor PV 10% factor PV

0 (98.00) 1.000 (98.00) 1.000 (98.00)
1–4 8.00 3.546 28.37 3.170 25.36
4 100.00 0.823 82.30 0.683 68.30
NPV 12.67 NPV (4.34)

IRR = 5% + (12.67/(12.67 + 4.34)) × (10% – 5%) = 8.72%

Post-tax = 8.72 × (1 – 0.17) = 7.24%
WACC

£m

Total market value of equity = (£82.5m/£0.50) × £2.65 = 437.250

Total market value of debt = £340m × 98/100 =

ICAEW 2021 Finance and capital structure 183

 £m

333.200

Total market value 770.450

WACC = (11% × 437.250/770.450) + (7.24% × 333.200/770.450) = 9.37%

(b)

Cost of equity = (1.1 × (11.4% – 5.2%)) + 5.2% = 12.02%

Cost of debt (as above) 7.24%
WACC = (12.02% × 437.250/770.450) + (7.24% × 333.200/770.450) = 9.95%

15.2 New market geared beta = 1.5

New market ungeared beta = 1.5 × 64 / (64 + (31 × 83%)) = 1.5 ×64 /89.73 = 1.07
Better Deal’s geared beta = [1.07 × (£437.25m + (£333.2m × 83%))] / £437.25 = 1.75
So, cost of equity = (1.75 × (11.4% – 5.2%)) + 5.2% = 16.05%
Cost of debt = 9% × 83% = 7.47%
WACC = (16.05% × £437.25m/£770.45m) + (7.47% × £333.2m/£770.45m) = 12.33%
It would be unwise to use the existing WACC (9.37%) as Better Deal’s plan involves
diversification and therefore a change in the level of systematic risk. Thus a new WACC must
be calculated. Systematic risk is accounted for by taking into account the beta of the
petroleum market and this is then adjusted to eliminate the financial risk (level of gearing) in
that market. The resultant ungeared beta is then ‘re-geared’ by taking into account the level of
gearing of the new funds being raised. Using this, the WACC can be calculated.
15.3 CAPM theory is based on the fact that there is one factor that affects the expected return on a
security (or portfolio) and that is systematic risk. This measure of risk is given by the equity beta
of a security (or portfolio).
Multiple factor models are based on the idea that other factors will also determine the return
as there are other aspects of risk attached to securities, not just the market portfolio. Arbitrage
pricing theory states that there are many factors, but it does not state what these factors are.
Some models have been developed which actually state factors, such as the French and Fama
model, which stated that the size of the company (size) and the difference between book and
market values of the shares (value) would also influence the level of returns.
Since their original model, the momentum has been added as a fourth factor which shows the
difference in returns between shares that are increasing in value and those that are decreasing
in value.
Multiple factor models have been designed to get around the problem caused by the
simplicity of the CAPM, but they are complex to understand and the factors are difficult to
identify and quantify.
15.4 Key theories regarding dividend policy:
(1) Traditional view
(2) Modigliani and Miller theory
(3) Residual theory
The key points of these should be expanded to attract a good mark.
Additional areas for comment:
(1) Dividend signalling
(2) Clientele effect
(3) Pecking order
Candidates will also have been given credit for covering these topics.

184 Financial Management ICAEW 2021

 Credit would also be given for (1) relating, where possible, dividend theory to the Better Deal
scenario and (2) producing a cohesive answer.

Examiner’s comments
Most candidates scored well on this question and it had the highest average mark in the paper.
It was based on a supermarket operation and covered the topics of cost of capital and dividend
policy. The first part was worth 10 marks and required candidates to calculate the company’s WACC
based on (a) the dividend growth model and then (b) the CAPM model.
The second part was worth 11 marks and tested the candidates’ understanding of geared and
ungeared betas and required them to calculate the relevant cost of capital for the company to use if
it diversified its operations into a new product range. The fourth part made up six marks and
candidates had to explain the relationship between a company’s dividend policy and the value of its
shares.
Part (a) of the first requirement was pretty straightforward and candidates generally did well.
However, a number of them were unable to calculate the rate of dividend growth correctly and a
disappointing number of candidates calculated the cost of redeemable debentures as if they were
irredeemable.
As expected, most candidates scored full marks for the calculation in part (b) of the first requirement.
The second requirement was more difficult, but many candidates scored well here. However, key
errors made were (1) book values rather than market values were used when re-gearing beta and (2)
too few candidates calculated the new WACC figure as required.
The final requirement was done well and candidates who produced a well-rounded answer will have
scored high marks.

16 Puerto plc

Marking guide Marks

16.1 Operating profit 1

Interest 1
Taxation 1
Marks Available 3
Maximum 3
16.2 Market capitalisation .5
Market value of debt .5
Gearing 30 November .5
No. of shares issued to SMC .5
Total no. of shares in issue .5
Market capitalisation of new share price 1
Market value of debt 1
Gearing 1 December .5
Marks Available 5
Maximum 5
16.3 Relevant discussion 9
Maximum 5
16.4 Cost of equity 1
Cost of debt 1
WACC at 30 November 1
Degear the equity beta 2

ICAEW 2021 Finance and capital structure 185

 Marking guide Marks

Regear the asset beta 2

Cost of equity 1
Cost of debt 1
WACC after 1 December 1
Marks Available 10
Maximum 10
16.5 Relevant discussion 7
Marks Available 7
Maximum 6
16.6 Relevant discussion 10
Marks Available 10
Maximum 6
Total 35

16.1 Income statement for the year to 30 November 20X4

£’000
Operating profit (2,280 + 3,000) 5,280
Interest (24,000 × 6% + 6,000 × 7%) (1,860)
Profit before tax 3,420
Taxation @ 17% (581)
Profit after tax 2,839

16.2 Gearing (debt/equity) by market values at 30 November 20X3:

Market capitalisation: 492 million × 10p = £49.2 million
Market value of debt: £68 million + £6 million = £74 million
Gearing 74/49.2 = 150%
Gearing (debt/equity) by market values after the restructuring on 1 December 20X3:
Number of shares in issue:
Issued to SMC (£68/4) × 30 = 510 million.
Total number of shares in issue = 492 + 510 = 1,002 million.
Market capitalisation at the new share price (10p × 1.35 = 13.5p): 1,002 × 13.5p = £135.27
million.
Market value of debt: Secured bank loans £6 million + Risky Bank £24 million = £30 million.
Gearing 30/135.27 = 22.18%
16.3 Profitability: Puerto has been loss making and the purchase of the additional vehicle leasing
business will make the business profitable.
Financial risk: The interest cover of Puerto before the restructuring is less than one. This
increases to 5,280/1,860 = 2.8 after the restructuring which appears to be reasonable and
should give the markets and stakeholders some comfort.
The 150% gearing of Puerto at 30 November is far in excess of the industry average of 25%
which means that the company is in serious risk of bankruptcy. This improves to 22% after the
restructuring which is below the industry average and should give the markets and
stakeholders confidence. However this is only the case if the share price does increase to

186 Financial Management ICAEW 2021

 13.5p. Puerto may be in danger of breaching SMC’s covenant if the share price does not reach
13.5p. If the share price remains at 10p the gearing will be:
Market capitalisation: 1,002 × 10p = £100.2 million
Debt £30 million
Gearing 30/100.2 = 30%
A gearing ratio of 30% breaches the Risky Bank plc covenant and, depending on the action
taken by Risky Bank plc, could cause problems for Puerto. Any other sensible comment will be
awarded marks.
16.4 The WACC of Puerto at 30 November 20X3:
Ke = 2.8 + 2.13 × 5 = 13.45%
Kd = 7% (non-convertible loans) and
3% (convertible loans)
Note: Since Puerto is not paying tax at this date no adjustment for tax is necessary.
WACC using the weightings previously calculated:
(13.45% × 49.2 + 7% × 6 + 3% × 68)/(49.2 + 74) = 7.37%
The WACC of Puerto at 1 December 20X3 immediately after the restructuring:
Ke. Since the financial risk of Puerto has changed the equity beta will have to be adjusted to the
new gearing level:
Degear the equity beta (Note: No tax adjustment is necessary since Puerto is not paying tax
prior to the restructuring): ßa = 2.13/(1 + (74/49.2)) = 0.8506
Regear the asset beta to calculate Puerto’s new equity beta (Note: Puerto is now paying tax
and tax adjustments are therefore necessary): ße = 0.8506 (1 + (30(1 – 0.17)/135.27)) = 1.007
Ke = 2.8 + (1.007 ×5) = 7.835%
Kd (1-tax) (Note: Puerto is now paying tax): 7%(1 – 0.17) = 5.81% and 6%(1 – 0.17) = 4.98%
WACC = (7.835% × 135.27 + 5.81% × 6 + 4.98% × 24)/(135.27 + 24 + 6) = 7.35%
16.5 Prior to the restructuring Puerto had a very high level of gearing at 150% compared to the
industry average of 25%. Consequently the cost of equity reflected this extreme level of
financial risk.
The traditional view of gearing is that at lower levels of gearing a company’s WACC will
decrease – this will cause the value of the company to rise. However, as gearing becomes a
greater proportion of total long term funds, the cost of debt will start to increase and WACC
will rise too, and the value of the company will fall.
The view of Modigliani and Miller (1963) is that a company’s WACC and therefore value is not
affected by the level of gearing other than through the effects of tax relief and that this leads to
a fall in WACC and a corresponding increase in the value of the company. However, at Puerto’s
very high level of gearing bankruptcy costs, tax exhaustion and agency costs can all cause the
cost of debt to increase and, as with the traditional theory, the WACC will start to rise and the
value of the company fall.
Now Puerto has a more normal level of gearing at 22% the WACC should now remain around
7.35%. Any other sensible comment will be awarded marks.
16.6 Prior to the restructuring Puerto is very highly geared at 150% and is also not profitable. The
various stakeholders’ reaction to the restructuring is likely to be:
• Shareholders: Shareholders have limited liability and may be tempted to take risks.
However in this case the shareholders have not received dividends since 2008 and the
share price has only recently risen. This may be because the industry has stabilised but also
may be in anticipation of a restructuring. Shareholders are likely to welcome the
restructuring since there is a very real possibility of increasing their wealth through dividend
income and capital gains. However the shareholders may be concerned about the change
in control due to the new shares issued to SMC.
• SMC: SMC was in a very vulnerable position before the restructuring since interest cover
was below one and there was a very real possibility of the company being unable to meet
interest payments. Since the loan was unsecured SMC would be uncertain as to how much

ICAEW 2021 Finance and capital structure 187

 it might receive if Puerto was wound up. Converting their loan to equity means that with the
company now profitable there is a very real chance of them realising their investment.
• Risky Bank plc: Risky Bank plc are secured and since the interest cover is now more
substantial at 2.8 and gearing is below the industry average, assuming a share price of
13.5p, the company is on a sound financial footing. The same comments apply to the
original secured bank loans.
• Employees: Employees should welcome the restructuring since the company now has a
much more certain future and they will feel more confident about keeping their jobs.
• Suppliers: Suppliers will also welcome the restructuring since Puerto will now be more likely
to continue and they will not lose the business that it creates for them.
• Customers: Customers of Puerto will be pleased that the company is now on a sound
financial footing and that it will be able to provide them with services in the future.
• Government: Puerto will now be paying tax.
Any other sensible point will be given marks.

Examiner’s comments
The scenario of this question was that a company had been in difficulty and was considering a
reconstruction, whereby debt would be converted to equity. The company would then purchase an
additional business opportunity, which would be financed by new borrowings.
The first part, for three marks, required candidates to restate the income statement in 12 months’
time assuming that the reconstruction went ahead. The second part, for five marks, required
candidates to calculate the gearing ratio, by market values, both before and immediately after the
reconstruction. Part three, for five marks required candidates to comment upon the financial health of
the company both before and after the reconstruction. Also candidates had to consider a covenant
imposed by the providers of the finance for the new business. Part four, for 10 marks, required
candidates to calculate, using the CAPM, the WACC of the company both before and after the
reconstruction. This involved adjusting the equity beta for gearing and consideration of taxation. The
fifth part, for six marks, required candidates to consider, with reference to relevant theories, how the
reconstruction would affect the WACC in the long term. The final part, for six marks, required
candidates to consider the likely reaction to the reconstruction of various stakeholders in the
company.
The first part was well answered by the majority of candidates. However it was disappointing to see
that some candidates did not really demonstrate a full understanding of the scenario and also
included the interest in the income statement for the loan which had been converted to equity.
The majority of candidates answered part two well, however some candidates failed to understand
the scenario and showed gearing increasing rather than decreasing, whereas a correct interpretation
of the facts would show a substantial decrease.
Part three was reasonably well answered, however those who had misinterpreted the question
scored poorly.
In part four many candidates did not take account of the fact that the company was not paying tax
until after the reconstruction. When taking into account the effect of the change in gearing on the
equity beta, weaker candidates showed that they need to practise gearing adjustments.
In part five a lot of candidates gave a generic answer and did not relate to the scenario of the
question.
The final part was well answered and many students identified a sufficient number of stakeholders.

17 Abydos plc

Marking guide Marks

17.1 Capital allowances/tax saving 2

Base case NPV

188 Financial Management ICAEW 2021

 Financing side effects
Give credit for technique
Marks Available 2
Maximum 10
17.2 Reward sensible discussion 6
Bonus mark for mention of real options
Marks Available 6
Maximum 6
17.3 Discussion of crowdfunding and P2P lending 6
Maximum 8
17.4 Discussion of data analytics 8
Maximum 6
17.5 Discussion of market efficiency and electronic share trading platforms 5
Maximum 5
Total 35

17.1 Expected APV

To calculate the base case NPV, the investment cash flows are discounted at the ungeared cost
of equity, assuming the corporate debt is risk free (and has a beta of zero).

E
E + D(1−t)
ßa= ße

0.6
0.6 + 0.4(1−0.17)
= 1.4 × = 0.901
The ungeared cost of equity can now be estimated using the CAPM:
Keu = 5 + 0.901(12 – 5)
= 11.31% (say, approximately 11%)
Capital allowances
These are on the £10 million part of the investment that is non-current assets (not working
capital or issue costs).

Capital allowance Tax saving

Year Value at start of year 18% 17%
£’000 £’000 £’000
1 10,000 1,800 306
2 8,200 1,476 251
3 6,724 1,210 206
4 5,514 993 169

Year 0 1 2 3 4
£’000 £’000 £’000 £’000 £’000
Pre-tax operating cash flows 3,000 3,400 3,800 4,300
Tax @ 17% (510) (578) (646) (731)
Tax savings from capital
allowances 306 251 206 169

ICAEW 2021 Finance and capital structure 189

 Year 0 1 2 3 4
£’000 £’000 £’000 £’000 £’000
Investment cost (11,500)
Issue costs
After tax realisable value 4,000
Net cash flows (11,500) 2,796 3,073 3,360 7,738
Discount factor 11% 1.000 0.901 0.812 0.731 0.659
Present values (11,500) 2,519 2,495 2,456 5,099

The expected base case net present value is £1,069,000.

Financing side effects
Issue costs
£1 million, because they are treated as a side-effect they are not included in this NPV
calculation.
Present value of tax shield
Debt issued by project = £5m
Annual tax savings on debt interest = £5m × 8% × 17% = £68,000
PV of tax savings for four years, discounted at the gross cost of debt 8%, is:
£68,000 × 3.312 = £225,216

( ( ) = 3.312)
1 1
1−
0.08 1.084

£’000
Adjusted present value
Base case NPV 1,069
Tax relief on debt interest 225
Issue costs (1,000)
294

The adjusted present value is £294,000.

17.2 Validity of the views of the two directors
Sales director
The sales director believes that the net present value method should be used, on the basis
that the NPV of a project will be reflected in an equivalent increase in the company’s share
price. However, even if the market is efficient, this is only likely to be true if:
• the financing used does not create a significant change in gearing (finance ratio × current
gearing so gearing may change).
• the project is small relative to the size of the company.
• the project risk is the same as the company’s average operating risk (but different line of
business).
Finance director
The finance director prefers the adjusted present value method, in which the cash flows are
discounted at the ungeared cost of equity for the project, and the resulting NPV is then
adjusted for financing side effects such as issue costs and the tax shield on debt interest. The
main problem with the APV method is the estimation of the various financing side effects and

190 Financial Management ICAEW 2021

 the discount rates used to appraise them. The ungearing process assumes risk free debt (5%)
which it is not as it costs 8%.
Problems with both viewpoints
Both methods rely on the restrictive assumptions about capital markets which are made in the
capital asset pricing model and in the theories of capital structure. The figures used in CAPM
(risk-free rate, market rate and betas) can be difficult to determine. Business risks are assumed
to be constant.
Neither method attempts to value the possible real options for abandonment or further
investment which may be associated with the project.
17.3 Crowdfunding allows a company to access finance by using an online crowdfunding platform
to pitch for finance from a large number of investors.
A successful crowdfunding pitch requires an attractive business plan that reassures prospective
investors about the prospects for the proposed product, and also about the quality of the
management team (ie, their skills and experience). As a listed company with a low gearing
ratio, Abydos appears to be in a strong position to expand and should be able to formulate a
strong business plan. Crowdfunding could be a suitable source of finance to fund the new
brewery, although investors may be concerned about whether the current management team
has the skills and experience required to make a success of this move. Abydos could approach
its key corporate customers to gauge if they would be interested in investing in the new
venture. By involving a large number of investors, crowdfunding could also help Abydos to
attract new customers and to build awareness of the company.
Peer-to-peer (P2P) lending connects businesses who are looking to borrow with investors who
want to lend, via an online platform.
Platforms usually require borrowers to have a trading track record, to submit financial
accounts, and will perform credit checks as part of the credit assessment. Given that Abydos
has a successful trading history as a listed company, it would appear to be an attractive
investment.
Investors can lend small parts of individual loans, which encourages a wide range of lenders to
participate in multiple loans. However, P2P loans can also be for large loans of several million
pounds. The capital cost of the establishing the new brewery is £12.5 million. P2P lending
would only be possible if there is access to a large enough group of lenders willing to invest in
the company.
P2P lending can offer quite a few advantages to borrowers such as competitive interest rates,
flexible terms and a fast and convenient online application process. Given that there is some
uncertainty over the expected operating cash flows to be generated by the brewery, keeping
the cost of financing the investment as low as possible will ease pressure on bottom line
margins.
17.4 The senior management team could make use of both predictive and prescriptive analytics to
help improve forecasting for the new brewery.
Predictive analytics
The increasing use of Big Data within organisations has created new forms of data that can be
used to create predictions and opportunities for identifying new types of trends to understand
how the organisation may be affected by future events. Abydos could consider, for example,
the use of linear regression, decision trees, or simulation.
Regression analysis is a statistical tool used to understand and quantify the relationship
between two variables, and it is used by management to help forecast things such as the
expected future demand for their products. Abydos could use regression analysis to forecast
sales of the new craft beer (the dependent variable) based on economic growth (the
independent variable). For example, if past data indicates that the growth in beer sales is one
and a half times the growth in the economy, this can be used to more accurately forecast the
revenue generated by the new brewery.
Decision trees are a predictive analytics technique that can be used to identify the impact of
different decisions and variables on the outcome of an investment. Decision trees can be used
to consider multiple decisions plus the impact of real options such as follow-on decisions. This
is important to Abydos given that it is investing in a significantly different line of business to its
existing operations. Decision trees could be used to consider the best, most likely and worst

ICAEW 2021 Finance and capital structure 191

 case scenarios for variables such as customer demand and the costs of the various ingredients
needed for different types of brews.
Simulation is a technique which allows the effect of more than one variable changing at the
same time to be assessed. The senior management team could therefore assess the impact on
the investment if the costs of different ingredients such as malt, hops and yeast all increase at
the same time.
Prescriptive analytics
By combining the statistical tools utilised in predictive analytics with artificial intelligence and
algorithms, prescriptive analytics software can be used to calculate the optimum outcome from
a variety of business decisions.
For Abydos, this could include identifying the optimal production level for producing the beer,
considering various factors such as expected customer demand, supplier lead times and the
use of machine learning within the main brewing process.
17.5 There are three levels of market efficiency:
The London Stock Exchange is generally regarded as at least semi-strong efficient. If the stock
market is semi-strong efficient then Abydos’s share price should rise (+NPV project) or fall (–
NPV) when the project is announced to the market eg, in the newspaper, or via a press release.
If the stock market is strong-form efficient then Abydos’s share price should remain unaltered
as the +NPV or –NPV will already be reflected in the share price ie, as soon as the decision is
made (however this is unlikely).
The ability of investors to research different companies and to trade in shares has been made
easier by the emergence of electronic share trading platforms.
Investors can buy and sell shares via a mobile app which offers real-time prices and regular
updates on selected companies and market movements overall. Automatic trading enables
rapid share trading in response to events alerted to the investor via their chosen trading app.
This can be argued to increase efficiency.
However, the emergence of electronic share trading platforms can lead to stock market
volatility if news leads to a number of investors all taking the decision to buy (or sell) shares at
the same time. The resulting volatility can reduce the efficiency of the stock market in terms of
its ability to price shares accurately.

18 Biddaford Lundy plc

Marking guide Marks

18.1 Total funds calculations 1

Total geared funds 1
Gearing calculation 2
One mark per relevant point 5
Marks Available 9
Maximum 9
18.2 Rights issue calculations 2
Theoretical ex-rights price 1
Value of a right per new share 1
Marks Available 4
Maximum 4
18.3 Current EPS 1
Current P/E ratio 1
Interest savings 2
New EPS 1
New P/E ratio 1

192 Financial Management ICAEW 2021

 Marking guide Marks

Reduction in EPS 1
Relevant discussion 3
10
18.4 Amended EPS 1
Ordinary shares required 1
Number of shares in rights issue 1
Rights issue price 1
Relevant discussion on rights issue success 2
Marks Available 6
Maximum 6
18.5 1–2 marks per relevant point made 6
Marks Available 6
Maximum 6
Total 35

18.1 BL’s gearing ratio:

Gearing level Par value Market value

£m £m
Ordinary share capital (50p) 67.50 (135m × £2.65) 357.75
Retained earnings 73.20
7% Preference share capital (£1) 60.00 (60m × £1.44) 86.40
4% redeemable debentures
(20X7 45.00 (45m × 0.9) 40.50
Total funds 245.70 484.65

Total geared funds (£m) 105.000 126.90

Gearing % 1 (Gearing/Total
Funds) 42.7% 26.2%
Or
Gearing % 2 (Gearing/Equity) 74.6% 35.5%

Traditional view
Loan finance is cheap because (a) it is low risk to lenders and (b) loan interest is tax deductible.
This means that as gearing increases, WACC decreases.
Shareholders and lenders are relatively unconcerned about increased risk at lower levels of
gearing.
As gearing increases, both groups start to be concerned – higher returns are demanded and
so WACC increases.
Thus, WACC decreases (value of equity increases) as gearing is introduced. It reaches a
minimum and then starts to increase again. This is the optimal level of gearing.
Modigliani and Miller (M&M) view
Shareholders immediately become concerned by the existence of any gearing.
Ignoring taxes, the cost of ‘cheap’ loan finance is precisely offset by the increasing cost of
equity, so WACC remains constant at all levels of gearing. There is no optimal level – managers
should not concern themselves with gearing questions. M&M ‘58 position Vg = Vu.

ICAEW 2021 Finance and capital structure 193

 Taking taxation into account, interest is cheap enough to cause WACC to fall despite
increasing cost of equity. This leads to an all-debt-financing conclusion. M&M ‘63 position Vg =
Vu + DT (Tax shield).
Modern view
M&M are probably right that gearing is only beneficial because of tax relief.
At high levels of gearing, investor worries about the costs of the business going into enforced
liquidation (‘bankruptcy’) become significant and required returns (both equity and debt)
would increase at high levels of gearing.
Conclusion: A business should gear up to a point where the benefits of tax relief are balanced
by potential costs of bankruptcy and interest rate increases – here WACC will be at a minimum
and value of the business at a maximum.
Presumably the directors feel that the current level of gearing is beyond the optimum ie, where
the WACC is minimised and the company’s value is maximised (perhaps because as an
engineering company its operational risk is very high and gearing adds additional financial
risk). Alternatively, they are incorrectly looking at the book value gearing ratio, as the market
value ratio doesn’t look particularly bad.
18.2

£m
Value of current ordinary shareholding 135m £2.65 357.750
Rights issue (135m/9) (£45m × 60%) 15m £1.80 27.000
Theoretical ex-rights values 150m £2.565 384.750

Theoretical ex-rights share price [TERP]

(£384.75m/150m) £2.565
Value of a right (£2.565 – £1.800) per new
share £0.765
OR per existing share £0.765/9 = £0.085

18.3

Current earnings per share (EPS) £32.4m/135m £0.240

Current P/E ratio £2.65/£0.24 11.04

£m
Current earnings figure 32.400
Savings on debenture interest (£45m × 60% × 4%
× 83%) 0.896

Amended earnings figure 33.296

New EPS £33.296m/150m £0.222
New P/E ratio (using TERP) £2.565/£0.222 11.55

The earnings per share figure will fall by 7.5% (from £0.240 to £0.222).
The proposed rights issue will, as the board suggests, cause a dilution of the EPS figure as the
additional shares issued have a greater negative impact than the interest saved from the
debenture redemption. Whilst in theory (TERP) the market price of BL’s ordinary shares will fall,
at least initially, it is very difficult to predict what will happen to the market value of the shares

194 Financial Management ICAEW 2021

 in practice. As gearing is being reduced the market may react favourably (ie, there would be a
share price increase). However, based on market values the gearing level is currently not high
(26.2% or 35.5%), and so the market may react negatively (ie, there would be a share price
decrease) if it considers that insufficient use is being made of the tax savings that gearing
affords.
18.4

Current earnings per share (EPS) £32.4m/135m £0.240

Amended EPS (with a 5% reduction) £0.24 × 95% £0.228
New earnings figure £33.296m
Thus required total ordinary shares ex-rights £33.296/£0.228 146.035m
146.035m –
New shares to be issued via rights 135.000m 11.035m
£27.000m/11.035
Rights issue price per share m £2.45

This rights issue price is only £0.20 less than the current market value, ie, a 7.5% discount and
this is likely to be an insufficient inducement for shareholders. As a result the issue would fail to
raise the £27 million of funds required for the debenture redemption.
18.5 Issue costs are a significant part of a rights issue. They have been estimated at around 4% on
£2 million raised but, as many of the costs are fixed, the percentage falls as the sum raised
increases.
Shareholders may react badly to firms who continually make rights issues as they are forced
either to take up their rights or sell them, since doing nothing decreases their wealth. They may
sell their shares in the company, driving down the market price.
Unless large numbers of existing shareholders sell their rights to new shareholders there
should be little impact in terms of control of the business by existing shareholders.
Unlisted companies often find rights issues difficult to use, because shareholders unable to
raise sufficient funds to take up their rights may not have available the alternative of selling
them if the firm’s shares are not listed. This is less likely to be a concern for a listed company
like Biddaford Lundy.

Examiner’s comments
This question was, overall, done poorly and produced the weakest set of answers in the examination.
In general, the first part was not done well. The book value of equity often excluded retained
earnings. When calculating the market value, a majority of candidates included retained earnings in
the equity figure. Very few of them could calculate the gearing ratio correctly – far too many included
preference shares as equity. In the discursive part of the answer, some candidates made no reference
to the theories on capital structure at all and some referred to the ‘Modigliani and Miller traditional
theory’. Disappointingly, very few candidates made reference to the ratios that they had calculated
(high/low gearing level etc).
Answers to the second part were better and the most common mistake was to confuse the market
value and the book value of debt when calculating the redemption figure.
The third part was very poorly answered. The vast majority of candidates ignored the reduction in
interest post-redemption. Also, far too many candidates restricted their discussion to a consideration
of the impact of the rights issue on the shareholders’ wealth. This was not relevant to the question,
which was about gearing.
In the final part there were some good attempts, but often candidates’ answers just consisted of
identifying a 5% fall in EPS.

ICAEW 2021 Finance and capital structure 195

19 BBB Sports plc

Marking guide Marks

19.1 (a) Calculation of WACC using CAPM:

Cost of equity 1
Cost of debt:
Use of ex interest debenture price 1
PV calculation 1
IRR calculation 1
Post-tax cost of debt 1
Ex-div share price 1
Market value of equity .5
Market value of debt .5
WACC calculation 1
Marks Available 8
Maximum 8
(b) Calculation of WACC using Gordon growth model:
Earnings per share 1
Proportion retained 1
Total earnings .5
Calculation of ARR 1.5
Growth rate .5
Cost of equity 1
WACC calculation .5
Marks Available 6
Maximum 6
19.2 Suitable WACC for appraising Climbhigh:
Commentary on use of appropriate equity beta 2
Degearing and regearing calculations 2
Degearing and regearing calculations 1
Revised WACC 1
Marks Available 6
Maximum 6
19.3 Overall WACC of BBB if Climbhigh goes ahead:
Overall equity beta 1
Overall cost of equity 1
Overall WACC 1
Appropriate commentary upon implications 3
Marks Available 6
Maximum 6
19.4 Political risk areas – 1 mark per point 4
Ways of limiting the effects of political risk factors 4
Marks Available 8
Maximum 6
19.5 Ethical considerations – 1 mark per point 3
Marks Available 3

196 Financial Management ICAEW 2021

 Marking guide Marks

Maximum 3
Total 35

19.1
(a) The current WACC using CAPM.
Ke = 2 + (1.1 × (7 – 2)) = 7.5%
Kd = The ex-interest debenture price is £94 (99 – 5).

Factors at Factors at
Timing – years Cash Flow 5% PV 10% PV
£ £ £
0 (94) 1 (94) 1 (94)
1–4 5 3.546 17.73 3.170 15.85
4 100 0.823 82.30 0.683 68.30
6.03 (9.85)

IRR = 5 + (6.03/(6.03 + 9.85)) ×5 = 6.90%

Kd = 6.90 × (1 – 0.17) = 5.73%
The ex div share price is 360p – 10p = 350p.
The market value of equity is: 350p × (365m/0.20) = £6,387.50m
The market value of debt is: £2,200m × (94/100) = £2,068m
The debt/equity ratio is: 0.24:0.76.
The current WACC is: (5.73 × 0.24) + (7.5 × 0.76) = 7.1%
(b) The current WACC using the Gordon growth model.
The growth rate is calculated using r × b:
Earnings per share = Share (ex div) × earnings yield = 350p × 0.07 = 24.5p.
The proportion of profits retained (b) = (24.5 – 10)/24.5 = 59%
Total earnings = EPS × the number of shares in issue = 24.5p × 1,825m = £447m (The
number of shares in issue = £365m/£0.20 = 1,825m)
The accounting rate of return (r) = £447m/ [£5,153 – (1,825m × £0.145)]m = 9.1%
The growth rate is: 0.091 × 0.59 = 0.054 or 5%
Using the Gordon growth model Ke = ((10 × 1.05)/350) + 0.05 = 0.08 or 8%
WACC = (8 × 0.76) + (5.73 × 0.24) = 7.46%
19.2 The gearing of BBB will be unchanged after the diversification and it is therefore appropriate
to apply the existing gearing ratio of debt:equity 0.24:0.76 in the calculation of the WACC to
be used to appraise the Climbhigh project.
However, the cost of equity to be included in the WACC calculation should reflect the
systematic risk of the climbing wall industry. This can be achieved by using an appropriate
equity beta in the CAPM. An equity beta for a company operating in the climbing wall industry
is 1.90, but the company has a different gearing ratio to BBB and gearing adjustments will
have to be made.
Degearing the equity beta: Ba = 1.90 × (6/(6 + 4 (1 – 0.17)) = 1.22
Regearing using BBB’s gearing ratio Be = 1.22 × ((0.76 + 0.24(1 – 0.17))/0.76) = 1.54
Ke = 2 + (1.54 (7 – 2)) = 9.7%
The appropriate WACC to appraise the project is:

ICAEW 2021 Finance and capital structure 197

 (9.7 × 0.76) + (5.73 × 0.24) = 8.75%
19.3 The overall equity beta of BBB if it undertakes the Climbhigh project will be:
(1.10 × 0.80) + (1.54 ×0.20) = 1.19
The overall Ke will be: 2 + (1.19 × (7 – 2 )) = 7.95%
The overall WACC will be: (7.95 × 0.76) + (5.73 × 0.24) = 7.42%
The overall WACC (using CAPM) excluding the Climbhigh project was 7.1% and with the
project it is 7.42%.
This is not a material change in the company’s WACC and, considering the discount rate alone,
there should not be any material reduction in the company’s value.
However, the actual effect will depend on the market’s view of the diversification.
19.4 BBB is considering investing in other countries, some of which are developing countries. BBB
could face the political risk of action by a country’s government, which might restrict its
operations. If a government tries to prevent the exploitation of its country by BBB, it may take
various measures including:
• Quotas: Limiting the quantities of goods that can be bought from BBB and imported.
• Tariffs: A tariff on goods imported by BBB, thereby making locally produced goods more
competitive.
• Non-tariff barriers: Legal standard of safety or quality could be imposed on BBB.
• Restrictions: Restricting BBB from buying other climbing wall companies.
• Nationalisation: A government could nationalise foreign-owned companies and their
assets.
• Minimum shareholding: A government could insist on a minimum shareholding in
companies by residents.
BBB can limit the effects of political risk by:
• Negotiations with the host government: The aim of such negotiations is to obtain a
concession agreement.
• Insurance: In the UK the Export Credits Guarantee Department provides protection against
various threats.
• Production strategies: It may be necessary to strike a balance between contracting out to
local sources and producing directly.
• Management structure: Possible methods include joint ventures or ceding control to local
investors.
19.5 The finance director should disregard the suggestion made by the contractor.
He should act with integrity and not be corrupted by self-interest, or the interests of other
parties.
He should be objective in his dealings with the contractor, and not be influenced by his
assertion that it is acceptable to disregard safety standards and cut corners.

Examiner’s comments
This was a five-part question that tested the candidates’ understanding of the financing options
element of the syllabus. The scenario of the question was that a company was considering
diversifying into a different industry sector. The diversification would have been in non-domestic
countries, some of which would be in developing countries.
Part (a) of the first requirement saw many basic errors, which really should not be occurring given
how many times this has been set. The errors included inability to calculate numbers correctly,
incorrect use of the CAPM equation, incorrectly calculating the number of shares in issue, not
calculating the ex-div share price and/or the ex-interest debenture price, for the cost of debt
calculating positive and negative values and interpolating outside the range calculated and no tax
adjustment for the cost of debt. Again there were many basic errors in part (b) of the first
requirement, despite very similar questions in the revision question bank, many had no idea at all.
However there were some good answers, but even those forgot to correctly calculate the retained

198 Financial Management ICAEW 2021

profits. Many students calculated unrealistic growth figures and blindly used them with no reality
check.
The second part was often confused with the third part. No reality checks again, with some students
clearly demonstrating that they have a very shallow knowledge of the topic; errors included
calculating unrealistic equity betas, eg, Beta = 20.485, degearing using MV and regearing with BV
despite the formulae sheet clearly stating MV should be used, degearing and regearing with same
debt/equity ratio and ending up with a different figure from the original. Explanations were very
brief. Despite this being set before and there being a detailed example in the Workbook, the third
part saw very poor attempts by most candidates. Candidates’ explanations of the relationship
between the value of the company and the discount rate were very poor.
Answers to the fourth part were fine when they talked about political risk as required, but weaker
candidates just talked about foreign exchange and hedging, or focussed on climbing wall
regulations. Answers to the final part were fine where they used the language of ethics, but many just
stated that it was unethical because it was unethical. Many candidates incorrectly thought that this
was a money laundering issue.

ICAEW 2021 Finance and capital structure 199

200 Financial Management ICAEW 2021
 Business valuations, plans, dividends and
growth
20 Cern Ltd

Marking guide Marks

20.1 (a) Freehold land and property adjustment 1

Investments adjustment 1
Preference shares adjustment 1
Debentures adjustment 1
Net assets value per share 1
Calculation of dividend per share 1
Choice of yield .5
Valuation per share 1
Non-marketability discount .5
Calculation of average EBIT 1
Calculation of profit after tax 1
EPS 1
Choice of P/E ratio .5
Valuation per share 1
Non-marketability discount .5
Marks Available 13
Maximum 13
(b) Basic weaknesses of net asset, dividend yield and P/E valuations 2
Other issues – 1 mark per point 5
Marks Available 7
Maximum 4
(c) 1 mark per point 4
Marks Available 4
Maximum 4
20.2 Calculation of each possible replacement cycle – 2.5 marks 10
Marks Available 10
Maximum 10
Total 31

20.1
(a)

Net asset valuation: £

Intangibles 900,000
Freehold land and property 4,500,000
Plant and equipment 3,600,000
Investments 1,350,000

ICAEW 2021 Business valuations, plans, dividends and growth 201

 Net asset valuation: £
Inventory 540,000
Receivables 1,080,000
Cash 180,000
12,150,000

Less
Current liabilities 1,080,000
Preference shares 648,000
Debentures 1,980,000
8,442,000

£8,442,000/3,600,000 = £2.345 per share

Dividend yield valuation:
Dividend in 20X2 = £180,000
Number of shares = 3,600,000
Dividend per share = £0.05
Average dividend yield of other two quoted firms: 3.7% (or the minimum 3.4%)
Valuation = £0.05/0.037 = £1.35 (or £0.05/0.034 = £1.47)
Less discount to reflect non-marketability (25% – any % will suffice) = £0.34 or £0.37
Valuation = £1.01 per share (or £1.10 per share)
Price/earnings valuation:
Average PBIT = (1,080 + 440 + 1,800)/3 = £1,106,667
Less interest £180,000 and tax £157,533 (£926,667 × 17%) = PAIT £769,134 – 43,200 =
£725,934
EPS = £725,933/3,600,000 = £0.2016
Average price-earnings ratio of the other two quoted firms: 8.3 (or the minimum 7)
Valuation = £0.2016 × 8.3 = £1.67 (or £1.41)
Less discount to reflect non-marketability (25%) = £0.42 (any % deduction will suffice)
Valuation = £1.25 per share (or £1.06)
(b) In addition to a discussion of basic elements surrounding the weaknesses of net asset
valuation (historic cost, omission of internally-generated intangibles) and dividend yield
and price/earnings valuations (comparator statistics, unrepresentative annual figures), the
following areas were worthy of comment in this specific scenario:
• The erratic profits in recent years suggests the earnings value may be somewhat
unreliable.
• Purchasers may prefer a valuation based on the present value of forecast future cash-
flows.
• Given the dividend yield and price/earnings valuations, Cern’s directors may prefer to
sell off the firm on a break-up basis rather than as a going concern.
• Is the discount for non-marketability reasonable?
(c)
(1) Synergy: the ‘2 + 2 = 5’ effect
(2) Risk reduction via diversification
(3) Removal of a competitor
(4) Vertical integration: safeguard Fenton’s position by acquiring a supplier or distributor

202 Financial Management ICAEW 2021

 (5) Access a new market (possibly overcoming barriers to entry)
(6) The acquisition of skills/knowledge
(7) Speed compared to organic growth
(8) Asset-stripping
20.2

Maximum annual production/sales (units) 300,000 285,000 270,000 255,000

Annual revenue @ £12 per unit (£) 3.60m 3.42m 3.24m 3.06m
Annual variable costs @ £8 per unit 2.40m 2.28m 2.16m 2.04m
Annual contribution 1.20m 1.14m 1.08m 1.02m

One-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4

Purchase price (480,000)
Scrap value 320,000
Maintenance costs (12,000)
Contribution 1,200,000
Net cash flow (480,000) 1,508,000

NPV (480,000) + (1,508,000 × 0.909) = £890,772/0.909 = £979,947

Two-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4

Purchase price (480,000)
Scrap value 200,000
Maintenance costs (12,000) (14,000)
Contribution 1,200,000 1,140,000
Net cash flow (480,000) 1,188,000 1,326,000

NPV (480,000) + (1,188,000 × 0.909) + (1,326,000 × 0.826) = £1,695,168/1.736 = £976,479

Three-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4

Purchase price (480,000)
Scrap value 80,000
Maintenance costs (12,000) (14,000) (16,000)
Contribution 1,200,000 1,140,000 1,080,000
Net cash flow (480,000) 1,188,000 1,126,000 1,144,000

NPV (480,000) + (1,188,000 × 0.909) + (1,126,000 × 0.826) + (1,144,000 × 0.751) =

£2,389,112/2.487 = £960,640
Four-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4

Purchase price (480,000)
Scrap value 10,000
Maintenance costs (12,000) (14,000) (16,000) (18,000)

ICAEW 2021 Business valuations, plans, dividends and growth 203

 Year 0 Year 1 Year 2 Year 3 Year 4
Contribution 1,200,000 1,140,000 1,080,000 1,020,000
Net cash flow (480,000) 1,188,000 1,126,000 1,064,000 1,012,000

NPV (480,000) + (1,188,000 × 0.909) + (1,126,000 × 0.826) + (1,064,000 × 0.751) + (1,012,000

× 0.683) = £3,020,228/3.170 = £952,753
Therefore, the directors should change their existing policy of replacing the processing
machine every three years to replacing it every year, as that gives the greatest annual
equivalent net revenue.

Examiner’s comments
Whilst there were many strong responses to the valuation questions, less well-prepared candidates
were undoubtedly exposed by the question and were particularly weak in dealing with the
technicalities of both the dividend yield and price/earnings valuation techniques. In the second
section, whilst many candidates were able to list classic text-book commentary on the respective
valuation techniques, far fewer were able to augment this basic analysis with insightful commentary
on the relevance of the techniques to the specific scenario set out in the question. The third and final
section of the first part of the paper, on take-over motives, was, however, generally very well
answered across the board.
The second part of the question was, again, very well answered by the stronger candidates but
performance was somewhat polarised as those candidates who had clearly banked on there being a
traditional NPV question found their lack of a firm grasp of the replacement methodology exposed.
Even some candidates who scored well on the calculations themselves arrived at incorrect
conclusions as a result of treating the calculated figures as equivalent annual costs rather than net
revenues.

21 Wexford plc

Marking guide Marks

21.1 Forecast income statement 8

Forecast balance sheet 8
Marks Available 16
Maximum 16
21.2 Rights issue: Up to 2 marks per valid point 7
Floating rate loan: Up to 2 marks per valid point 6
Report format 1
Marks Available 14
Maximum 14
21.3 Discussion of prescriptive analytics 5
5
Total 35

21.1 Rights Issue

Forecast income statement for the year ending 30 November 20X9

£’000
Revenue (270 × 1.15) 310,500
Direct costs ((171 – 19) × 1.18) 179,360

204 Financial Management ICAEW 2021

 £’000
Depreciation (18 + (20% × 25)) 23,000
Indirect costs (40 + 10) 50,000
Profit from operations 58,140
Interest 5,000
Profit before tax 53,140
Taxation (17%) 9,034
Profit after tax 44,106
Dividends declared ((22.68/44.82) × 44,106) 22,319
Retained profit 21,787

Forecast balance sheet at 30 November 20X9

£’000 £’000
Non-current assets (carrying amount) (152.59 + 25 – 23) 154,590
Current assets:
Inventory (35 + 10) 45,000
Receivables ((49/270) × 310.5) 56,350
Cash at bank (balancing figure) 45,316
146,666
301,256
Capital and reserves:
£1 Ordinary shares (50 + 10) 60,000
Share premium (25 – 10) 15,000
Retained earnings (81.41 + 21.787) 103,197
178,197
Non-current liabilities:
10% Debentures (repayable 20Y5) 50,000
Current liabilities:
Trade payables ((43/152) × 179.36) 50,740
Dividends payable 22,319
73,059
301,256

Floating rate loan

Forecast income statement for the year ending 30 November 20X9

£’000
Revenue 310,500
Direct costs 179,360
Depreciation 23,000
Indirect costs 50,000

ICAEW 2021 Business valuations, plans, dividends and growth 205

 £’000
Profit from operations 58,140
Interest (5 + (25 × 8%)) 7,000
Profit before tax 51,140
Taxation (17%) 8,694
Profit after tax 42,446
Dividends declared ((22.68/44.82) × 42.446) 21,479
Retained profit 20,967

Forecast balance sheet at 30 November 20X9

£’000 £’000
Non-current assets (carrying amount) 154,590
Current assets:
Inventory 45,000
Receivables 56,350
Cash at bank (balancing figure) 43,656 145,006
299,596
Capital and reserves:
£1 Ordinary shares 50,000
Retained earnings (81.41 + 20.967) 102,377
152,377
Non-current liabilities:
10% Debentures (repayable 20Y5) 50,000
Loan 25,000
75,000
Current liabilities:
Trade payables 50,740
Dividends payable 21,479
72,219
299,596

21.2 Reports

To: The board of directors

From: Company Accountant
Date: x – x – xx
Subject: Methods of financing expansion plans
In terms of gearing, the rights issue will produce lower gearing than the floating rate loan
(ie, a lower level of financial risk), although in neither case does the proposed level of
gearing appear beyond the ability of the company to service (see interest cover below).
In terms of eps, the rights issue will produce a figure of 73.5p per share, whilst the floating
rate loan will boost eps to 84.9p per share.

206 Financial Management ICAEW 2021

 In terms of interest cover, with the rights issue interest cover is a comfortable 11.6 times
against 8.3 times with the floating rate loan. In neither case, therefore, does interest cover
appear to be a cause for concern.
In terms of cost of capital, the floating rate loan may reduce the company’s cost of capital as
a result of the tax shield applying to loan interest (depending on what happens to the cost
of equity as a result of the increased financial risk).
The issues surrounding the use of the rights issue are as follows:
• Issue costs likely to be more than the arrangement fees associated with the floating rate
loan.
• There may also be underwriting costs if the company decides to protect its position.
Shareholders’ reaction may be negative.
• Control – no dilution of control for those shareholders who take up their rights.
• The need to discount the offer price to ensure that the issue is fully subscribed and to
cover the possibility that the market price of shares might fall between the
announcement of the rights issue and its conclusion.
• The use of a rights issue leaves credit lines free to finance further expansion and enables
the freehold land and buildings to be used to secure other lines of finance, if required.
The issues surrounding the use of the floating rate loan are as follows:
• The advantage of avoiding being tied into higher fixed rates if market interest rates fall.
• The risk of interest rates rising and the uncertainty of cash budgeting that this creates.
• Issue costs (arrangement fees) – likely to be less than those associated with a rights issue.
• The potential for early repayment if the company finds this to be beneficial.
• Marks were also available for discussion of security and/or covenants, increased
operating gearing and the potential cash flow issues surrounding the loan.

21.3 The new equipment will use artificial intelligence and automated processes to reduce the
need for human intervention. It will also provide management with new information through
the visualisation of data and key performance indicators that will help to improve decision
making in the future. By combining the statistical tools utilised in predictive analytics with
artificial intelligence and algorithms, prescriptive analytics software can be used to calculate
the optimum outcome from a variety of business decisions.
Advantages
Prescriptive models have the capability to identify optimum investment decisions whilst
considering the impact of multiple decisions and variables. Wexford would therefore be able
to consider the optimal product mix to produce to enable the company to improve profitability
and grow while managing its risk and its access to capital. It could model the impact of
different investment plans as it tries to expand in an ever changing environment, recognising
possible capital rationing issues and modelling how best to overcome them.
Limitations
Creating reliable prescriptive models is complex and requires specialist data science skills,
which may be outside the scope of Wexford’s managers.
The reliability of such models depends on the reliability of the data that they use and the
ability to predict future outcomes accurately from past data. Given that Wexford has only
experienced modest growth in recent years, it is likely that the use of past data only will be
inappropriate.

Examiner’s comments
A question which most candidates found to their liking, with many scoring very strongly in the
numerical first section. The second section once again served to polarise performance between
stronger and weaker candidates.
For the most part, candidates performed well on the first section of the question, although there
were some common errors among weaker candidates, most notably the incorrect treatment of both
the cash and dividend figures. Weaker candidates completely overlooked the fact that cash was the

ICAEW 2021 Business valuations, plans, dividends and growth 207

 balancing figure in the whole exercise and simply chose to leave the original cash figure unchanged.
In a similar fashion, the dividends were often left at their original level with no changes incorporated
to reflect profits in 20X9.
In the second section, stronger candidates combined relevant discussion of the two sources of
finance with the calculation of relevant calculations to underpin that discussion. However, a feature
among weaker candidates was their failure to undertake any calculations in spite of the precise
instruction in the question. Another common feature of weaker answers was a lack of breadth in their
response. For example, there was a tendency for some candidates to correctly identify the issue of
the potential impact on the firm’s cost of capital but then to write at great length all they knew on the
underlying theory. Whilst this invariably earned the full marks available for this aspect of the answer,
this represented minimal reward in the context of the overall question and was often achieved at the
cost of many more marks that were available for discussion of other relevant issues.

22 Loxwood

Marking guide Marks

22.1 Total asset value 1

Total revalued assets 2
Dividend valuation 2
Earnings valuation 2
EV/EBITDA multiples 4
Profit before tax 2
Profit after tax 1
Retained profit after dividends 1
Strengths and weaknesses of each valuation method 10
Marks Available 25
Maximum 25
22.2 SVA explanation 3
Problems of future cash flow and residual value 4
Marks Available 7
Maximum 7
22.3 Discount at an effective 1% pa 1
Present value calculation 2
Compare to £500k offered and advise not to sell land 1
Ignore £120,000 as common to both alternatives 1
Marks Available 5
Maximum 5
22.4 Difficulties valuing software company 5
Marks Available 5
Maximum 5
22.5 Professional accountants’ conduct:
Be honest and truthful 1
Avoid making exaggerated claims of what they can do, and their qualifications
and experience 2
Avoid making disparaging claims of others 1
Not use confidential information from other clients in campaign 1
Marks Available 5

208 Financial Management ICAEW 2021

 Marking guide Marks

Maximum 3
Total 45

22.1
Hampton Richmond
Total asset value (historic) £21.7m £22.7m
Value per share (£21.7m/17.6m) £1.23 (£22.7m/9.8m) £2.32

Total revalued assets

[45.2 + 25.1 - 11.3 – 24.75] [24.1 + 35.2 – 13.7 – 15.44]
£34.25m £30.16m
Value per share (£34.25m/17.6m) £1.94 (£30.16m/9.8m) £3.08
Dividend valuation

d1
ke−g
(1.140 × 1.075) (1.216 × 1.09)
(9%−7.5%) (10.5%−9%)
Dividends (W1) £88.363m
£88.363m/9.8
Value per share £81.7m/17.6m £4.64 m £9.02
Earnings valuation (Earnings × P/E)
£3.258m ´ 15.2 £2.702m × 15.2 (Hampton)
£49.52m £41.07m
Value per share £49.52m/17.6m £2.81 £41.07m/9.8m £4.19

When it comes to valuation using an EV/EBITDA multiple, we can use the multiples of
Hampton and Walton (as listed companies) to estimate a value for Richmond.
Hampton
EV = £74.27m, being:
Market capitalisation = £2.81 ´ 17.6m shares (above) = £49.52m, plus
Market value of debentures = 1.10 ´ £22.5m = £24.75m
EBITDA of Hampton = £5.5m + £2.9m = £8.4m
EV/EBITDA multiple = £74.27m/£8.4m = 8.84
Walton
Need to calculate a market capitalisation, using earnings × P/E:

£m
PBIT 36.2
Less interest (£70m × 7%) (4.9)
Profit before tax 31.3
Tax at 17% (5.3)
Profit after tax / earnings 26.0

ICAEW 2021 Business valuations, plans, dividends and growth 209

 Market capitalisation = £26m × 16.5 = £429m
Market value of debentures = 1.25 × £70m = £87.5m
EV of Walton = £516.5m
EBITDA is £36.2m + £6.5m = £42.7m
EV/EBITDA multiple = £516.5m / £42.7m = 12.1
Applying these multiples to the EBITDA of Richmond:
EBITDA = £4.8m + £0.9m = £5.7m
Appling EV/EBITDA multiple of Hampton: £5.7m × 8.84 = £50.388m
Appling EV/EBITDA multiple of Walton: £5.7m × 12.1 = £68.97m
Commentary
Asset values – historic so not equal to MV and only considers tangible assets and ignores
income. Revalued figures are better as more up to date, but still have the same disadvantages.
The P/E ratio is a better guide for Hampton as it will give the company’s actual market value at
28 February 20X4 but based only on a small number of shares changing hands at any one time
– a premium would normally be paid above MV to get control. Also, have there been
significant changes since 28 February which would affect the value?
It is a takeover bid and so, presumably, Walton will be looking forwards and intending to
generate future earnings from Hampton, not liquidate (asset strip) it as in asset values. For
Richmond (a private company) it would be reasonable to use Hampton’s P/E ratio (same
market), but it will be necessary to discount (by 25% to 50%) this valuation because Richmond’s
shares will be less marketable. For both companies, are the current year’s earnings reasonable
ie, not distorted in any way? Synergy is also ignored in the calculations.
When it comes to the EV/EBITDA valuation, the market value of Richmond’s debt (£15.44m)
will need to be deducted to obtain an equity valuation, giving a range between £34.948
million and £53.53 million.
These figures are before any discount that might be made for the non-marketability of
Richmond’s shares. If we were to apply say a 25% discount, this would give a range of values
between £26.21 million and £40.15 million.
It should also be noted that care needs to be taken when using the EBITDA multiple of either
Walton or Hampton when valuing Richmond. These companies may be trading on higher or
lower multiples than the average for the sector due to various market factors.
The dividend growth model (DGM) gives the highest valuations for both companies, but the
cost of equity and dividend growth rate will need to be treated with caution as they are very
close to each other giving high values. This puts the valuation in some doubt. Particularly one
should bear in mind that the market has priced Hampton at a much lower figure (via P/E) than
the value given by the DGM. Similar comments re synergy apply.

WORKING

£m £m

Profit before interest and 5.500 4.800

tax

less: Interest (£22.5m × 7%) (1.575) (£19.3m × 8%) (1.544)

Profit before tax 3.925 3.256

less: Tax at 17% (0.667) (0.554)

Profit after tax/Earnings 3.258 2.702

less: Dividends (35% × (1.140) (45% × £2.702m) (1.216)

£3.258m)

Retained 2.118 1.486

210 Financial Management ICAEW 2021

22.2 Shareholder value analysis (SVA) concentrates on a company’s ability to generate value and
thereby increase shareholder wealth. SVA is based on the premise that the value of a business
is equal to the sum of the present values of all of its activities.
The value of the business is calculated from the cash flows generated by drivers 1–6 which are
then discounted at the company’s cost of capital (driver 7). SVA links a business’ value to its
strategy (via the value drivers).
The seven value drivers are a key element of the SVA approach to valuing a company.
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
Company projections tend to show cash flows growing steadily upwards into an indefinite
future. In the real world, economies falter, competition increases and margins decline.
The majority of a DCF value estimate comes from the ‘residual value’, the worth of the
company at the end of the projection period. That, naturally, depends heavily on the cash flows
estimate in the final year modelled – a result, logically, of the trend in the early years.
22.3 £60k inflating at 3% pa discounted at 4% pa is the same as £60k discounted at an effective 1%
pa so:
[£60,000 × 9.471] + [£120,000 × 0.905] (assuming land sold at year 10) = £676,860 (Present
Value) vs £500,000 offered, so do not sell the land.
£120,000 ignored as common to both alternatives
22.4 The value of KT’s tangible assets are likely to be low, it is currently not profitable, and its sales
will be hard to predict. As such, traditional valuation models will be hard to apply to value KT.
The main part of the value of KT is driven by the value attached to its main digital assets. KT’s
digital assets are represented by the smart platform and machine learning solutions the
company has created to the help businesses predict customer needs. The ability to gauge
customer needs and satisfaction through analytics results in the power to give customers what
they want, which is hugely valuable to any company. However, valuing digital assets is difficult
since value is only generated if the assets are well managed.
In addition to this, valuing technology companies such as KT becomes more complicated due
to periodic swings in stock market sentiment (herd behaviour) that may result in over-valuation.
In more recent times, the valuation of technology companies specialising in areas such as
artificial intelligence and data analytics has also been criticised as being too optimistic, partly
due to investors desperately looking for growth opportunities in an era of low interest rates.
Despite these difficulties, the DCF approach is likely to be the most valid approach for
estimating the value of KT. Revenue growth prospects and margins could be estimated
through comparison with more mature businesses in different countries or companies that
have a similar business model. Different scenarios can be created and analysed using
probabilities, although clearly these will be subjective. Cash flows should be discounted at a
suitable risk-adjusted cost of capital.
22.5 When marketing themselves and their work, professional accountants should:
• be honest and truthful.
• avoid making exaggerated claims about (a) what they can do (b) their qualifications and
experience.
• avoid making disparaging references to the work of others.
• not use confidential information from other clients in the campaign.

ICAEW 2021 Business valuations, plans, dividends and growth 211

 Examiner’s comments
This question had the lowest average mark on the paper and, in general, was done very badly
indeed.
It was a four-part question that tested the candidates’ understanding of the investment decisions and
valuation element of the syllabus.
In the scenario a firm of ICAEW Chartered Accountants is advising three clients in its Business
Valuations Unit (BVU):
Client One is considering a takeover bid for two of its competitors. Candidates were given financial
data about the client and its target companies. Using this data they were asked to calculate a range
of suitable prices for the targets and a commentary on the strengths and weaknesses of each of the
valuation methods used.
Client Two had read a newspaper article which outlined a court case in which a company had been
valued using Shareholder Value Analysis (SVA). Candidates were required to explain how SVA works
and the problems that can arise from its employment.
Client Three was a landowner who, in effect, needed to calculate the present value of 60 acres of his
agricultural land for which he had been offered 10 years of rental income. Candidates were given
annual discount and inflation rates.
Finally, in the last part, candidates were asked to outline the ethical issues that the firm should
consider when planning a marketing campaign for its BVU.
In the first part many candidates’ calculations of value were very poor or non-existent. For example
they were unable to identify the net assets figure straight from the financial data made available with
many just using assets rather than assets less liabilities. Also they couldn’t change that number (for
asset revaluation) with the two adjustments that were given in the data. Many used the profit before
interest figure as earnings (and therefore the basis for the dividend figure). Interest and tax details
were provided for calculating profit after interest and tax.
In the second part there was a poor understanding of the SVA method of valuation, in particular the
issues associated with future cash flows and residual value.
The third part was probably the worst overall performance in the paper. Very few candidates
demonstrated an understanding of basic discounting. Many discounted the cash flows using the
annual inflation rate rather than cost of capital. In addition many compared terminal values and
present values to get to their decision.
Many candidates answered the final part by dealing with ethics in the context of valuing companies,
rather than in the context of the promotional campaign. In other words they didn’t answer the
question.

23 Sennen plc

Marking guide Marks

23.1 (a) Sales revenue 1

Operating profit .5
Tax 1
After tax synergies 1
Working capital 1
Additional CAPEX 1
Free cash flow .5
Present value 1
Terminal value 2
Value per share 2
Advantages and disadvantages 2

212 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 13
Maximum 13
(b) Sensitivity to change in after tax synergies 3
Marks Available 3
Maximum 3
(c) Operating profit .5
Interest .5
Investment income .5
Tax .5
Share price 1
Strengths and weaknesses 2
Marks Available 5
Maximum 5
(d) Relevant discussion 3
Marks Available 3
Maximum 3
(e) Advice on suitability of each method 8
Marks Available 8
Maximum 8
23.2 Ethical issues 3
Marks Available 3
Maximum 3
Total 35

23.1 REPORT

To: Partner in NWCF

From: Accountant
Date: x – x – xx
Subject: Possible acquisition of Sennen plc

(a)

Year
0 1 2 3
£m £m £m £m
Sales revenue 21.00 22.0 23.15
Operating profit 3.15 3.31 3.47
Tax (17%) –0.54 –0.56 –0.59
After tax synergies 0.53 0.55 0.58
Working capital –0.21 –0.22 –0.23 –0.24
Additional CAPEX –0.42 –0.44 –0.46
Free cash flow –0.21 2.50 2.63 2.76

ICAEW 2021 Business valuations, plans, dividends and growth 213

 Year
0 1 2 3
Present value factor
(7%) 1.00 0.935 0.873 0.816

Present value –0.21 2.34 2.30 2.25

£m
Present value of free cash flow years 0–3 6.68

Terminal value: (2.76(1 + 0.02)/(0.07 – 0.02)) × 0.816 45.94

Enterprise value 52.62

Less debt –10.00
Add short term investments 2.00
Equity 44.62

Value per share in pence (44.62/17 × 100p) 262

This methodology has the advantage of valuing the free cash flows of the company and is
not distorted by accounting policies which can affect other methods. However the
valuation is dominated by the terminal value. The methodology is also heavily dependent
upon the inputs to the model such as estimating cash flows and growth. For example,
reducing the estimated sales growth after the competitive advantage period to, say, 1%
would reduce the terminal value to (2.76(1 + 0.01)/(0.07 – 0.01)) × 0.816 = £37.91m, a
reduction of 47p per share.
(b) The sensitivity of the enterprise value to a change in the after tax synergies: PV of
synergies/total value:

1 2 3
£m £m £m
After tax synergies 0.53 0.55 0.58
PV @ 7% 0.5 0.48 0.47

£m
Present value years 1–3 1.45
Amount in terminal value (0.58(1 + 0.02)/(0.07 – 0.02)) × 0.816 9.65
Total present value of synergies 11.10

£11.10m/£54.62 = 20.3%.
Synergies represent 20.3% of the value of debt plus equity.
(c) The earnings per share has to be calculated:

£m
Operating profit £20m × 0.15 3
Less interest £10m × 0.05 (0.5)

214 Financial Management ICAEW 2021

 £m
Add investment income £2m × 0.03 0.06
Taxable 2.56
Tax at 17% (0.44)
Profit after tax 2.12
Earnings per share £2.12m/17m = 12.47p

Note: Credit any attempt to calculate prospective EPS rather than historic.
The share price using the p/e ratio for recent takeovers = 12.47p × 17 = 212p
The p/e ratio basis is a market measure and has the advantage of valuing the shares by
comparison to other takeovers. However we do not know how comparable to Sennen the
other companies are. Also the valuation is based on historic EPS and a more realistic
measure might be a prospective EPS.
(d) The range in values is 212p – 262p.
The free cash flow valuation can be considered as a maximum value, however the
valuation is quite sensitive at 20.3% to the synergistic savings which may or may not be
made and the growth rate of sales in perpetuity.
Both measures offer a premium to the current share price of 160p and the Board of
Morgan should feel comfortable offering the shareholders of Sennen a bid premium.
(e) Students should take into account that the company is highly geared and their answers
should reflect this. They should consider both the shareholders of Sennen and Morgan in
their answers. Some areas that they may mention and expand upon for each method are
as follows:
• The ability of Morgan to raise extra funds by borrowing and/or an issue of shares,
maybe a rights issue
• Does Morgan have any cash reserves
• Dilution of control
• The tax position of Sennen’s shareholders
• Risk
23.2 There is a serious conflict of interest with the management team who are party to the MBO also
considering making an offer for the company. The management team should be acting in the
interests of the shareholders of Sennen and be recommending to the shareholders the best
price for their shares. It would be highly unethical for any member of the management team
who are party to the MBO to take part in negotiations with Morgan or to make
recommendations to Sennen’s shareholders.

Examiner’s comments
This was a six-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus. The scenario of the question was that a company had identified a takeover
target.
The acquirer has had a policy of expanding by acquisition and, as a result, is highly geared
compared to its peers. Also there is a potential bid from the management of the target in the form of
a management buyout (MBO). Part (a) of the first requirement required candidates to use
Shareholder Value Analysis (SVA) to value the target. The valuation included after tax synergies, also
candidates were required to state the strengths and weaknesses of the valuation method. Part (b) of
the first requirement needed candidates to calculate how sensitive the valuation using SVA was to a
change in the synergies. Part (c) of the first requirement required candidates to value the target using
p/e ratios and to state the strengths and weaknesses of the valuation method. Part (d) of requirement
one required candidates to discuss the range of values and whether the acquirer should have
offered the target company’s shareholders a bid premium. The final part of the first requirement
required candidates to discuss the methods that the acquirer could have used to pay for the shares
of the target. The second requirement of the question required candidates to discuss the ethical
position of the members of the MBO team.

ICAEW 2021 Business valuations, plans, dividends and growth 215

 In part (a) of requirement one, the basic discounting was fine with some candidates making the usual
timing errors, however the inclusion and computation of the perpetuity flow and discounting it was
variable. Few candidates made adjustments to the present value of the free cash flows for the debt
and investments. Many candidates wasted time by stating the seven drivers of SVA, which was not
required.
In part (b) of requirement one many candidates were able to calculate the present value of the after
tax synergies but did not realise that this should then be stated as a percentage of the value
calculated in part (a).
Part (c) of requirement one was very disappointing since p/e valuations have been tested several
times in the past. Many candidates lost marks by making no attempt to calculate the earnings.
Instead a common calculation was to divide the target share price by the p/e ratio given in the
question for recent takeovers in the sector and then multiplying the resultant figure back up again:
17 × eps = 160p, eps = 9.41p, Offer price = 9.41p × 17 = 160p!
Part (d) of requirement one had reasonable responses. However weaker candidates did not make
reference to their range of values calculated in parts (a) and (c) of the requirement.
Part (e) of requirement one was quite well answered but weaker candidates did not refer to the
offeror being already highly geared compared to its peers.
In the second requirement many candidates ignored the ethical position of the members of the
MBO team.

24 Tower Brazil plc

Marking guide Marks

24.1 Theoretical ex-rights price:

Funds to be raised by rights issue 1
Market value 1
TERP calculation 1
Marks Available 3
Maximum 3
24.2 (a) Current EPS 1.5
Current earnings plus debenture interest saved 2
New earnings 1
New EPS 1
Marks Available 5.5
Maximum 5.5
(b) New EPS if EPS reduces by 10% 1
New total shares 1
Current shares in issues .5
New shares to be issued .5
Rights issue price/share 1
Rights issue would be unsuccessful as above current market price 1.5
Marks Available 5.5
Maximum 5.5
24.3 Gearing level (BV) 1
Gearing level (MV) 2
Advise whether there is gearing problem 3
Gearing theory 3

216 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 9
Maximum 9
24.4 Dividend policy and share price 7
Impact of special dividend 2
Marks Available 9
Maximum 9
24.5 Impact of special dividend 3
Marks Available 3
Maximum 3
Total 35

24.1 Theoretical ex-rights price

£m
Funds to be raised by rights issue: 60% × £46,750 × 1.10 30.855

Current market capitalisation 16.50m £4.20 69.300

1 for 2 rights issue 8.25m £3.74 30.855
24.75m 100.155

TERP = £100.155/24.75m £4.05/share

24.2
(a) Current earnings per share (£5.825m – £0.480m)/16.5m £0.324

£m
Current earnings figure (£5,825m – £0.480m) 5.345
plus: Debenture interest saved (£28.050m × 5%× 83%) 1.164
New earnings figure 6.509

New EPS £6.509m/24.75m £0.263

(b) If EPS reduces by 10%, then new EPS is £0.324 × (1 – 10%) £0.2916

New total shares £6.509m/£0.2916 22,322m

Current shares in issue 16.500m
New shares to be issued 5.822m
Rights issue price/share £30.855m/5.822m £5.30

24.3

Gearing level (BV) £54,750/£97,670 56.1%

Gearing level (MV) Equity MV £69,300
PSC MV 6,400

ICAEW 2021 Business valuations, plans, dividends and growth 217

 Debt MV (£46,750 × 1.10) 51,425
127,125 £57,825/£127,125 45.5%

So gearing at MV is under 50%. Gearing would be a problem if it was causing WACC to rise
(tax advantage outweighed by debenture holders and shareholders wanting a higher return)
and MV to fall.
Gearing theory – Traditional view/Modigliani & Miller (MM) view/Modern view – balance
between tax benefits and bankruptcy costs.
24.4 Dividend policy and share price – Traditional view/MM and irrelevance theory/Modern view –
including signaling, clientele effect and agency theory.
Impact of special dividend – the market is not in favour of such dividends generally, ie, the
share price may well fall as a result, and so it seems to defeat the object of retaining profit for
investment.
24.5 Unpublished information of a price sensitive nature should remain confidential, not be
disclosed and not be used to obtain a personal advantage.

Examiner’s comments
This question had the second highest average mark on the paper and the majority of candidates did
well enough to ‘pass’ it.
This was a five-part question that tested the candidates’ understanding of the financing options
element of the syllabus.
In the scenario the board of a UK manufacturer was concerned about the company’s gearing levels.
The board is considering either (a) a rights issue to buy back debt or (b) reducing future dividend
payments.
In the first part for three marks candidates were required to calculate the company’s theoretical ex-
rights price. The second requirement was worth 11 marks. Half of these were allocated to part (a)
which required candidates to calculate next year’s EPS figure (based on the fact that some of the
debt would have been repaid). In part (b) of this requirement candidates were required to calculate
and explain the implications for the rights issue of restricting the change in the company’s EPS to
10%. The third part for nine marks asked candidates to calculate the company’s current gearing
levels and then advise the board, with reference to their calculations and generally accepted theory,
whether or not the company had a gearing ‘problem’. The fourth part was a more discursive section
and candidates were asked to explain (again with reference to generally accepted theory) the
possible impact of a change in dividend policy on the company’s share price. Finally, for three marks,
the final part tested the candidates’ understanding of the ethical implications facing an ICAEW
Chartered Accountant when in possession of price-sensitive information.
In the first part most candidates scored full marks, but many failed to calculate correctly the market
value of the debt being redeemed via the rights issue.
Part (a) of the second requirement was reasonably well done, but many candidates struggled with (or
ignored) the calculation of the adjustment to the interest charge caused by the debenture
redemption. Also, as noted in previous papers, many candidates calculated, incorrectly, the earnings
figure before preference dividends.
Part (b) of the second requirement was also reasonably well done, but many candidates tried to
adjust the earnings figure rather than, as was required, the number of shares.
In the third part it was the calculation of gearing using market values that caused most problems
(again, as in previous papers). A disappointing number of candidates included retained earnings in
their market value of equity figure. Most candidates’ understanding of the theory of gearing and
market value were good, but, in general, there was too little application of this understanding to the
actual scenario.
The fourth part was mostly done well, but too few candidates gave a sufficient range of points
regarding the ‘real world’ impact of the dividend policy and most candidates ignored the special
dividend.
In general the final part was answered well.

218 Financial Management ICAEW 2021

25 Brennan plc

Marking guide Marks

25.1 Sales calculations 1.5

Operating profit 1
Tax 1
Working capital investment 1.5
Non-current asset investment 1.5
Discount rate 1
Post year six cash flows 1.5
Short-term investments 1
Comment 3
Marks Available 13
Maximum 13
25.2 1–2 marks per valid comment 7
Marks Available 7
Maximum 7
Total 20

25.1
Year
1 2 3 4 5 6
Sales (£m) (W1) 212.00 224.72 238.20 252.50 267.65 283.70
Op profit (15%) 31.80 33.71 35.73 37.87 40.15 42.56
Tax at 17% (5.41) (5.73) (6.07) (6.44) (6.83) (7.24)
Working capital
investment (W1) (0.84) (0.89) (0.94) (1.00) (1.06) (1.12)
Non-current asset
investment (W1) (1.44) (1.53) (1.62) (1.72) (1.82) (1.93)

Free Cash Flows 24.11 25.56 27.10 28.71 30.44 32.27

Factor 9% (W2) 0.917 0.842 0.772 0.708 0.650 0.596
PV 22.11 21.52 20.92 20.33 19.79 19.23

PV of cash flows years 1–6 = £123.9m

Post year 6 cash flows (in perpetuity) = 32.27/0.09 × 0.596 = £213.7m
Total SVA value = £123.9m + £213.7m + £2.5m = £340.1m
The majority of the value calculated (63%) comes from the residual value, which is based on
the assumption of zero growth in cash flows from year 6. This is highly dependent on the
growth being as predicted in the period of competitive advantage.
The SVA value is significantly higher than the market capitalisation of £250 million. This may be
caused by the market assuming a lower growth rate or a higher discount rate than those used
in the SVA calculation.

ICAEW 2021 Business valuations, plans, dividends and growth 219

 WORKINGS
(1)

Year
0 1 2 3 4 5 6
Sales (increasing at 6%) 200.00 212.00 224.72 238.20 252.50 267.65 283.70
Increase in sales 12.00 12.72 13.48 14.29 15.15 16.06
Working capital (7%) 0.84 0.89 0.94 1.00 1.06 1.12
Non-current asset
investment (12%) 1.44 1.53 1.62 1.72 1.82 1.93

(2)
Discount factor = 3 + 0.75(11 – 3) = 9%
25.2 The current market capitalisation of Brennan is below its net assets value which suggests that
Brennan plc may be worth more if it was liquidated. However this assumes that the net book
value of assets matches the market value of the assets and this may not be the case in reality.
This does give a possible explanation for the low market capitalisation of Brennan, the market
may see no future in the company and is already valuing it on a break up basis.
There are other factors which may cause the market to place such an apparently low valuation
on Brennan.
The dividend policy offers a relatively low payout of 10%. If there are no plans to reinvest
retained earnings then cash balances will be substantial. This could also help to explain the
high net assets valuation.
The stock market may be suspicious of the level of control exercised by the founding family.
The founding family appears to control the board and also own a substantial number of shares
and as such they may be able to dominate the smaller shareholders. The market may view the
current management as less able than similar companies due to this family dominance and this
affects the valuation.
Brennan is currently all equity funded, which the market may think is inadvisable and does not
allow Brennan to exploit the advantage of debt being cheaper than equity due to the tax
shield.

220 Financial Management ICAEW 2021

 Risk management
26 Fratton plc

Marking guide Marks

26.1 (a) Forward market:

Forward rate 1
Net receipt 1
Money market:
Euro borrowing 1
Sterling conversion 1
Interest 1
Option Market:
Type of option 1
Number of contracts 1
Premium in euros 1
Premium in sterling 1
Scenario 1: Option not exercised 1
Scenario 1: Sterling receipt 1
Scenario 2: Option exercised 1
Scenario 2: Gain on option 1
Scenario 2: Sterling receipt 1
Marks Available 14
Maximum 10
(b) Transaction costs 1
Exact date does not need to be known 2
Cannot tailor contracts 1
Hedge inefficiencies 1
Limited number of currencies 1
More complex than forwards 1
Marks Available 7
Maximum 7
26.2 (a) Sterling receipt 1
Marks Available 1
Maximum 1
(b) Problems with cryptocurrencies 3
3
26.3 (a) Buy a 3–6 FRA at a fixed rate 1
Calculation of amount bank to pay Fratton 1
Payment on the underlying loan 1
Net payment on the loan 1
Marks Available 4
Maximum 4
(b) Sell three-month interest rate futures 1
Number of contracts 1

ICAEW 2021 Risk management 221

 Marking guide Marks

Calculation of gain 1
Futures outcome 1
Payment in the spot market 1
Marks Available 5
Maximum 5
Total 30

26.1
(a) Forward market
Bank sells £ at €1.1856/£
Forward rate = €1.1797 (1.1856 – 0.0059)
So €2,960,000/1.1797 = £2,509,112.49
Money market
To hedge a euro receivable, Fratton needs to create a euro liability which, with interest, will
exactly equal the receivable in three months’ time:
€2,960,000/1.004 = £2,948,207.17
Convert to £ at spot (1.1856) to give £2,486,679.46.
Which with three months’ interest at 0.2875% gives £2,493,828.66.
Options
Fratton should enter into a call option to buy £ at €1.18/£
Number of contracts = €2,960,000/1.18 = £2,508,475/10,000 = 250.85 = 250 contracts
The premium would be €60,000 (0.024 ×10,000 × 250)
Which at spot would cost £50,654.28 (60,000/1.1845)
Scenario 1
Spot on expiry €1.12/£ – Exercise price €1.18/£ – intrinsic value: nil – exercise? No
£ receipt at spot = €2,960,000/1.12 = £2,642,857.14 (net £2,592,202.86)
Scenario 2
Spot on expiry €1.20/£ – Exercise price €1.18/£ – intrinsic value: €0.02 per £ – exercise?
Yes
Gain on option of €50,000 (0.02 × 10,000 × 250)
Sell €3,010,000/1.20 = £2,508,333.33 (net £2,457,679.05)
(b) Advantages:
• Transaction costs of futures should be lower and they can be traded.
• The exact date of receipt or payment of the foreign currency does not need to be
known because the futures contract does not have to be closed out until the underlying
transaction takes place (subject only to the expiry date of the futures contract).
Disadvantages:
• The contracts cannot be tailored to the user’s exact requirements.
• Hedge inefficiencies are caused by standard contract sizes and basis.
• Only a limited number of currencies are available with futures contracts.
• The procedure for converting between two currencies neither of which is the $ is more
complex with futures compared to a forward contract.
26.2
(a) 50 Bitcoins x £7,550 = £377,500

222 Financial Management ICAEW 2021

 The spot rate is irrelevant if a forward hedge is used.
£7,550 is the correct forward rate to use for selling Bitcoin in 3 months’ time.
(b) Using cryptocurrencies for international transactions presents two key problems:
Exchangeability. Cryptocurrency exchanges are only likely to exchange Bitcoins for a
narrow range of major currencies eg, sterling, US dollars and euros. This appears to be
less of a problem for Fratton given that it is a UK company and will be receiving sterling.
Price volatility. Cryptocurrency exchange rates are extremely volatile, with prices moving
significantly each day. However, Fratton can choose to hedge this risk using OTC
agreements such as forward contracts (if these are available) and also using derivative
agreements such as futures. In both cases there is the possibility that the rate quoted by
the markets is unattractive.
26.3
(a) As a borrower Fratton should buy a 3–6 FRA and can thereby fix a borrowing rate of
2.60%.
At 3.00% rates have risen, so the bank will pay Fratton £2,500 (2.5m × {3.00%-2.60%} ×
3/12). Payment on the underlying loan will be 3% × 2,500,000 × 3/12 = £18,750
Net payment on the loan: £16,250 (18,750 – 2,500) – an effective rate of 2.60%
(b) Fratton will need to sell three-month £ interest rate futures contracts.
Fratton will need to sell five contracts (2,500,000/500,000 × 3/3)
Sell at 97.20 and buy at 97.00 for a gain of 0.20%.
Futures outcome: 0.20% × 500,000 × 3/12 × 5 = £1,250
Payment in the spot market: 2,500,000 × 3% × 3/12 = £18,750 – £1,250 = £17,500
(=2.80%)

Examiner’s comments
This four-part question combined the interest rate and exchange rate risk management elements of
the Financial Management syllabus and was generally well answered by the well-prepared
candidates. There is now significant evidence that candidate performance in this relatively new area
is increasing to the levels seen in other areas of the syllabus. The average mark achieved was 20.3/30
(67.6%).
The first part of the question required candidates to illustrate how they would hedge foreign
exchange risk in the scenario set out in the question using the forward market, the money market
and the options market. For the most part, this was well answered although weaker candidates often
made fundamental errors in the choice of exchange rate in the first part and then often chose the
wrong type of option to hedge the foreign exchange exposure.
Part (b) of the first requirement of the question required candidates to discuss the advantages and
disadvantages of using futures contracts as opposed to forward contracts to hedge foreign
exchange risk. For the most part this posed few problems for stronger candidates.
The second part of the question required candidates to illustrate the use of a forward rate agreement
to manage interest rate risk. Again, this was generally well answered and confirmed the continuing
improvement amongst most candidates in this area of the syllabus.
The final part of the question required candidates to illustrate the use of interest rate futures
contracts to manage interest rate risk. The vast majority of candidates scored well on this question,
although the most common omission was the identification of the actual interest rate achieved as a
result of the transaction.

27 Sunwin plc

Marking guide Marks

27.1 Type of contract 1

ICAEW 2021 Risk management 223

 Value of one contract 1
Number of contracts needed 1
Premium 1

(a) If index rises – abandon 1

Outcome if index rises 1
Marks Available 2
Maximum 4
(b) Gain if index falls 1
Outcome if index falls 1
Marks Available 2
Maximum 4
27.2 (a) Type of contract 1
Number of contracts 1
Futures outcome 1
Net outcome 1
Effective interest rate 1
Hedge efficiency 1
Marks Available 6
Maximum 6
(b) Type of contract 1
Number of contracts 1
Premium cost 1
Case 1 - exercise .5
Case 1 - futures outcome 1
Case 1 - effective interest rate 2
Case 2 - do not exercise .5
Case 2 - effective interest rate 2
Marks Available 9
Maximum 9
(c) 1 mark per point 3
Marks Available 3
Maximum 3
Total 26

27.1 Sunwin requires an option to sell – a December put option with an exercise price of 5,000.
Portfolio value = £5.6m Exercise price = 5,000
Value of one contract = 5,000 × £10 = £50,000
Number of contracts required = £5.6m/50,000 = 112 contracts
Premium: 70 points × £10 per point ×112 contracts = £78,400
(a) If the index rises to 5,900, the put option gives Sunwin the right to sell @ 5,000, so the
option would be abandoned (with zero value).

Overall position: £
Value of portfolio 6,608,000

224 Financial Management ICAEW 2021

 Overall position: £
Gain on option –
Less premium (78,400
6,529,600

(b) If the index falls to 4,100, the put option gives Sunwin the right to sell @ 5,000, so the
option would be exercised (value = £9,000 {900 × £10} × 112 contracts = £1,008,000).

Overall position: £
Value of portfolio 4,592,000
Gain on option 1,008,000
Less premium (78,400
5,521,600

27.2
(a) Sunwin needs to sell a three-month contract
Number of contracts = 4m/0.5m ×9/3 = 24 contracts
Futures outcome:
Selling at the opening rate of 96 and buying at the closing rate of 95 yields a gain of 1%
Therefore 1% × 0.5m × 3/12 × 24 = £30,000
Net outcome:
Spot market £4m × 4.5% × 9/12 = (£135,000) plus the futures receipt of £30,000 =
(£105,000)
Effective interest rate 105,000/4m × 12/9 = 3.5%
Hedge efficiency:
Increase in spot rate = 1.5% so increase in interest = £60,000 (1.5% × 4m) × 9/12 =
£45,000
So the hedge efficiency = 30,000/45,000 × 100 = 66.7%
(b) Traded interest rate options on futures:
Sunwin requires a March put option with a strike price of 96.25 (100 – 3.75)
The number of contracts required = 4m/0.5m × 9/3 = 24 contracts @ 0.18%
So the premium = 24 × 0.18% × 0.5m × 3/12 = £5,400
Case 1:

Spot price 4.4%

Futures price 95.31
Strike price 96.25
Exercise? Yes
0.94% therefore 0.94% × 0.5m × 3/12 × 24
Gain on future = £28,200
Borrowing cost at spot £132,000
Option (£28,200)

ICAEW 2021 Risk management 225

 Premium £5,400
Effective interest rate £109,200/4m × 12/9 = 3.64%

Case 2:

Spot price 2.1%

Futures price 97.75
Strike price 96.25
Exercise? No
Gain in future -
Borrowing cost at spot £63,000
Option -
Premium £5,400
Effective interest rate £68,400/4m × 12/9 = 2.28%

(c)
(1) The time period to expiry of the option – the longer the time to expiry, the more the
time value of the option will be.
(2) The volatility of the underlying security price – the more volatile, the greater the
chance of the option being ‘in the money’, which increases the time value of the
option.
(3) The general level of interest rates (the time value of money) – the time value of an
option reflects the present value of the exercise price.

Examiner’s comments
Following its introduction into the syllabus at the last review, this subject area was initially very
challenging for many candidates. However, at this sitting and in a reflection of an emerging trend on
the paper in more recent sittings, candidates’ grasp of the material appears to get stronger and
stronger, so much so that it was this question, rather than the traditional NPV question, that provided
many candidates with the basis of their pass on the paper.
Most candidates performed strongly on the first part of this question, although where errors were
made they primarily related to incorrect calculation of the number of contracts and the premium.
The only real areas of weakness in most candidates’ responses to the second requirement were in
their being unable to effectively calculate hedge efficiency (many candidates simply did not even
make an attempt to do so) and in the mis-calculation of time-period adjustments and, consequently,
premiums. However, overall candidate strength in this area of the syllabus is pleasing to see.

28 Padd Shoes Ltd

Marking guide Marks

28.1 (a) Sterling receipt if rupee weakens by 1% 2

Maximum 2
(b) Option 2.5
Maximum 2.5
(c) Forward contract 2.5
Maximum 2.5
(d) Money market hedge 3

226 Financial Management ICAEW 2021

 Maximum 3
28.2 Relevant discussion 8
Marks Available 8
Maximum 8
28.3 Government stability 1
Political and business ethics 1
Economic stability 1
Import restrictions 1
Remittance restrictions 1
Special taxes, regulations for foreign companies 1
Trading risks – physical risk, credit risk, liquidity risk etc 1
Marks Available 7
Maximum 5
28.4 Option 2
FRA 2
No hedge 1
Recommendation 2
Marks Available 7
Maximum 7
Total 30

28.1

INR200,000,000
Sterling receipt at
95.4930
spot rate = £2,094,394

(a)

Sterling receipt if
INR200,000,000 INR200,000,000
rupee weakens by
(95.4930 × 1.01) 96.4479
1% £2,073,658

(b)

INR200,000,000
Option (@ exercise
95.5500
price) £2,093,145
Less cost (£8000)
£2,085,145

(c)

INR200,000,000 INR200,000,000
Forward
(95.4930 + 0.2265) 95.7195
contract £2,089,438
(£4,500)

ICAEW 2021 Risk management 227

 £2,084,938

(d)

Money Market
Hedge

INR200,000,000
1.012
Borrow in rupees INR 197,628,450

INR197,628,450
95.4930
Convert @ spot rate £2,069,560
Lend in sterling £2,069,560 × 1.008 £2,086,116

28.2 Padd’s directors’ attitude to risk is important.

The interest rates and the forward rate discount suggest that the rupee will weaken. A weaker
rupee will produce less sterling on conversion, so hedging may be worthwhile.
The worst case scenario from 28.1 is if the rupee weakens by 1% over the next three months.
The MMH (which would give a fixed sterling amount) gives the highest sterling figure, followed
closely by the OTC option, with which there is some flexibility for the directors.
The forward contract (which would also give a fixed sterling amount) produces a comparatively
poor sterling remittance. It has a high arrangement fee.
Were sterling to remain at spot rate then this would give the best outcome and a
strengthening of the rupee would enhance the sterling receipt even more.
28.3 Government stability
Political and business ethics
Economic stability
Import restrictions
Remittance restrictions
Special taxes, regulations for foreign companies
Trading risks – physical risk, credit risk, liquidity risk etc
28.4

LIBOR + 1 4% 7%
Option
Exercise? Indifferent Yes
Rate (4%) (4%)
Premium (0.75%) (0.75%)
(4.75%) (4.75%)
Annual interest payment (on £8.5m) (£403,750) (£403,750)

FRA
Pay at LIBOR +1 (4%) (7%)
(Payment to)/receipt from bank (0.5%) 2.5%

228 Financial Management ICAEW 2021

 (4.5%) (4.5%)
Annual interest payment (on £8.5m) (£382,500) (£382,500)

No hedge
Pay at LIBOR + 1 (4%) (7%)
Annual interest payment (on £8.5m) (£340,000) (£595,000)

If LIBOR is 3% then it’s better not to hedge and at 6% the FRA seems to be the cheapest
option.
It also depends on the board’s attitude to risk.
The FRA eliminates down side risk (rates rising) as well as upside risk (rates falling).

Examiner’s comments
The average mark for this question was the highest in the paper, equated to a clear pass and so,
overall, was done well.
This was a four-part question that tested the financial risk element of the syllabus.
The scenario was based on a UK footwear manufacturer/exporter and included relevant exchange
rates and interest rates. The question tested (a) candidates’ understanding of foreign exchange risk
management, (b) the more general risks associated with trading overseas and (c) how to hedge
against interest rate movements.
The first requirement, for 10 marks, required candidates to calculate (a) the impact of a strengthening
of sterling on a proposed export contract and (b) the outcome of three possible hedging strategies
for that contract. The second requirement was worth eight marks and here candidates had to advise
the company’s board as to which hedging technique was preferable (if any), based on their
calculations in the first requirement. The third requirement, for five marks, asked candidates to advise
the company of the risks (non-currency) to consider when trading abroad. Finally, for seven marks,
candidates had to recommend whether or not the company, which has borrowed a large amount,
should hedge against the impact of interest rate movements on that loan.
The first requirement was very similar to past exam questions but despite this many candidates did
not get all of the calculation marks available. Typical errors were (a) using a call option rather than a
put and (b) ignoring contract costs.
The discussion in the second requirement was, in many cases, brief and very basic for eight marks.
The third requirement was, as expected, answered well.
The fourth requirement caused many students difficulty. Too few of them produced sufficient
workings to enable them to produce suitable recommendations.

29 Lambourn plc

Marking guide Marks

29.1 (a) Net currency exposure 1

Forward rate 1
Cost of payment 2
Maximum 4
(b) Type of option and strike price 1
Number of contracts 1
Calculation of premium 1
Decision to exercise 1

ICAEW 2021 Risk management 229

 Gain on future 1
Total cost 1
Maximum 6
(c) Sell December contracts 1
Number of contracts 1
Futures outcome 1
Spot market outcome 1
Maximum 4
(d) Deposit amount 1
Sterling equivalent of deposit amount 1
Total cost including interest 1
Maximum 3
29.2 Explain the use of bitcoin futures 2
Calculate the outcome of the hedge 3
Marks Available 5
Maximum 5
29.3 (a) December contracts 1
Put option 1
Strike price 1
Number of contracts 1
Calculation of premium 1
Decision to exercise 1
Gain on future 1
Gain outcome 1
Net position 1
Effective interest rate 1
Marks Available 10
Maximum 10
(b) Basis risk 1.5
Rounding 1.5
Marks Available 3
Maximum 3
Total 35

29.1
(a) Lambourn’s net foreign currency exposure is the net $ payment due = $1,550,000.
The sterling payments and receipts can be ignored.
The forward rate would be 1.6666 – 0.0249 = $1.6417/£.
The cost of the payment would therefore be 1,550,000/1.6417 = £944,143.
(b) The current spot rate is $1.6666/£ so Lambourn should buy December put options on £
with a strike price of $1.67 as $1.65/£ and $1.63/£ are worse than current spot rate.
Number of contracts = $1,550,000/1.67/10,000 = 92.8 = 93 contracts
Premium = 93 × 10,000 × 0.0555 = $51,615 at spot ($1.6666) would cost £30,970
Outcome if the spot rate is $1.6400/£: Exercise the option
Option $1.67 Spot $1.64 so profit of ($0.03 × 93 × 10,000) = $27,900

230 Financial Management ICAEW 2021

 Convert $1,550,000 – $27,900 = $1,522,100/1.64 = £928,110 + £30,970 = £959,080
Alternatively:
This will realise 10,000 × 93 × $1.67 = $1,553,100
Excess $ = $3,100 which at spot would realise £1,884 (3,100/1.6454)
Cost = (10,000 × 93) + 30,970 – 1,884= £959,086
(c) Sell December futures @ 1.6496
$1,550,000/1.6496 = £939,622
Therefore 939,622/62,500 =15.03 = 15 contracts
Futures market outcome:
Sell at 1.6496
Buy at 1.6400
Profit 0.0096 × 15 × 62,500 = $9,000
Spot market outcome: Buy $1,541,000 @ $1.6400/£ = £939,634
(d) Lambourn requires $1,550,000 in six months’ time – the company therefore needs to
deposit $1,546,135 now (1,550,000/1.0025).
To buy $1,546,135 now will cost £927,718 (1,546,135/1.6666).
The cost of this payment with six months’ interest is £941,634 (927,718 × {1+0.015}).
29.2 Given that Lambourn are due to receive Bitcoin they should sell futures to protect the value of
the transaction.
Number of contracts = 50 (transaction size) ÷ 5 (standard contract size) = 10 contracts
Lambourn should use August futures to cover the transaction date of 30 August.
Step 1
Position in spot market
Loss on transaction = 50 bitcoin × (£8,500 – £6,500) = £100,000
Step 2
Calculate gain or loss on futures
Buy futures at lower price than we sold them for (closing out). The price to close out the
position is £6,500.
Initially committed to sell futures for £8,344
Now buy futures for £6,500
Gain on closing out futures £1,844 × 5 Bitcoin × 10 contracts = £92,200
Step 3
Calculate net position
Net position = £92,200 gain on futures – £100,000 loss on spot = £7,800 loss overall
The final outcome is that 50 Bitcoins are received and sold at the spot rate of £6,500 per
Bitcoin (50 × market price of £6,500 = £325,000) and compensation is received from the
futures market (£92,200) so total revenue is £325,000 + £92,200 = £417,200.
29.3
(a)

Contract: December
Contract type: Put option
Strike price: 96.25 (to cap the interest rate at 3.75% pa)
Number of contracts: £1.5m/£0.5m × 6/3 = 6 contracts
Premium December put options at 96.25 = 0.96%
Therefore: 6 × 0.96% × £500,000 × 3/12 = £7,200

ICAEW 2021 Risk management 231

 Closing prices:
Case 1 Case 2
Spot price 4.4% 2.1%
Futures price 95.31 97.75
Outcome:
Options market:
Strike price (sell) 96.25 96.25
Closing price (buy) 95.31 97.75
Exercise? YES NO
Gain on future 0.94% N/A
0.94% × £500,000 × 3/12 ×
Outcome 6 = £7,050 N/A
Net position:
Borrow at spot rate 33,000 15,750
Gain from option (7,050) N/A
Option premium 7,200 7,200
£33,150 £22,950
Interest rate 33,150/1,500,000 × 12/6 22,950/1,500,000 × 12/6
= 4.42% pa = 3.06% pa

(b) Futures may give less than 100% efficiency because of:
• basis risk – the price of a future may differ from the spot price on a given date. Basis is
nil at expiry but before then the change in the spot rate is not matched by the change
in the futures price preventing a hedge from being 100% efficient.
• rounding – frequently the number of contracts has to be rounded as dealing in
fractional contracts is not possible. This can also cause inefficiency.

Examiner’s comments
This risk management question produced the highest average mark of the three questions. This
reflects the fact that a firm knowledge of the techniques involved provides candidates with a good
opportunity to score highly on such questions, particularly when (as many do) they benefit from the
application of the ‘follow-through’ principle when such questions are marked. As usual, however,
there was very little middle ground – the failing candidates on the paper overall had little or no grasp
of the techniques involved in this question and scored poorly.
The most common errors in the first part were a failure to correctly calculate the firm’s net transaction
exposure, often including the sterling amounts, incorrect identification of the correct type of option,
a failure to accurately calculate the number of contracts and the use of the wrong rate when
calculating the premium.
The second part was generally well answered.

30 Bridge Engineering plc

Marking guide Marks

232 Financial Management ICAEW 2021

30.1 Intrinsic value:
Calculation of value of call options 1
Calculation of value of put options 1
Time value – deduct intrinsic value from the option premium 2
Marks Available 4
Maximum 4
30.2 Explanation of each of the three factors:
Time period to expiry 1
Market price volatility 1
General level of interest rates 1
Marks Available 3
Maximum 3
30.3 Explanation of the two factors:
Exercise price 1
Share price 1
Marks Available 2
Maximum 2
30.4 How Bridge can protect itself:
Put options 1
Choice of exercise price 1
Calculations 2
Marks Available 4
Maximum 4
30.5 To hedge against a rise in LIBOR:
Date of option .5
Put option .5
Exercise price .5
Calculation of number of contracts 1.5
Premium Payable 1
Marks Available 4
Maximum 10
(a) Effective interest rate scenario (b):
Exercise? .5
Gain 1
Total interest payable .5
Net cost of the loan 1
Effective interest rate .5

(b) Effective interest rate scenario (b):

Exercise? .5
Total interest payable .5
Total cost 1
Effective interest rate .5

30.6 Advantages of traded interest rate options:

Hedge downside risk, and take advantage of upside 1

ICAEW 2021 Risk management 233

 FRAs and interest rate futures lock in the interest rate 1
Options set a maximum interest rate 1
Liquid market, can be closed out if not needed 1
Disadvantages of traded interest rate options:
Cost of the premium 1
Margin requirements 1
Contracts are standard sizes so may not fit perfectly 1
FRAs can be tailor made 1
Marks Available 8
Maximum 7
Total 30

30.1 Intrinsic value

Only options that are in the money have an intrinsic value.
For the call options:
• the call options with an exercise price of 280p are in the money and have an intrinsic value
of 7p (287 – 280).
• the call options with an exercise price of 290p are out of the money and have a zero
intrinsic value.
For the put options:
• the put options with an exercise price of 290p are in the money and have an intrinsic value
of 3p (290 – 287).
• the put options with an exercise price of 280p are out of the money and have a zero
intrinsic value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:

Calls Puts

Exercise price January March January March

280 1.5 9 1.5 10.5

290 2.5 11 2.5 13.0

30.2 The three factors that affect the time value of the options on Stickle’s shares are:
• the time period to expiry of the option. The longer the time to expiry, the more the option is
worth.
• the volatility of the market price of Stickle’s shares. For example, if Sickle’s share price
becomes more volatile this will increase the probability of the options becoming either in
the money or, if they are already in the money, becoming deeper in the money. This would
increase the value of the options.
• the general level of interest rates. The exercising of the option will be at some point in the
future, and so the value of the option depends on the present value of the exercise price.
For example, for the call options on Stickle’s shares if interest rates rise the options will
become more valuable.
30.3 The factors that affect the intrinsic value of the options on Stickle’s shares are:
• The exercise price:
– For a call option: The lower the exercise price in relation to the share price the higher will
be the intrinsic value and this will make the option more valuable.

234 Financial Management ICAEW 2021

 – For a put option: The higher the exercise price in relation to the share price the higher
will be the intrinsic value and this will make the option more valuable.
• The share price:
– For a call option: As the share price rises the option becomes deeper in the money and
more valuable as the intrinsic value increases. The reverse is the case for a fall in the
share price.
– For a put option: As the share price falls the option becomes deeper in the money and
more valuable as the intrinsic value increases. The reverse is the case for a rise in the
share price.
30.4 Bridge can protect itself against a fall in the Stickle share price by holding put options that
expire on 31 March 20X6.
The choice of exercise price will depend on the level of cover required and how much
premium Bridge is willing to pay.
If the Stickle share price is 250p at the end of March the results of holding put options will be
as follow:
With an exercise price of 280p
Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the put options 280 – 250 = 30p
Premium: 10.5p
The maximum loss: 37 – 30 + 10.5 = 17.5p
Alternative: 287 – 280 + 10.5 = 17.5p
With an exercise price of 290p
Loss in the value of the shares 287 – 250 = 37p
Gain on exercising the options 290 – 250 = 40p
Premium: 16p
Maximum loss: 37 – 40 + 16 = 13p
Alternative: 287 – 290 + 16 = 13p

30.5 To hedge against a rise in LIBOR from 0.62% pa during the period from 31 December 20X5 to
31 July 20X6, Bridge will need to hold September put options with an exercise price of 99.38
(100 – 0.62).
Using options on three-month interest rate futures to hedge a seven-month period, the
number of contracts to be held is: (£20 m/£0.5 m) × (7/3) = 93.33; round to 93 contracts.
This leaves the company slightly under hedged.
The premium payable is: 93 × 0.52% × 0.5m × 3/12 = £60,450.
The results of the hedge on 31 July 20X6 are as follows:
(a) LIBOR is 0.80% pa and the futures price is 99.15.
Exercise the options? Yes, since the exercise price is 99.38 and more than the futures
price.
Gain on futures: 99.38 – 99.15 = 0.23%. 0.23% × 0.5m × 93 × 3/12 = £26,738.
Borrowing cost: 0.80 + 4.00 = 4.80% pa.
Total interest payable to the bank: 20m × 0.048 × 7/12 = £560,000
Net cost of the loan including the option premium:
560,000 + 60,450 – 26,738 = £593,712
The effective interest rate is: (593,712/20m) × (12/7) = 5.09% pa
Alternative: LIBOR + 4.00 – Gain on exercise + premium = 0.80 + 4.00 – 0.23 + 0.52 =
5.09% pa
(b) LIBOR is 0.40% pa and the futures price is 99.66

ICAEW 2021 Risk management 235

 Exercise the options? No, since the exercise is 99.38 and less than the futures price.
Borrowing cost: 0.40 + 4.00 = 4.40% pa
Total interest payable to the bank: 20m × 0.044 × 7/12 = £513,333
Total cost including the option premium: 513,333 + 60,450 = £573,783
The effective interest rate is: (573,783/20m) × (12/7) = 4.92% pa
Alternative: LIBOR + 4.00 + premium = 0.40 + 4.00 + 0.52 = 4.92% pa
30.6 The advantage of using options on interest rate futures rather than FRAs or interest rate futures
is that Bridge can hedge the downside risk (LIBOR rising) and take advantage of upside
potential (LIBOR falling).
Both FRAs and interest rate futures will lock Bridge into an estimate of LIBOR on 31 July 20X6.
The options will set a maximum on the interest rate that Bridge will have to pay.
The major disadvantage of using options on interest rate futures is the cost of the premium.
Both options on interest rate futures and interest rate futures are traded instruments and there
is a liquid market. Should Bridge not require the loan on 31 July 20X6 it can close out the
contracts.
There will be margin requirements, and there is the possibility of having to meet margin calls.
With both these instruments basis risk exists and it is not possible to construct a perfect hedge,
since the contracts are in standard sizes of £500,000.
FRAs on the other hand are over-the-counter instruments, and can be tailor made to Bridge’s
requirements.
The disadvantage of FRAs is that there is no liquid market for them should Bridge not need to
borrow the £20 million on 31 July 20X6.

Examiner’s comments
This was a six-part question that tested candidates’ understanding of the risk management element
of the syllabus. The scenario was that a company had used derivative instruments to hedge risk that
locked the company into one rate or asset price. The finance director of the company wished to
know more about the use of financial options in risk management. Two risks in particular that the
finance director was concerned about were the risks associated with buying shares and the interest
rate risk associated with taking out loans.
There were many weak answers to the first part of the question, but there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. The second
part was poorly answered, which is surprising since this has been examined before. However, again,
there were some excellent answers.
There were many weak answers to the third part of the question, however there were some excellent
answers, which demonstrated a good understanding of the characteristics of options. In the fourth
part, many students successfully applied the knowledge that they had acquired from their studies of
FTSE 100 index options. However, basic errors included using calls instead of puts and picking the
incorrect month of exercise. The fifth part has been examined before, yet there were many basic
errors which included using calls instead of puts, an incorrect number of contracts, the wrong date
for the contracts and an inability to calculate an effective interest rate.
The final part was well answered by the majority of candidates.

236 Financial Management ICAEW 2021

 March 2016 exam questions
31 Aranheuston Pharma plc

Marking guide Marks

31.1 Net present value of the AP525 product:

Sale of old equipment .5
Calculation of tax due on sale 1
New equipment cost and subsequent sale 1
Calculation of tax relief on equipment 2
Sales 1
Variable costs 1
Rent 1
Fixed costs 1.5
Taxation 2
Working capital 2
Discount factor 1
Ignore depreciation, head office costs, interest (1 mark each) 3
Conclusion 1
Marks Available 18
Maximum 18
31.2 Variable costs .5
Taxation 1
Discount factor 1
Correct calculation of sensitivity and appropriate conclusion 2.5
Marks Available 5
Maximum 5
31.3 Value drivers 2
Methodology 2
Key features of the approach 2
Marks Available 6
Maximum 6
31.4 (a) Takeover
Empire building, vested interests (1 mark per valid point) 3
Maximum 3
(b) Debt levels (1 mark per valid point) 3
Time horizons (1 mark per valid point) 3
Marks Available 6
Maximum 3
Total 35

31.1

ICAEW 2021 March 2016 exam questions 237

 Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Old equipment – Sale 70,000
Tax due (1) (11,900)
New equipment cost/sale (1,150,000) 100,000
Tax relief on equipment (2) 35,190 28,856 23,662 90,792
Sales (3) 2,705,040 742,846
Variable costs (4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (5) (164,800) (169,744) (174,836)
Taxation (6) 13,600 41,616 (204,584) (55,694)
Working capital (7) 0 (267,800) 193,537 74,263
Net cash flow after taxation (1,123,110) (442,128) 1,216,049 536,971
8% factor 1.000 0.926 0.857 0.794
PV (1,123,110) (409,411) 1,042,154 426,355
NPV (64,012)

Ignore depreciation as it is not a cash flow.

Ignore HO costs as they are allocated – and therefore not incremental cash flows.
Ignore interest as it is part of the cost of capital.
AP525 produces a negative NPV, and so should not be undertaken as it would reduce
shareholder wealth.

Year to Year to Year to Year to

31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
(1)
WDV b/f 0
Balancing charge 70,000
WDV/sale 70,000

Tax (17% × balancing charge) 11,900

(2)
Equipment purchase/WDV 1,150,000 943,000 773,260 634,073
WDA @ 18%/Bal.allowance (207,000) (169,740) (139,187) (534,073)
WDV/sale 943,000 773,260 634,073 100,000

Tax (17% × WDV/Bal.allowance) 35,190 28,856 23,662 90,792

238 Financial Management ICAEW 2021

 Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
(3)
Sales (March 20X6 prices) 2,600,000 700,000
Inflate at 2% pa × (1.02)2 × (1.02)3
“Money” sales income 2,705,040 742,846

(4)
Variable cost 1,180,000 220,000
(March 20X6 prices)
Inflate at 3% pa × (1.03)2 × (1.03)3
“Money” variable cost 1,251,862 240,400

(5)
Fixed costs
(March 20X6 prices) 290,000 290,000 290,000
less: HO cost allocation (130,000) (130,000) (130,000)
160,000 160,000 160,000
Inflate at 3% pa × 1.03 × (1.03)2 × (1.03)3
“Money” fixed costs 164,800 169,744 174,836

(6)
Sales (W3) 2,705,040 742,846
Variable costs (W4) (1,251,862) (240,400)
Rent (80,000) (80,000) (80,000)
Fixed costs (W5) (164,800) (169,744) (174,836)
Trading profit/(loss) (80,000) (244,800) 1,203,434 327,610

Tax reclaim/(payable) @ 17% 13,600 41,616 (204,584) (55,694)

(7)
Total working capital 0 260,000 70,000 0
× 1.03 × (1.03)2
“Money” total working capital 0 267,800 74,263 0

Incremental working capital 0 (267,800) 193,537 74,263

31.2 PV of variable costs

ICAEW 2021 March 2016 exam questions 239

 Year to Year to Year to Year to
31/3/16 31/3/17 31/3/18 31/3/19
£ £ £ £
Variable costs (1,251,862) (240,400)
Taxation @ 17% 212,817 40,868
Net cash flow after taxation (1,039,045) (199,532)
8% factor 0.857 0.794
PV (890,462) (158,428)

Total PV of variable costs (£890,461 + £158,428) £(1,048,890)

% change in variable costs required 6.1%
Thus, ignoring all other factors, variable costs would need to fall by 6.1% before the NPV
became positive and the AP525 was viable. This is a relatively small change required to make
the NPV positive.
31.3 With shareholder value analysis (SVA), a company’s value is based on the present value of its
future cash flows, so it is forward-looking. This is theoretically the most superior valuation
method. SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) List of capital
Predictions are very difficult, as cash flows are technically in perpetuity. Once a company’s
period of competitive advantage is over then its growth rate is much slower and a terminal
(residual) value is calculated, based on its cash flows to perpetuity. This terminal value is often
the major part of the overall value of the company.
Once the total value of the company has been calculated, based on the future cash flows and
value drivers, then, to calculate the value of equity, it is necessary to add the value of any short-
term investments held and deduct the market value of any debt held.
31.4
(a) A takeover – eg, empire building by directors, making acquisitions which are not in the
shareholders’ best interest (negative NPV). Or, alternatively, a takeover might lead to the
directors being made redundant, so they would avoid a takeover which would have been
in the shareholders’ best interest (positive NPV).
(b)
• Debt levels – it is an all-debt financed equipment purchase here, but the directors are
likely to be cautious over risk and may prefer lower levels of debt than would be at the
optimal level (where share price maximised) for the shareholders.
• Time horizons – directors may take a short-term view of the firm as their performance is
usually judged in the short-term. However, shareholder wealth is affected by the long-
term performance of the company. Thus directors might turn down a possible
investment that has short-term losses, but a long-term positive NPV. This would not
occur in the case of AP525, as it has a negative NPV.

Examiner’s comments
This question had easily the highest percentage mark on the paper. Overall, the candidates’
performance was very good indeed.

240 Financial Management ICAEW 2021

 This was a four-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus. In the scenario a pharmaceutical company was considering the
development of a new product and the possible takeover of a competitor. In the first part, for 18
marks, candidates were required to calculate the net present value of the proposed product
development. They were given forecast life-cycle data for the new product and had to take account
of non-relevant cash flows, inflation rates and corporation tax implications. Secondly, for five marks,
they were required to calculate the sensitivity of that decision to the variable costs of the product. For
a further six marks they were asked to outline how Shareholder Value Analysis (SVA) could be used
when valuing a target company. Finally, for six marks, candidates were required to apply their
understanding of agency theory to three specific elements of the scenario.
The first part was very well answered by most candidates. However, common errors noted were:
• no balancing charge calculated on the old equipment to be disposed of.
• rental costs (fixed) were inflated and/or in arrears, not in advance.
• tax savings from negative cash flows in Year 0 and Year 1 were omitted.
• working capital – did not net to zero, was applied to the wrong years, the inflation
calculations were poor.
Also, many candidates lost marks for not explaining why depreciation, head office costs and interest
charges were not relevant cash flows. ‘Not relevant’ was insufficient. In the second part, the sensitivity
calculations were generally fine. The most common errors were (a) using sales or contribution figures
rather than variable costs and (b) missing out the effect of taxation in the calculations.
As in previous papers the candidates’ understanding of SVA was generally poor. A disappointing
number of them concentrated, wrongly, on NPV rather than PV and discussed SVA in regard to a
project and not the valuation of a target company. Thus, many candidates did not mention terminal
value. Agency theory was generally answered well. The weakest area here was candidates’
explanation of the conflicts that might arise in relation to short-term versus long-term performance
appraisal in the context of the project. Too many used a takeover context instead.

32 Oliphant Williams plc

Marking guide Marks

32.1 Calculation of gearing ratio:

Book value 1.5
Market value 1.5
Marks Available 3
Maximum 3
32.2 Gearing and share price:
View on gearing 2
Comparison of book value and market value 2
No industry comparison available 1
Reduction in gearing will have positive effect on share price 1
Marks Available 6
Maximum 6
32.3 Impact of rights issue:
Calculation of funds needed for debenture redemption 2
Calculation of TERP 3
Value of a right .5
Current value of 10,000 shares .5
Marks Available 6
Maximum 9

ICAEW 2021 March 2016 exam questions 241

 Marking guide Marks

(a) Current value of 10,000 shares 1

Maximum
(b) Effect of selling the rights 1
Maximum
(c) Effect of ignoring the rights 1
Maximum
32.4 OW share price:
Current EPS 1
Current PE ratio 1
Calculation of new earnings figure 2
New EPS 1
MV per share post rights 1
Commentary 1
Marks Available 7
Maximum 7
32.5 Dividend policy:
M&M theory 2
Traditional theory 2
Other theories 2
Change in dividend policy likely to have effect 1
Marks Available 7
Maximum 7
32.6 Ethical implications:
Objectivity 1
Integrity 1
Professional behaviour 1
Marks Available 3
Maximum 3
Total 35

32.1

Long term finance Book value Market value

£m £m
Ordinary share capital 96.0 326.4
retained earnings (RE) 43.8 n/a
Preference share capital (PSC) 28.0 50.4
3.5% debentures 160.0 168.0
327.8 544.8

Total fixed return capital (debentures + PSC) 188.0 218.4

242 Financial Management ICAEW 2021

 Long term finance Book value Market value
£m £m
Gearing % 188.0/327.8 = 57.4% 218.4/544.8 = 40.1%

32.2 The main theories of gearing and market value are the traditional view, M&M 1958 and 1963.
The modern view is that the optimum gearing level (where company value is maximised) is a
balance between the benefits of the tax shield and bankruptcy costs. The impact on OW’s
WACC (and value) depends on where its optimum gearing level is.
OW’s gearing at book value is over 57%; this is rather high and may depress OW’s market
value.
However, gearing at market value is 40%. This is much lower, which may have a positive effect
on the value of OW’s shares.
It is hard to say where OW’s optimal gearing level is likely to be, as there are no industry
comparisons.
If OW’s gearing level is currently above its optimal level, then a reduction in its gearing will
have a positive effect on its share price and vice versa.
32.3 Total funds needed for debenture redemption = £160m × 50% × £110.40/£100 = £88.32m

Shares
m £m
Currently 192.0 £1.70 326.400
Rights issue (2 for 5) 76.8 £1.15 88.320
268.8 £1.5429 414.72

TERP = £1.5429
Value of a right = £1.5429 – £1.15 = £0.3929
Current wealth 10,000 × £1.70 = 17,000
(a)

Take up rights £ £
10,000 × 7/5 ×
Investment ex-rights 1.5429 21,600
10,000 × 2/5 ×
Cost of extra shares £1.15 (4,600) 17,000

(b)

Sell rights £ £
Investment ex-rights 10,000 × 1.5429 15,429
10,000 × 2/5 ×
Sale of rights £0.39 1,571 17,000

(c)

Ignore rights £ £
Investment ex-rights 10,000 × 1.5429 15,429

32.4 OW’s current earnings per share (EPS) £21.12m/192.0m = £0.11

OW’s current p/e ratio £1.70/£0.11 = 15.5
[or £326.4m/£21.12m = 15.5 for 2 marks]

ICAEW 2021 March 2016 exam questions 243

 £m
OW’s current earnings 21.120
plus: Interest saved (after tax) £160m/2 × 3.5% × 83% 2.324
OW’s new earnings 23.444

OW’s new earnings per share (EPS) £23.444m/268.8m = £0.0872

OW’s MV/share post-rights £0.0872 × 15.5 = £1.35
Thus if OW’s P/E ratio remains unchanged post-rights, its market value will fall (from £1.70 per
share) by approx. £0.35 per share (20.6%). This fall has been caused by a dilution in the EPS
figure (the extra shares have outweighed the impact of the debenture interest saved).
However the debenture redemption will cause a fall in gearing. This decline in gearing may
prompt an increase in OW’s p/e ratio (because of lower financial risk).
32.5 M&M theory – share value is determined by future earnings and the level of risk.
The amount of dividends paid will not affect shareholder wealth, providing the retained
earnings are invested in profitable investment opportunities (positive NPV’s).
Any loss in dividend income will be offset by gains in the share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or capital
gains in the future. Cash now is more certain than cash in the future.
Supplementing these main theories:
• Impact of signalling
• Clientele effect
A change in dividend policy may have a negative impact on OW’s share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change,
Communication with them is important.
32.6 ICAEW provides ethical guidance that will ensure that recipients of corporate finance advice
can rely on the objectivity and integrity of advice given to them by members. The other ethical
principle at risk here is that of professional behaviour.

Examiner’s comments
This question had the lowest percentage mark on the paper. The majority of candidates achieved a
“pass” standard in the question, however.
This was a six-part question that tested the candidates’ understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it. It was based
around a design company which was planning to restructure its balance sheet. This would be
achieved by financing the redemption of long-term debt via a rights issue of ordinary shares. The first
part of the question, for three marks, required candidates to calculate the current gearing levels of
the company, using both book and market values. In the second part, for six marks, they were asked
to discuss the impact of a change in the company’s gearing levels on its share price. Candidates were
expected to make reference to relevant theories and their calculations from the first part. The third
part, for nine marks, required the candidates to calculate the theoretical ex-rights price (TERP) of the
company and the impact of the proposed rights issue on the wealth of a shareholder holding 10,000
of the company’s shares. The fourth part (seven marks) tested candidates’ understanding of (a) the
company’s P/E figure and (b) the impact of the debt redemption on the company’s earnings figure.
The fifth part, again for seven marks, required candidates to apply their understanding of dividend
policy theory to the scenario. Finally, for three marks, the final part required candidates to comment
as an ICAEW Chartered Accountant on the ethical implications of issuing misleading information to
shareholders.
Many candidates’ answers to the first part were disappointingly weak. Typical errors were: (a) not
including preference shares as debt (contra to the Workbook and past questions) and (b) ignoring
retained earnings in their book value calculations, but including it in their market value calculations.
In the second part, many candidates only scored three marks by focusing just on the theory of
gearing and company value. Those scoring higher marks noted that there was a lack of industry

244 Financial Management ICAEW 2021

 comparison available in the question and, better still, noted the importance of where the company is
now in relation to its optimum gearing level.
In the third part, a significant number of candidates calculated a TERP in excess of the current market
value – clearly this is wrong. This was mainly because they assumed that the par value of ordinary
shares was £1 (not 50p) and insisted that the share price was £3.40, not £1.70, as given in the
question. Many candidates did not calculate the correct debenture redemption figure. Most
candidates did well with the impact of the rights issue on the shareholder’s wealth, but many
calculated a large increase in wealth when it should be zero or a loss from doing nothing.
Candidates’ performance in the fourth part was very variable indeed and was probably the weakest
set of answers on the whole paper. Very few candidates adjusted the company’s earnings figure for
saved interest (less tax). A disappointing number calculated the P/E ratio, wrongly, as follows:
£1.70/£21.12m.
The fifth part was answered very well, as expected. The final part was also answered well, but a high
number of candidates included money laundering in their answers – not relevant here.

33 Tully Carlisle Ltd

Marking guide Marks

33.1 (a) Hedging strategies:

Forward contract 2
Money market hedge 3
OTC currency option 3
Marks Available 8
Maximum 8
(b) Advice on hedge:
Use of spot rates to analyse costs 3
Conclusion re options 1
Effect of continually weakening rouble on spot rate 1
Advantages of options (flexibility) 2
Other factors to consider (risk attitudes, political risk) 2
Marks Available 9
Maximum 9
(c) Three month forward rate:
Interest rate parity 2
Calculation of three-month forward rate using IRP formula 2
Calculation of discount 1
Marks Available 5
Maximum 5
33.2 Interest rate swap:
Calculation of interest rate differences 1
Details of swap 2
Net new rate for TC 1.5
Net new rate for SSM 1.5
Details of new interest payments 2
Marks Available 8
Maximum 8
Total

ICAEW 2021 March 2016 exam questions 245

 Marking guide Marks

30

33.1
(a) Forward contract

R145.6m R145.6m
Payment in sterling would
(78.81 + 0.55) (79.36)
be (£1,834,677)
plus: arrangement fee 145.6 × £40 (£5,824)
(£1,840,501)

Money market hedge

R145.6m R145.6m
Payment in sterling would R143,589,740
(1 + 5.6%/4)) 1.014
be lent

R143,589,740
78.81
Converted at spot rate (£1,821,973)
£1,821,974 ×
Borrowed at 3.6% p.a. (3.6%/4) (£16,398)

(£1,838,371)

OTC currency option

A call option would be used (ie, at 79.85R/£)

R145.6m
79.85
Payment in sterling would be (£1,823,419)
plus: Option premium 145.6 × £90 (£13,104)
(£1,836,523)

(b)

R145.6m
Sterling payment at a spot
78.81 (£1,847,481)
rate

R145.6m
Comparative payment at
78.81 (£1,832,599)
earlier dates 31/12/X4

R145.6m
78.81 (£1,903,019)
31/12/X5

Stronger sterling gives the lowest payment, and weaker sterling the highest.
The forward contract discount suggests a weakening of the rouble. It has weakened from
December 20X5 to February 20X6, so this may be a trend.

In order (lowest to highest cost)

Option (£1,836,523)

246 Financial Management ICAEW 2021

 In order (lowest to highest cost)
Money market hedge (£1,838,371)
Forward contract (£1,840,501)
Spot (£1,847,481)

The option gives the best outcome (it has a slightly lower cost than the money market
hedge and the forward contract). However, if the rouble continued to weaken then the
sterling cost would fall further. For example, a 1% increase in the spot value of sterling
over the next three months would make this the lowest sterling payment (145.6mR/(78.81
× 1.01) = £1,829,146.
An option gives flexibility (the ability to abandon, or to take advantage of any upside)
unlike the money market hedge or forward contract (which are both fixed, binding, and
have no upside/downside).
The directors’ attitude to risk is important, as is a consideration of issues such as the
potential for political risk associated with operations in Russia.
(c)

1 + Average rouble interest rate (3mths)

Average spot rate × 1 + Average sterling interest rate (3mths)
= Forward contract rate (3mths)

The rouble interest rates are higher than those of sterling. Using the interest rate parity
(IRP) equation above, the value of sterling against the rouble will rise. The rouble’s loss of
value is called a discount.
Average UK rate 3.25% pa or 0.8125% per 3 months
Average Russian rate 6.1% pa or 1.525% per 3 months
Average spot = (90.62 – 78.81)/2) + 78.81 = 84.715
Forward = 84.715 × (1.01525/1.008125) = 85.31 ie, a discount of 0.6
Average discount given = 0.59, so IRP is working
33.2

TC SSM Difference
Fixed 5.2% 6.4% 1.2%
Variable LIBOR + 1.2 LIBOR + 1.6 0.4%
Difference between differences 0.8%

This potential gain can be split evenly, ie, 0.4% to each party. This means that TC would pay
LIBOR + 0.8% (LIBOR + [1.2% – 0.4%] and SSM would pay fixed 6.0% (6.4% – 0.4%).
The interest rate swap would look like this:

TC SSM
Currently pays (5.2%) (LIBOR + 1.6)
TC pays SSM (LIBOR) LIBOR
SSM pays TC (balancing figure) 4.4% (4.4)
New net payment (LIBOR + 0.8) (6.0%)

TC and SSM would both pay at less (0.4% in each case) than their available fixed and variable
rates.

TC SSM
New net interest rate (LIBOR + 0.8) 4.3% pa 6.0% pa
£’000 £’000

ICAEW 2021 March 2016 exam questions 247

 TC SSM
Interest on £18.5m pa (795.5) (1,110.0)

Alternatively

£’000 Rate £’000 £’000 Rate £’000

Interest paid now 18,500 (5.2%) (962.0) 18,500 (5.1%) (943.5)
SSM pays TC 4.4% 814.0 (4.4%) (814.0)
TC pays SSM (3.5%) (647.5) 3.5% 647.5
New interest
payment (795.5) (1,110.0)

Examiner’s comments
The average mark for this question was very good and most candidates demonstrated a good
understanding of this area of the syllabus.
This was a four-part question which tested the candidates’ understanding of the risk management
element of the syllabus. In the scenario a construction company was investigating firstly how it might
manage its exposure to foreign exchange rate risk and then whether a proposed interest rate swap
on borrowed funds was worthwhile. Part (a) of the first requirement, for eight marks, required
candidates to calculate the sterling cost arising from a range of hedging techniques applied to a
large Russian purchase contract. In part (b), for nine marks, candidates were required to advise the
company’s board whether it should hedge the Russian (rouble) payments. Part (c), for five marks
required candidates to explain, with relevant workings, the concept of interest rate parity (IRP). In the
second part, for eight marks, the company was planning to swap its borrowings from a fixed rate to a
variable rate of interest and candidates were asked to provide workings for the board demonstrating
how the swap would work and calculating the resultant annual interest payments.
Most candidates’ answers to part (a) of the first requirement were very good, but the most common
error noted was that a minority of candidates used the wrong approach with regard to the call
option. Answers to part (b) were not as good as hoped. Too many candidates discussed recent spot
movements or forward contract versus money market hedge versus option, rather than both. In part
(c) the concept of IRP was, in most cases, answered well, but many candidates used 12-month rather
than three-month figures. A minority of candidates did not mention IRP, and so scored zero.
In the second requirement, the interest rate swap was done very well and most candidates scored
maximum marks. The weakest area was with the initial overall saving on interest cost (0.8%), which a
small percentage of candidates did not calculate correctly.

248 Financial Management ICAEW 2021

 June 2016 exam questions
34 Zeus plc

Marking guide Marks

34.1 Valuation using NPV:

Gross profit calculation 3
Selling and admin costs 1.5
After tax operating cash flows 1
New equipment .5
Tax saved on capital allowances 2.5
Working capital 2.5
Continuing value 3
Discount factor 10% .5
NPV .5
Marks Available 15
Maximum 15
34.2 Multiple of current earnings:
Profits after tax 1
Use of mean P/E ratio 1
Marks Available 2
Maximum 2
34.3 Advantages and disadvantages of valuation methods: .5
Advantages of NPV valuation .5
Disadvantages of NPV valuation .5
Advantages of multiples valuation .5
Reservations regarding the NPV valuation – 0.5 marks each 2
Reservations regarding the multiples valuation – 0.5 marks each 2
Marks Available 6
Maximum 5
34.4 Offer for sale 1
Offer for subscription 1
Marks Available 2
Maximum 2
34.5 Underwriting:
Explanation of underwriting 1
Advantages for Zeus 2
Disadvantages for Zeus 2
Marks Available 5
Maximum 4
34.6 Compare ICO to IPO 4
Marks Available 4
Maximum 4
34.7 Ethical issues:
Identification of threats 1

ICAEW 2021 June 2016 exam questions 249

 Marking guide Marks

Ways to mitigate them – 0.5 marks each 2

Marks Available 3
Maximum 3
Total 35

34.1

0 1 2 3 4
£m £m £m £m £m
Gross profit 111.21 133.85 161.10 193.90
Selling and administration (73.50) (77.18) (81.04) (85.09)
Operating cash flows 37.71 56.67 80.06 108.81
Tax 17% (6.41) (9.63) (13.61) (18.50)
After tax operating cash flows 31.30 47.04 66.45 90.31
New equipment (10.00)
Tax saved on CA’s 0.31 0.25 0.21 0.17 0.77
Working capital (26.00) (5.29) (6.37) (7.67) 45.33
Continuing value 1,013.48
Net cash flows (35.69) 26.26 40.88 58.95 1,149.89
PV factors at 10% 1.00 0.91 0.83 0.75 0.68
Present value (35.69) 23.90 33.93 44.21 781.93
NPV 848.28

Gross profit = £92.4 million (140 × 66%)

Gross profit year:
1 = 92.4 × 1.18 × 1.02 = £111.21 million
2 = 111.21 × 1.18 × 1.02 = £133.85 million
3 = 133.85 × 1.18 × 1.02 = £161.10 million
4 = 161.10 × 1.18 × 1.02 = £193.90 million
Selling and administration £70 million (72 – 2) increasing at 5% pa, as depreciation is not a
cash flow.
Continuing value = (90.31 × 1.01)/(0.10 – 0.01) = £1,013.48 million
Ignoring balance sheet asset values (valuing the income that the assets generate)
Capital allowances and the tax saved thereon

Cost/WDV CA Tax
£m £m £m
0 10.00 1.80 0.31
1 8.20 1.48 0.25
2 6.72 1.21 0.21
3 5.51 0.99 0.17
4 4.52 4.52 0.77

250 Financial Management ICAEW 2021

 Working capital

Total Increment
£m £m
0 (26.00) (26.00)
1 (31.29) (5.29)
2 (37.66) (6.37)
3 (45.33) (7.67)
4 45.33

34.2 Profits after tax at 30 June 20X6 = £10 million.

The value of Venus based on the mean p/e ratio = £550 million (10 × 55).
34.3 The advantages of the NPV valuation are that it values the future cash flows of the company
and takes into account both risk and the time value of money. However it has the disadvantage
that the inputs into the model are critical in arriving at a reliable estimate of the value of Venus.
The major advantage of the multiples valuation is that it values Venus by comparison to its
peers, and reflects the future growth potential of the market. However the disadvantages are
that no company is truly comparable with another, and establishing a maintainable earnings
figure is problematic.
In relation to Venus, reservations include:
For the NPV valuation: Is 18% growth realistic for the next four years? How has this figure been
estimated? Does the 10% discount factor truly reflect the risk of the company? Is it reasonable
to calculate the continuing value by treating the fourth year after tax operating cash flow as a
growing perpetuity? How has the 1% growth figure been calculated? Is it reasonable to
assume that the gross profit percentage will increase by 10%?
For the multiples valuation: The p/e ratio of 55 is the mean of a sample of comparable
companies, but what is the spread of p/e ratios, and have outliers been excluded? Is taking
historic earnings realistic – should prospective earnings be calculated instead?
34.4 With an offer for sale shares in Venus would be sold to an issuing house, which would then
offer the shares for sale to the general public.
With an offer for subscription (or direct offer) the shares in Venus would be offered directly to
the public ie, not through an issuing house.
34.5 Underwriting is a form of insurance, which ensures that all securities are sold and Zeus can be
certain of obtaining the funds required.
The danger for Zeus of not using a underwriter for the IPO is that there might be insufficient
demand for all the securities to be issued. This is especially important when a fixed issue price
is set in advance of the issue date, and the market is volatile. The market appetite for Venus’s
stocks might be less than expected, especially with the value placed on the company, which
depends on high future growth.
The major disadvantage of underwriting is the cost. The cost depends on the characteristics of
the company issuing the security and the state of the market. With a company such as Venus,
the cost is likely to be at the upper end of the scale. Fees usually range from 1% to 2% of the
total finance to be raised.
Another disadvantage of underwriting is that it may signal that the company is not confident in
the issue being fully taken up.
34.6 An ICO is an Initial Coin Offering, like an Initial Public Offering (IPO), an ICO raises finance from
investors. However, there are two key differences:
(1) An investor receives a token; this might be a share, or it might be a utility token that gives
an entitlement to use a product or service.
(2) Payment is made in a cryptocurrency such as Bitcoin.
Initially one of the attractions of an ICO was its simplicity. The issuer raises money simply by
issuing a white paper, providing details of the concept that the venture intends to build and

ICAEW 2021 June 2016 exam questions 251

 details of the tokens that will be issued in exchange for cryptocurrency. The white paper is
available via the venture’s website, which also provides the mechanism for payment of
cryptocurrency to the venture’s account (typically Bitcoin or Ether).
However, increasingly regulators are viewing ICOs as offering future income streams and are
judging them to be securities. This means that ICOs are likely to have to fulfil the related
regulatory criteria for an issue of securities (eg, production of a full prospectus). This has led to
a moderation in the use of ICOs.
The other key risk of an ICO to Zeus is the value of cryptocurrency, which is highly volatile.
ICO’s are basically blockchain crowd sales, the cryptocurrency version of crowdfunding. They
would normally be used to raise finance for a new, potentially high-growth project. An ICO is
therefore potentially appropriate to the divestment of Venus.
34.7 For SA there is an issue of confidentiality here, and a potential conflict of interest. This can be
resolved by:
• the use of different partners and teams for different clients.
• taking the necessary steps to prevent the leakage of confidential information between
different teams and sections within the firm’s “Chinese walls”.
• regular review of the situation by a senior partner or compliance officer not personally
involved with either client.
Advising clients to seek additional independent advice, where it is appropriate.

Examiner’s comments
This was a seven-part question, which tested candidates’ understanding of the investment decisions
element of the syllabus. The scenario of the question was that a company is divesting itself of a
division by offering it to the public through an Initial Public Offering.
The first part was well answered by many candidates. Common errors that weaker candidates made
were: including operating cash flows in time zero; incorrect calculation of the continuing value;
adding the 18% growth and 2% price increase figures together instead of compounding them;
omitting to explain why certain inputs were not to be included in the cash flows; applying a non-
marketability discount to the final valuation.
The second part was also well answered by the majority of candidates. However, many candidates
applied a non-marketability discount to the p/e ratio, which was inappropriate for the valuation of an
IPO. Responses to the third part were mixed and often did not relate to the scenario of the question
despite the requirement specifically asking for this. Very few students submitted correct answers to
the fourth part of the question, and often made up definitions.
Responses to the fifth part were mixed, with a lot of candidates showing that they did not understand
what underwriting means. Responses to the sixth part were good, although often candidates did not
consider the scenario of the question. The final part was well answered by the majority of candidates.
However, as in previous sittings, a number of candidates did not use the language of ethics.

35 Ross Travel plc

Marking guide Marks

35.1 (a) Calculation of WACC using Gordon growth model:

Ex-div share price .5
Shares in issue .5
Total earnings calculation 1
Total dividends .5
Retentions 1
Calculation of rate of return 2
Calculation of growth rate .5

252 Financial Management ICAEW 2021

 Cost of equity 1
Cost of debt 3
MV of equity 1
MV of debt 1
12
(b) Calculation of WACC using CAPM:
Cost of equity 1
Cost of debt 1
2
35.2 Limitations of the Gordon growth model:
One mark per point to a maximum of 3
Marks Available 3
Maximum 3
35.3 WACC for appraisal of Happytours:
Explanation of need to reflect risk 3
Degearing of the beta for the new sector 1.5
Regear using Ross’s capital structure 1.5
New cost of equity .5
Calculation of WACC .5
Marks Available 7
Maximum 6
35.4 New debentures:
Higher yield likely to be required: risk, coupon rate; maturity 2
Calculation of issue price 4
Calculation of nominal value to be issued 1
Marks Available 7
Maximum 7
35.5 Convertible debentures:
Explanation and features of convertible debentures 3
Advantages – 0.5 marks each 2.5
Disadvantages – 0.5 marks each 1
Marks Available 6.5
Maximum 5
Total 35

35.1
(a) WACC using the Gordon growth model:
The growth rate = g = r × b
Where r = the current accounting rate of return
b = the proportion of profits after tax retained
The profits after tax = the current ex-div share price × the earnings yield × the number of
shares in issue.
The ex-div share price = 565p (576p – 11p)
The number of shares in issue = 640m (£32m/£0.05)
The total earnings = £216.96m (565p × 0.06 × 640m)
Total dividends = £70.40m (11p × 640m)

ICAEW 2021 June 2016 exam questions 253

 Retentions = £146.56m (£216.96m – £70.40m) b = 67.55% (£146.56m/£216.96m)
r = Earnings/Opening equity capital employed = £216.96/(£3,104m – £146.56m) = 7.33%
g = 7.33% × 67.55% = 4.95% say 5%
ke = (d1/MV) + g = (11p(1.05)/565p) + 0.05 = 7%
The cost of debt (kd) =

Year Cash Flow 1% PV 5% PV

0 (105) 1 (105.00) 1 (105.00)
1–4 6 3.902 23.41 3.546 21.28
4 100 0.961 96.10 0.823 82.30
14.51 (1.42)

The yield to maturity is a little under 5% = 1 + ((14.51/(14.51 + 1.42) × (5 – 1)) = 4.64%

kd = 3.85% (4.64 × (1 – 0.17))
Market values:
Equity = £3,616m (565p × 640m)
Debt = £638.4m (£608m × 1.05)
WACC = (7% × 3,616 + 3.85% × 638.4)/(3,616 + 638.4) = 6.5%
(b) WACC using the CAPM:
ke = 2 + (0.65 × 5) = 5.25%
kd = 3.85%
WACC = ((5.25% × 3,616) + (3.85% × 638.4))/(3,616 + 638.4) = 5%
35.2 Particular issues are as follows:
• The model relies on accounting profits.
• It assumes that b and r remain constant.
• It can be distorted by inflation.
• It relies on historic information.
• It assumes that all new finance is from equity or that gearing is held constant.
35.3 The discount rate to appraise the Happytours project must reflect its systematic risk. Ross
operates in the public transport sector; the holiday and sightseeing sector of the
transportation industry is likely to have a higher systematic risk since it relies more on
discretionary spending than the public transportation sector.
The discount rate should also reflect the financial risk of Ross; in this case the finance will be
raised in such proportions that the market value gearing will remain constant.
A beta factor from a company operating in the new sector should be selected to reflect the
systematic risk. However gearing adjustments are likely to be necessary.
Equity beta of the new sector = 1.3.
Degear the beta factor: 1.3 × (1/(1 + (1 × 0.83)) = 0.71.
Regear the beta factor using Ross’s capital structure:
0.71 × ((3,616 + (638.4 × 0.83)/3,616) = 0.81.
Ross’s current equity beta is 0.65 and the equity beta for the new industry sector is 0.81, which
reflects its higher systematic risk.
ke becomes = 2 + (0.81 × 5) = 6.05%
WACC = ((6.05% × 3,616) + (3.85% × 638.4))/(3,616 + 638.4) = 5.72%
35.4 The yield to maturity that investors in the debentures will require should reflect the riskiness of
the debentures, the coupon rate and the maturity date. The new debentures have a longer
maturity date and a lower coupon rate than Ross’s current debentures. Therefore it is likely that

254 Financial Management ICAEW 2021

 investors in the new debentures will require a higher yield to maturity than investors in the
existing debentures.
The issue price of the new debentures is arrived at by discounting their cash flows at an
appropriate yield to maturity.
Using the yield to maturity of the current debentures of 4.64%, the issue price will be:
Annuity factor for five years at 4.64% = (1 – 1/(1 + 0.0464)5)/0.0464 = 4.373%
Note: If an annuity factor and discount factor at 5% are used, full marks will be given.
The issue price per £100 nominal value = (4 × 4.373) + 100 × 1/1.04645 = £97.20
The total nominal value that will have to be issued to raise £75 million = £75m/0.972 = £77.16
million.
35.5 Convertible debentures are fixed return securities that can be either secured or unsecured.
They may be converted, at the option of the holder (and sometimes the company) into
ordinary shares in the same company at a future date, or a series of future dates.
The coupon on convertible debentures is normally lower than on redeemable debentures
because of the value of the conversion rights.
Advantages for Ross include the following:
• Obtaining finance at a lower rate of interest than on redeemable debentures
• Encouraging possible investors with the prospect of a future share in profits
• Introducing an element of short-term gearing
• Avoiding the problem of redemption if the conversion rights are taken up
• Being able to issue equity cheaply if the debentures are converted
Disadvantages for Ross include the following:
• Dilution of control if the conversion rights are taken up
• Uncertainty as to whether the conversion rights will be taken up and the debentures have to
be redeemed in cash

Examiner’s comments
This was a five-part question that tested the candidates’ understanding of the financing options
element of the syllabus. The scenario of the question was that a company is expanding its operations
into a different sector of its market.
There were many basic errors in the first part which really should not be occurring given how many
times this has been set. The errors included the inability to calculate numbers correctly; incorrectly
calculating the number of shares in issue; not calculating the ex-div share price and/or the ex-interest
debenture price; for the cost of debt calculating positive and negative values and interpolating
outside of the range calculated; no tax adjustment for the cost of debt and using book values for the
WACC calculation. In the second requirement part (b) it was disappointing to see that many
candidates were deducting the risk free rate from the market risk premium. Also a number of
candidates were using the 1.3 equity beta from the sightseeing tour sector rather than Ross’s existing
equity beta of 0.65.
The second part was well answered by the majority of candidates. Answers to the third part were
mixed and often there were no reality checks made, with some candidates clearly demonstrating that
they have a very shallow knowledge of the topic. Errors included calculating unrealistic equity betas
(over 300 in one script); degearing using Ross’s market values and regearing the gearing ratio of the
holiday and sightseeing tour sector; regearing using book values despite the formulae sheet stating
market values; degearing and regearing with the same debt/equity ratio and ending up with a
different figure from the start; when regearing changing the gearing ratio, even though the question
states that this will not change; very brief or non-existent explanations of the rationale.
Despite the fourth part being set before, and with a very similar detailed example in the Workbook,
most candidates made a poor attempt. Few candidates used the redemption yield of the existing
debentures, which they had calculated in the first part; there were only brief or no explanations of the
terms of the debenture issue.
The fifth part was well answered by the majority of candidates, but some answers gave explanations
of Modigliani and Miller, which was not relevant to this question.

ICAEW 2021 June 2016 exam questions 255

36 Heaton Risk Management

Marking guide Marks

36.1 (a) Sterling receipt using forward contract:

Appropriate forward rate 1.5
Calculation of sterling receipt .5
Sterling receipt using currency futures:
September futures 1
Number of contracts 1
Loss arising 1
Calculation of sterling receipt 1
Sterling receipt using OTC currency option:
Call option 1
Premium 1
Cost of lost interest 1
Exercise the option 1
Net sterling receipt 1
11
(b) Hedging techniques:
Forwards and futures do not allow for upside potential 1
Options protect against downside 1
Options allow benefit from upside 1
Option premium is expensive 1
Other advantages and disadvantages – 0.5 marks each 4
Recommendation for Orchid 1
9
36.2 August put options 1
Exercise price 1
Number of contracts .5
Premium .5
Marks Available 3
Maximum 7
(a) Let options lapse 1
Overall position .5

(b) Exercise the option 1

Calculation of gain 1
Overall position .5

36.3 Factors affecting time value of options:

Three factors:
Identification of each – 0.5 marks each 1.5
Explanation – 0.5 marks each 1.5

256 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 3
Maximum 3
Total 30

36.1
(a) Forward contract:
The appropriate forward rate = $/£ 1.5392 (1.5402 – 0.0010)
This will result in a sterling receipt of = £1,624,220 ($2,500,000/$1.5392)
Currency futures:
Orchid will buy September futures to hedge the dollar receipt.
The number of contracts = ($2,500,000/$1.5379)/£62,500 = 26.01 (round to 26 contracts)
The futures contracts will be closed out on 30 September 20X6 resulting in a loss of:
$9,588 ((1.5379 – 1.5320) × 26 × £62,500).
The sterling receipt will be: £1,625,065 (($2,500,000 – $9,588)/£1.5325))
OTC currency options:
Orchid will use a call option to buy sterling with an exercise price of $1,5300.
The premium will cost: £75,000 ($2,500,000 × £0.03)
The cost including interest lost on surplus cash deposits = £75,900 (£75,000 × (1+ 0.36 ×
4/12))
If the spot rate for buying sterling on 30 September 20X6 is $/£1.5325, Orchid will
exercise the options and buy sterling at $/£1.5300.
The sterling receipt will be = £1,633,987 ($2,500,000/$1.5300)
The net receipt after taking the option premium and lost interest into account =
£1,558,087 (£1,633,987 – £75,900)
(b) The sterling receipt for each of the three hedging techniques:
Forward contract £1,624,220
Currency futures £1,625,065
OTC currency option £1,558,087
The forward contract and futures contracts both lock Orchid into an exchange rate and do
not allow for the upside potential of the dollar strengthening against sterling more than
expected.
The options however protect Orchid against the downside risk of sterling strengthening
against the dollar and allow for the upside potential of the dollar strengthening against
sterling; however, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include the
following.
Forwards:
• Tailored specifically for Orchid
• However there is no secondary market should the customers not pay Orchid
Currency futures:
• Not tailored so one has to round the number of contracts
• Requires a margin to be deposited at the exchange
• Need for liquidity if margin calls are made
• However there is a secondary market

ICAEW 2021 June 2016 exam questions 257

 • Basis risk exists
OTC currency options:
There is no secondary market.
It is unlikely that the dollar is going to strengthen enough to cover the cost of the option
premium, and so it is not recommended that the company use foreign currency options.
There is very little difference between the receipt using forwards or futures (£845).
Since there is potential for margin calls using futures, it is recommended that Orchid use
forward contracts to hedge its foreign currency risk.
36.2 To protect the current value of the portfolio over the next three months Sheldon should hold
August put options with an exercise price equal to the current FTSE 100 index of 6,525.
The number of contracts = 148 (£9,657,000/6,525 × £10)
The premium will cost = £235,320 (159 × £10 × 148)
(a) Sheldon should let the options lapse since the Index has gone up and is higher, at 7,075,
than the exercise price of the put option.

Overall position £
Portfolio value 10,471,000
Less option premium (235,320)
10,235,680

(b) Sheldon should exercise the options since the index has fallen to 5,875, which is below the
put option exercise price.
The gain on exercising the options = £962,000 ((6,525 – 5,875) × £10 × 148)

Overall position £
Portfolio 8,695,000
Gain on options 962,000
Original value 9,657,000
Less option premium (235,320)
9,421,680

36.3 The three factors that affect the time value of the FTSE 100 options are:
• Time to maturity – For example: The longer the time to maturity the more chance there is
that the option will be in the money at expiry. Also there will be a greater interest element in
the option value.
• The risk free rate – For example: The level of the risk free rate will affect the interest element
in the options value. The higher it is the more interest element.
• Volatility – For example: Higher volatility will increase the option value since there is more
chance of the option being in the money, or deeper in the money, at expiry.

Examiner’s comments
This was a four-part question that tested the candidates’ understanding of the risk management
element of the syllabus. The scenario of the question was that a risk management company is giving
advice to two clients: to one client, on hedging foreign exchange rate risk and to the second on
hedging the fall in the value of a portfolio of FTSE 100 shares.
The first requirement was well answered by most candidates. However some of the errors
demonstrated by weaker candidates included calculating the number of futures contracts using the
spot rate rather than the futures price; stating that currency futures should be initially sold; treating
an over the counter option like a traded option; confusing puts and calls. There were average
responses from a lot of candidates to part (b), often without any reference to the numbers calculated
in part (a); however there were some excellent answers. There were some excellent answers to the
second part from the majority of candidates. Weaker candidates confused calls and puts and

258 Financial Management ICAEW 2021

demonstrated that they clearly did not know the difference between the two. There were many
excellent answers to the third part, with a good understanding of the factors that contribute to the
time value of options. However weaker candidates tended to only give one correct factor and then
made up the other two.

ICAEW 2021 June 2016 exam questions 259

260 Financial Management ICAEW 2021
 September 2016 exam questions
37 Northern Energy Ltd

Marking guide Marks

37.1 FRA 2
Option 2
No hedge 1
Interest rate swap not applicable 1
Appropriate commentary 3
Marks Available 9
Maximum 9
37.2 (a) Currency futures contracts 5
Maximum 5
(b) OTC currency option 3
Maximum 3
(c) Forward contract 2
Maximum 2
(d) Money market hedge 3
Maximum 3
37.3 Spot rate calculations 2
Appropriate commentary – 1 mark per point 6
Marks Available 8
Maximum 8
Total 30

37.1

Assuming on 31 March 20X7 LIBOR will be: 5% 7%

LIBOR + 2 7% 9%
FRA
Pay at LIBOR +2 (7.00%) (9.00%)
(Payment to)/receipt from bank (0.25%) 1.75%
(7.25%) (7.25%)
Total interest payment over 12 months (on £9.5m) (£688,750) (£688,750)
Option
Exercise? Yes Yes
Rate (6.5%) (6.5%)
Premium (1.0%) (1.0%)
(7.5%) (7.5%)
Total interest payment over 12 months (on £9.5m) (£712,500) (£712,500)
No hedge
Pay at LIBOR + 2 (7%) (9%)

ICAEW 2021 September 2016 exam questions 261

 Assuming on 31 March 20X7 LIBOR will be: 5% 7%
Total interest payment over 12 months (on £9.5m) (£665,000) (£855,000)

An interest rate swap would not be appropriate here as it is short-term and would in all
likelihood be very difficult to arrange.
If LIBOR is 5% then it would be best not to hedge. If LIBOR is 7% the FRA gives the lowest
interest figure. The figures are not conclusive, and the board’s attitude to risk will be important.
The FRA eliminates downside risk (rates rising) as well as upside risk (rates falling).
37.2
(a) Currency futures contracts
Dollars will be purchased. Therefore sell £ on futures exchange.
Contracts to be sold = £4.8m/1.5095/£62,500 = 50.9, (round to 51 [or 50])

At 31/1/X7 Buy futures at 1.4945

Sell futures at 1.5095
Profit 0.015 × 51 × $62,500 $47,813

$
Cost of consignment (4,800,000)
Profit on futures 47,813
Net cost (4,752,187)
Net cost at spot rate
(31/1/X7) ($4,752,187)/1.4895 (£3,190,458)

(b) OTC currency option

If the spot rate at 31/1/X7 was $1.4895 then the option would be exercised.
A call option would be used (ie, at $1.5020/£)

$4.8m
1.502
Receipt in sterling would be (£3,195,739)
plus: Option premium 4.8m × £0.011 (£52,800)
(£3,248,539)

(c) Forward contract

$4.8m $4.8m
Payment in
(1.5150−0.0112) 1.5038
sterling (£3,191,913)
plus:
Arrangement
fee 4.8m×£0.004 (£19,200)

(£3,211,113)

(d) Money market hedge

Payment in
$4.8m $4.8m
sterling would
[1 + (3.6%/3)] 1.012
be $4,743,083 lent

Converted at (£3,130,748)

262 Financial Management ICAEW 2021

 $4,743,083
spot rate 1.5150

Borrowed at £3,130,748 ×
6.9% p.a. (6.9%/3) (72,007)
(£3,202,755)

37.3

$4.8m
1.5150 (£3,168,317)
Sterling payment at spot rate 30/9/X6

$4.8m
1.4895 (£3,222,558)
Sterling payment at spot rate 31/1/X7

The forward contract premium suggests a strengthening of the $. A weaker £ means a higher
payment, and vice versa for a stronger £.
Order (cheapest first)

Spot at 30/9/X6 £3,168,317

Currency futures contracts £3,190,458
MMH £3,202,755
Forward contract £3,211,113
Spot at 31/1/X7 £3,222,558
OTC option £3,248,539

Thus three of the four hedging results lie between the two spot rates.
The futures contracts give gives best outcome (lower than the MMH, FC and OTC). However, if
the dollar were to weaken by January 20X7 (against expectations) then it might be best to not
hedge at all.
Option gives flexibility (abandon, upside) unlike MMH or FC (fixed, binding, no
upside/downside). Futures contracts can be cheaper (lower transaction costs), but contracts
cannot be tailored to user’s exact requirements.
The directors’ attitude to risk is also important in deciding which strategy to pursue.

Examiner’s comments
This question had easily the highest percentage mark on the paper. Overall, the candidates’
performance was very good. This was a three-part question which tested the candidates’
understanding of the risk management element of the syllabus. In the scenario a UK electricity
generator was considering hedging (1) the interest costs of a large loan and (2) its exposure to
foreign exchange rate risk on a planned purchase from an American supplier. In the first part, for nine
marks, candidates were required to calculate the interest payments that would arise on its planned
loan were it to make use of an FRA, an option or a swap. Two different rates of LIBOR were given to
the candidates. Candidates were then required to recommend which of the hedging techniques the
company should choose at each of the LIBOR rates. The second requirement was worth 13 marks
and asked candidates to calculate the sterling cost arising from a range of hedging techniques
applied to the American purchase. Finally the third part, for eight marks, required candidates to
advise the company’s board whether it should hedge the American (dollar) payments.
The first part was answered well by many candidates. However, common errors made were:
• candidates based their calculations on a borrowing period of six months rather than 12 (the
loan was to be taken out for 12 months, starting in six months’ time).

ICAEW 2021 September 2016 exam questions 263

 • the majority of candidates failed to calculate the implications of not hedging the borrowing
and so comparisons were difficult.
• a significant number of candidates abandoned the option when LIBOR was 5% because
they compared 5% v 6.5% instead of 7% v 6.5% ie, they failed to recognise that the
company was borrowing at LIBOR + 2% pa.
Very few candidates spotted that the swap was irrelevant because it was a short-term borrowing (ie,
12 months). Most candidates’ answers to the second part were very good, but the most common
errors noted were:
• currency futures – many chose the wrong date for calculating the number of futures
contracts, bought futures instead of sold them and calculated the profit on the futures trade
in £ instead of $.
• OTC currency options – far too many candidates exercised puts rather than calls
The forward contract calculations were generally very good as were those for the money market
hedge. The main stumbling blocks with the latter were (1) choosing the wrong interest rate and (2)
using three months rather than four. The advice given by candidates on the foreign exchange
hedging in part three was generally good, but, if candidates did not calculate the relevant spot rates
then they lost marks. The performance of overseas candidates in this section was, overall, very poor.

38 Roper Newey plc

Marking guide Marks

38.1 (a) Dividend growth rate 1.5

Cost of equity .5
Cost of preference shares 1
Cost of redeemable debt 4
Cost of irredeemable debt 2
WACC calculation 2
Marks Available 11
Maximum 11
(b) Cost of equity 1
WACC 1
Marks Available 2
Maximum 2
38.2 Advice that 7% is an inappropriate rate, with reasons 3
Marks Available 3
Maximum 3
38.3 Reasons for using CAPM 5
Marks Available 5
Maximum 5
38.4 Calculation of ungeared beta 1.5
Geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Reasons for using a new WACC, and how it is calculated 4
Marks Available 10
Maximum 10

264 Financial Management ICAEW 2021

 Marking guide Marks

38.5 Explanation of APV 4

Marks Available 4
Maximum 4
Total 35

38.1
(a) Ordinary dividend per share in 20X6 (£3,797,500/15,500,000) 24.5 pence
Ordinary dividend growth rate = £0.201/£0.245, which over four years 5% p.a.

(d1) + g
Cost of equity (£0.245 × 1.05)
+ 5%
MV £5.20
(ke) = 9.95%
Cost of d=
d £0.06
preference = (£540,000/9m)
MV £1.08
shares (kp) = £0.06 5.55%

COST OF REDEEMABLE DEBT (KDR)

Year Cash Flow 2% factor PV 3% factor PV

0 (103.00) 1.000 (103.00) 1.000 (103.00)
1–3 4.00 2,884 11.54 2.829 11.32
3 100.00 0.942 94.20 0.915 91.50
NPV 2.74 NPV (0.18)

IRR = 3% – (0.18/(2.74 + 0.18)) = 2.94%

less: Tax at 17% (2.94% × 83%) =2.44%
Cost of irredeemable debt (kdi) (£5 × 83%) / £96 = 4.32%

WACC

Total MV’s
£’000 Cost × weightingWACC
Equity 15.5m×£5.20 80,600 9.95% × 80,600/106,615 7.52%
Pref.shares 9m×£1.08 9,720 5.55% × 9,720/106,615 0.51%
£6.5m ×
Red. debt 103/100 6,695 2.44% × 6,695/106,615 0.15%
£10.0m ×
Irred. debt 96/100 9,600 4.32% × 9,600/106,615 0.39%
26,015 1.05%
Total market
value 106,615 8.57%
(b)
Cost of equity (1.2 × (9.5% – 1.9%)) + 1.9 = 11.02%
Weighted cost of equity 11.02% × 80,600/106,615 8.33%
Weighted cost of debt (as
above) 1.05%

WACC

ICAEW 2021 September 2016 exam questions 265

 9.38%

38.2 Roper is using 7% as its hurdle rate. In fact a more accurate figure would be 8.57% (say 9%) or
9.38% (say 10%). This means it could be making poor investment decisions. If it takes on a
project with an IRR of 8% this will be destroying shareholder value as the IRR is less than the
company’s cost of capital.
38.3 CAPM theory:
Systematic vs unsystematic risk, and portfolio theory
Beta – a measure of systematic risk against market average
CAPM gives an alternative cost of equity which is used to calculate the WACC
38.4 New market geared beta = 1.9

1.9 × 90 (1.9 × 90)

New market ungeared beta = (90 + (25 × 83%))
= 110.75
= 1.54

1.54 × (£80.60m + 9.720 + (£16.295m × 83%))

Better Deal's geared beta = £80.60m
= 1.98

So, cost of equity = (1.98 × (9.5% – 1.9%)) + 1.9 = 16.95%

Cost of debt = 6% × 83% = 4.98%
WACC = (16.95% × £80,600/£106,615)) + (4.98% × £26,015/£106,615)) = 14.03%
It would be unwise to use the existing WACC (9.38%) as Roper’s plan involves diversification
and therefore a change in the level of systematic risk. Thus a new WACC must be calculated.
Systematic risk is accounted for by taking into account the beta of the petroleum market and
this is then adjusted to eliminate the financial risk (level of gearing) in that market. The resultant
ungeared beta is then “re-geared” by taking into account the level of gearing of the new funds
being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed above)
is used.
Using this, the new WACC can be calculated.
38.5 Adjusted PV (APV) – if the capital structure changes maybe the cost of capital will as well (M&M
1963). If new debt is raised to finance/part-finance a new investment, what is the new cost of
capital? To find this one needs to know the new MV of the company’s shares and to know this
one needs to know the NPV. This cannot be calculated without the new cost of capital. So it’s a
conundrum, unless a simplifying assumption is made as in this question ie, the finance is
issued in such a way as to leave the gearing unchanged.
Thus use the APV approach:
(1) Calculate the base cost of the project – assume that the company is not geared.
(2) Calculate the PV of the tax shield (tax saved via interest payments)
Combine 1 and 2. If APV is positive, then proceed.

Examiner’s comments
This question had, marginally, the lowest percentage mark on the paper. The majority of candidates
achieved a ‘pass’ standard in the question, however.
This was a five-part question that tested the candidates’ understanding of the financing options
element of the syllabus. It was based around a UK engineering company which was planning to
diversify into the UK fracking industry. As a result various calculations regarding its current and future
cost of capital were deemed necessary. The first part of the question, for 13 marks, required
candidates to calculate the current weighted average cost of capital (WACC) of the company using
(1) the dividend growth model and (2) the CAPM. In the second part, for three marks, candidates
were asked to explain whether the company should continue to use its existing hurdle rate for its
decisions on large-scale investments. The third part, for five marks, required candidates to explain

266 Financial Management ICAEW 2021

 the underlying logic of employing the CAPM within a WACC calculation. The fourth part was worth
10 marks. Here, candidates were tested on their ability to re-work their CAPM calculations, which was
necessary because of the company’s proposed diversification into fracking, which would alter the
level of systematic risk. Finally, for four marks, candidates were asked to explain the circumstances in
which it would be appropriate to use the adjusted present value approach to investment appraisal.
Most candidates did well in the first requirement, part (a) but common errors were:
• inaccurate (and, at times, inappropriate) calculations of the dividend growth rate.
• not using the market value (MV) when calculating the cost of preference shares.
• for the cost of redeemable debentures – not using the ex-interest MV, choosing four years to
redemption rather than three, inaccurate IRR calculation from NPV’s.
• irredeemable debentures – not using the ex-interest MV, using the post-tax coupon rate as
the cost of debt.
Combining the costs of the redeemable and irredeemable debt, rather than treating them
separately.
Part (b) was done very well. Only a few candidates failed to calculate the CAPM correctly.
The second part was generally well answered and most candidates were able to identify the key
issue – ie, Roper could be making poor investment decisions. In the third part too few candidates
answered the question fully and concentrated more on a discussion of de-gearing/re-gearing. In the
fourth part the de-gearing/re-gearing calculations were mostly done well, but too many candidates’
explanation of their approach here concentrated on ‘how’ rather than ‘why’ it was done. The fifth part
was, overall, done well and candidates demonstrated a reasonable understanding of APV.

39 Darlo Games Ltd

Marking guide Marks

39.1 (a) Net assets at historic cost 1

Revalued net assets 2
P/E ratio 1
Discount for lack of marketability .5
Dividend yield 1
Discount for lack of marketability .5
PV of future cash flows:
To 20X9 2
Post 20X9 2
Calculation of WDAs and tax 4
Marks Available 14
Maximum 10
(b) Advantages of each method 5
Disadvantages of each method 5
Marks Available 10
Maximum 10
39.2 SVA explanation 4
Assessment of information 4
Marks Available 8
Maximum 8
39.3 Challenges with traditional valuation models 4
Marks Available 4

ICAEW 2021 September 2016 exam questions 267

 Marking guide Marks

Maximum 4
39.4 Ethical issues around confidentiality 3
Marks Available 3
Maximum 3
Total 35

39.1
(a)

Per share

£4,998
Net Assets
500
(historic cost) £10.00

(£4,998 + £3,150 + £3,370−£2,400−£3,200) £5,918

Net Assets
500 500
(revalued) £11.84

(£2,340 × 10) £23,400

500 500
P/E ratio £46.80
Less (say) 30% for lack of marketability of
shares £32.76

(£740/8%) £9,250
500 500
Dividend yield £18.50
Less (say) 30% for lack of marketability of
shares

PV of future cash
flows y/e 20X7 y/e 20X8 y/e 20X9 Total
£’000 £’000 £’000 £’000
Pre-tax cash profits 2,900 3,000 3,100
Tax at 17% (W2) (465) (487) (422)
Net cash flow 2,435 2,513 2,678
× × ×
12% factor 0.893 0.797 0.712
PV 2,174 2,003 1,907 6,084
Post 20X9 net cash
inflows 2,000

× 1/12%
Discounted to
16,667
infinity
Discounted to PV
from 20X9 ×0.712
11,867

268 Financial Management ICAEW 2021

 PV of future cash
flows y/e 20X7 y/e 20X8 y/e 20X9 Total
£’000 £’000 £’000 £’000
Total PV of future
cash flows 17,951

£17,951/50
0 £35.90

WORKINGS
(1)

WDV b/f 920 754 618

WDA @ 18%/Bal All (166) (136) (618)
WDV c/f 754 618 0

(2)

Pre-tax cash profits 2,900 3,000 3,100

WDA/BA (W1) (166) (136) (618)
Taxable profits 2,734 2,864 2,482

Tax due at 17% (465) (487) (422)

(b) Net assets (historic cost) – tends towards low historic values, so an undervaluation.
Intangibles are ignored. Earnings potential and future earnings are ignored.
Net assets (revalued) – as above, except that the asset values used are current.
P/E ratio – Looks at earnings. Will it be a majority stake? If so, then control will be gained,
so shares for this controlling stake should cost more. In this scenario it gives a much higher
value than assets. However, are these earnings stable into the future? Is the company over-
reliant on the two successful games from 20X3? Future earnings – are there new games
planned? Will they be successful?
Dividend yield – this is based on dividend income and is applicable where it’s to be a
minority stake. Are these dividends stable? Will there be dividend growth?
PV of future cash flows – considers cash flows not profits and estimates forwards. These are
large estimates, especially the terminal value. Is it over-reliant on the two successful games
(as above)?
Overall – a value close to £30/share should be a minimum price.
39.2 SVA is an alternative method of calculating the value of a company, based on future cash flows
and seven “value drivers”. These value drivers can, in most cases, be managed by the company
and so the influence of company strategy will be evident.

Value driver Information available

Length of project Yes

Sales growth rate Implied

Profit margin Implied

Fixed assets investment Implied

Working capital investment No

Tax rate Yes

ICAEW 2021 September 2016 exam questions 269

 Value driver Information available

Discount rate Yes

39.3

Valuation method Application to technology company like Darlo

Asset The asset method is not easy to apply because the value of
capital in terms of tangible assets for a company like Darlo
may not be high. Most of the investment is likely to be in
people, digital assets, and/or intellectual rights that are not
capitalised as assets. A game has a typical lifespan of three to
five years and therefore Darlo’s success is dependent on the
ability of its employees to develop and produce new
successful games.
Value could be assessed by estimating how much it would
cost for an investor to create the assets of the company from
scratch. However, such approaches would not capture the
value resulting from the potential future growth, which is likely
to represent the main part of Darlo’s value.

Earnings It may be difficult to find a company with a similar risk profile

to Darlo as their games are likely to be unique and have a
short product lifecycle. The use of the PE ratio of 10 for similar
listed companies may therefore not be appropriate.

Dividend We don’t have any information on Darlo’s dividend policy. The

dividend policy is likely to be unique to the requirements of
Michelle and Rob given that they own 70% of the shares.
Using and average dividend yield of 8% is therefore unlikely to
provide an accurate valuation of Darlo’s shares.

DCF Despite the problems with estimating future cash flows, the
DCF approach is likely to be the most valid approach for
Darlo.
Revenue growth prospects and margins could be estimated
through the use of predictive analytics or by comparing
companies that have a similar business model (eg, Epic
Games). Different scenarios can be created and analysed
using techniques such as simulation.
Cash flows should be discounted 12% which reflects Darlo’s
risk profile.

39.4 An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:
• be kept confidential;
• not be disclosed, even inadvertently such as in a social environment; and
• not be used to obtain personal advantage.

Examiner’s comments
This was a three-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus and there was also a small section with an ethics element to it. In the scenario
a software development company was considering investing in a company that designs games for
use on computers and mobile phones. Candidates were given financial information relating to the
target company.
In the first requirement, part (a) was worth 14 marks and required candidates to calculate the value of
one share in the target company using five different valuation methods. Whilst in part (b), for 10

270 Financial Management ICAEW 2021

marks, candidates had to explain, making reference to their previous calculations, the advantages
and disadvantages of using each of the valuation methods. The second requirement, for eight marks,
candidates were required to explain the reasoning underpinning the shareholder value analysis
(SVA) method of valuation. They also had to explain whether SVA could be used to value this
particular target company, bearing in mind the information provided. Finally, in the third
requirement, for three marks, candidates had to explain the ethical issues arising for an ICAEW
Chartered Accountant who is privy to price-sensitive information which is not in the public domain.
Generally the first requirement part (a) was answered well. A surprising number of candidates were
unable to calculate the share value based on the net asset basis (historic cost), but were able to
calculate it with the net asset basis revalued. The P/E and dividend yield valuations were generally
done very well. Most candidates scored well using the PV of future cash flows method of valuation.
Candidates’ discussion was limited to mainly knowledge in the first requirement part (b) – few
considered whether the techniques were suitable for a majority/minority holding despite being
guided in that direction in the question. The vast majority of candidates ignored the ‘elephant in the
room’, ie, the fact that the target company’s computer games had a limited life of three to five years
and the successful games were three years old.
In general candidates’ understanding of the theory of SVA was good, but too few were able to
explain adequately whether it could be used in this particular scenario. Candidate’s understanding of
the ethical issues was generally good.

ICAEW 2021 September 2016 exam questions 271

272 Financial Management ICAEW 2021
 December 2016 exam questions
40 Ribble plc

Marking guide Marks

40.1 Net present value calculation:

Contribution 3
Rent, managers costs, consultancy saved 4
Contribution lost 2
Fixed overhead 2
Tax, working capital, capital allowances 6
NPV and conclusion 3
Marks Available 20
Maximum 20
40.2 (a) Sensitivity to sales revenue:
Contribution 1
Tax and discount factor 1.5
PV calculation .5
Sensitivity and conclusion 1
Marks Available 4
Maximum 4
(b) Sensitivity to the residual value of equipment:
Maximum loss of scrap value 1
Increase in the balancing charge 1.5
PV calculation .5
Sensitivity and conclusion 1
Marks Available 4
Maximum 3
40.3 Real options:
1 mark to identify, and 1.5 marks to explain
(two real options required)
Marks Available 0
Maximum 5
40.4 Ethical issues identified (1 mark each point) 3
Marks Available 3
Maximum 3
Total 35

40.1

0 1 2 3 4
Units million 0.096 0.115 0.098 0.083
Selling price £ 299.00 299.00 299.00 299.00
Variable costs per unit £ –164.45 –172.67 –181.3 –190.37
Contribution per unit £ 134.55 126.33 117.7 108.63

ICAEW 2021 December 2016 exam questions 273

 0 1 2 3 4
£m £m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Rent –1 –1 –1 –1
Managers lump sum 0.1 –0.12
Managers salary –0.12 –0.12 –0.12 –0.12
Consultancy saved 0.05 0.05
Contribution lost –0.24 –0.29 –0.25 –0.21
Fixed overhead –0.30 –0.31 –0.32 –0.33
Taxable –0.9 11.31 12.86 9.84 8.24
Tax @ 17% 0.15 –1.92 –2.19 –1.67 –1.40
Working capital –1 –0.2 0.18 0.15 0.87
Machinery and equipment –24.00 4
Tax saved on CAs 0.73 0.60 0.49 0.40 1.16
Cash flows –25.02 9.79 11.34 8.72 12.87
Discount factor @ 10% 1 0.909 0.826 0.751 0.683
PV –25.02 8.90 9.37 6.55 8.79

NPV 8.59

The NPV is positive and Ribble should therefore accept the project to increase shareholder
wealth.
Marks are awarded for not including the research and development costs of £100,000 and
allocated fixed overheads, since they are sunk costs and allocated costs respectively.
Units:
• 8,000 × 12 = 96,000
• 96,000 × 1.2 = 115,200
• 112,200 × (1 – 0.15) = 97,920
• 97,920 × (1 – 0.15) = 83,232
Lost contribution:
• (96,000 units/10) × £25 = £240,000
• (115,200 units/10) × £25 = £288,000
• (97,920 units/10) × £25 = £244,800
• (83,232 units/10) × £25 = £208,080
Working capital

cumulative Increment
0 –1 –1
1 –1.2 –0.2
2 –1.02 0.18
3 –0.87 0.15
4 0 0.87

Capital allowances and the tax saved thereon

274 Financial Management ICAEW 2021

 Cost/WDV CA Tax @ 17%
0 24.00 4.32 0.73
1 19.68 3.54 0.60
2 16.14 2.91 0.49
3 13.23 2.38 0.40
4 10.85
Sale 4.00 6.85 1.16

40.2
(a) Sensitivity to sales revenue:

1 2 3 4
£m £m £m £m
Contribution 12.92 14.53 11.53 9.02
Contribution lost –0.24 –0.29 –0.25 –0.21
Total 12.68 14.24 11.28 8.81
Total ´ (1 – 0.17) 10.52 11.82 9.36 7.31
Discount factor @ 10% 0.909 0.826 0.751 0.683
PV 9.56 9.76 7.77 4.99

Total PV = 32.08
Sensitivity NPV/PV
(8.59/32.08) 27%

Given the risky nature of this project, the board of Ribble might consider the project to be
too sensitive to changes in the sales revenue.
(b) Sensitivity to the residual value of equipment:

£m
Maximum loss of scrap value 4
Increase in the balancing charge × 17% –0.68
Net cash flows 3.32

PV @ 10% (× 0.683) 2.27

Although this represents 26% (2.27/8.59) of the overall NPV, the project is insensitive to
the residual value, since there would be a substantial NPV even if the value fell to zero.
40.3 Ribble has:
The option to delay the project for one year to see whether the competitor launches their
hoverboard onto the market.
The option to abandon the project should sales levels be below those estimated eg, if the rival
company’s hoverboard is launched and proves to be more popular than the Ribbleboard.
There is a follow on option in that Ribble could expand if the competitor’s product fails and/or
sales of the Ribbleboard are better than expected.
Candidates might also state growth or flexibility options.

ICAEW 2021 December 2016 exam questions 275

 40.4 The CEO should disregard the comments that Ribble should continue to manufacture an
unsafe hoverboard. The CEO should act with integrity and ensure that he is not corrupted by
self-interest. He should be objective and not come under the undue influence of other board
members. He should act with professional competence and exercise sound and independent
judgement.

Examiner’s comments
This was a four-part question, which tested the candidates’ understanding of the investment
decisions element of the syllabus. The scenario of the question was that a company is considering
launching on to the market a new version of an existing product.
The first part was well answered by many candidates, but the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; only taking account of
half of the relevant costs; not stating that research and development costs should be ignored; not
stating that allocated overheads should not be included in the NPV computations. Responses to the
second part were mixed, with many candidates not taking into account all the relevant cash flows and
many ignoring taxation. There were few candidates who made meaningful comments regarding the
sensitivity of the project to changes in the inputs. Responses to the third part were good, although
some candidates wasted time by mentioning more than the required two real options.
Responses to the fourth part of the question were also mixed, and many did not relate to ethical
issues, instead discussing commercial issues. Where the ethical issues were discussed, a number of
candidates did not use the language of ethics.

41 Bristol Corporate Finance

Marking guide Marks

41.1 (a) CAPM calculation 1

Marks Available 1
Maximum 1
(b) Discount calculation 2
TERP 1
Discussion 2
Marks Available 5
Maximum 5
(c) Yield to maturity calculation 2
Issue price 2
Total nominal value 1
Discussion 2
Marks Available 7
Maximum 7
(d) Interest cover calculation 1.5
Gearing 1.5
Advantages and disadvantages – max of 3
Commentary on gearing – max of 3
Commentary on cost of capital – max of 3
Advice 2
Marks Available 14
Maximum 12
41.2 (a) Sources/forms of finance – 0.5 mark each point 3

276 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 3
Maximum 3
(b) Sources/forms of finance – 0.5 mark each point 2
Marks Available 2
Maximum 2
(c) Financial information – 0.5–1 mark each point 5
Marks Available 5
Maximum 5
Total 35

41.1
(a) The cost of capital = Ke = 3 + (1.1 × (8 – 3)) = 8.5%
(b) A 1 for 2 rights issue will require 40/2 = 20 million new shares to be issued.
The price per share = £70 million/20 million = £3.50
A discount on the current market price of: (5.00 – 3.50)/5.00 = 30% (or £1.50)
The theoretical ex-rights price is:

Number of shares Value per share £ Number × Value £

Existing shares 2 5.00 10.00
New shares 1 3.50 3.50

Total shares 3 Total value 13.50

Theoretical ex-rights price = £13.50/3 = £4.50.

The actual share price will depend on the market’s reaction to the rights issue eg, whether
it is fully taken up, and whether the proceeds are invested in positive net present value
projects.
If we were told the net present value of the projects this could be incorporated in the
theoretical ex-rights price of £4.50, giving a more realistic estimate of the actual share
price post rights issue.
(c) The yield to maturity of the Wood plc debentures is calculated as follows:
The ex-interest price of the debentures = 110 – 7 = £103

Cash Flow Factors at PV Factors at PV

Timing Years £ 5% £ 10% £
0 (103) 1 (103) 1 (103)
1–4 7 3.546 24.82 3.170 22.19
4 100 0.823 82.30 0.683 68.30
4.12 (12.51)

IRR = 5 + (4.12/(4.12+12.51) × 5 = 6.24% Say 6%

The issue price is:

Cash Flow Factors at PV

TimingYears £ 6.00% £
1–10 7 7.360 51.52

ICAEW 2021 December 2016 exam questions 277

 Cash Flow Factors at PV
TimingYears £ 6.00% £
10 100 0.558 55.80
Issue price 107.32

The total nominal value will be: 70/(107.32/100) = £65.22 million.

Wood plc has similar risk to Middleton so it may be reasonable to assume that debenture
holders would require the same yield to redemption in return for investing with either
company. But how similar is similar? Eg, how comparable is Wood to Middleton in terms
of gearing? However the Wood plc debentures have only four years until redemption,
whilst the Middleton debentures mature in 10 years. It is likely that debenture holders
would require a higher yield to redemption for investing in the Middleton debentures to
compensate them for the risk of investing for a further six years.
(d) The gearing and interest cover ratios of Middleton immediately after the debenture issue
will be as follows:
Interest cover: Interest 65.22 × 7% = £4.57m. Interest cover = 25.00/4.57 = 5.47 times
Gearing by market values assuming the current market price per share:
Market capitalisation 40 × 5 = £200m. Gearing (D/E) 70/200 = 35%
In time both interest cover (more operating profits) and gearing (greater equity value) are
likely to improve with the acceptance of positive NPV projects and any favourable market
reaction to the issuance of debt and its tax shield (see below).
General advantages and disadvantages of debt v equity, points that candidates might
mention include: Control issues; obligation to return capital; interest v dividends
(including tax relief); issue costs; liquidation of the investment (can the investor get out
easily?); risk/reward.
Note: Candidates might also comment on EPS and produce the following figures:
Current EPS 51.9p (20.75m/40m)
EPS with a rights issue 34.6p (20.75m/60m)
EPS with a debenture issue 42.4p (( 25 – 4.57) × 0.83))/40m
Addressing the concerns of the board:
The company will have a gearing ratio of 35% and an interest cover of 5.47 times. Gearing
is between the industry maximum and average of 40% and 30% respectively, interest
cover is between the industry minimum and average of five and six respectively. Since this
is the first time that Middleton has borrowed both shareholders and the stock market
might be concerned and prefer these ratios to be around the averages or better. Some
shareholders might be attracted to investing in Middleton because currently it has no
gearing. However if the £70 million is to be invested in positive NPV projects both
shareholders and the stock market should welcome the company borrowing.
Borrowing should reduce the current 8.5% cost of capital of the company since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. Also the company receives tax relief on the interest that it pays. Because there is
increased financial risk when a company borrows the shareholders may require a higher
return but this is unlikely to offset the cheaper proportion of debt finance. The company
value should increase as a result of the cost of capital reducing and new funds being
invested in positive NPV projects.
Advice: It would be prudent for the company to restrict its borrowing to the industry
average gearing level especially since its interest cover would be near to the minimum for
the industry. I would advise the company not to borrow the full £70 million, perhaps this
could be achieved by revising its plans for raising the finance. For example, an issue of
both debt and equity to ensure that gearing and interest cover ratios are more favourable.
Or selling surplus assets.
41.2
(a) The source and form is typically:

278 Financial Management ICAEW 2021

 The management team invest in equity (Candidates may mention that the funding for this
can be raised from various sources for example: Family; savings; sale of/refinancing of
personal assets; etc)
A venture capital provider will invest in equity and debt
Other financiers – for example banks would provide loans
(b) The various parties who invest in the MBO will require an exit route, typically after between
three to five years. This may be in the form of:
• selling the company to a third party
• a secondary MBO or MBI
• floating the company on the Stock Exchange
• if the company is not successful the least desirable exit would be liquidation
(c) The financial information section of the business plan will typically include:
• an historic financial analysis
• the amount and timing of the finance required
• key risks and a contingency plan
• anticipated gearing
• the purpose of any finance required
The following forecasts should be included:
• cash flow in months for the first year of the plan
• revenue forecasts in months or longer for the first year with evidence
• financial forecasts in quarterly or annual intervals up to five years
Often a project appraisal and sensitivity analysis will be included.

Examiner’s comments
This was a seven-part question that tested the candidates’ understanding of the financing options
element of the syllabus. The scenario of the question was that a corporate finance firm is giving
advice to two clients. Client one (requirement 1) is a company seeking to raise additional funds and
client two (requirement 2) is a management buyout team.
Part (a) of the first requirement of the question was well answered by the majority of candidates.
However, in the CAPM equation a surprising number did not deduct the risk free rate from the
market return.
Part (b) of the first requirement was also well answered by the majority of candidates. However,
considering that the area has been examined many times before some basic errors were made which
included: incorrectly calculating the number of new shares to be issued; not calculating the discount
that the rights price represents on the current share price of the company (despite this being
specifically asked for).
Also, many candidates were unable to comment on whether and why the actual share price might
not be equal to the theoretical ex-rights share price after the rights issue.
Responses to part (c) of the first requirement were mixed and, since the topic has been examined
many times before, rather disappointing. Candidates were asked to calculate the yield to redemption
(YTR) of debentures that a similar company to the client company already had in issue. They then had
to use the YTR that they had calculated to price a new debenture issue, and to calculate the total
nominal value of the new issue. Common errors included: using the cum-interest debenture price in
the YTR computation; attempting to calculate the YTR on the new issue; deducting tax from the YTR;
incorrectly calculating the total nominal value of the new issue; many mathematical errors in the YTR
computations; calculating, and using, the interest yield of the debentures rather than the YTR for the
new issue, using the coupon rate to calculate the issue price (and not arriving back at the par value!);
for the new issue, using the cost of equity to calculate the issue price.
Also, comments on whether the YTR of the similar company was appropriate to use for the client
company were poor.
Responses to part (d) of the first requirement were extremely disappointing considering that similar
questions have been asked before. In the scenario the candidates were provided with average and

ICAEW 2021 December 2016 exam questions 279

 maximum gearing ratios for the industry sector that the client operated in, and also a definition of
gearing as debt/equity by market values. Also the candidates were given the average and minimum
interest cover for the industry. Candidates were instructed in the question requirement to refer to this
data when discussing whether the client company should raise the finance required by debt or a
rights issue.
Many candidates gave very generic answers to this part of the question, just brain dumping the
advantages and disadvantages of debt and equity without referring to the industry data or the
scenario of the question. Disappointingly a large number of candidates also gave a detailed
description of Modigliani and Miller’s theory on capital structure without any reference to the
traditional theory and how it might or might not be appropriate. However it was alarming to see
many candidates calculating the gearing ratio as debt/(debt + equity) and then comparing their
number with the industry data, which had been calculated in a different way. In one instance a
candidate calculated the gearing ratio using both methods and then picked the most favourable
when comparing with the industry data. This lack of understanding is not acceptable from candidates
sitting a finance examination. Also few candidates gave supported advice on how the additional
finance should be raised.
Turning to interest cover, there were some basic errors made here which included: calculating
interest cover on profits after tax; incorrect interest calculations not using the total nominal value to
be raised.
Responses to part (a) of the second requirement were poor, with few candidates showing an
understanding of how a management buyout is financed. Responses to part (b) of the second
requirement were also poor, and few candidates described realistic exit routes for the financiers that
contribute to the funding of a management buyout.
Responses to part (c) of the second requirement were mixed, and many candidates described areas
such as business strategy, which would not appear in the financial information section of a business
plan.

42 Orion plc

Marking guide Marks

42.1 (a) Forward contract 2

Maximum 2
(b) Currency futures:
Buy 1
Number of contracts 1
Profit 2
Sterling receipt 1
Maximum 5
(c) OTC option:
Premium 1
Lost interest 1
Choose to exercise 1
Sterling receipt 1
Maximum 4
42.2 Advantages and disadvantages:
Forwards 2
Futures 3
Options 2
Advice 1

280 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 8
Maximum 8
42.3 Explanation of interest rate parity 2
Calculation of forward rate and explanation of discount 3
Marks Available 5
Maximum 5
42.4 Explanation of economic risk 2
Application to Orion 2
Risk mitigation – 0.5 mark each for identifying and explanation 2
Marks Available 6
Maximum 6
Total 30

42.1
(a) The forward rate is: $/£ 1.4430 (1.4340 + 0.0090)
This results in a sterling receipt of £3,465,003 ($5,000,000/$1.4430)
(b) Orion should buy March sterling futures (ie, to buy £ with $).
The number of contracts to buy is: ($5,000,000/$1,4410)/£62,500 = 55.52 contracts.
Round to 56 contracts. Slightly over hedged. (Full marks given if 55 contracts used.)
On 31 March the futures will be closed out and sold at $1.4487. This will result in a profit
of: ($1.4487 – $1.4410) × (£62,500 × 56) = $26,950
Sterling will be purchased on the spot market and the total receipt will be: ($5,000,000 +
$26,950)/$1.4490 = $3,469,255
(c) Over the counter option:
The option premium is $5,000,000 × 3p = £150,000.
The premium with interest lost is £150,000 × (1 + 0.03 × 4/12) = £151,500
If the spot price on 31 March is $/£1.4490 Orion will exercise the options.
The sterling receipt will be ($5,000,000/$1.4390) – £151,500 = £3,323,135
42.2 The forward contract and futures contracts both lock Orion into an exchange rate and do not
allow for upside potential.
Forwards:
• Tailored specifically for Orion
• No secondary market
Currency futures:
• Not tailored, so need to round the number of contracts
• Requires a margin to be deposited at the exchange
• Need for liquidity if margin calls are made
• Secondary market
OTC currency options:
• The options are expensive
• No secondary market
• However, the options allow Orion to exploit upside potential and protect downside risk
Advice:
Without hedging, the sterling receipt would be £3,450,656 (5,000,000/1.4490)

ICAEW 2021 December 2016 exam questions 281

 The OTC option results in a much lower receipt at £3,323,135.
Both the forwards and futures result in a higher sterling receipt, with the futures being
marginally better resulting in a receipt of £3,469,255 compared to £3,465,003.
Since futures require margins, and they are not a perfect hedge due to rounding and basis risk,
it is recommended that a forward contract is used as it is much simpler for a similar result.
42.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are possible if
the rates out of alignment. The forward rate tends to be an unbiased predictor of the future
spot exchange rate.
The forward rate in four months is calculated as follows:
Middle spot rate × (1 + the middle US interest rate)/(1 + the middle UK interest rate) = Forward
rate.
$1.4338 × (1 + 0.05 × 4/12)/(1 + 0.0315 × 4/12) = $1.4426
Because the dollar is depreciating against sterling it is at a discount.
The discount is $0.0088 (1.4426 – 1.4338). The spread increases or decreases this, in this case
$/£ 0.0086 – 0.0090.
42.4 Economic risk is the risk that longer-term exchange rate movements might reduce the
international competitiveness of a company. It is the risk that the present value of a company’s
future cash flows might be reduced by adverse exchange rate movements.
Orion is an importer and exporter. It buys its raw materials in euros, exports the sports nutrition
products to the USA and receives payment in dollars.
If over a period of several years the pound appreciates against the dollar and depreciates
against the euro the sterling value of Orion’s income will fall and its cash flows decline.
Points that can be mentioned to mitigate economic exposure include:
• diversify operations world-wide both for purchasing raw materials and selling its products.
• market and promotional management; the company must carefully decide in which
markets to operate.
• product management; economic exposure may mean high-risk product decisions.
• pricing strategy must respond to the risk of fluctuations in exchange rates.
• production management; economic exposure may influence the supply and location of
production.

Examiner’s comments
This was a four-part question that tested the candidates’ understanding of the risk management
element of the syllabus. The scenario of the question was that of a company reviewing its foreign
exchange rate risk hedging strategy.
The first part was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate rather
than the futures price; stating that currency futures should be initially sold rather than bought;
calculating the futures gain in £ rather than $; treating an over the counter option like a traded
option; calculating the option premium in $ rather than £; omitting interest on the option premium.
There were a lot of average responses to the second part, some without any reference to the
numbers calculated in the first part. Many candidates did not give a firm conclusion. However there
were some excellent answers.
Responses to the third part were mixed, with many candidates demonstrating a lack of
understanding of interest rate parity. Very often computations did not make sense and were very
difficult to follow.
Few candidates gave adequate answers to the fourth part, and showed little knowledge of what
economic risk is. However again there were some excellent answers.

282 Financial Management ICAEW 2021

 March 2017 exam questions
43 Sentry Underwood plc

Marking guide Marks

43.1 Sales .5
Variable costs 1
Fixed costs .5
Interest 1.5
Tax .5
Dividends 1.5
Retained earnings .5
Marks Available 6
Maximum 6
43.2 Earnings per share 2
Gearing calculation 4
Marks Available 6
Maximum 6
43.3 Current EPS .5
Target profit before tax 1.5
Interest added back 1
Fixed costs added back 1
Contribution/sales ratio 1
Target sales figure 1
Marks Available 6
Maximum 6
43.4 Rights issue v debenture issue
1 mark per valid point up to a maximum of 8 8
Marks Available 8
Maximum 8
43.5 Explanation of dividend policy theory 6
Marks Available 6
Maximum 6
43.6 Explanation of dividend policy theory 3
Marks Available 3
Maximum 3
Total 35

43.1

Rights issue Debt issue

£m £m
Sales (£78.5m × 1.20) 94.200 94.200
Variable costs (72% × sales) (67.824) (67.824)

Fixed costs (£13.85m + £2m)

ICAEW 2021 March 2017 exam questions 283

 Rights issue Debt issue
£m £m
(15.850) (15.850)
Profit before interest 10.526 10.526
Interest (Workings) (1.421) (3.021)
Profit before tax 9.105 7.505
Tax @ 17% (1.548) (1.276)
Profit after tax 7.557 6.229
Dividends payable (4.920) (3.000)
Retained earnings 2.637 3.229

WORKING

£20.3m ×7% 1.421 1.421

£20.0m × 8% 1.600
1.421 3.021

43.2

Rights issue Debt issue

£m £m
Ordinary share capital (additional 8m shares) 20.500 12.500
Share premium (8m new shares × £1.50) 12.000 0.000
Retained earnings 13.923 14.515
46.423 27.015
Debentures 20.300 40.300
Total long term funds 66.723 67.315
Profit before tax £7.557 £6.229
Shares 20.500 12.500
£0.369 £0.498
Gearing £20.300 £40.300
£66.723 £67.315
30.4% 59.9%

43.3

Current EPS £5.568m £0.445m

12.500
£0.445m
×
20.500
Target earnings £9.123m

284 Financial Management ICAEW 2021

 Add back tax (17%) ÷ 83%
Target profit before tax £10.992m
Add back interest 1.421m
Add back fixed costs 15.850m
Target contribution £28.263m
Contribution/sales ratio ÷ 28%
Target sales
Current sales £78.500m
Target sales/current sales (£100.939m/£78.500m) 1.286
Thus sales would need to increase by 28.6% or £22,439m

43.4 Sentry’s current earnings per share figure is 44.5p. The predicted EPS are 36.9p (rights issue)
and 49.8p (debt issue). So the rights issue leads to a lower EPS whilst the debt issue increases
EPS and may, for this reason, be favoured by shareholders.
Rights issue:
As would be expected, the level of gearing is much lower than under the debenture issue
option (30.4% compared to 59.9%). It’s also lower than Sentry’s current level of gearing (46.0%
[£20,300/44.086]).
However if one takes the market value into account then the current gearing figure (34.5%) is
much lower. Current MV of equity = 40.000m (£3.20 × 12.5m). Current MV of debt = £21.112
million (1.04 × £20.3m). (£21.112/[£21.112 + £40.000]) = 34.5%
The interest cover ratio of 7.4 is higher than that for the debenture issue (3.5) and the existing
figure (5.7).
The rights issue (£20m) represents 50% of Sentry’s current market capitalisation (£3.20 ×
12.500 = £40m). This could deter current shareholders from investing and so there might be a
dilution of shareholders (and control).
Debenture issue:
This creates a very high level of gearing (59.9%) and the interest cover is 3.5 (compared to the
current cover figure of 5.7). So the extra financial risk taken on might concern the shareholders.
It would need sales to increase by 29% for the EPS under the rights issue to remain at its
current level – is this achievable? Roger Smyth’s comments suggest otherwise.
Other issues to consider:
The current debentures are due to be repaid in 20X9–20Y0. This will create additional financial
pressure.
Issue costs – the cost of issuing debentures is likely to be cheaper.
Tax shield – the debenture issue would give Sentry more chance to take advantage of the tax
shield and its WACC may fall accordingly, unless the gearing level was then deemed by
investors to be too high.
43.5 Reference to main dividend policy theory:
M&M theory – share value is determined by future earnings and the level of risk. The amount
of dividends paid will not affect shareholder wealth, providing the retained earnings are
invested in profitable investment opportunities (ie, those with positive NPV’s). Any loss in
dividend income will be offset by the gains in share price.
Traditional theory – shareholders would prefer dividends today rather than dividends or
capital gains in future. Cash now is more certain than in the future.
Supplementing these main theories:
• Impact of signalling
• Clientele effect

ICAEW 2021 March 2017 exam questions 285

 A change in dividend policy may have a negative impact on Sentry’s share price. So it is
important that if dividends are cut, shareholders are given clear reasons for the change, ie,
communication with them is effective.
43.6 ICAEW provides ethical guidance that will ensure that shareholders can rely on the objectivity
and integrity of information given to them by members. The other ethical principle at risk here
is that of professional behaviour.

Examiner’s comments
This question was generally answered well and most candidates achieved a ‘pass’ standard.
This was a six-part question that tested the candidates’ understanding of the financing options
element of the syllabus and there was also a small section with an ethics element to it.
In the scenario, a listed UK drinks manufacturer planned to raise £20 million to finance a major
change in the company’s trading strategy. This additional funding would be raised either via a rights
issue or a debenture issue. In the first part, for six marks, candidates were required to prepare a
forecast income statement for both of these methods of funding. The second part was also worth six
marks and asked candidates to calculate (a) the EPS and (b) the gearing ratio for both methods of
funding. The third part, for six marks, tested sensitivity analysis – what level of sales would be
necessary to maintain the EPS at its current level. The fourth part was worth eight marks. It brought
together the three parts above and required candidates to discuss the implications for the
shareholders of the two funding methods. The fifth part, for six marks, tested candidates’
understanding of dividend theory. Finally, in the sixth part, for three marks, candidates had to explain
the ethical issues arising for an ICAEW Chartered Accountant who is aware of a plan to overstate the
company’s forecast sales figures.
The third part was a good discriminator and, whilst many candidates were able to work backwards to
a forecast sales figure, a large minority scored very poorly here.
Most candidates did very well in the first part and the majority scored full marks. The most common
errors occurred with the estimated variable costs, interest charges and dividend payments. A small
minority of candidates were unable to calculate the number of new shares issued via the rights issue
and used, erroneously, a 1 for 1 issue (rather than dividing £20 million by the issue price of £2.50).
The second part was generally well answered, but a number of candidates were unable to identify
the earnings figure from the income statement and used the retained profit figure instead. A
significant number of candidates were unable to calculate the correct gearing ratios. Typical errors
here were: (a) calculating debt/equity instead of debt/debt + equity, despite instructions to the
contrary, (b) omission of forecast retained profits, (c) addition of par value of new shares rather than
sum raised and (d) using market values rather than book values, again contrary to the instruction
given.
Overall the answers to the fourth part were disappointing. Too many candidates said little beyond
the fact that EPS and gearing would move up/down, depending on the funding method chosen. Very
few considered the impact on interest cover or the required size of the equity issue. The discussion of
financial risk was, generally, limited and too many candidates spent too much time on M&M theories.
The fifth part was, overall, answered very well, although some candidates discussed capital structure
theory here. The sixth part was, in general, answered very well.

44 White Rock plc

Marking guide Marks

44.1 (a) Relevant money cash flows

Newcastle sales & contribution 2
Tax on profit .5
Factory closure .5
Tax on closure .5
Working capital .5

286 Financial Management ICAEW 2021

 Tax saving on machinery 1
Lease cancellation .5
Tax saving .5
Newcastle working capital 1.5
Discount factor 1
Irrelevant costs: lease, head office, fixed 2

London sales 1
London variable costs 1
London fixed costs 1
Tax on profit .5
Factory closure .5
Tax on closure .5
Lease payments .5
Tax saved on lease .5
Machinery sale .5
Tax saving 1.5
London working capital 1.5
Discount factor 1
Marks Available 21
Maximum 21
(b) Advice 1
Marks Available 1
Maximum 1
44.2 Project rankings 2
NPV with divisible projects 2
NPV with indivisible projects 2
Marks Available 6
Maximum 6
44.3 Explanation of EMH – levels of efficiency 4
Examples of irrational behaviour 4
Maximum available 7
Marks Available 15
Maximum 7
Total 35

44.1
(a)

Closure March 20X7 : 20X7 20X8 20X9

y0 y1 y2
£m £m £m
Newcastle sales (W1) 1,326.000 1,575.900
Newcastle VC’s (sales ´ 35%) (464.100) (551.565)
Tax on profit (W2) (146.523) (174.137)

ICAEW 2021 March 2017 exam questions 287

 Closure March 20X7 : 20X7 20X8 20X9
y0 y1 y2
£m £m £m
Factory closure (1,600.000)
Tax on closure (@ 17%) 272.000
WC reversal 800.000
Machinery sale 1,700.000
Tax saving on machinery (W3) 238.000
Lease cancellation (3,000.000)
Tax saving on cancellation 510.000
Newcastle working capital (W4) (132.600) (24.990) 157.590
Total cash flows (1,212.600) 690.387 1,007.788
Discount factor 1.000 0.901 0.812
PV (1,212.600) 621.970 817.943
NPV 227.314

WORKINGS
(1) W1

Newcastle sales £1.3m × 1.02 1,326.000

£1.5m × 1.02 × 1.03 1,575.900

(2) W2

Newcastle contribution
(sales × 65%) 861.900 1,024.339

Tax @ 17% 146.523 174.137

(3) W3

WDV 3,100.000
Balancing Allowance (1,400.000)
Sale 1,700.000
Tax saved (17% × £1,400,000) 238.000

(4) W4

Working capital (132.600) (157.590) 0.000

Balance b/f 0.000 132.600 157.590
Increment (132.600) (24.990) 157.590

20X7 20X8 20X9

Closure March 20X9 : y0 y1 y2

288 Financial Management ICAEW 2021

 £m £m £m
London sales (W1) 7,344.000 5,778.300
London variable costs (sales ´ 40%) (2,937.600) (2,311.320)
London fixed costs (W2) (1,428.000) (1,470.840)
Tax on profit (W3) (506.328) (339.344)
Factory closure (2,300.000)
Tax on closure 391.000
Lease payments (1,800.000) (1,800.000)
Tax saved on lease 306.000 306.000
Machinery sale 600.000
Tax saving on machinery (W4) 94.860 77.785 252.355
London working capital (W5) 65.600 156.570 577.830
Total cash flows (1,639.540) 1,212.427 1,483.981
Discount 1.000 0.901 0.812
PV (1,639.540) 1,092.277 1,204.432
NPV 657.169

(5) W1

London sales £7.2m × 1.02 7,344.000

£5.5m × 1.02 ×
1.03 5,778.300

(6) W2

London fixed costs £1.4m × 1.02 (1,428.000)

£1.4m × 1.02 ×
1.03 (1,470.840)

(7) W3

London contribution (sales × 60%) 4,406.400 3,466.980

less: London fixed costs (1,428.000) (1,470.840)
London ‘profit’ 2,978.400 1,996.140
Tax on ‘profit’ @ 17% (506.328) (339.344)

(8) W4

WDV 3,100.000 2,542.000 2,084.440

WDA (558.000) (457.560) (1,484.440)
WDV/sale 2,542.000 2,084.440 600.000
Tax saved (WDA ´ 17%) 94.860 77.785 252.355

(9) W5

Working capital (734.400) (577.830) 0.000

Balance b/f 800.000 734.400 577.830

ICAEW 2021 March 2017 exam questions 289

 Increment 65.600 156.570 577.430

(b) White should choose March 20X9 for closure of the London factory as it has the higher
NPV and will enhance shareholder wealth the most.
44.2

Project 1 2 3 4 Total
£’000 £’000 £’000 £’000 £’000
Investment required (£m) 6,000 4,500 4,700 3,850 19,050
Net Present Value 621 563 869 622
NPV/£ invested £0.104 £0.125 £0.185 £0.162
Ranking 4 3 1 2

Divisible projects 1 2 3 4 Total

£’000 £’000 £’000 £’000 £’000
Invested 1,950 4,500 4,700 3,850 15,000
NPV 202 563 869 622 2,256
Funds used 32.5% 100% 100% 100%
of of of of
P1 P2 P3 P4

Indivisible projects

Using trial and error:

1 2 3 4 Total
£’000 £’000 £’000 £’000
Invested 6,000 4,500 3,850 14,350
NPV 621 563 622 1,806

1 2 3 4 Total
£’000 £’000 £’000 £’000
Invested 6,000 4,700 3,850 14,550
NPV 621 869 622 2,112

1 2 3 4 Total
£’000 £’000 £’000 £’000
Invested 4,500 4,700 3,850 13,050
NPV 563 869 622 2,054

The highest NPV is achieved via the combination of projects 1, 3 and 4. This would generate an
NPV of £2,112,000.

20X7 20X8 20X9

Closure March 20X9 : y0 y1 y2
£m £m £m

290 Financial Management ICAEW 2021

 20X7 20X8 20X9
Closure March 20X9 : y0 y1 y2
London sales (W1) 7,344.000 5,778.300
London variable costs (sales × 40%) (2,937.600) (2,311.320)
London fixed costs (W2) (1,428.000) (1,470.840)
Tax on profit (W3) (506.328) (339.344)
Factory closure (2,300.000)
Tax on closure 391.000
Lease payments (1,800.000) (1,800.000)
Tax saved on lease 306.000 306.000
Machinery sale 600.000
Tax saving on machinery (W4) 94.860 77.785 252.355
London working capital (W5) 65.600 156.570 577.830
Total cash flows (1,639.540) 1,212.427 1,483.981

44.3 The efficient markets hypothesis (EMH) holds that stock markets are considered in the main to
be efficient, ie, all share prices are ‘fair’. Investment returns are those expected for the risks
undertaken. Information is rapidly and accurately incorporated into share values. When share
prices at all times rationally reflect all available information, the market in which they are traded
is said to be efficient. In efficient markets investors cannot make consistently above-average
returns other than by chance.
An efficient market is one in which share prices reflect all of the information available. There
are three levels of efficiency:
Weak form – prices only change when new information about a company is made available.
There are no changes in anticipation of new information. Information arrives in a random
manner (the random walk theory) and so the chartist theory (technical analysis) will not hold up
here. The market is efficient in the weak form if past prices cannot be used to earn consistently
abnormal profits.
Semi strong form – prices reflect all information about past price movements and all
knowledge that is publicly available/anticipated. The market can anticipate price changes
before new information is formally announced. The market is efficient in the semi-strong form if
publicly available information (eg, historical share prices, dividend announcements) cannot be
used to earn consistently abnormal profits.
Strong form – share prices reflect all information about past price movements, all knowledge
that is publicly available/anticipated and from insider knowledge available to specialists or
experts. The market is efficient in the strong form if all information (private and public) cannot
be used to earn consistently abnormal profits.
Behavioural finance questions the validity of the EMH and posits that investors’ irrational
behaviour may affect share price movements. Examples of irrational behaviour are:

Overconfidence Representativeness Narrow framing

Miscalculation of Ambiguity aversion Positive feedback

probabilities

Cognitive dissonance Availability bias Conservatism

Examiner’s comments
This question had the lowest percentage mark on the paper. The majority of candidates achieved a
‘pass’ standard in the question, however.

ICAEW 2021 March 2017 exam questions 291

 This was a three-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.
It was based around a UK cosmetics manufacturing company which has three factories (in London,
Newcastle and Manchester). In the first part of the question, for 22 marks, the company had decided
to close the London factory and relocate some of its production to the Newcastle factory. Its board is
not sure of the best closure date (20X7 or 20X9). Candidates were given financial information about
the two factories and were asked to calculate the relevant money cash flows associated with closing
the London factory (a) in 20X7 and (b) in 20X9. From these calculations candidates were required to
calculate the NPV for each scenario. The second part, for six marks, considered the Manchester
factory and tested candidates’ understanding of capital rationing. The third part, for seven marks,
required candidates to explain the key principles of the Efficient Market Hypothesis and the influence
of behavioural factors.
As expected, in the first requirement parts (a) and (b) were very effective discriminators. A good
number of candidates did really well here, but a significant minority really struggled and were unable
to identify the relevant cash flows adequately. This was largely due to an inability to stand back and
think the scenario through carefully before diving in and doing the calculations. Typical errors made
were:
• The inclusion of opportunity costs (despite instructions to the contrary)
• Including irrelevant cash flows, eg, leases, head office costs, fixed costs
• Inaccurate inflation adjustments
• Poor working capital calculations
• Too many candidates mixed together the London and Newcastle sales/contribution figures
• Many candidates considered only 20X7 cash flows for the 20X7 closure date and will have
lost marks
Most candidates scored well in the second part and the most common error was a failure to apply
the trial and error approach for the indivisible projects.
The third part was answered well by most candidates.

45 ST Leonard Foods

Marking guide Marks

45.1 Net payment due 1

No hedge 2
OTC option 3
Money market hedge 3
Forward contract 2
Marks Available 11
Maximum 11
45.2 Hedging advice comparing the methods under each exchange rate 8
Marks Available 8
Maximum 8
45.3 Rates payable with LIBOR 4% 2
Rates payable with LIBOR 6% 2
Annual interest calculation 1
Conclusion 2
Marks Available 7
Maximum 7
45.4 FRAs v futures – 1 mark per valid point 4

292 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 4
Maximum 4
Total 30

45.1

Net payment due at 30/6/X7 = €1,750,000 – €600,000 €1,150,000

Spot rate @ 30/6/X7 Spot rate @ 30/6/X7

€1.1875 – 1.1960/£ €1.2745 – 1.2860/£

Do not hedge €1,150,000 (£968,421) €1,150,000 (£902,314)

1.1875 1.2745

€1.1875 – €1.2745 –
OTC option 1.1960 1.2860
Call option
Exercise option Yes No
Rate 1.2540 1.2745

Sterling payment €1,150,000 €1,150,000

1.2540 1.2745

(£917,065) (£902,315)
plus: Premium cost
(€1,150k/€100 × £0.70) (8,050) (8,050)
Total cost (£925,115) (£910,365)

Money market hedge

Lend euros now €1,150,000 €1,150,000 €1,143,709
1 + (2.2%/4) 1.0055

Convert at spot rate €1,143,710 (£903,975)

1.2652

Sterling borrowed at 4.6% pa 903,975 × [1 + (4.6%/4)] (£914,370)

Forward contract

Sterling payment €1,150,000 1,150,000 (£913,133)

ICAEW 2021 March 2017 exam questions 293

 (1.2652 – 0.0058) 1.2594

Arrangement fee (5,500)

(£918,633)

45.2 In summary

Spot rate – €1.1875/£ Spot rate – €1.2745

Do not hedge (£968,421) (£902,314)
OTC option (£925,115) (£910,365)
MMH (£914,370) (£914,370)
Forward contract (£918,633) (£918,633)
Sterling payment @ current spot rate €1.150m/1.2652 (£908,947)

The forward rate suggests that the euro will strengthen (sterling will weaken) over the next
three months. STL would prefer sterling to be stronger (purchases are then cheaper).
With an exchange rate of €1.1875/£
Sterling is much weaker, and the MMH and forward contract produce the lowest sterling
payments.
With an exchange rate of €1.2745/£
Sterling is stronger, and the option and no hedge produce the lowest sterling payments. Once
the exchange rate exceeds €1.2577/£ (€1.150,000/£914,370) then the option produces a
lower payment than the MMH (and also, therefore, the forward contract).
Directors’ attitude to risk is also important in deciding which approach to take.
45.3

LIBOR 4% LIBOR 6%

FRA Option No hedge FRA Option No hedge

Pay (5.0%) (5.0%) (5.0%) (7.0%) (5.2%) (7.0%)

(Pay)/refun (0.8%) 1.2%

d

Premium (0.5%) (0.5%)

Total (5.8%) (5.5%) (5.0%) (5.8%) (5.7%) (7.0%)

£’000 £’000 £’000 £’000 £’000 £’000

Annual (243.6) (231.0) (210.0) (243.6) (239.4) (294.0)

interest

At the lower LIBOR rate it is best not to hedge, but with LIBOR at 6% the option is slightly
cheaper than the FRA.
45.4 FRA’s allow lenders/borrowers to fix a rate of interest. The bank will pay/receive any difference
between the agreed rate and the actual rate paid/received (see workings in 45.3 above).
Interest rate futures are similar to FRA’s in that they are contracts on an interest rate, but the
terms, amounts and periods are standardised.
Entitlement to interest rate receipts is bought with futures and the promise to make to interest
rate payments is sold with futures.
The pricing of an interest rate futures contract is calculated as (100–r), so if the rate in a futures
contract is 5% then the contract will be priced at 95. Profits/losses on the buying and selling of
futures are offset against the moves in interest rates.

294 Financial Management ICAEW 2021

Examiner’s comments
Most candidates demonstrated a good understanding of this area of the syllabus and this question
had the highest average mark on the paper.
This was a four-part question which tested the candidates’ understanding of the risk management
element of the syllabus.
In the scenario a UK frozen food company was considering hedging its exposure to (a) foreign
exchange rate risk on a planned €1.15 million (net) payment (three months ahead) and (b) interest
rate risk on a £4.2 million loan from its bank (also three months ahead).
The first part was worth 11 marks and asked candidates to calculate, at two spot rates, the sterling
cost arising from a list of hedging techniques that could be applied to the euro payment. In the
second part, for eight marks, candidates were required to advise the company’s board whether it
should hedge the euro payment. In the third part, for seven marks, candidates were required to
calculate the annual interest payments that would arise on its planned loan were it to make use of an
FRA, an option or to not hedge at all. Two different rates of LIBOR were given to the candidates. From
these calculations, candidates were then required to recommend which of the hedging techniques
the company should choose at each of the LIBOR rates given. Finally, for four marks, candidates were
asked to explain how FRA’s differ from interest rate futures.
The first part was generally answered well. However, a minority of candidates added the euro receipt
to the euro payment or kept them separate and so will have lost marks. One disturbing error, which
occurred too frequently, was that candidates calculated two different MMH and forward contract
results using the two future spot rates given, rather than a single result for each, based on the current
spot rate. Also, many wasted time by recalculating the correct MMH and forward contract results for
the second set of spot data, rather than just stating ‘no change’. The examining team has no
explanation for this as many similar questions have been set in the past without these issues
occurring. With the currency option, the most common errors were (a) choosing a put rather than a
call option and (b) using a traded option rather than an OTC.
Overall, the second part was disappointing in that too few candidates went beyond only comparing
the best outcome at each spot rate. Most answers here needed to demonstrate a deeper
understanding of the issues involved.
In the third part many candidates scored full marks, which was good to see. However, a number of
candidates lost marks as they were confused by the timings in the scenario. Rather than calculate the
annual interest cost as required, they calculated, incorrectly, a three month cost, ie, between now and
when the loan is to be taken out.
Overall, the final part was answered well.

ICAEW 2021 March 2017 exam questions 295

296 Financial Management ICAEW 2021
 June 2017 exam questions
46 Brighton plc

Marking guide Marks

46.1 Contribution 3
Costs 1.5
Recognition of sunk costs .5
Rent forgone 1
Tax 1
New equipment/capital allowances 3
Working capital 2.5
Discount factor 1
NPV conclusion 1.5
Marks Available 15
Maximum 15
46.2 PV of contribution 2.5
Sensitivity % .5
Conclusion 1
Marks Available 4
Maximum 4
46.3 Listing the seven value drivers 2
Application to the scenario 4
Marks Available 6
Maximum 6
46.4 1 mark for each option, 1 mark for application 4
Marks Available 4
Maximum 4
46.5 1.5 marks for each example 3
Marks Available 3
Maximum 3
46.6 State and apply the relevant principles 3
Marks Available 3
Maximum 3
Total 35

46.1

0 1 2 3 4
£m £m £m £m £m
Contribution 2.97 3.18 2.92 2.68
Fixed overheads –0.10 –0.10 –0.11 –0.11
Selling and administration –0.50 –0.52 –0.53 –0.55
Rent forgone –0.40 –0.40 –0.40 –0.40

ICAEW 2021 June 2017 exam questions 297

 0 1 2 3 4
£m £m £m £m £m
Operating cash flows –0.40 1.97 2.16 1.88 2.02

Tax 17% 0.07 –0.33 –0.37 –0.32 –0.34

After tax operating cash flows –0.33 1.64 1.79 1.56 1.68

New equipment –8.00

Tax saved on CA’s 0.24 0.20 0.16 0.13 0.62
Working capital –1.00 –0.07 0.09 0.08 0.90
Net cash flows –9.09 1.77 2.04 1.77 3.20
PV factors at 10% 1.00 0.909 0.826 0.751 0.683
Present value –9.09 1.61 1.68 1.33 2.19
NPV –2.28

The project has a negative NPV therefore it should not proceed.

Contribution:
(1) 5,500 × 12 × £100 × 45% = £2.97m
(2) 2.97 × 1.02 × 1.05 = £3.18m
(3) 3.18 × 1.02 × 0.90 = £2.92m
(4) 2.92 × 1.02 × 0.90 = £2.68m
Fixed overheads only 50% incremental: £0.2m ×0.5 = £0.1m
(1) 0.1
(2) 0.1 × 1.03 = 0,103
(3) 0.103 ×1.03 = 0.106
(4) 0.106 × 1.03 = 0.109
Selling and administration:
(1) 0.50
(2) 0.50 × 1.03 = 0.515
(3) 0.515 × 1.03 = 0.531
(4) 0.531 × 1.03 = 0.546
Marketing costs and centrally allocated costs are a sunk costs and therefore not included.
Capital allowances and the tax saved thereon.

Cost/WDV CA Tax
0 8.00 1.44 0.24
1 6.56 1.18 0.20
2 5.38 0.97 0.16
3 4.41 0.79 0.13
4 3.62 3.62 0.62

298 Financial Management ICAEW 2021

 Working capital
Total Increment
0 –1 –1
1 –1.07 –0.07
2 –0.98 0.09
3 –0.9 0.08
4 0.9

The discount factor should be calculated as follows:

(1.07 ×1.025) –1 = 0. 0968 It is acceptable to round this to 0.10 (10%).

Examiner’s comments
This was a six-part question, which tested the candidates’ understanding of the investment decisions
element of the syllabus. The scenario of the question was a company considering launching a new
product on to the market.
The first part was well answered by many candidates, however the following were common errors:
incorrect calculation of sales and variable costs; timing errors for cash flows; not stating that research
and development costs should be ignored because they are a sunk cost; not stating that allocated
fixed overheads should not be included in the NPV computations.

46.2

£m £m £m £m
Sensitivity:
Contribution × (1– 0.17) 2.47 2.64 2.42 2.22
PV factors 0.909 0.83 0.75 0.68
PV 2.25 2.18 1.82 1.52

Total PV 7.77

Sensitivity
– 2.28/7.77 = –29.3%

Sales revenue will have to increase by 29.3% to arrive at a zero NPV. The project is therefore
relatively insensitive to revenue changes.

Examiner’s comments
Responses to the second part were mixed, with many candidates basing calculations on sales rather
than contribution, and many ignoring taxation. There were few candidates who made meaningful
comments regarding the sensitivity of the project to changes in the inputs. Responses to the third
part were also mixed, with weaker candidates merely listing the seven drivers with no application to
the scenario.

46.3 SVA is the process of analysing the activities of a business to identify how they will result in
increasing shareholder wealth.
Answers should outline the seven drivers and relate them to the project and its negative
NPV:
Sales growth rate – can this be increased, are the estimates realistic.

ICAEW 2021 June 2017 exam questions 299

 Operating profit margin – can the 45% contribution be improved by reducing costs.
Investment in non-current assets – can the cost of the project be reduced, perhaps by leasing
plant and machinery.
Investment in working capital – can the project operate with less investment in working capital
without causing liquidity problems.
Cost of Capital – is the cost of capital at its optimum level.
Life of projected cash flows – is the project life cycle correct and is there any value in cash flows
beyond the fourth year.
Corporation tax rate – is the company tax efficient.
46.4 The project has a negative NPV, which signals that Brighton should reject it. The real options
are as follows (any TWO):
A follow-on option – investing into this competitive market now will allow Brighton to invest
more in the future, perhaps when other competitors have left the market.
An abandonment option – Brighton might commence the project with a view to future
investment. However, if it is apparent that the sector is not going to offer future opportunities,
Brighton can abandon the project at any time eg, by selling out to a rival.
A timing option – Brighton could delay its investment and wait and see if competitors leave the
market, making it more attractive to invest later on.
A growth option – As well as manufacturing overseas, Brighton also has the opportunity to
expand overseas via acquistion.
A flexibility option – Manufacturing overseas would perhaps give the flexibility to access
overseas markets more easily.

Examiner’s comments
Responses to the fourth part were good, but some candidates listed all real options rather than just
stating two as per the requirement. Only the first two are marked. Responses to the fifth and sixth
part were also good.

46.5 The over-riding objective of companies is to create long-term wealth for shareholders.
However this can only be done if we consider the likely behaviour of other stakeholders. For
example (TWO only):
Employees – cutting employee benefits in pursuit of creating short-term profits could have
long-term detrimental effects on shareholder wealth, for example if the company has high staff
turnover which affects productivity or service levels.
Creditors – delaying payments to creditors could have repercussions for future supplies, which
could reduce longer- term shareholder wealth.
Managers – if managers and employees are not motivated adequately, the costs of
inefficiencies will be borne by shareholders.
46.6 The directors of Brighton should develop an ethical policy in respect to using overseas
manufacturers where labour is cheap and safety standards for employees may be low. This
should relate to not using suppliers who make use of child labour or slave labour, or who
employ people in dangerous working conditions. In relation to this, the principles of integrity,
objectivity and professional behaviour are relevant.

47 Easton plc

Marking guide Marks

47.1 Cost of equity 1

Cost of debt 4
MV equity 1
MV debt 1

300 Financial Management ICAEW 2021

 Marks Available 1
8
Maximum 8
47.2 Explanation 2
De-gearing 1.5
Re-gearing 1.5
Cost of equity associated with the project 1
Marks Available 6
Maximum 6
47.3 Overall equity beta 1.5
Cost of equity 1
WACC 1.5
Commentary 2
Marks Available 6
Maximum 6
47.4 2 marks for definitions; 0.5 marks for each examples 6
Marks Available 6
Maximum 6
47.5 Portfolio theory 1
Stock market reaction 1.5
Shareholder reaction 1.5
Marks Available 4
Maximum 4
47.6 Identification of APV 1
Description of its application - 1 mark per point 4
Marks Available 5
Maximum 5
Total 35

47.1 The current WACC using CAPM is calculated as follows: Ke = 2 + 0.45 (9 – 2) = 5.15%
Kd using linear interpolation:
The ex-interest debenture price is £105 (109 – 4).

Timing Cash Flow Factors at PV Factors at PV

Years £ 1% £ 5% £
0 (105) 1 (105) 1 (105)
1–8 4 7.652 30.61 6.463 25.85
8 100 0.923 92.30 0.677 67.70
17.91 (11.45)

IRR = 1 + (17.91/(17.91 + 11.45) × 4 = 3.44%

Kd = 3.44 × (1 – 0.17) = 2.86%
The ex div share price is 252p – 10p = 242p.
The market value of equity is: 242p × (5m/0.01) = £1,210m. The market value of debt is:
£200m × (105/100) = £210m. The debt equity ratio is: 0.15:0.85
The current WACC is: (5.15% × 0.85) + (2.86% × 0.15) = 4.81%

ICAEW 2021 June 2017 exam questions 301

Examiner’s comments
This was a six-part question that tested the candidates’ understanding of the financing options
element of the syllabus. The scenario of the question was a company considering diversifying its
activities, and calculating the WACC that should be used to appraise the diversification. Also there is
debate about whether the company should be diversifying in the first place, and how the markets
and shareholders might react.
Responses to the first part were good. However a number of candidates made basic errors when
calculating the cost of debt, with a surprising number not able to carry out interpolation correctly.
Strangely, some candidates correctly calculated the cost of equity using the CAPM, but then used
this number in the DVM as growth. They then attempted to use the DVM model to calculate the cost
of equity.

47.2 The cost of equity should reflect the systematic risk of the project. An equity beta from a listed
company operating veterinary practices can be used as a surrogate in the CAPM. Since the
gearing ratio of the surrogate is materially different to Easton, gearing adjustments will have to
be made.
De gearing to find Ba: 0.80 = Ba (1 + (3 × 0.83)/7) Solving for Ba. Ba = 0.59
Gearing up to reflect the gearing ratio of Easton to find Be: Be = 0.59 (1 + (0.15 × 0.83)/0.85)
Solving for Be. Be = 0.68
The Ke to reflect the systematic risk of the project = 2 + 0.68 (9 – 2) = 6.76%

Examiner’s comments
Responses to the second part were disappointing, but there were some excellent answers.
Common mistakes were: de-gearing the company’s existing equity beta; de-gearing the correct beta
but re-gearing using book values rather than market values. Explanations of the rationale for
calculating the cost of equity for the project were poor.

47.3 The overall Be of Easton will reflect the systematic risk of both pet-related products and
veterinary practices.
The overall Be = (0.45 × 0.75) + (0.68 × 0.25) = 0.51
Ke = 2 + 0.51 (9 – 2) = 5.57%. The overall WACC = (5.57% × 0.85) + (2.86% × 0.15) = 5.16%
Easton’s WACC has increased to 5.16% from 4.81%. An increase in the WACC is associated
with a reduction in value, but assuming that the project has a positive NPV this could result in
an increase in value.

Examiner’s comments
Responses to the third part were mixed. A number of candidates did not calculate the overall equity
beta of the company, and used the equity beta from the second part. Explanations of the effect of a
rise in the overall WACC of the company were poor. Responses to the fourth part were poor, and
many candidates were confused about what the terms systematic and unsystematic risk mean. Often
students quoted incorrect examples of each risk.

47.4 Systematic risk is the type of risk that all companies are exposed to, no matter which market
sector they operate in. Systematic risk cannot be eliminated through diversification. Examples
of systematic risk include: interest rate changes, economic recession, oil price changes and
wars.
Unsystematic risk is the risk that affects a particular market sector or individual company. Most
of this risk can be diversified away by investing in a portfolio of randomly selected securities.
Examples of unsystematic risk include: the chairman resigning, strikes by the employees of a
company or changes in regulations that affects a particular market sector.
47.5 Portfolio theory shows that the only logical portfolio to hold is one which is fully diversified. The
reaction of each group might be:

302 Financial Management ICAEW 2021

 The stock market might not welcome the diversification, since diversified companies usually
trade at a conglomerate discount. The stock markets might assume that Easton does not have
the expertise to operated veterinary practices.
Shareholders who hold a well-diversified portfolio would not welcome Easton diversifying its
operations (as they already regard themselves as well-diversified without this), so the market
value might fall.

Examiner’s comments
Responses to the fifth part were also mixed, with many candidates not able to demonstrate a good
grasp of the topic area. Few candidates mentioned that diversified companies often trade at a
conglomerate discount.

47.6 If the financing of the project results in a change in the capital structure of Easton, the
WACC/NPV should not be used. An alternative project appraisal technique is APV.
The project will be appraised as if it were only financed by equity, to arrive at a base case NPV.
The base case NPV is then adjusted for the present value of the costs and benefits of the actual
type of finance used, including the present value of the tax shield on interest paid.
The discount rate will be the all equity discount rate using the Ba for the project: 2 + 0.59 (9 – 2)
= 6.13%

Examiner’s comments
Responses to the sixth part were reasonable. Many candidates were able to identify APV and
describe the process. However, few candidates calculated the appropriate discount rate.

48 Lake Ltd

Marking guide Marks

48.1 Forward contract 2

Money market hedge 3
Currency futures 4
OTC currency options 5
Marks Available 14
Maximum 14
48.2 Implications of hedging techniques 3
Advantages and disadvantages 5
Recommendation 2
Marks Available 10
Maximum 10
48.3 2 marks for each risk identified and explained 4
Ways to mitigate the risks 2
Marks Available 6
Maximum 6
Total 30

48.1 Forward contract:

The appropriate forward rate is $/£1.3110 (1.3092 + 0.0018). The sterling receipt will be
£991,609 (£1,300,000/$1.3110).
Money market hedge:

ICAEW 2021 June 2017 exam questions 303

 Borrow in US$ against the receipt due in three months:
Borrow $1,288,085 = (1,300,000/(1 + 0.037/4)
Buy £ spot = £983,871 (1,288.085/1.3092)
Total receipt of £991,497 (983,871 × (1 + 0.031/4))
Currency futures:
Lake will buy September futures to hedge the $ receipt.
The number of contracts to buy is = ($1,300,000/$1.3105)/£62,500 = 15.87 round to 16.
The futures contracts will be closed out on 30 September 20X7 resulting in a profit of:
$12,500 ((1.3230 – 1.3105) × 16 × 62,500)
The sterling receipt will be: £990,566 ((1,300,000 + 12,500)/1.3250).
OTC currency options:
Lake will use a call option to buy £ with an exercise price of $/£1.3200. The premium will cost =
£26,000 (1,300,000 × 0.02).
Together with interest the premium will cost £26,208 (26,000 × (1 + 0.032/4))
If the spot rate for buying £ with $ on 30 September is $/£ 1.3250 the option will be exercised.
The total receipt will be = £958,640 ((1,300,000/1.3200) – 26,208).

Examiner’s comments
This was a three-part question that tested the candidates’ understanding of the risk management
element of the syllabus. The scenario of the question was a company that has recently started
exporting to the US, and a member of staff is asked to give advice to the board on hedging FOREX,
and other risks associated with overseas trading activities.
The first part was well answered by most candidates. However some of the errors demonstrated by
weaker candidates included: calculating the number of futures contracts using the spot rate rather
than the futures price; stating that currency futures should be initially sold rather than bought;
calculating the futures gain in £ rather than $; choosing put options rather than call options; treating
an over the counter option like a traded option; calculating the option premium in US$ rather than £;
omitting interest on the option premium

48.2 The four hedging techniques result in sterling receipts of:

Forward contract £991,609

A money market hedge £991,497

Currency futures £990,566

OTC currency option £958,640

The forward contract, money market hedge and futures contracts all lock Lake into an
exchange rate. The options protect Heaton against the downside risk of the £ strengthening
against the $, and allow for the upside potential of the $ strengthening against the £.
However, the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for Lake.
However there is no secondary market should the customers not pay Lake.
Money market hedge:
The money market hedge is the same as a forward contract. However it is more difficult to
arrange and might use up Lake’s credit lines, on the other hand it does allow Lake to decrease
its overdraft immediately.
Currency futures:
Not tailored so one has to round the number of contracts.

304 Financial Management ICAEW 2021

 Requires a margin to be deposited at the exchange.
Need for liquidity if margin calls are made.
However, there is a secondary market.
Basis risk exists.
OTC currency options:
There is no secondary market.
Advice to Lake:
Spot is $1,300,000/$1.3250 = £981,132
It is unlikely that the dollar is going to strengthen enough to cover the cost of the option
premium, so it is not recommended that the company uses foreign currency options. There is
very little difference in the receipt using forwards, the money markets and futures, and they are
all better than spot.
Since there is potential for margin calls using futures, and the use of credit lines using the
money markets, it is recommended that Lake uses forward contracts to hedge its foreign
currency risk.

Examiner’s comments
There were average answers to the second part from a lot of candidates, some without any reference
to the numbers calculated in the first part. Many candidates did not give a firm conclusion, but there
were some excellent answers.

48.3 Risks that students might identify and explain are (two only):
• physical risk – the risk of goods being lost or stolen in transit, or the documents
accompanying the goods being lost.
• credit risk – the possibility of payment default by the customer.
• trade risk – the risk of the customer refusing to accept the goods on delivery, or cancellation
of the order in transit.
• liquidity risk – the inability to finance the credit given to customers.
• other risks that would be given marks include political risk and cultural risk.
These risks may be mitigated with the help of banks, insurance companies, credit reference
agencies and government agencies such as the UK’s Export Credits Guarantee Department.
Other ways to reduce these risks include risk transfer. Lake might be able to agree a contract
obligating the courier to pay for losses in excess of its statutory liability.

Examiner’s comments
Responses to the third part were mixed, with many candidates demonstrating a lack of knowledge of
overseas trading risks. Even though the requirement stated that the risks identified should be other
than FOREX, a number of candidates quoted this as one of their two risks.

ICAEW 2021 June 2017 exam questions 305

306 Financial Management ICAEW 2021
 September 2017 exam questions
49 Merikan Media plc

Marking guide Marks

49.1 (a) P/E ratio 2

Dividend yield 2
EBITDA 5.5
Net assets at historic cost 1
Net assets revalued 1.5
Marks Available 12
Maximum 12
(b) 1 point per valid point on each of the valuation methods 7
Advice on price range 1
Marks Available 8
Maximum 8
49.2 (a) Sales and operating margin 2
Tax and depreciation 2
Non-current assets 2
Working capital 1
Terminal value 2.5
Present values .5
Short term investments 1
Long term debt 1
Marks Available 12
Maximum 12
(b) Methods to fund MBO – 1 mark per point 3
Marks Available 3
Maximum 3
Total 35

49.1
(a)

Value per
Total value share
£’000 £
P/E ratio £6,391,000 × 8.5 = 54,324 /3,500 15.52
Lower marketability
(25% discount, say) 11.64
Dividend yield £1,750,000/5% = 35,000 /3,500 10.00
Lower marketability
(25% discount, say) 7.50
Enterprise value £’000

Profit before interest & 8,100

ICAEW 2021 September 2017 exam questions 307

 Value per
Total value share
£’000 £
tax
Depreciation 3,500
Amortisation 1,200
EBITDA 12,800 × 6.5 = 83,200
less: Debt at MV 8,000 × £110% = (8,800)
74,400 /3,500 21.26
Lower marketability
(25% discount, say) 15.94
Net assets – historic cost
Ordinary share capital 3,500
Retained earnings 27,206
30,706 /3,500 8.77
8.94
Net assets – revalued
Historic cost (as above) 30,706
Non-current assets (£37,800 – £36,310) 1,490
Current assets (£4,200 – £4,316) (116)
Debentures (£8,000 – £8,800) (800)
31,280 /3,500

(b) Asset valuations are the lowest. They are historic figures and balance sheet-based, with no
intangibles. Merikan is buying Coastal to run it, not to break it up.
P/E and enterprise value are the most relevant as they are forward-looking and based on
profits/earnings.
Using the dividend yield is acceptable, but it is a 100% purchase and the yield calculation
is only relevant for minority interests. Also, this method ignores growth. So a price range of
£12 to £16 per share looks reasonable.
49.2
(a)

Terminal
20X7 20X8 20X9 20Y0 value
£m £m £m £m £m
Sales 70.0 73.5 75.7 77.2 77.2
Operating margin 5.9 6.8 6.9 6.9
Tax (17%) (1.0) (1.2) (1.2) (1.2)
Depreciation 1.5 1.5 1.5 1.5
Operating cash flows 6.4 7.2 7.3 7.3
Replacement non-current
assets (1.5) (1.5) (1.5) (1.5)

308 Financial Management ICAEW 2021

 Terminal
20X7 20X8 20X9 20Y0 value
Incremental non-current
assets (0.2) (0.1) 0.0 0.0

Incremental working capital (0.2) (0.1) (0.1) 0.0

Free cash flows 4.5 5.4 5.7 5.8
Discount factor (8%) 0.926 0.857 0.794 0.794
4.6
/8%
Present values 4.2 4.7 4.5 57.2
Total present value 70.6
plus: Short-term investments 0.7
less: Long-term debt
(£10m × £95%) (9.5)
Market value of equity 61.8

So GB’s equity is worth approximately £61.8m

(b) Methods by which management might fund its MBO:
From management’s equity
From venture capitalists – via equity and debt
Borrowing from bank(s) – debt

Examiner’s comments
This question was generally answered poorly and a very slim majority of candidates achieved a pass
standard. It was a four-part question that tested the candidates’ understanding of investment
decisions. In the scenario a UK-listed media group is planning to (1) purchase an unquoted
commercial radio company and (2) sell all of its shares in an unquoted newspaper company via a
Management Buy Out (MBO).
Many candidates did well in part (a) of the first requirement and some scored full marks. However,
overall this was not answered as well as expected. A considerable number of candidates were unable
to calculate the company’s net assets and/or earnings figures, which was very disappointing. The
enterprise value (EV) calculation was a recent addition to the syllabus. Overall this was answered
reasonably well, but many candidates did not attempt it at all. Part (b) of the first requirement was,
overall, done well, but to score high marks here candidates needed to consolidate valuation theory
with the figures that they had calculated.
For part (a) of the second requirement there was a wide range of answers. Some candidates did
really well here, whilst others produced very little. The figures themselves were not difficult, and a
methodical approach would have generated a good mark. There was evidence of time pressure, as
there were many incomplete answers. Part (b) of the second requirement was done well by most
candidates. A similar question to this was set recently, but many candidates did poorly because they
failed to concentrate their answers on the directors behind the MBO, rather than the company itself.

50 Ramsey Douglas Motors plc

Marking guide Marks

50.1 Cost of equity 2

Cost of preference shares 1

ICAEW 2021 September 2017 exam questions 309

 2
Cost of redeemable debt 4
WACC 1
Marks Available 10
Maximum 10
50.2 Current market value of redeemable debentures 2
Effect of rise in yield 1
Marks Available 3
Maximum 3
50.3 Use of WACC figure – 1 mark per valid point 5
Marks Available 5
Maximum 5
50.4 Identification of key ethical issues 3
Marks Available 3
Maximum 3
50.5 Calculation of ungeared beta 1.5
Calculation of geared beta 1.5
Cost of equity 1
Cost of debt 1
WACC 1
Appropriate commentary 4
Marks Available 10
Maximum 10
50.6 Application of EMH theory – 1 mark per point 4
Marks Available 4
Maximum 4
Total 35

(d1) (£5,440 × 1.03)

MV
+g £65,600
+ 3%
50.1 Cost of equity (ke) = 11.54%

d £640
MV £10,800
Cost of preference shares (kp) = 5.93%

(£275 × 83%)
£6,000
Cost of irredeemable debt (kdi) = 3.80%

Cost of redeemable debt (kdr)

Year Cash flow 4% factor PV 5% factor PV

£’000 £’000 £’000
0 (4,200) 1.000 (4,200.0) 1.000 (4,200.0)
1–3 240 2,775 666.0 2.723 653.5
3 4,000 0.889 3,556.0 0.864 3,456.0
NPV 22.0 NPV (90.5)
IRR = 4% + (22/(22 + 90.5)) = 4.20%

310 Financial Management ICAEW 2021

 Year Cash flow 4% factor PV 5% factor PV
£’000 £’000 £’000
less: Tax at 17% (4.20% × 83%) = 3.49%

WACC

Total MV’s Cost × weighting WACC

£’000 £’000
11.54% ×
Equity 65,600 65,600/86,600 8.74%
5.93% ×
Pref. shares 10,800 10,800/86,600 0.74%
Irredeemable 3.80% ×
debt 6,000 6,000/86,600 0.26%
Redeemable 3.48% ×
debt 4,200 4,200/86,600 0.17%

21,000 1.17%
Total market
value 86,600 9.91%

50.2 From 50.1 above:

Year Cash flow 5% factor PV

£’000 £’000
1–3 240 2.723 653.5
3 4,000 0.864 3,456.0
Present value 4,109.5

Thus current market value would be £4,109.5/£4,000 = £102.74%

Yield increases to 5% and market value falls to £102.74%. It is an inverse relationship.
50.3 When using WACC to appraise projects the following assumptions are implied:
(1) Ramsey’s historic proportions of debt and equity are not to be changed
(2) Ramsey’s systematic business risk is not to be changed
(3) The finance is not project-specific (eg, cheap government loans)
In this case the finance is of a material size, being 11% of total funds at market value
(£9.5m/£86.6m) and the historic gearing does not appear to be met (it is 50:50 ignoring
project NPV).
The systematic business risk, as far as we are aware, does not change as it is still the same
industry.
It is not project-specific finance.
Therefore it is unwise to use the existing WACC, but the after-tax cost of the bank loan is not
the WACC either, as this ignores the required returns of shareholders.
50.4 Ethical guidance – key areas of ethical concern regarding the press release:
Integrity – members need to show honesty, fair dealing and truthfulness.
Objectivity – members must not succumb to the undue influence of others.
Interest of shareholders and owners must be taken into account – members must not let their
own self-interest influence their actions.
50.5 New market geared beta = 2.10

ICAEW 2021 September 2017 exam questions 311

 (2.10 × 72) (2.10 × 72)
(72 + (16 × 83%))
= 85.28
New market ungeared beta = = 1.77

1.77 × (£65.6m + £10.8m + (£10.2m × 83%))

£65.5m
Ramsey’s geared beta = = 2.29
So, cost of equity = (2.29 × (9.15% – 2.25%)) + 2.25 = 18.05%
Cost of debt = 9% × 83% 7.47%
WACC = (18.05% × £65.6m/£86.6m) + (7.47% × £21.0m/£86.6m)) = 15.48%
It would be unwise to use the existing WACC (9.91%) as Ramsey’s plan involves diversification,
and therefore a change in the level of systematic risk (beta rises to 2.29 from 1.25). Thus a new
WACC must be calculated. Systematic risk is accounted for by taking into account the beta of
the driverless cars market, and this is then adjusted to eliminate the financial risk (level of
gearing) in that market. The resultant ungeared beta is then ‘re-geared’ by taking into account
the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased risk discussed above)
is used.
Using this, the new WACC can be calculated.
50.6 Markets set prices based on the information available. If the market ‘takes fright’ at the
proposed investment in driverless cars, then the market value of Ramsey’s shares will fall and
may not recover. It all depends on the market’s view of the company’s likely future success.
Efficiency does not mean that prices return to a ‘normal level’. Markets have no memory.
Efficiency means that shares cannot be bought cheaply and then sold quickly at a profit. Share
prices are ‘fair’, and investment returns are those that would be expected for the risks
undertaken.

Examiner’s comments
This was a six-part question that tested the candidates’ understanding of financing options, with a
small ethics element. It was poorly done and had the lowest percentage mark on the paper. The
majority of candidates failed to reach a ‘pass’ standard. It was based around a UK-listed car
manufacturer that was considering investing in (1) a computerised manufacturing system and (2) the
development of driverless cars.
There were many very good answers to the first part, with candidates securing the full marks
available. The calculation of WACC has been examined frequently. However, in this exam candidates
were, not for the first time, given total figures, rather than unit figures, to work with. Many candidates,
when given the total nominal value and the nominal value per share or debenture, were incapable of
deducing the number of shares or debentures in issue. Also a significant number altered the share
and debt values to make them ex-div, despite the fact that the question stated that all dividends and
interest due for the year had already been paid.
The second part was a good test of candidates’ understanding of the market price and yield of
redeemable debt. Generally, it was answered very poorly. Many candidates commented that if the
redemption yield of the debt were to increase then so would the price of that debt, thus totally
misunderstanding the relationship between required return and value.
Candidates’ responses to the third part were also very disappointing. Too many candidates restricted
their answers to a discussion about the impact on the company’s gearing levels, without taking into
account the wider aspects of when to employ the current WACC figure. In the fifth part most
candidates scored well with the de-gearing and re-gearing calculations, but only a few were able to
work through to the end of the calculations.
The sixth part caught out the majority of candidates – they were unable to apply EMH theory to this
practical example. Responses that centred on the three forms of efficiency and/or behavioural
aspects scored poorly.

312 Financial Management ICAEW 2021

51 Jenson Grosvenor plc

Marking guide Marks

51.1 (a) Currency option 3

Maximum 3
(b) Forward contract 2
Maximum 2
(c) Money market hedge 3
Maximum 3
(d) Strengthening sterling 1
Maximum 1
51.2 Hedging advice – 1 mark per relevant point 7
Marks Available 7
Maximum 7
51.3 Explanation of relevant economic risk 3
Marks Available 3
Maximum 3
51.4 Advantages of using currency futures – 2 marks
Disadvantages of using currency futures – up to 4 marks
Maximum available 4
Marks Available 4
Maximum 4
51.5 Call options intrinsic value 1
Put options intrinsic value 1
Time value 2
Marks Available 4
Maximum 4
51.6 Factors affecting the time value – 1 mark per point 3
Marks Available 3
Maximum 3
Total 30

51.1
(a)

OTC currency option £ £

£5,200,000
1.6245
Put option 3,200,985

£5,200,000
= 52,000 ×
100 (39,000)
Cost £0.75 3,161,985

(b) Forward contract

1.6385 + 0.0085 =
1.6470 3,157,256

ICAEW 2021 September 2017 exam questions 313

 £5,200,000
1.6470

£5,200,000
100 (18,200) 3,139,056
Fee = 52,000 × £0.35

(c)

Money market hedge

£5,200,000
1.013
Borrow C$ £5,133,268

£5,133,268
1.013
Convert @ spot 3,132,907
3,132,907
Lend @ UK × 1.007 3,154,837

(d) Strengthening £

£5,200,000
1.6385 × 1.05
1.7204
= 1.7204 3,022,509

51.2

Conversion at spot rate £3,173,634

If £ strengthens 3,022,509
Option 3,161,985
Forward 3,139,056
Money market hedge 3,154,837

The current spot rate gives best result.

The worst result is from the strengthening £, and the forward contract discount predicts a
strengthening of the £.
C$ is depreciating, and £ strengthening, which is bad for UK exporters. The forward contract
provides certainty, as does the money market hedge.
An option gives flexibility, but it is expensive.
51.3 Jenson’s imports are purchased mostly in euros. If exports were, for example, mostly in
Canadian dollars then Jenson would be disadvantaged by both a strong euro and a weak
dollar (as in 51.1 and 51.2 above).
51.4 Advantages of using currency futures over forward contracts:
• Lower transaction costs
• The exact date of receipt or payment does not have to be known
Disadvantages of using currency futures over forward contracts:
• The contracts cannot be tailored to the user’s exact requirements.
• Hedge inefficiencies (due to needing a whole number of contracts, and basis risk) may
occur.

314 Financial Management ICAEW 2021

 • Only a limited number of currencies can make use of futures contracts.
• If neither currency is $US, then this can complicate matters.
51.5 Intrinsic value
Only options that are in the money have an intrinsic value.
For the call options:
The call options with an exercise price of 355p are in the money and have an intrinsic value of
10p (365p – 355p).
The call options with an exercise price of 370p are out of the money and have a zero intrinsic
value.
For the put options:
The put options with an exercise price of 370p are in the money and have an intrinsic value of
5p (370p – 365p).
The put options with an exercise price of 355p are out of the money and have a zero intrinsic
value.
Time value
The time value is calculated by deducting the intrinsic value from the option premium:

Calls Puts

Sept Oct Sept Oct

355 1.0 11.0 2.0 13.5

370 3.5 14.0 4.0 15.5

51.6 The time value of the options will be affected by:

• the time period to expiry of the options.
• the volatility of the market price of the underlying item.
• the general level of interest rates.

Examiner’s comments
Most candidates demonstrated a reasonable understanding of this area of the syllabus and this
question had the highest average mark on the paper. It was a six-part question which tested the
candidates’ understanding of the risk management element of the syllabus.
The scenario was centred on a UK-based manufacturer of industrial pumps. The company was
considering hedging its exposure to (1) foreign exchange rate risk on a C$5.2 million receipt (three
months ahead) from a Canadian customer and (2) a fall in the value of a large quoted shareholding.
Foreign exchange risk is a regular topic in this examination, and the first part was generally answered
well. However, many candidates lost marks unnecessarily, eg, choosing a call rather than a put
option, failing to deal with fees correctly, or choosing the wrong interest rates for the MMH. Over half
of the candidates believed that strengthening sterling meant getting less foreign currency.
Generally the second part was answered adequately, but bearing in mind how frequently this is
examined, it was disappointing. Too few candidates went beyond only comparing the best outcome
at each rate. Answers here needed to demonstrate a deeper understanding of the issues involved.
Many candidates stated, wrongly, that interest rates indicated that sterling would weaken. Also too
few commented on the negative impact of a stronger pound on an exporter.
In the third part few candidates scored full marks. Those that did explained how a strengthening
pound when exporting and a weakening pound when importing would both be bad for the
company in question. The fourth part was generally answered well, but many candidates just listed
the advantages and disadvantages of currency futures and/or a forward contract, rather than
answering the question as set. The fifth part has been examined before, albeit rarely. A minority of
candidates answered it well and scored full marks, but most were unable to calculate the values
required. The sixth part was answered well and most candidates scored full marks.

ICAEW 2021 September 2017 exam questions 315

316 Financial Management ICAEW 2021
 December 2017 exam questions
52 Innovative Alarms

Marking guide Marks

52.1 (a) Contribution/contribution lost 5

Fixed overheads 1
Tax charge 1
Sale proceeds 2
Working capital 2
Machinery and equipment 1
Tax saved on capital allowances 2
PV and recommendation 2
Marks Available 16
Maximum 16
(b) Disadvantages of sensitivity analysis
Simulation
Total possible marks
Marks Available 0
Maximum 4
(c) Discussion of real options – abandonment, follow-on 4
Marks Available 4
Maximum 4
(d) Ethical issues 3
Marks Available 3
Maximum 3
52.2 Replacement after one year 1
Replacement after two years 2
Replacement after three years 2.5
Recommendation and limitations 2.5
Marks Available 8
Maximum 8
Total 35

52.1
(a) Units pa 30,000

0 1 2 3
Units 000’s
(×1.06) 30.00 31.80 33.71

Selling price £
(×1.03) 399.00 410.97 423.30

Contribution
per unit £ (see 159.6 164.39 169.32

ICAEW 2021 December 2017 exam questions 317

 0 1 2 3
skilled)

0 1 2
£’000 £’000 £’000 £’000
Contribution 4,788.00 5,227.60 5,707.78
Contribution lost (1,500.00) (1,637.70) (1,788.15)
Fixed overhead (500.00) (525.00) (551.25)
Taxable 0 2,788.00 3,064.90 3,368.38
Tax @ 17% 0 (473.96) (521.03) (572.62)

Sale proceeds 9,759.88

Working capital (2,000.00) (183.60) (200.45) (2,384.05)
Machinery and equipment (8,000.00) 2,000.00
Tax saved on CAs 244.80 200.74 164.60 409.86
Cash flows (9,755.20) 2,331.18 2,508.02 (17,349.55)

PV @ 10% (9,755.20) 2,119.25 2,072.74 13,034.97

NPV (£’000) 7,471.76

The Defender project has a positive NPV, which will increase shareholder wealth. The
project should therefore be accepted.
Working capital

Year Cumulative Increment

£’000 £’000
0 (2,000.00) (2,000.00)
1 (2,183.60) (183.60)
2 (2,384.05) (200.45)
3 2,384.05

Capital allowances and the tax saved thereon

Year Cost/WDV CA Tax

£’000 £’000 £’000
0 8,000.00 1,440.00 244.80
1 6,560.00 1,180.80 200.74
2 5,379.20 968.26 164.60
3 4,410.94
Sale (2,000.00) 2,410.94 409.86

318 Financial Management ICAEW 2021

 Contribution lost
The contribution of the other product is:

£
Selling price 175
Materials and skilled labour (150)
Contribution 25
Contribution lost per unit of the defender (50)

Year 1 = (50) × 30 = (1,500.00)

Year 2 = (50) × 1.03 × 31.80 = (1,637.70)
Year 3 = (50) × 1.032 × 33.71 = (1,788.15)
The skilled labour cost of £15 per hour is common to both alternatives, so may be
ignored. In year 1 the contribution on the Defender is £189.60 ignoring labour. The
contribution lost is £40 × 2 = £80 ignoring labour. The net gain is £189.60 – £80 = £109.60
per Defender. If labour costs are included in the figures as above the net gain is the same
ie, £159.60 – £50 = £109.60.
If the gross figures are used in the NPV then they are as follows:
Defender 5,688 6,210 6,781
Lost contribution 2,400 2,620 2,861
Which nets to the same as shown in the NPV calculation above

Sale proceeds £’000

Contribution 5,707.78
Contribution lost (1,788.15)
Net Contribution 3,919.63
Net contribution × 3 × (1 – 0.17) 9,759.88

(b) The disadvantages of sensitivity analysis are as follows:

• It assumes that changes to variables can be made independently.
• It ignores probability. It only identifies how far a variable needs to change to result in a
zero NPV; it does not look at the probability of such a change.
• It is not an optimising technique and does not point directly to a correct decision.
Simulation goes some way to address the weaknesses of sensitivity analysis. The main
advantage is that it allows the effect of more than one variable changing at the same time
to be assessed. This gives more information about the possible outcomes and their
relative probabilities and it is useful for problems that cannot be solved analytically.
However it should be noted that simulation is also not an optimising technique and does
not point directly to a correct decision.
(c) Abandonment option: If the defender project is not successful it is unlikely the team will
buy the rights to manufacture the new alarm system. Therefore Innovative has the option
to abandon and sell the assets.
Follow on option: Rather than sell the rights to manufacture the new alarm system there
might be the opportunity to launch a second (and third and so on) version, which could be
highly profitable, or could lose money, for Innovative.
The mention of growth options rather than follow on options would also gain marks.
(d) There is a clear conflict of interest regarding the computation of the sale proceeds of the
rights to manufacture the Defender after the time horizon of three years.
Since the finance director will be a member of the team he should act with integrity and
have the interests of shareholders in mind. In these circumstances he should not be

ICAEW 2021 December 2017 exam questions 319

 involved in negotiating the price that the team will buy the rights for. He should be
objective and demonstrate professional behaviour.
52.2 Replacement after one year (£):
(30,000) + (22,500 – 500)/1.15 = (10,870) Annual equivalent cost (AEC) = (10,870)/0.870 =
(12,494)
Replacement after two years (£):
(30,000) + (500)/1.15 + (17,000 – 2,500)/(1.15)2 = (19,471) AEC = (19.471)/1.626 = (11,975)
Replacement after three years (£)
(30,000) + (500)/1.15 + (2,500)/(1.15)2 + (12,000 – 3,500)/(1.15)3 = (26,736)
AEC = (26,736)/2.283 = (11,710)
The optimal replacement period is that which gives the lowest AEC; in this case, replacing the
vans after three years is preferable.
Limitations include the following:
• Changing technology, leading to obsolescence
• Changes in design
• Inflation – affecting estimates and the replacement cycles
• How far ahead can estimates be made and with what certainty
• Ignores taxation

Examiner’s comments
This was a five-part question, which tested candidates’ understanding of the investment decisions
element of the syllabus. The scenario of the question was that of a company launching a new product
onto the market, and also considering how often it should replace its fleet of delivery vans. Part (a) of
the first requirement was well answered by many candidates, but there were common errors:
incorrect calculation of contribution; timing errors for cash flows; incorrect calculations of the
contribution lost; incorrect calculations of the value of the rights at the end of the project and in
some cases ignoring it altogether; not explaining why the project should be accepted; not providing
workings so no marks could be awarded when the figure presented was incorrect. Responses to part
(b) of the first requirement were mixed, with many candidates not able to adequately explain the
disadvantages of sensitivity analysis. The question only asked for disadvantages, but many
candidates wasted time by stating advantages. The explanations of simulation as an alternative to
sensitivity analysis were poor. Responses to parts (c) and (d) of the first requirement were good.
However some candidates did not read the question and stated real options which did not apply at
the end of the project. Responses to the second question requirement were mixed.

53 Peel Kitchens plc

Marking guide Marks

53.1 (a) Ordinary dividend growth 1.5

Ex-div share price 1
Cost of equity .5
Cost of debt 4
WACC calculation 2
Maximum 9
(b) CAPM 1
Maximum 1
53.2 Systematic risk unchanged 2.5
Explanation 2.5

320 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 5
Maximum 5
53.3 Calculations (max 3 marks if no use made of historic information) 6
Discussion and advice 6
Marks Available 12
Maximum 12
53.4 Identification and explanation of APV 2
Calculation of discount rate 1
Marks Available 3
Maximum 3
53.5 Identification of 50% payout ratio over time 2
Appropriate discussion 3
Marks Available 5
Maximum 5
Total 35

53.1
(a) Growth can be estimated by ordinary dividend growth for the past four years, excluding
the special dividend as a one-off:
Growth = (25.2/19.80)(1/4) – 1 = 0.0621 or 6.21%
Shares in issue = 180m (90 × 2)
20X7 dividends per share = 14p (25.20/180)
Ex div share price = 278p (292 – 14)
Ke = (14(1.0621)/278) + 0.0621 = 0.1156 or 11.56%
Kd is calculated as the yield to maturity of the 7% debentures × (1 – t):
The ex-interest debenture price is £104 (111 – 7)

Years Cash Flow Factors PV Factors PV

£ 5% 10%
0 (104.00) 1 (104.00) 1 (104.00)
1 to 5 7.00 4.329 30.30 3.791 26.54
5 100.00 0.784 78.40 0.621 62.10
4.70 (15.36)

The yield to maturity = 5 + (4.7/(4.7 + 15.36) × 5) = 6.17%

Kd = 6.17 × (1 – 0.17) = 5.12
The market value of debt and equity =
Debt – £495.04m (476 × 1.04).
Equity – £500.40m (278p × 180m)
Total debt and equity = £995.44m
WACC = ((11.56 × 500.40) + (5.12 × 495.04))/995.44 = 8.35%
(b) Using the CAPM
Ke = 3 + 1.3 × 6 = 10.80%
WACC = ((10.80 × 500.40) + (5.12 × 495.04))/995.44 = 7.98%

ICAEW 2021 December 2017 exam questions 321

53.2 Ungear existing activities: Peel’s equity beta of 1.3 = Ba(1 + 50(1 – 0.17)/50), so Ba = 0.71
Supply of domestic appliances ungeared: This has an equity beta of 1.1 = Ba(1 + 40(1 –
0.17)/60) so Ba=0.71.
So the systematic business risk does not change, which may mean that the existing WACC as
calculated in 53.1 applies.
However, the use of WACC/NPV assumes that, over the life of the project, the gearing ratio of
Peel will remain constant and that the project is marginal. Peel is considering financing a
diversification that represents 20% (200/995) of the company’s total market value of debt and
equity, which cannot be considered marginal. As gearing is likely to change, the existing
WACC cannot be used. The finance is not project specific (eg, from a government loan) so that
condition for using the existing WACC is met.
53.3 Gearing (D/E by market values):
The current gearing ratio is 99% (495.04/500.40)
Gearing if the finance is raised with debt = 139% ((200 + 495.04)/500.40)
Gearing if the finance is raised with equity = 71% (495.04/(200 + 500.40))
Note: This assumes no change in the share price as a result of the diversification. In the longer
term, a positive NPV would affect the ratios calculated.
Interest cover (best and worst case, as PBIT varies)
Current:

20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 33.32 33.32
Interest cover 2.37 2.82

Interest cover if debt is raised:

Total interest will equal £45.32m (33.32 + (200 × 6%))

20X4 20X7
£m £m
EBIT 78.86 94.04
Interest 45.32 45.32
Interest cover 1.74 2.08

EPS (although not explicitly required, students may also calculate and comment on EPS)
Current:
20X4 37.8/180 = 21p
20X7 50.4/180 = 28p
Equity:
20X4 37.8/280 = 13.5p
20X7 50.4/280 = 18p
Debt:
20X4 (78.86 – 45.32)0.83/180 = 15.5p
20X7 (94.04 – 45.32)0.83/180 = 22.5p
The decision to raise the finance wholly by debt or equity will radically change Peel’s gearing
ratio and interest cover.

322 Financial Management ICAEW 2021

 Interest cover: Since 20X3 Peel has been operating with an interest cover between the average
of 2.4 and maximum of 3 for the industry sector that it operates in. Currently Peel has an
interest cover of 2.82, which is near the maximum. Interest cover will be unchanged if Peel
raises equity, however if debt is raised the interest cover will be 2.08, which is near to the
minimum of 2 for the industry sector. In previous years, interest cover would have been below
the minimum.
Gearing ratio: Peel is currently operating with a gearing ratio of 99%, which is around the
average for the industry of 100%. If the company raises debt finance the gearing ratio will rise
to 139%, which is above the industry maximum of 135%; if equity is raised the gearing ratio will
fall to 71%, which is below the industry minimum of 80%.
Given the above, the reaction of the financial markets is likely to be unfavourable if Peel raises
the finance by an issue of debentures. The share price could fall and also the cost of debt
increase. Shareholders are also likely to be concerned if the finance is raised by debt, and it is
unlikely that they would approve the diversification if it were financed in such a way.
Raising the finance by equity would make the company much safer in terms of financial risk.
However, shareholders might be concerned about potential control issues, unless the funds
are raised by way of a rights issue. The financial markets might consider that the company is
not using spare debt capacity.
Given the potential financial risks involved, it would be prudent for Peel to raise the finance by
an issue of shares, or a combination of debt and equity, to keep the gearing ratio and interest
cover more in line with the 20X7 figures.
53.4 If the finance is raised by either debt or equity, then the gearing of Peel will radically change. In
these circumstances, WACC/NPV is not a suitable investment appraisal technique to use. An
alternative technique would be Adjusted Present Value (APV), which assumes that the project is
financed purely by equity. The resultant NPV of cash flows is then adjusted for the actual
benefits and costs of the finance used. A suitable all equity discount rate, which reflects the
systematic risk of the project, would be:
Taking the equity beta of a company in the domestic appliance sector we calculate the asset
beta and use it in the CAPM (53.2 above).
The all equity discount rate using CAPM = 7.26% (3 + (0.71 × 6)).
53.5 Since dividends are rising and falling with profits, it would appear that Peel has a policy of
maintaining a constant dividend payout ratio. The dividend payout ratios have been:

20X3 20X4 20X5 20X6 20X7

£m £m £m £m £m
Profits after tax 39.60 37.80 45.00 43.20 50.40
Ordinary dividend 19.80 18.90 22.50 21.60 25.20
Payout ratio 50% 50% 50% 50% 50%

Note: Candidates are not required to calculate the payout ratio for all years, but a clear
identification of a 50% payout across the period given is required.
A listed company seeks to give ordinary shareholders a constant dividend with some growth.
This cannot be achieved by having a policy of maintaining a constant payout ratio, since
dividends rise and fall with profits. Peels current dividend policy is not usually considered
appropriate for a listed company and may lead to a fluctuating share price (this is known as the
signalling effect).

Examiner’s comments
This was a five-part question that tested understanding of financing options. The scenario of the
question was that of a company diversifying its operations and raising finance by either debt or
equity. Candidates were also asked to discuss the company’s dividend policy. Responses to the first
part were mixed. Many candidates did not consider whether their answers were reasonable, for
example using a cost of equity of 50% in their WACC computations. There were basic errors in many
calculations.

ICAEW 2021 December 2017 exam questions 323

 Answers to the second part were disappointing, with many candidates demonstrating that they do
not know the basic assumptions regarding the use of WACC. Hardly any candidates mentioned that
since the company is raising a large amount of capital by either debt or equity the gearing might not
remain constant and that, because of its size, the project could not be considered marginal. Most
candidates centred their discussion of systematic risk, which they assumed would change. However if
some very basic calculations were carried out it could be seen that the systematic risk of the new
project was the same as existing projects.
Responses to the third part were extremely disappointing despite an almost identical question being
asked in a recent past paper. The question gave industry gearing and interest cover figures, so that
candidates could perform analysis looking at current gearing and interest cover, and then gearing
and interest cover after raising the new finance by either debt or equity. Five years’ historic
information was also given to calculate interest cover figures. It was very disappointing that a large
number of candidates did not use this information or calculated the gearing in a different way to that
specified, or used book values despite the question stating market values had been used. In addition
many candidates did not consider the likely reaction of shareholders and markets to the finance
being raised by either debt or equity. Finally, a large number of candidates wasted time explaining
the theories of M & M when theory was not asked for in the question.
Responses to the fourth part were mixed, with many candidates identifying APV as an alternative to
WACC/NPV. However few candidates calculated the discount rate that should be used in APV. Again
this has been examined many times before. Responses to the fifth part were also mixed, with many
candidates not able to demonstrate a good understanding of dividend policy. Few candidates used
the historic information to establish the company’s current dividend policy. Many repeated theory,
despite this not being required.

54 Jewel House Investments Ltd

Marking guide Marks

54.1 (a) Forward rate and resulting receipt 2

OTC option 4
Marks Available 6
Maximum 6
(b) Advantages and disadvantages of each 2.5
Advice and recommendation 2.5
Total possible marks 5
Marks Available 10
Maximum 4
(c) Discussion of futures – half mark per point 2
Marks Available 2
Maximum 2
54.2 (a) Identification of value and number of contracts 3
Loss on portfolio 1.5
Gain on futures contracts 1.5
Marks Available 6
Maximum 6
(b) Reasons why hedge is not efficient (1 mark per point) 2
Marks Available 2
Maximum 2
54.3 (a) Interest rate differential 1
Rates and flows achieved through swap 3
Marks Available 4

324 Financial Management ICAEW 2021

 Marking guide Marks

Maximum 4
(b) Calculations 2
Marks Available 2
Maximum 2
(c) Advantages – 1 mark per point 4
Marks Available 4
Maximum 4
Total 30

54.1
(a) The forward rate is: $/£ 1.2526 (1.2492 + 0.0034)
This results in a sterling receipt of £6,386,716 ($8,000,000/$1.2526)
Over the counter option:
The option premium is $8,000,000 × 2p = £160,000.
The premium with interest lost is £160,000 × (1+0.03 × 4/12) = £161,600.
If the spot price on 31 March is $/£1.2700, Orion will exercise the options.
The sterling receipt will be ($8,000,000/$1.2400) – £161,600 = £6,290,013.
(b) The forward contract locks Jewel into an exchange rate and does not allow for upside
potential.
Forwards:
• Tailored specifically for Jewel.
• There is no secondary market.
OTC currency options:
• The options are expensive.
• There is no secondary market.
• However, the options allow Jewel to exploit upside potential and protect downside
risk.
Advice:
Without hedging, the sterling receipt would have been £6,299,213 ($8,000,000/$1.2700).
The currency option results in a sterling receipt of £6,290,013, which is marginally worse
than the spot rate on 31 March 20X8. However the forward contract results in a higher
sterling receipt of £6,386,716.
It is recommended that a forward contract is used to hedge any unanticipated fall in the
value of the dollar.
(c) Futures are possibly not appropriate, since they have the following disadvantages:
• Not tailored, so it is necessary to round the number of contracts
• Basis risk exists
• Require a margin to be deposited at the exchange
• A need for liquidity if margin calls are made
However, there is a secondary market and if the client decides not to invest it would be
possible to close out the position, which could result in a gain or loss on the futures trade
54.2
(a) The value of one contract = 7,195 × £10 = £71,950
March contracts will be sold.

ICAEW 2021 December 2017 exam questions 325

 The number of contracts = £100,000,000/£71,950 = 1,389.85. Rounded to 1,390.
On 31 March the portfolio value will fall to:
£100,000,000 (7,010/7,261) = £96,543,176, representing a fall of £3,456,824.
Since there is a loss on the portfolio, there will be a gain on the futures contracts.
The futures position will be closed out and the gain will be =
(7,195 – 7,010) × £10 × 1,390 = £2,571,500.
(b) The hedge is not 100% efficient due to:
Basis risk ie, the futures price at 30 November is not the same as the FTSE 100.
The rounding of the number of contracts.
54.3
(a) First it is necessary to calculate the interest rate differentials:

Jewel Nevis Differentials

Fixed rates 6.5% 5.0% 1.5%
Floating rates LIBOR + 4% LIBOR + 3.5% 0.5%
Net differential 1.0%
This net differential will be shared 0.50% each

The interest rates that can be achieved through the swap are:

Jewel Nevis
Fixed market rate 6.5% ——
Floating market rate —— LIBOR + 3.5%
Less the differential 0.5% 0.5%
Rates achieved through the swap 6.0% LIBOR + 3.0%

Cash flows would typically be: LIBOR from Nevis to Jewel and fixed of 2.0% from Jewel to
Nevis.
(b) Jewel is paying 4.36% (0.36 + 4) on its floating rate borrowings, and would be paying a
fixed rate of 6% through the swap. The initial difference in interest rates is 1.64% (6.00 –
4.36)
For the floating rate to equal the fixed rate of 6% achieved through the swap, LIBOR would
have to rise to 2% (1.64 + 0.36).
(c) The advantages to Jewel of an interest rate swap include the following:
• The arrangement costs are significantly less than terminating an existing loan and
taking out a new one.
• Interest rate savings are possible, either out of the counterparty or out of the loan
markets by using the principle of comparative advantage.
• They are available for longer periods than the short-term methods of hedging such as
FRAs, futures and options.
• They are flexible since they can be arranged for tailor-made amounts and periods.
They are also reversible.
• It is possible to obtain the type of interest rate, fixed or floating, that the company
wants.
• Swapping to a fixed interest rate assists in Jewel’s cash flow planning.

Examiner’s comments
This was an eight-part question that tested the candidates’ understanding of the risk management
element of the syllabus.

326 Financial Management ICAEW 2021

Part (a) of the first requirement was well answered by most candidates. However some of the errors
demonstrated by weaker candidates included: using the incorrect spot rate; deducting the forward
discount; not including interest on the option premium, or including interest but taking a whole year;
treating the OTC option as a traded option.
Part (b) of the first requirement produced average answers from a lot of candidates, some without
any reference to the numbers calculated in part (a). Many candidates did not give a firm conclusion.
Responses to part (c) of the first requirement were good.
Responses to parts (a) and (b) of the second requirement were also good, however some candidates
made some basic errors as follows: incorrect calculation of the number of contracts and the value of
one contract by using the current index price and not the current futures price; incorrect
computation of the loss on the portfolio; stating that contracts should be initially bought not sold;
incorrect computation of the gain on futures by using the current index price and not the futures
price.
Responses to the third requirement were good, but many candidates did not read the question when
they demonstrated the cash flows that would typically occur when the swap was implemented.

ICAEW 2021 December 2017 exam questions 327

328 Financial Management ICAEW 2021
 March 2018 exam questions
55 Wells Bakers plc

Marking guide Marks

55.1 (a) Cost of equity (dividend valuation model) 3

Cost of preference shares 1
Cost of irredeemable debt 2
Cost of redeemable debt 4
WACC calculation 4
14
(b) Cost of equity (CAPM) 1
WACC calculation 1
Marks Available 2
Maximum 2
55.2 Appropriate discussion of directors’ views 6
Marks Available 6
Maximum 6
55.3 Geared/ungeared beta calculations 3
Cost of equity 1
Cost of debt 1
WACC 1
Discussion 4
Marks Available 10
Maximum 10
55.4 Ethics – points re confidentiality 3
Marks Available 3
Maximum 3
Total 35

55.1
(a) Cost of equity (ke)

£1.716m
£1.570m
Dividend growth rate = = 1.093 over 3 years, so 1.0931/3 – 1 = 3% pa

£1.716m
6.6m
Latest dividend (d0) = £0.26
Ex div market value per share = (£3.46 – £0.26) = £3.20

(d1) (£0.26 × 1.03)

MV
+g (£3.20)
+ 3%
Cost of equity (ke) 11.36%

d1 £0.07
MV £1.34
Cost of preference shares (kp) 5.19%

ICAEW 2021 March 2018 exam questions 329

 (i - t) (£6 × 83%)
MV £106
Cost of irredeemable debt (kdi) 4.70%

Cost of redeemable debt (kdr)

Year Cash Flow 5% factor PV 6% factor PV

0 (96) 1.000 (96.000) 1.000 (96.000)
1–3 4 2,723 10.892 2.673 10.692
3 100 0.864 86.400 0.840 84.000
NPV 1.292 NPV (1.308)

IRR = 5% + (1.292/(1.292 + 1.308)) = 5.50%

less: Tax at 17% (5.50% × 83%) = 4.57%
WACC

Total MVs
Cost ×
£m £m weighting WACC
11.36% ×
Equity (6.6m × £3.20) 21.120 21.120/25.470 9.42%
5.19% ×
Pref. Shares (1m × £1.35) 1.350 1.35/25.470 0.28%
Irredeemable debt 4.70% ×
(£1.2m × 1.06) 1.272 1.272/25.470 0.23%
Redeemable debt (£1.8m 4.57% ×
× 0.96) 1.728 1.728/25.470 0.31%

4.350 0.82%
Total market value 25.470 10.24%

(b) Cost of equity (ke) using the CAPM

Expected market return 10.8%

less: Expected risk-free return (2.4%)
Expected risk premium 8.4%

Applying Wells’ beta to the risk premium 1.25 × 8.4% 10.5%

plus: Expected risk-free return 2.4%
Cost of equity (ke) 12.9%

WACC

Total MVs
Cost ×
weightin
£m £m g WACC
12.90%
×
21.120/2
Equity (6.6m × £3.20) 21.120 5.470 10.70%

330 Financial Management ICAEW 2021

 Total MVs
Cost ×
weightin
£m £m g WACC
5.19% ×
1.35/25.
Pref. Shares (1m × £1.35) 1.350 470 0.28%
4.70% ×
Irredeemable debt (£1.2m 1.272/25.
× 1.06) 1.272 470 0.23%
4.57% ×
Redeemable debt (£1.8m 1.728/25.
× 0.96) 1.728 470 0.31%

4.350 0.82%
Total market value 25.470 11.52%

55.2 Phil Turner – to use the cost of preference shares would be completely wrong, as it is only one
element of the firm’s total long-term finance and 7% is the coupon rate, not the current cost.
Alana Clarke and Alison Hughes – ordinary shares (cost of equity) should be taken into
account. It makes sense to use Wells’ current WACC figure for the investment appraisal if:
(1) the historical proportions of debt and equity will not change.
(2) the systematic business risk of the firm will not change.
(3) the new finance is not project-specific.
Regarding the above, the bank borrowing will not change the gearing as sufficient equity will
be raised to maintain the gearing at its current level. The systematic business risk of the firm is
likely to change as it is moving into a different market. The finance is not project-specific.
55.3 New market geared beta = 1.80

(1.80 × 77) (1.80 × 77)

(77 + (23 × 83%)) 96.09
New market ungeared beta = 1.44

1.44 × (£21.12m + £1.35m + (£3m × 83%))

£21.12m
Wells’ geared beta = 1.70
So, cost of equity = (1.70 × (10.80% – 2.40%)) + 2.40 = 16.7%
Cost of debt = 8.5% × 83% = 7.06%
WACC = (16.70% × £21.12m/25.47m) + (7.06% × £4.35m/£25.47m)) = 15.05%
It would be unwise to use the existing WACC, as Wells’ plan involves diversification and
therefore a change in the level of systematic risk (beta rises from 1.25 to 1.70). Thus a new
WACC must be calculated. Systematic risk is accounted for by taking into account the beta of
the retail bakery market and this is then adjusted to eliminate the financial risk (level of
gearing) in that market. The resultant ungeared beta is then ‘re-geared’ by taking into account
the level of gearing of the new funds being raised.
Cost of new debt (which is higher than existing because of the increased systematic risk
discussed above) is used.
Using this, the new WACC can be calculated.
55.4 You work for Wells and are party to confidential information which, if made public, could
influence the market price of Wells’ shares.
An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:
• be kept confidential.

ICAEW 2021 March 2018 exam questions 331

 • not be disclosed, even inadvertently such as in a social environment.
• not be used to gain personal advantage.

Examiner’s comments
This was a four-part question that tested candidates’ understanding of the financing options element
of the syllabus, and there was also a small section on ethics. In the scenario a UK-listed bakery
company was planning to open a number of retail outlets across the UK. This investment would cost
the company £17 million, which would be raised in such a way as to not alter its existing gearing
ratio. In the first part, for 16 marks, candidates were required to calculate the company’s current
WACC from the information given, based on (1) the dividend growth model and (2) the CAPM. The
majority of candidates did really well in part (a) of the first requirement and many scored full marks.
Typical errors made were (1) incorrect number of years used in the dividend growth calculation (2)
not adjusting the cum-div and cum-int market prices (3) forgetting the tax adjustment in the cost of
debt and (4) not using market values in the WACC calculation.
The second part was worth six marks and required candidates to respond to recent comments made
by three of the company’s directors about the best discount rate to use when appraising the £17
million investment. Overall, candidates’ answers to the second part were disappointing. The
comments made were rather general and so marks will have been lost. Too few scripts considered
the conditions that need to apply for the current WACC to be used, ie, gearing and systematic risk to
remain unchanged, and any new finance is not project-specific.
The third part, for 10 marks, tested the candidates’ understanding of (and the need for) de-gearing
and re-gearing beta within the CAPM calculation in the given scenario. It was good to see that the
numerical and discursive elements of the third part were both done well by a good number of
candidates. Where candidates scored badly, it was clear from their calculations that many did not
understand the logic of de-gearing and then re-gearing. Also many were unable to explain the
theory underpinning for those calculations. This is an area of the syllabus that has been examined
regularly recently. The fourth part was worth three marks, with particular reference to the issue of
confidentiality and it was answered well.

56 Hunt Trading plc

Marking guide Marks

56.1 (a) Sell June futures 1

Number of contracts 1
Profit/loss on futures 4
Interest cost 1
Total cost 1
Marks Available 8
Maximum 8
(b) Options cost – 1 mark for each scenario 3
Marks Available 3
Maximum 3
(c) Recommendation 2
Marks Available 2
Maximum 2
56.2 (a) No hedge 2
Forward contract 2
Money market hedge 3
Marks Available 7
Maximum 7

332 Financial Management ICAEW 2021

 Marking guide Marks

(b) Summary of various payments 2

Forward contract discussion 2
Money market hedge discussion 2
Directors’ attitude to risk 1
Marks Available 7
Maximum 7
(c) Differences identified – 1 mark per point 3
Marks Available 3
Maximum 3
Total 30

56.1
(a) Futures
Sell June futures

£4,500,00
£500,000
No of contracts: × 6/3 = 18

(a) (b) (c)

Interest rate 7.50% 8.00% 5.50%

Opening rate 93.2 93.2 93.2

Closing rate 92.2 91.8 94.1
Movement 1.0 1.4 (0.9)

P/L on futures 18 × £500,000 × 3/12 2,250,000 2,250,000 2,250,000

×
×
1.0% 1.4% (0.9%)
= = =
Profit/(loss) on futures £22,500 £31,500 (£20,250)
Interest cost = £4.5m × 6/12
=£2,250,000 × 7.5% (£168,750)
8.0% (£180,000)
5.5% (£123,750)
Total cost (146,250) (148,500) (144,000)

(b) Options

(a) (b) (c)

Interest rate 7.50% 8.00% 5.50%
Take up option Y Y N

ICAEW 2021 March 2018 exam questions 333

 (a) (b) (c)
Interest cost % 7.30% 7.30% 5.50%
Interest cost = £4.5m × 6/12 =
£2,250,000 × 7.3% (£164,250)
7.3% (£164,250)
5.5% (£123,750)
Premium (£4,500,000 × 0.2%) (£9,000) (£9,000) (£9,000)
Total cost (£173,250) (£173,250) (£132,750)

(c) If interest rates increase, then futures are less costly than options.
If rates fall, then options are lower cost.
56.2
(a) Sterling weakens by 5%
Spot rate = €1.1764 × 0.95 = €1.1176
€1,700,000/1.1176 (£1,521,144)
Forward contract

€
Spot rate 1.1764
plus: Forward contract discount 0.0059
1.1823

£
(£1,700,000)/1.1823 (1,437,875)
plus: Arrangement fee (4,600)
(£1,442,475)

Money market hedge

(€1,700,000) (€1,700,00)
(1 + 8%/4) 1.02
Lend euros now (€1,666,667)

€1,666,667
1.1764
Convert at spot rate (£1,416,752)
Sterling borrowed at 6.6% pa (£1,416,752) × [1 + (6.6%/4)] (£1,440,128)
(b) In summary

At spot rate (€1,700,000/1.1764) (£1,445,087)

Sterling weakens by 5% (£1,521,144)
Forward contract (£1,442,475)
Money market hedge (£1,440,128)

The forward rate suggests that the euro will weaken (sterling will strengthen, rather than
weaken by 5%) over the next three months. This is good for UK importers such as Hunt, as
supplies would get cheaper.

334 Financial Management ICAEW 2021

 The money market hedge gives the lowest price, based on these rates, but if sterling is
likely to strengthen then perhaps do not hedge at all (but there are no guarantees).
The directors’ attitude to risk is also important when giving advice on which strategy to
pursue.
(c) Differences between traded currency options and OTC currency options:
• OTCs are, typically, purchased from a bank.
• OTCs are tailor-made and so will lack negotiability.
• Traded options are for standardised amounts and can be traded and a profit/loss
made.
• Traded options are not available in every currency.

Examiner’s comments
This question was based on a UK manufacturer of timber products. The first half of the scenario
considered the company’s need to borrow £4.5 million of short-term finance via a bank loan and its
plan to hedge the interest costs of that loan. In the second half of the question the company had
agreed to purchase €1.7 million of timber from a Finnish supplier. Candidates had to investigate the
foreign exchange risk implications of this contract for the company. In part (a) of the first requirement
of the question, for eight marks, candidates were required to calculate the cost to the company if it
used traded sterling interest rate futures to hedge its interest rate risk. Part (b) of the first
requirement, for three marks, required candidates to calculate the cost to the company if it used OTC
interest rate options to hedge the risk. Part (c) of the first requirement was worth two marks and
asked candidates to conclude, based on their calculations, which of the hedging methods should be
chosen. For the first requirement there were many very good answers with candidates demonstrating
a thorough understanding of the techniques involved. Those areas where candidates struggled
were: (1) a failure to identify that the company would sell interest rate futures (2) charging 12 months
interest rather than six (3) using six months, rather than three months, in the futures gain/loss
calculation and (4) a failure to calculate the option premium correctly (a very common error).
Part (a) of the second requirement, for seven marks, asked candidates to calculate the (sterling
equivalent) payment to the Finnish supplier if (1) there was a weakening of sterling and (2) two
hedging techniques were employed. In part (b) of the second requirement, also for seven marks,
candidates were required to advise the company’s board whether it should hedge the euro payment.
Finally, part (c) of the second requirement, for three marks, asked candidates to identify the
differences between traded currency options and OTC currency options. The second part was,
overall, done well. The calculations in part (a) were good, but typical errors included (1) choosing the
wrong exchange rate (2) strengthening rather than (as required) weakening sterling and (3)
subtracting the forward contract fee from the overall cost of the transaction. Foreign exchange risk
management is an area of the syllabus that is examined regularly and so candidates’ answers to the
discussion in part (b) were disappointing. There was a lack of depth to the candidates’ conclusions
and too many commented, erroneously, that a forward contract discount meant that sterling would
be weakening.

57 Bishop Homes Ltd

Marking guide Marks

57.1 Construction costs and land clearance 1.5

Sales 1
Rental income 2
Bad debts 1
New staff 1
Extra costs 1
Tax 1.5

ICAEW 2021 March 2018 exam questions 335

 Green machine and tax 3
Net cash flows 2
Discount factors 2
PVs 1
NPV 1
Marks Available 18
Maximum 18
57.2 Sales and tax 1.5
Discount factors .5
Sensitivity 1
Minimum selling price 1
Marks Available 4
Maximum 4
57.3 Incremental construction costs 1
Tax 2
Discount factors 1
NPV and conclusion 1
Marks Available 5
Maximum 5
57.4 Sensitivity analysis v simulation – 1 mark per point 4
Marks Available 4
Maximum 4
57.5 Explanation of real options 1
Identification of appropriate real options – 1.5 marks per point 3
Marks Available 4
Maximum 4
Total 35

57.1

20X8 20X9 20Y0 20Y1 20Y2-Z8

Y0 Y1 Y2 Y3 Y4–20
£’000 £’000 £’000 £’000 £’000
Construction costs (19,000) (19,000) (19,000)
Land clearance (1,400)
Sales 25,500 25,500
Rental income (W1) 1,040 2,079 2,079
Bad debts (W1) (16) (31) (31)
New staff (46) (92) (92)
Extra costs (W1) (31) (62) (62)
Tax (W2) 238 (2,882) (3,042) (322) (322)
Green machine 0 (1,200) 100
Tax on machine (W3) 37 30 120
Total cash flows (20,162) 2,455 4,434 1,792

336 Financial Management ICAEW 2021

 20X8 20X9 20Y0 20Y1 20Y2-Z8
Y0 Y1 Y2 Y3 Y4–20
£’000 £’000 £’000 £’000 £’000
1,572
6% factors (W4) 1.000 0.943 0.890 0.840
8.801
PV (20,162) 2,316 3,947 1,504 13,831
NPV 1,436

The development produces a positive NPV and so should be accepted as it will enhance
shareholder wealth.

WORKINGS
(1)
Rental income (Y2) = 175 × £5,940 = £1,039,500
Bad debts (Y2) = 1.5% × £1,039,500 = £15,592
Extra costs (Y2) = 3% × £1,039,500 = £31,185
Rental income (Y3) = × £5,940 = £2,079,000
Bad debts (Y3) = 1.5% × £2,079,000 = £31,185
Extra costs (Y3) = 3% × £2,079,000 = £62,370
(2)

20X8 20X9 20Y0 20Y1 20Y2-Z8

Y0 Y1 Y2 Y3 Y4–20
£’000 £’000 £’000 £’000 £’000
Construction
(75/500 × £57m) (8,550) (8,550)
Land clearance (1,400)
Sales 25,500 25,500
Rental income 1,040 2,079 2,079
Bad debts (16) (31) (31)
New staff (46) (92) (92)
Extra costs (31) (62) (62)
Taxable (loss)/profit (1,400) 16,950 17,897 1,894 1,894
Tax at 17% 238 (2,882) (3,042) (322) (322)

(3)

20X9 20Y0 20Y1

Y1 Y2 Y3
£’000 £’000 £’000
Green machine cost/WDV 1,200 984 807
WDA (18%)/Balancing allowance (216) (177) (707)
WDV/Sale price 984 807 100

ICAEW 2021 March 2018 exam questions 337

 20X9 20Y0 20Y1
Y1 Y2 Y3
£’000 £’000 £’000

Tax saving (17% × WDA) 37 30 120

(4)

6% annuity factor for Y4 – Y20 Y20 11.470 or 10.477

Y4 (2.673) × 0.840
8.797 8.801

57.2

Y1 Y2 Total
£’000 £’000 £’000
Sales 25,500 25,500
Tax (4,335) (4,335)
Total cash flows 21,165 21,165
6% factors 0.943 0.890
PV 19,967 18,837 38,804

1,436
38,804
Sensitivity = 3.7%
Minimum selling price = (£340,000 – 3.7%) £327,420
57.3

Y0 Y1 Y2 Total
£’000 £’000 £’000 £’000
Incremental construction costs (35,000) 19,000 19,000
Tax on costs (£8.55m × 3/57 × 17%) (77) (76)
Total cash flows (35,000) 18,923 18,924
6% factors 1.000 0.943 0.890
PV (35,000) 17,844 16,842 (314)

The NPV would decrease by £314,000, and so it is less likely that Bishop’s board would
proceed with the development.
57.4 Sensitivity analysis advantages:
• It facilitates subjective judgment (by management for example).
• It identifies areas critical to the success of a project, eg, sales volume, materials price.
• It is relatively straightforward.
Sensitivity analysis disadvantages:
• It assumes that changes to variables can be made independently.
• It ignores probability.
• It does not point to a correct decision.

338 Financial Management ICAEW 2021

 Simulation advantages:
• More than one variable at a time can be changed.
• It takes probabilities into account.
Simulation disadvantages:
• It is not a technique for making a decision.
• It can be time consuming and expensive.
• Certain assumptions that need to be made could be unreliable.
57.5 NPV analysis only considers cash flows related directly to a project. A project with a negative
NPV could be accepted for strategic reasons. This is because of (real) options associated with a
project that outweigh its negative NPV.
With regard to the Garthwick development the following options could be identified (two only
required):
• Follow-on options – future development of mixed (rental/private) developments.
• Growth options – Bishop could build a few properties and then build more later, if
necessary.
• Flexibility options – Bishop could sell some of its rented properties rather than rent them
and vice versa.
• Abandonment options – Bishop could sell all the properties and quit the development after
two years.
• Timing options – Bishop could delay the start of the clearance and development.

Examiner’s comments
The scenario was based around a UK property company that builds low-cost houses for sale and for
rent. The company had the opportunity to invest in a new development of 500 identical low-energy
houses on one of its vacant sites. The company planned to use a house-building firm to construct the
houses over a two year period. The first part was worth 18 marks and required candidates to make
use of the information given and calculate the NPV of the proposed investment. It was a difficult NPV
calculation and so it was good to see that, overall, candidates did well here. The main areas of
difficulty were: (1) the tax calculation for the allowable building costs (2) the timing of the cash flows
and (3) the need to include cash flows (and then discount them) for Years 4 to 20. The second and
third parts, for four marks and five marks respectively, tested candidates’ proficiency with, and
understanding, of sensitivity analysis. The second part was also done well, but some candidates used
the price per house figure rather than the total sales figure and so will have lost marks. The third part
was a more difficult proposition and candidates’ answers here were very variable. Those who
produced a set of calculations revised from the first part scored well, but too many produced a
discussion rather than calculations. The fourth part was worth four marks and here candidates were
asked to compare the strengths and weaknesses of sensitivity analysis with those of simulation. The
fourth part was, overall, done well and a majority of candidates scored full marks. In the fifth part,
again for four marks, candidates had to explain the concept of real options and to identify two real
options that could apply to the development in question. In the fifth part most candidates were able
to identify examples of real options from the scenario, but too few explained the more general issue
of real options, ie, that of turning a negative NPV into a positive one.

ICAEW 2021 March 2018 exam questions 339

340 Financial Management ICAEW 2021
 June 2018 exam questions
58 Helvellyn Corporate Finance

Marking guide Marks

58.1 (a) Enterprise value 4.5

P/E ratio 1.5
Net assets historic 1
Net assets revalued 1
Marks Available 8
Maximum 8
(b) Discussion of asset v income based measures 3
Recommendation 1
Marks Available 4
Maximum 4
(c) Discussion of SVA, including drivers and problems 3
Marks Available 3
Maximum 3
58.2 (a) Proposal 1:
Sales 1
Contribution 1
Redundancy .5
Tax 1
Working capital 1.5
Plant and equipment .5
WDA’s 1.5
PV .5
Proposal 2 – proceeds net of tax 1
Proposal 3 – after tax PV 1.5
Marks Available 10
Maximum 10
(b) 2 marks for each – one advantage, one disadvantage 6
Marks Available 6
Maximum 6
(c) Comparison of PVs and advice on limitations 3
Recommendation 1
Marks Available 4
Maximum 4
Total 35

58.1
(a) Enterprise value
EBITDA = £10,000 (3,500 + 6,000 + 500)
Enterprise value = £65,000 (10,000 × 6.5)
Net debt = £34,000 (41,000 – 7,000)

ICAEW 2021 June 2018 exam questions 341

 The total value of equity = £31,000 (65,000 – 34,000)
The value of one share = £10.33 (31,000/3,000)
Price earnings ratio
EPS = 70.53p (2116/3000)
The value of one share = £8.53 (70.53 × 12.1)
Net assets (historic)
The value of one share = £5 (15,000/3,000)
Net assets (re-valued)
The value of one share = £7 ((15,000 + 59,000 – 53,000)/3,000)
(b) The range of values is from £5 to £10.33.
It is unlikely that the board of Evans would be happy with an issue price based on net
assets, either historic or re-valued. The major problem with asset valuations is that they do
not reflect the earning capacity of the assets. The board is more likely to be happy with an
issue price based on income, either P/E ratio or enterprise value, which range from £8.53
to £10.33.
So an issue price in this range is likely to be acceptable.
I would suggest an issue price of £10 per share. (Candidates may suggest a different
price; any supported price would be given marks.)
(c) Shareholder value analysis (SVA) would be a useful additional valuation methodology
since it is based on the future free cash flows that the company generates. The free cash
flows are forecasted using seven value drivers (sales growth; operating profit margin; tax
rate; investment in non-current assets; investment in working capital; cost of capital; life of
cash flows). The cash flows will be forecast over a planning horizon, typically three to five
years, and then a terminal value calculated.
Problems with this technique include: estimating the inputs into the model; estimating
growth; the length of the planning horizon; the terminal value dominates the valuation.
58.2
(a) Proposal 1

20X9 20Y0 20Y1

£m £m £m
Sales 22.50 20.25 18.23
Contribution 13.50 12.15 10.94
Redundancy (0.50)
Pre-tax 10.44
Tax @ 17% (2.30) (2.07) (1.78)
Working capital 0.20 0.18 1.62
Plant and equipment 9.00
WDAs 0.09 0.08 (1.19)
Total 11.49 10.34 18.09
Factors @ 10% 0.909 0.826 0.751
Present value 10.44 8.54 13.59

Total present value = £32.57 million

Working capital
20X9 2 × 0.10 = 0.20
20Y0 1.8 × 0.10 = 0.18

342 Financial Management ICAEW 2021

 20Y1 1.62
WDAs
3,000
(540)@17% = 0.09
2,460
(443)@17% = 0.08
2017
9,000
6,983@17% = (1.19)
Proposal 2
Sale proceeds net of tax = £31.54 million (38 × (1 – 0.17))
Proposal 3
The present value of the payments = 15 + 13/(1.1) + 13/(1.1)2 = £37.56 million
After tax = £31.18 million (37.56 × (1 – 0.17)
(b) Winding down operations
Advantages include keeping control – should the company decide to keep Supercover in
business it can do.
Disadvantages include the use of estimates of sales and resale values. The operations may
take longer than three years to wind down.
Selling to another company
Advantages include being paid upfront, and no long term involvement.
Disadvantages include the possible difficulty in finding a buyer; the buyer may wish to buy
Supercover for a cheaper price.
MBO
The main advantage is that Huzzey has a buyer.
The disadvantage is that the sale proceeds are to be paid over two years. If Supercover
goes into liquidation or has cash flow difficulties, the full sale proceeds may not be
received.
(c) The present values are:
Winding down operations £32.57 million
Selling to another company £31.54 million
MBO £31.18 million
To maximise shareholder wealth, Huzzey should wind down operations since it produces
the highest present value. However, the present value relies upon a number of
assumptions about sales volume, the release of working capital and the proceeds of
selling plant and equipment. The present value is not sufficiently higher to warrant
choosing it over the other two proposals, given these uncertainties and the fact that the
figures are pretty similar.
In present value terms there is little to choose between selling to another company or an
MBO. Since it might be difficult to find a buyer for Supercover, the preferred proposal
would be for the current management team of the company to buy it.

Examiner’s comments
The scenario of the question was consideration of two tasks for a firm of corporate financiers:
Task 1 – The valuation of a company that is considering an IPO.
Task 2 – A quoted conglomerate is considering divesting itself of one of its subsidiaries.
The first part was well answered by many candidates, however the following were common errors:
for enterprise value: incorrect EBITDA; no deduction of debt and addition of cash to arrive at the
value of the shares; using the incorrect multiple; calculating a negative share price and making no

ICAEW 2021 June 2018 exam questions 343

 comment that this is not possible. For P/E ratio: using profits before tax. For net assets (historic):
using gross assets; using gross assets and only deducting long-term debt. For net assets basis (re-
valued): many candidates re-valued the non-current assets and then made the same errors as for the
net assets (historic) computations.
Overall a large number of candidates reduced their valuations to take into account non-marketability.
Since this is an IPO, such adjustments were not necessary.
Responses to part (b) of the first requirement were mixed. Many candidates only referred to their
range of values and did not recommend an issue price. The justification of the price was quite poor.
Responses to part (c) were good. However, poorer candidates only stated what the seven value
drivers in SVA are, with no further explanation of the methodology. Responses to part (a) of the
second requirement were generally good. However a large number of candidates attempted to
calculate the Net Present Values and not the Present Values of each of the proposed divestment
methods. Responses to part (b) of the second requirement were mixed, with candidates often
struggling to state sensible advantages and disadvantages. Responses to part (c) of the second
requirement were mixed; many candidates simply picked the highest present value with little other
consideration.

59 Blackstar plc

Marking guide Marks

59.1 (a) Share price calculations 2

TERP calculation and discussion 3
Marks Available 5
Maximum 5
(b) Yield to maturity calculation 3
Debenture issue price 3
Discussion 2
Total possible marks 8
Marks available 7
Marks Available 23
Maximum 7
(c) Numerical analysis 4
Advantages of debt v equity 3
Reaction of shareholders and the market 5
Advice 2
Total possible marks 14
Marks available 12
Marks Available 40
Maximum 12
59.2 (a) Special dividend 2
Share repurchase 2
Marks Available 4
Maximum 4
(b) Blackstar’s dividend policy 2
Evaluation of alternatives 2
Marks Available 4
Maximum 4
59.3 Ethics – issues and safeguards 3

344 Financial Management ICAEW 2021

 Marking guide Marks

Marks Available 3
Maximum 3
Total 35

59.1
(a) The number of new shares to be issued = 40 million (60 × 2/3)
The price per share = £3.75 (150/40)
This represents a discount on the current share price of 50% or £3.75. (3.75/7.50)
The theoretical ex rights price is:

Number of shares Value per share Number × value

£ £
Existing shares 3 7.50 22.50
New shares 2 3.75 7.50

Total shares 5 Total value 30.00

The theoretical ex rights price = £6.00 (30/5)

The actual share price will depend on the market’s reaction to the rights issue, eg, whether
it is fully taken up, and whether the proceeds are invested in positive net present value
projects. The net present value of the projects could be incorporated in the theoretical ex-
rights price of £6.00, giving a more realistic estimate of the actual share price post rights
issue.
(b) The yield to maturity of Blue’s debentures is:
The ex-interest price of Blue’s debentures is £104 (109 – 5)

Timing Cash Flow Factors @ 1% PV Factors @ 5% PV

Years £ £
0 (104) (104) (104)
1–5 5 4.853 24.27 4.329 21.65
5 100 0.951 95.10 0.784 78.40
15.37 (3.95)

IRR (Yield to maturity) = 1 + (15.37/(15.37 + 3.95)) × 4 = 4.18% Say 4%

The issue price of Blackstar’s debentures will be:
The annuity factor for seven years (2018 to 2025) = (1 – (1.04)-7)/0.04 = 6.002
The seven year present value factor at 4% = 1/(1.04)7 = 0.760
The issue price = 6 × 6.002 + 100 × 0.760 = £112.01
The total nominal value of the debentures to be issued = 150/1.1201 = £133.91 million.
Say £134 million.
Blackstar and Blue are in the same industry sector, so it is reasonable to assume that the
yield to redemption of 4% is acceptable. However the financial risk of Blue might be
different to Blackstar and this should be reflected in the yield to redemption.
Blue’s debentures mature in five years, and Blackstar’s debentures mature in seven years. It
is likely that investors in Blackstar’s debentures would require a higher yield to redemption
than 4%.

ICAEW 2021 June 2018 exam questions 345

 (c) The gearing and interest cover ratios of Blackstar immediately after the debenture issue
will be as follows:
Interest cover: Interest £134m × 6% = £8.04m. Interest cover = 50.00/8.04 = 6.21 times
Gearing by market values assuming the current market price per share:
Market capitalisation 60m × £7.50 = £450m. Gearing (D/E) 150/450 = 33%
Current EPS 69.2p (50(1 – 0.17)/60)
EPS with a rights issue 41.5p (50(1 – 0.17)/100m)
EPS with a debenture issues 58p (50 – 8.04)(1 – 0.17)/60m
In time both interest cover (more operating profits) and gearing (greater equity value) are
likely to improve, with the acceptance of positive NPV projects and any favourable market
reaction to the issuance of debt and its tax shield (see below).
Advantages and disadvantages of debt versus equity include consideration of control
issues; obligation to return capital; interest payments versus dividend payments (including
consideration of tax relief); issue costs; liquidation of the investment (can the investor get
out easily?); risk versus reward.
Analysis:
The company will have a gearing ratio of 33% and an interest cover of 6.21 times. Gearing
is between the industry maximum and average of 35% and 25% respectively, but near to
the maximum; interest cover is between the industry minimum and average of 6 and 8
respectively, but near to the minimum.
Since this is the first time that Blackstar has borrowed, both shareholders and the stock
market might be concerned and prefer these ratios to be near the industry averages or
better. Some shareholders might be attracted to investing in Blackstar because currently it
has no gearing. However if the £150 million is to be invested in positive NPV projects both
shareholders and the stock market should welcome the company borrowing.
Borrowing should reduce the current cost of capital of the company, since debt is
generally less expensive than equity because it is less risky than equity for the debt
holders. The company also receives tax relief on the interest that it pays. Because there is
increased financial risk when a company borrows, the shareholders may require a higher
return but this is unlikely to offset the effect of cheaper debt finance. The company value
should increase as a result of the cost of capital reducing, and new funds being invested in
positive NPV projects.
It would be prudent for the company to restrict its borrowing to the industry average
gearing level, especially since its interest cover would be near to the minimum for the
industry. I would advise the company not to borrow the full £150 million; perhaps this
could be achieved by revising its plans for raising the finance. For example, an issue of
both debt and equity would help to ensure that gearing and interest cover ratios are more
favourable. Selling surplus assets is another possible source of finance.
59.2
(a) A special dividend is a ‘one off’ dividend payment in addition to the ordinary dividend.
A share repurchase is an alternative to dividend payments. Instead of paying dividends a
company may consider using the cash to repurchase issued shares.
(b) Blackstar’s current dividend policy is unlikely to be appropriate for a listed company, since
dividends will rise and fall with profits and may cause signalling issues.
It is more usual for a listed company to pay a constant dividend with some growth. So both
directors A and B are correct in stating that Blackstar should do this. However,
shareholders are unlikely to be happy with the company leaving surplus cash in the bank
where returns will be lower than the company’s cost of capital. Surplus cash should be
returned to shareholders in the form of a special dividend or share repurchase.
59.3 Professional accountants in public practice should be aware of the danger of a conflict of
interest. In its dealings with Goldwing and Blackstar, Evans could implement the following
safeguards:
• Use different partners and teams for the two clients.

346 Financial Management ICAEW 2021

 • Take all steps to ensure that there is no leakage of confidential information between the two
teams.
• Ensure that there is regular review by a senior partner or compliance officer who is not
personally involved with either client.
• Advise the clients to seek additional independent advice where appropriate.
(Credit also given for mentioning integrity, objectivity and confidentiality.)

Examiner’s comments
The scenario of the question involves giving advice to a listed client on two issues:
Issue 1 - Whether to raise additional funding by debt or equity.
Issue 2 - A review of dividend policy and also an ethical situation.
Responses to part (a) of the first requirement were quite good with many candidates scoring full
marks. Weaker candidates made some of the following mistakes: confusing a 2 for 3 rights issue for a
3 for 2 rights issue; not calculating the discount the rights issues represented on the current share
price; inadequate discussions on whether the actual share price is likely to be equal to the theoretical
ex-rights price.
Generally responses to part (b) of the first requirement were disappointing, but there were some
excellent responses. Poorer candidates made some of the following mistakes: using the new debt
issues terms to calculate the YTM rather than Blue’s; using the cum interest debenture price in YTM
computations; deducting tax from the YTM when calculating the issue price for the new debenture
issue; when interpolating arriving at two negative NPVs by discounting at 5% and 10%, then arriving
at a YTM of more than 5%; incorrect calculations when calculating the nominal value of the new
issue.
Responses to part (c) of first requirement were extremely disappointing despite almost identical
questions being asked in recent papers. The question gave industry gearing and interest cover
figures so that the candidates could perform analysis looking at the gearing and interest cover
should the company decide to borrow. It was very disappointing that a large number of candidates
did not use this information or calculated gearing in a different way to that specified. In addition
many candidates did not consider the likely reaction of the shareholders and markets to the finance
being raised by either debt or equity. Finally, a large number of candidates wasted time explaining
the theories of M & M, when theory was not asked for in the question.
Responses to part (a) of the second requirement were mixed, with a surprising number of candidates
not knowing what a special dividend is. Also the explanations of a share repurchase were poor.
Responses to part (b) of the second requirement were mixed, with many candidates not able to
demonstrate a good understanding of dividend policy. Many candidates did not identify that the
policy of maintaining a constant payout ratio means that dividends will rise and fall with profits.
Comments on the views of the two directors were often confused and hard to follow. However, again,
there were some excellent responses. The third part was well answered, but a large number of
candidates did not recognise that there was a conflict of interest for Mitchells.

60 Tarbena plc

Marking guide Marks

60.1 Net payment 1

Forward rate 1.5
Sterling equivalent .5
Sell September futures 1
Number of contracts 1
Loss on futures on closeout 2
Dollar purchase 1

ICAEW 2021 June 2018 exam questions 347

 Call options to buy dollars 1
Option calculations 3
Marks Available 12
Maximum 12
60.2 Advantages and disadvantages of hedging techniques 5
Advice 2
Marks Available 7
Maximum 7
60.3 Interest rate parity explanation 2
Calculations 3
Marks Available 5
Maximum 5
60.4 Purchasing power parity explanation 3
Marks Available 3
Maximum 3
60.5 Points re importance of translation risk – 1 to 2 marks each 3
Marks Available 3
Maximum 3
Total 30

60.1 The net payment = $4,000,000 (10,000,000 – 6,000,000)

The forward rate is: $/£ 1.3166 (1.3078 + 0.0088)
This is result in a sterling payment of £3,038,129 ($4,000,000/$1.3166)
Tarbena should sell Sept sterling futures (ie, to buy $ with £).
The number of contracts to sell is: ($4,000,000/$1.3096)/£62,500 = 48.87 contracts, rounded
to 49 contracts. This means that it is slightly over hedged. (Full marks also to be given if 48
contracts are used.)
On 30 September, the futures will be closed out and bought at $1.3171. This will result in a loss
of:
($1.3096 – $1.3171) × (£62,500 × 49) = $(22,969)
Dollars will be purchased on the spot market and the total payment will be:
($4,000,000 + $22,969)/$1.3167 = £3,055,342
Over the counter option, call options to buy dollars will be used:
The option premium is $4,000,000 × 4p = £160,000.
The premium with interest lost is £160,000 × (1 + 0.0328 × 4/12) = £161,312.
If the spot price on 30 September is $/£1.3167 Tarbena will exercise the options.
The sterling payment will be ($4,000,000/$1.3170) + £161,312 = £3,198,518.
60.2 The forward contract and futures contracts both lock Tarbena into an exchange rate and do not
allow for upside potential.
Forwards:
• Tailored specifically for Tarbena.
• There is no secondary market.
Currency futures:
• Not tailored, so the number of contracts needs to be rounded.
• Requires a margin to be deposited at the exchange.
• There is a need for liquidity if margin calls are made.

348 Financial Management ICAEW 2021

 • There is a secondary market.
OTC currency options:
• The options are expensive.
• There is no secondary market.
• Options allow Tarbena to exploit upside potential and protect downside risk.
Advice:
Without hedging, the sterling payment would be £3,037,898 ($4,000,000/1.3167).
The OTC option results in a higher payment of £3,198,518.
Both the forwards and futures result in a lower sterling payment of £3,038,129 and £3,055,342,
which are not materially different.
Since futures require margins and they are not a perfect hedge due to rounding and basis risk,
it is recommended that a forward contract is used as it is much simpler for a similar result.
Tarbena’s attitude to risk is also important.
60.3 The forward rate is calculated using interest rate parity. Interest rate parity links the forward
exchange rate with interest rates in an exact relationship, because risk-free gains are possible if
the rates out of alignment. The forward rate tends to be an unbiased predictor of the future
spot exchange rate.
The forward rate in four months is calculated as follows:
Middle spot rate × (1 + The middle US interest rate)/(1 + The middle UK interest rate) =
Forward rate.
Middle rates:
Spot $/£1.3079 ((1.2078 + 1.3080)/2)
Interest rates:
Dollar 5.9% ((6 + 5.8)/2)
Sterling 3.13% ((3.28 + 2.98)/2)
The forward rate = $1.3079 × (1 + 0.059 × 4/12)/(1 + 0.0313 × 4/12) = $1.3169
Because the dollar is depreciating against sterling, it is at a discount.
The discount is $0.0090 (1.3079 – 1.3169). The spread increases or decreases this, in this case
$/£ 0.0088 – 0.0092.
60.4 Purchasing power parity (PPP) is the theory that in the long-term exchange rates between
currencies will tend to reflect the relative purchasing power of the currency of each country.
The theory is based on the idea that a basket of goods in one country will, after the effect of
the exchange rate, cost the same no matter where it is traded. It is sometimes called the law of
one price.
The impact of different inflation rates in different countries will cause prices to change at
different speeds. So even if parity is achieved, disequilibrium will be created. PPP predicts that
the disequilibrium will be removed by changes in the exchange rate.
60.5 There are opposing arguments as to whether translation exposure is important. The arguments
centre on whether the reporting of a translation loss will affect the company’s share price.
There is an argument that, to the extent that cash flows are not affected, translation exposure
can be ignored. Therefore there will be no effect on Tarbena’s share price.
On the other hand, those who believe that accounting results are an important determinant of
the share price argue that translation losses should be reduced to a minimum, as translation
losses could reduce Tarbena’s share price.

Examiner’s comments
The scenario of the questions is that of a board wanting some clarification on forex issues. The first
part was well answered by most candidates. However some of the errors demonstrated by weaker
candidates included: using the incorrect spot rate; deducting the forward discount; incorrect
computation for the number of futures contracts; making the incorrect decision of whether to sell or
buy futures; assuming that the futures loss was in £; choosing the put option and not the call option;

ICAEW 2021 June 2018 exam questions 349

not including interest on the option premium, or including interest but taking a whole year; treating
the OTC option as a traded option; not netting receipts and payments and presenting calculation on
both transactions. The second part saw average answers from a lot of candidates, some without any
reference to the numbers calculated in the first part. Many candidates did not give a firm conclusion.
However there were some excellent answers. Responses to the third part were mixed, with some
good explanations of interest rate parity. However many candidates did not perform computations,
or computations were incomplete. Responses to the fourth part were poor, with many candidates
displaying no knowledge of what purchasing power parity is. Responses to the fifth part were also
poor and displayed no knowledge of what translation exposure is, or what the likely effects are.

350 Financial Management ICAEW 2021

 September 2018 exam questions
61 Thomas Rumsey Group plc

Marking guide Marks

61.1 Revised Economic Value: 1

Sales correct in summary calculation 1
Sales workings 1
Y1 Expected Value 1
Y1 Inflation 1
Y2 Expected Value 1
Y2 Inflation 1
Y3 Expected Value 1
Y2 Inflation 1
Variable Cost 1
Fixed Cost 2
Close down costs 1
Tax 1
Sale of Plant and Machinery 1
Tax saved on Plant and Machinery 2
Working capital 1
Discounting 1
Economic Value 1
Marks Available 20
Maximum 18
61.2 Revised Economic Value: 1
Scrap value 1
Tax rebate 1
Discounting 1
New economic value 1
Marks Available 5
Maximum 4
61.3 Ethics and fundamental principles:
Behave with integrity 1
Behave objectively with no conflict of interest 1
Behave professionally 1
Marks Available 3
Maximum 3
61.4 Impact of real options:
Explain impact of real option on – NPV 1
Identify abandon real option and explain using scenario 2
Identify growth real option and explain using scenario 2
Marks Available 5
Maximum 5
61.5 Shareholder Value Added (SVA)

ICAEW 2021 September 2018 exam questions 351

 Marking guide Marks

Explain SVA 1
Advantage of SVA 1
Explain seven drivers of SVA 2
Disadvantage of predicting 1
Disadvantage of terminal value on SVA 1
Adjust SVA with short terms investments and debt 1
Marks Available 7
Maximum 5
Total 35

61.1

Y1 Y2 Y3
Year to 31/8/X9 31/8/Y0 31/8/Y1
£’000 £’000 £’000
Sales (W1) 6,375 4,411 2,653
VCs (30%) (1,913) (1,323) (796)
FCs (W2) (1,122) (1,144) (1,167)
Close down costs (W3) (637)
Tax (W4) (568) (330) (9)
P&M sale 1,500
P&M tax saving (W5) 101 83 122
Working capital 200 300 1,300
Net cash flows 3,073 1,997 2,966
11% factors 0.901 0.812 0.731
PV 2,769 1,622 2,168
Economic value 6,559

WORKINGS
(1)

Y1 Y2 Y3
£’000 £’000 £’000 £’000
Sales (£7m × 0.7) 4,900 (£5m × 0.6) 3,000 2,500
(£4.5m × 0.3) 1,350 (£4m × 0.4) 1,600 × (1.02)3
6,250 4,600 × 0.7 3,220 2,653
×1.02 (£4m × 0.4) 1,600
6,375 (£3m × 0.6) 1,800
3,400 × 0.3 1,020
4,240

352 Financial Management ICAEW 2021

 Y1 Y2 Y3
£’000 £’000 £’000 £’000
× (1.02)2
4,411

(2)

£’000
Annual fixed cost cash flows = (£1.7m – £0.6m) £1.1m × 1.02 1,122 (Y1)
Depreciation excluded as not a cash flow £1.1m × (1.02)2 1,144 (Y2)
£1.1m × (1.02)3 1,167 (Y3)

(3)
Close down costs = £0.6m × (1.02)3
= £637,000
(4)

Y1 Y2 Y3
£’000 £’000 £’000
Sales 6,375 4,411 2,653
VCs (1,913) (1,323) (796)
FCs (1,122) (1,144) (1,167)
Close down costs (637)
Taxable profit 3,340 1,944 53
Tax payable @ 17% 568 330 9

(5)

Y1 Y2 Y3
£’000 £’000 £’000
WDV b/f 3,300 2,706 2,219
WDA @ 18%/Balancing Allowance (BA) (594) (487) (719)
WDV/sale 2,706 2,219 1,500
Tax saving (WDA/BA × 17%) 101 83 122

Examiner’s comments
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a ‘pass’ standard in this question.
This was a five-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.
The scenario was based on a UK manufacturer of computer hardware. The company’s board has
decided to close down one of its subsidiary companies in three years’ time. This is due to the latter’s
recent poor performance. The board has learned that the subsidiary’s senior management would like
to investigate the possibility of a management buy-out (MBO). The board has decided that the
subsidiary’s buy-out price would be its current economic value, based on predicted trading results
for the next three years. The first part was worth 18 marks and required candidates to make use of
the information given and calculate the subsidiary’s economic value, based on discounted future
cash flows. The second part, for four marks, candidates were asked to re-work their figures from the

ICAEW 2021 September 2018 exam questions 353

first part because of a change in the data provided. This tested their understanding of sensitivity
analysis. The third part was worth three marks and examined the Ethical Guide, with particular
reference to the issues of integrity, objectivity and professional behaviour. The fourth part, for five
marks, tested candidates’ understanding of real options and asked them to identify two real options
that could apply to the subsidiary as alternatives to the MBO. Finally, again for five marks, candidates
had to explain the shareholder value analysis (SVA) approach to company valuation, with its
advantages and disadvantages.
In the first part the majority of candidates produced good answers. Relevant cash flows were, in the
main, correctly identified. However, the expected sales calculations did cause many candidates
problems. Common errors made by candidates were:
• poor expected value (EV) calculations for Year 2. Some candidates showed no real
understanding by producing an EV higher than any of the individual sales figures.
• no explanation of why depreciation is ignored in the cash flows.
• closure costs were ignored as irrelevant when they were not.
• the tax written down value brought forward was treated as a cash outlay.
• an extra writing down allowance was included in Year 0.
• the money discount rate (given) was increased by the inflation rate in the question.
The second part was answered very well by most candidates. They demonstrated a good
understanding of the key factors involved in the sensitivity analysis.
Answers for the third part were very variable. Candidates who scored well will have explained why
the key ethical issues (integrity, objectivity and professional behaviour) are under threat in the given
scenario. Many candidates failed to do this and produced a ‘shopping list’, without explanation. In
addition, a lot of candidates rolled integrity and objectivity into one issue rather than two.
The fourth part was done well by the majority of candidates, but it was disappointing to see a
number of scripts where the candidate did not know the definition of a real option. Also, many
candidates did not apply their real option knowledge to the actual scenario. Instead, they listed many
(some irrelevant) options. Finally, some candidates gave more than the two options required in the
question.
SVA has been examined many times recently and, as expected, most candidates produced very
good answers for the final part. Typical errors here were: (a) not knowing the seven value drivers and
(b) applying SVA as if this was an investment appraisal, rather than a company valuation.

61.2

£’000
Scrap value = £1 million, therefore loss of cash = £1.5m – £1.0m 500
Tax rebate (balancing allowance) × 83%
Discounted to Y0 × 0.731
Economic value decreases by 303
New economic value = £6,559 – £303 6,256

61.3 An ICAEW member is being asked to falsify the economic value of Snowdog and thus mislead
potential buyers, ie, Snowdog’s directors. To do so would break the principles of the ICAEW
Ethical Guide which states, inter alia:
• A member should behave with integrity – ie, be honest and truthful. The member’s advice
and work should not be influenced by the interests of other parties, which would be the
case here were s/he to overvalue Snowdog.
• A member should strive for objectivity in all professional and business judgements – ie,
there should be no bias, conflict of interest or undue influence of others. The member has a
conflict of interest here. S/he is being asked to act with bias in favour of one party (Rumsey’s
directors) over another (Snowdog’s directors).

354 Financial Management ICAEW 2021

 • A member should behave professionally – ie, avoid any action that discredits the profession.
If the member falsified the valuation of Snowdog then the ICAEW’s reputation is at risk.
61.4 NPV analysis only considers cash flows related directly to a project. However, a project with a
negative (or low) NPV could be accepted for strategic reasons. This is because of (real) options
associated with a project that outweigh the poor NPV.
With regard to Snowdog two real options are:
• abandonment – if there is no MBO Snowdog could be closed before the three years are up.
• growth (calling it follow on or timing also ok) – if Snowdog performs better than expected it
could be kept open longer than three years.
61.5 With SVA a company’s value is based on the PV of its future cash flows, so it is forward-looking.
The advantage is that this is theoretically the most superior valuation method compared with
earnings (which may be manipulated) or assets (which don’t focus on the income generated).
SVA considers seven value drivers, which link to (or drive) company strategy:
(1) Life of projected cash flows
(2) Sales growth rate
(3) Operating profit margin
(4) Corporate tax rate
(5) Investment in non-current assets
(6) Investment in working capital
(7) Cost of capital
The disadvantage is that predictions are very difficult as cash flows are technically in perpetuity.
Once a company’s period of competitive advantage is over then its growth rate is much slower
and a terminal (residual) value is calculated, based on its cash flows to perpetuity. This terminal
value is often the major part of the overall value of the company.
Once the total value of the company has been calculated, based on the future cash flows and
value drivers, then, to calculate the value of equity, it is necessary to add the value of any short-
term investments held and deduct the market value of any debt held.

62 Heath Care plc

Marking guide Marks

62.1 (a) Calculation of WACC using Gordon growth model:

Calc growth: opening shareholders’ funds 1
Calc growth: r 1
Calc growth: b 1
Calc growth: r × b 1
Cost of equity 2
Cost of preference shares 1
Cost of irredeemable debt cashflows 2
Cost of redeemable debt cashflows 2
IRR pre-tax 1
IRR post-tax 1
WACC: MV of equity × cost equity 1
WACC: MV of red debt × cost red debt 1
WACC: MV of irr debt × cost irr debt 1
WACC: MV of pref div × cost pref shares 1
Marks Available 17

ICAEW 2021 September 2018 exam questions 355

 Maximum 17
(b) Calculation of WACC using CAPM:
CAPM 1
WACC: MV of equity × cost equity 1
WACC: Revised weightings and WACC 1
Marks Available 3
Maximum 3
62.2 Explain Gordon growth model:
One mark per point to a maximum of 2
Explain diversification and beta:
Explain systematic risk – cannot be diversified away 1
Explain non-systematic risk – can be diversified away 1
Explain beta and how determined by market 1
Impact of risk on beta 1
Marks Available 6
Maximum 5
62.3 WACC assumptions and APV:
Three WACC assumptions – 1 mark per assumption 3
Explain impact of high gearing with numbers 2
APV base case 1
APV PV of tax shield 1
APV adjustment .5
APV identification of total .5
Marks Available 8
Maximum 6
62.4 Portfolio theory: 1
Define portfolio 1
Investor spread investments to reduce risk 1
Investors can spread the risk themselves 1
Managers may want to diversify creating agency conflict 1
Heath’s managers no experience of care home management 1
Some of Heath’s investors may not be diversified 1
Marks Available 7
Maximum 4
Total 35

62.1
(a) ke Dividend growth (g = br)

Opening equity capital employed = £2,520 – (£1,050 – £630)

£2,100
r= £1,050/(£6,300 + £2,100) 12.5%
b= £420/£1,050 0.4
g=r×b 12.5% × 0.4 5%
d1 + g / M = ((£630/6,300) × 1.05)/(£3.45 – £0.10) +
ke = 5% 8.13%

356 Financial Management ICAEW 2021

 Kp = d/mv

(£1 × 9%)/(£1.62 – £0.09) = £0.09/£1.53 5.89%

Kdr Yr Cash Flow 4% PV 5% PV

£ £ £
0 (99) 1.000 (99.00) 1.000 (99.00)
1–3 4 2.775 11.10 2.723 10.89
3 100 0.889 88.90 0.864 86.40
1.00 (1.71)
IRR = approx 4.4%
Kdr = 4.4% × 83% 3.65%

Kdi = i/mv (£5 × 83%)/£94 4.41%

WACC

MV Cost Weighting WACC

£’000
Ord. shares (6,300 × £3.35) 21,105.0 8.13% × 21,105.0/24,091.3 7.1
Pref. shares (750 × £1.53) 1,147.5 5.89% × 1,147.5/24,091.3 0.3
Redeemable debs
(680 × £99%) 673.2 3.65% × 673.2/24,091.3 0.1
Irredeemable debs
(1,240 × £94%) 1,165.6 4.41% × 1,165.6/24,091.3 0.2
24,091.3 7.7%

(b)

Ke via CAPM = (8.25% – 3.35%) × 1.4 = 6.86%

3.35%
10.21%

MV Cost Weighting WACC

£’000
Ord. shares (6,300 × £3.35) 21,105.0 10.21% × 21,105.0/24,091.3 8.9%
Pref. shares (750 × £1.53) 1,147.5 5.89% × 1,147.5/24091.3 0.3%
Redeemable debs
(680 × £99%) 673.2 3.65% × 673.2/24,091.3 0.1%
Irredeemable debs
(1,240 × £94%) 1,165.6 4.41% × 1,165.6/24,091.3 0.2%
24,091.3 9.5%

62.2 Gordon’s Growth Model (GGM) is also known as Earnings Retention Model. Dividend growth
based on proportion of dividends that are retained and the rate of return on those retained
profits. Thus g = rb. The GGM is based on the premise that these profits are the only source of

ICAEW 2021 September 2018 exam questions 357

 funds. Growth is achieved by re-investing earnings. This is then put into the Dividend Valuation
Model to get the cost of equity, assuming the value of a share = PV of growing future
dividends.
CAPM – specific/unsystematic risk can be diversified away by investors, so it is assumed that
investors are rational and that they have a diversified portfolio. Systematic risk can’t be
diversified away – macro-economic factors. A company’s beta is calculated from the
performance of its share price against the market average and is taken as a measure of the
market’s view of the risk attached to the security in question. The higher the perceived risk,
then the higher the beta figure and thus the higher the equity return required by investors.
62.3 When using WACC to appraise projects the following assumptions are implied:
(1) Heath’s historic proportions of debt and equity are not to be changed (which they are –
see below).
(2) Heath’s systematic business risk is not to be changed (it does not change as it’s still the
same industry).
(3) The finance is not project-specific (eg, cheap government loans, which it is not).
In this case the finance is very substantial, ie, 42% of total funds at market value (£10m/£24m)
and as it would be borrowed money then this will affect the company’s gearing level
significantly (it is only just over 12% at present and would increase to 38% @ MV).
APV – increased gearing may lead to a fall in WACC because of the tax shield on loan interest.
To find the new WACC requires the new MV of the company’s shares. However, this requires
the NPV of the proposed investment to be known, which needs the new WACC. So:
(1) Calculate a base case value
(2) Calculate the PV of the tax shield
(3) Adjust for issue costs
Total up 1, 2 and 3 to give APV – if positive then proceed with investment.
62.4 A portfolio is a combination of investments. Many investors attempt to reduce their risks by
holding a portfolio. The idea is that by investing in different securities they are ‘not putting all
of their eggs in one basket’. It is better to spread investment risks.
Investors can spread the risk themselves (via their investment strategy) and do not need
managers to do it for them. Indeed, managers may want to diversify in order to protect their
own jobs – which are not diversified. This creates agency conflict.
Heath’s managers may well not know anything about running a care home (conglomerate
discount) and so it may be dangerous for investors to allow this investment.
Some of Heath’s investors may not be diversified or may be unable to purchase certain
investments because they are private companies.

Examiner’s comments
This question had the second highest percentage mark on the paper. A large majority of candidates
reached a ‘pass’ standard in the question.
This was a four-part question which tested the candidates’ understanding of the financing options
element of the syllabus.
The question was centred on an online retailer of baby products which is based in the UK. The
company’s market share has been falling and its board is investigating the possibility of establishing
a small chain of shops across the UK, at a cost of £10 million. This expansion could be funded by a
bank loan, thereby taking advantage of current low interest rates. An alternative view within the
board is that the company should invest in a completely different type of business, in this case a
chain of care homes. In the first part, for 20 marks, candidates were required to calculate the
company’s current WACC figure, based on (a) Gordon’s Growth Model and (b) the CAPM. The
second part, for five marks, required candidates to compare and contrast the two valuation methods
above. In the third part (six marks) candidates were asked to advise the company’s board whether the
existing WACC figure (from the first part) should be used in when appraising the proposed
investment in shops. The candidates’ understanding of the APV technique was also tested here.
Finally, for four marks, candidates were required to explain the portfolio effect and discuss the
validity of the proposal to invest in a completely different type of business.

358 Financial Management ICAEW 2021

 The requirements of the first part have been examined regularly in recent examinations. Accordingly,
many candidates produced very good answers, scoring heavily. As expected, for candidates the most
difficult element here was the calculation of the dividend growth rate (based on g = b × r). It was
clear that some candidates had no idea how to approach the calculation of g = b × r. In addition,
many candidates calculated unrealistically high figures for g, b and r (and then the cost of equity)
without question. Elsewhere, it was disappointing to see a number of candidates (wrongly)
deducting the ordinary dividend for their preference share calculations and using the ordinary
dividend growth rate with preference dividends. Also, a surprising number of candidates used 5%
(the coupon rate) as the pre-tax irredeemable cost of debt, omitting to take the current market value
of the debt into account. Most candidates’ IRR calculations for the cost of redeemable debt were
good. However, too many showed a lack of understanding from here and produced an illogical IRR
calculation from NPV figures that were correct. The CAPM calculation for cost of equity was very
straightforward and the vast majority of candidates scored full marks. However, a significant number
did not put the right numbers in to the CAPM and so did not calculate the correct cost of equity.
The overall standard of answers given for the remaining parts of the question (theory and advice)
was disappointing when compared to the accuracy of (most of) the calculations in the first part.
Whilst many scripts scored well in the second part, far too many were unable to explain the basics of
Gordon’s Growth Model and the CAPM.
For the third part, too few candidates explained the three conditions required to use the existing
WACC and then apply them to the given scenario. Generally, there was a good understanding of the
APV technique, but typical errors here were choosing the wrong cost of equity (it should be
ungeared) and then deducting (rather than adding) the PV of the tax shield.
For the fourth part, most candidates showed a good understanding of portfolio theory. However, too
many failed to distinguish between company and investor portfolios in the scenario.

63 Eddyson Cordless Ltd

Marking guide Marks

63.1 Hedging strategies:

No hedge 2
FTC outcome 1
FTC fee 1
MMH: Borrow 1
MMH: Convert 1
MMH: Lend and result 1
Option: strategy 1
Option: no of contracts 1
Option: cost of option premium 2
Option: decision 1
Option: gain 1
Option: due from customer 1
Option: convert to £’s 1
Option: net receipt 1
16
63.2 Advice on hedge:
Summary of hedging outcomes 1
Best outcome at $1.3350 2
Best outcome at $1.4050 2
Impact on Eddyson if dollar ($) strengthens 1

ICAEW 2021 September 2018 exam questions 359

 Marking guide Marks

Marks Available 6
Maximum 6
63.3 Interest rate parity:
State and explain interest rate parity 2
Average UK and US three-month rates 1
Average spot rate 1
Calculation of forward rate/average premium 1
Marks Available 5
Maximum 5
63.4 Economic risk:
96% UK sales so little exposure 1
Increase in economic risk as US sales increase 1
Weaker $ would be bad for Eddyson 1
Marks Available 3
Maximum 3
Total 30

63.1 No hedge

Spot rate Spot rate

1.3350 1.4050
$2,300,000 $2,300,000
1.3350 1.4050

£1,722,846 £1,637,011

Forward contract (FC)

1.3775 – 0.0044 = 1.3731 $2,300,000/1.3731 £1,675,042

$2,300,000/$100 = 23,000 ×
Fee £0.30 (£6,900) £1,668,142

Money market hedge (MMH)

Borrow $ $2,300,000/1.01 $2,277,228

Convert @ spot $2,277,228/1.3775 £1,653,160
Lend @ UK £1,653,160
×
1.0115 £1,672,171

Option
Buying £s, so a November call option

$2,300,000/$ $1,666,667/£ 167

No. of contracts = 1.38 10,000 166.66 contracts

360 Financial Management ICAEW 2021

 $33,233/1.3
Cost of option 167 × 0.0199 × 10,000 655 £24,338

Future spot rate 1.3350 1.4050

Bought for (1.3800) (1.3800)
(Loss)/Profit (0.0450) 0.0250

So therefore Abandon option Take up option

Gain on option $0.0250

× 10,000
× 167
$41,750

Due from customer $2,300,000 $2,300,000

Gain on option 0 41,750
Due from customer $2,300,000 $2,341,750

Converted to £ ($2.3m/1.3350) £1,722,846 ($2,341,750/1.4050) £1,666,726

less: Cost of option (24,338) (24,338)
Net receipt £1,698,508 £1,642,388

Examiner’s comments
This question had the lowest average mark on the paper, but most candidates achieved a ‘pass’
standard.
This was a four-part question that tested the candidates’ understanding of the risk management
element of the syllabus.
The scenario here involved a UK manufacturer of home and garden appliances. The company has
recently received a large order from an American customer. Its board is considering whether or not
to hedge the foreign exchange rate risk. The first part of the question, for 16 marks, required
candidates to calculate the net sterling receipt for each of four possible strategies. These were (a) no
hedge, (b) a forward contract, (c) a money market hedge and (d) sterling traded currency options.
The second part was worth six marks and required candidates to advise the company’s board, based
on their previous calculations. In the third part (five marks) candidates needed to demonstrate their
understanding of interest rate parity. The fourth part was worth three marks. Here, candidates were
asked to explain whether, taking into account the information provided, additional sales to the US
might expose the company to economic risk.
For most elements of the first part candidates scored well. Forward contracts (FC) and money market
hedges (MMH) are examined regularly and most candidates accrued full marks here. Candidates
need to make the best use of the spreadsheet provided in the examination. In a number of instances
candidates reduced their exchange rates to two decimal places, thus losing marks unnecessarily.
One common error amongst candidates was to add, rather than subtract, the forward contract fee. It
was disappointing to see that some candidates used the two future spot rates given to calculate
alternative sterling receipts for the FC and then also for the MMH. Both of these hedging techniques
produce one, fixed sterling figure each. As expected, candidates found the currency options element
of the question more difficult. Whilst many of them scored well, common errors noted were:

ICAEW 2021 September 2018 exam questions 361

 • choosing a put rather than a call option and then getting the exercise/abandon decision
wrong as well.
• calculating the wrong number of contracts, by failing to use the option exercise price.
• calculating the profit on exercising the option in sterling rather than in $.
• treating it as an OTC option rather than a sterling traded currency option.
Interest rate parity (IRP) has been examined fairly regularly and many candidates did well in the third
part. However, there were quite a few poor scripts and some candidates used 12 months rather than
three months when trying to prove that the IRP was working in this scenario.
The fourth part produced a very varied set of answers. Whilst many candidates scored full marks
here, many scored zero, as they had no understanding of economic risk, frequently mentioning
(wrongly) the impact of tariffs, quotas and political unrest.

63.2

Spot rate Spot rate

1.3350 1.4050
No hedge £1,722,846 £1,637,011
FC £1,668,142 £1,668,142
MMH £1,672,171 £1,672,171
Option £1,698,508 £1,642,388

So with spot rate at 1.3350 (weakening £ and strengthening $) the best outcome for Eddyson
is not to hedge the dollar receipt.
With the spot rate at 1.4050 (strengthening £ and weakening $) the best outcome is to hedge
the dollar receipt via a money market hedge. The FC and the MMH both give a fixed sterling
receipt – the MMH produces a slightly higher figure. The FC and MMH are safest techniques to
use for a risk-averse board.
The £/$ interest rates and the forward contract premium indicate that the market is expecting
the dollar to strengthen (sterling to weaken). This would be good for Eddyson, an exporter, as
sterling receipts would be higher. The board’s attitude to risk will be important here.
63.3 Average spot rate × (1 + Average dollar interest rate (3 mos.))/(1 + Average sterling interest
rate (3 mos.)) = Average forward rate
The dollar interest rates are lower than those of sterling. Using the interest rate parity (IRP)
equation above (which shows that differences in interest rates cannot be exploited as forward
rate will adjust to offset any gains), the value of sterling against the dollar will fall. The dollar’s
gain in value is called a premium. So, using the data in the question:
• Average UK rate 5.10% pa or 1.01275% per three months.
• Average US rate 3.6% pa or 1.009% per three months.
• Average spot rate = 1.3715
• Forward rate = 1.3715 × 1.009/1.01275 = 1.3664 ie, a premium of $0.0051/£
• Average premium given = $0.0052/£ so IRP is working
63.4 Currently very little economic risk as the majority of Eddyson’s sales are in the UK (96%).
However, if more sales are to the US then economic risk would increase – $ sales and €
purchases.
A weakening $ and a strengthening € would both be bad for Eddyson.

362 Financial Management ICAEW 2021

 September 2019 exam questions
64 Hodder Specialist Engineering Ltd

Marking guide Marks

64.1 (a) NPV annual income:

Machinery 1
Tax saved via CA’s 2
Labour/materials 2
Fixed costs 2
Sales income 1
Tax on profit 1
Working capital 4
Discount factors 1
NPV 1
Ignore depreciation 1
Ignore interest 1
Decision and reason 1
Marks Available 18
Maximum 18
(b) NPV one off income:
Sales income 1
Tax on profit 1
NPV 1
Decision 1
Marks Available 4
Maximum 4
64.2 Sensitivity analysis and simulation
Explain strengths and weaknesses of sensitivity analysis 3
Explain strengths and weaknesses of simulation 3
Marks Available 6
Maximum 5
64.3 Real options
Definition 1
Example 2
Marks Available 3
Maximum 3
64.4 Risks
Overseas trading risks 2
Political risks 2
Cultural risks 2
Marks Available 6
Maximum 5
Total 35

ICAEW 2021 September 2019 exam questions 363

 Developing your ACA Professional Skills
The key to demonstrating professional skills in the first part of this question is being able to
apply your technical knowledge efficiently. Investment appraisal questions are time pressured
therefore it is important that you have good logical approach and make use of the standard
NPV proforma when attempting this question. In the remaining three requirements you need
to be able to apply sensitivity analysis and the theory of real options to the proposal and
explain clearly the risks faced by the company if it expands overseas. Your answer must
therefore combine different technical skills in a practical situation.

Assimilating and using information

You need to interpret the information provided in the scenario correctly. Some of the cash
flows are given in real terms and need to be inflated while others (e.g. sales) are given in
money terms and already include inflation.
In requirement two you are asked to compare sensitivity analysis with simulation as methods
of assessing risk. Make sure that your points relate to a discussion of the two techniques and
not simply a list of all of the possible advantages and disadvantages of each individual
technique.

Structuring problems and solutions

In each of the four requirements for this question, you are being asked to identify and apply
relevant technical knowledge and skills to analyse an investment decision. This means that
you need to analyse both the financial and non-financial data provided in the scenario to
identify opportunities to add value.
Requirement one clearly states that you should calculate the NPV of the proposal and advise
the board if it should be accepted based on two different contract process. The money cost of
capital was given indicating that a ‘with inflation’ approach to the NPV should be adopted. You
therefore need to read the information carefully noting the timings of relevant cash flows and
excluding non-relevant costs such as depreciation and interest.

Applying judgement
Clearly, when advising the board whether it should accept the proposal, you are going to
need to display sound logic that your recommendation follows on from the outcome of your
NPV calculation.
In requirement two you can use your judgement to criticise simulation and sensitivity analysis.
In requirement three you asked to identify one real option that could apply to the proposal,
make sure that you select an appropriate real option that is relevant to the information given
in the scenario (so not an option to abandon or delay).

Concluding, recommending and communicating

As long as you answer the question set, you will have demonstrated that you can present
analysis and recommendations in accordance with instructions. However, addressing each
requirement with a logical course of action based on your evaluation of the matters raised in
the scenario will also demonstrate that you can make evidence-based recommendations
which can be justified by reference to supporting data and other information. For example,
requirement one asks you to advise the board whether it should accept the DC proposal at
two different contract prices. When communicating your advice, ensure that you demonstrate
an understanding of the meaning of the calculations performed in your NPV.

364 Financial Management ICAEW 2021

 The final requirement asks you to outline the potential risks that Hodder could face if it
expands its operations into China and India. When answering this requirement, it is important
that you identify and explain risks that are relevant to the scenario.

64.1
(a)

20X9 20Y0 20Y1 20Y2

£’000 £’000 £’000 £’000
Machinery (1,200.000) 140.000
Tax saved via CA’s (W1) 36.720 30.110 24.691 88.679
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Sales income 550.000 550.000 550.000
Tax on profit (W4) (59.340) (58.657) (57.960)
Working Capital (W5) (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) 313.730 304.750 574.085
Discount factors 1.000 0.917 0.841 0.772
PV (1,213.280) 287.691 256.295 443.194
NPV – Decision (a) (226.100)

Ignore depreciation as it’s not a cash flow

Ignore interest cost as it’s in discount rate (WACC)
Decision (a) – do not invest. NPV is negative. Shareholder wealth would decline.
(b)

20X9 20Y0 20Y1 20Y2

Machinery (1,200.000) 140.000
Tax saved via CA’s 36.720 30.110 24.691 88.679
Labour/Materials (165.240) (168.545) (171.916)
Fixed costs (35.700) (36.414) (37.142)
Sales income 1,900.000
Tax on profit (W6) 34.160 34.843 (287.460)
WC (50.000) (6.100) (6.324) 62.424
TCF (1,213.280) (142.770) (151.749) 1,694.585
1.000 0.917 0.841 0.772
PV (1,213.280) (130.920) (127.621) 1,308.220
NPV – Decision (b) (163.601)

Alternative presentation for Decision (b) with changes from original NPV:

20X9 20Y0 20Y1 20Y2

£’000 £’000 £’000 £’000
Change in annual
income (550.000) (550.000) 1,350.000

ICAEW 2021 September 2019 exam questions 365

 20X9 20Y0 20Y1 20Y2
£’000 £’000 £’000 £’000
× × ×
less: Tax at 17% 0.830 0.830 0.830
× × ×
Discounted at 9% 0.917 0.841 0.772
PV change (418.611) (383.917) 865.030
Overall change to NPV 62.499
NPV in (a) (226.100)
Amended NPV (163.601)

Decision (b) – do not invest. NPV is still negative. Shareholder wealth would decline.

WORKINGS
(1) Tax saved via CA’s

W1 20X9 20Y0 20Y1 20Y2

£’000 £’000 £’000 £’000
Machinery cost/WDV b/f 1,200.000 984.000 806.880 661.640
WDA @ 18% (216.000) (177.120) (145.238) (521.642)
WDV/Sale proceeds 984.000 806.880 661.640 140.000
WDA × 17% 36.720 30.110 24.691 88.679

(2) Labour and materials

W2 20Y0 20Y1 20Y2

£’000 £’000 £’000
Labour and materials costs (162.000) (165.240) (168.545)
Inflated at 2% ×1.02 ×1.02 ×1.02
Money cash flow (165.240) (168.545) (171.916)

(3) Fixed costs

W3 20Y0 20Y1 20Y2

£’000 £’000 £’000
Fixed costs (35.000) (35.700) (36.414)
Inflated at 2% ×1.02 ×1.02 ×1.02
Money cash flow (35.700) (36.414) (37.142)

(4) Tax on profit

W4 20Y0 20Y1 20Y2

£’000 £’000 £’000
Sales income 550.000 550.000 550.000
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)

366 Financial Management ICAEW 2021

 W4 20Y0 20Y1 20Y2
£’000 £’000 £’000
Profit 349.060 345.041 340.942
Tax on profit at 17% (59.340) (58.657) (57.960)

(5) Working capital

W5 20X9 20Y0 20Y1 20Y2

£’000 £’000 £’000 £’000
Working capital investment 50.000 5.000 5.000
Total Working Capital (WC) 50.000 55.000 60.000
×1.00 ×1.02 ×(1.02)2
Total WC (inflated) 50.000 56.100 62.424
(50.000) (6.100) (6.324) 62.424

(6) Tax on profit (2)

W6 20Y0 20Y1 20Y2

£’000 £’000 £’000
Sales income 0.000 0.000 1,900.000
Labour/Materials (W2) (165.240) (168.545) (171.916)
Fixed costs (W3) (35.700) (36.414) (37.142)
Profit (200.940) (204.959) 1,690.942
Tax on profit at 17% 34.160 34.843 (287.460)

64.2 Sensitivity analysis

• It facilitates subjective judgment (by management for example).
• It identifies areas critical to the success of a project, eg, sales volume, materials price.
• It is relatively straightforward.
But
• It assumes that changes to variables can be made independently.
• It ignores probability.
• It does not point to a correct decision.
Simulation
• More than one variable at a time can be changed.
• It takes probabilities into account.
But
• It is not a technique for making a decision.
• It can be time consuming and expensive.
• Certain assumptions that need to be made could be unreliable.
64.3 NPV analysis only considers cash flows related directly to a project. However, a project with a
negative (or low) NPV could be accepted for strategic reasons. This is because of (real) options
associated with a project that outweigh the poor NPV.
Follow-on option. Initial NPV is negative, but future contracts could be profitable.
64.4 There will be risks trading overseas - local finance costs, tax systems, dividend restrictions.

ICAEW 2021 September 2019 exam questions 367

 Also, there are political risks, eg, import quotas, tariffs, nationalisation, minimum shareholding
for local residents. Finally, there could be cultural risk – business practices and social mores
may be very different.

Examiner’s comments
This question had the highest percentage mark on the paper. The vast majority of candidates
achieved a “pass” standard in this question.
This was a four-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.
The scenario was based around a UK engineering company, which provides a powder-coating
service for UK customers in the consumer goods sector. This company was considering diversifying
its operations via a three-year contract with DCL, a UK car manufacturer. An alternative plan was to
expand its existing market into India and China. Candidates were cast as an employee in the
company’s finance team and were given relevant data. In the first part, for 22 marks, candidates were
required to prepare NPV calculations for the DCL proposal. This would enable them to advise the
company’s board whether it was worth proceeding with the contract. In the second part, for five
marks, candidates had to compare the strengths and weaknesses of sensitivity analysis and
simulation as methods of assessing the risk of the DCL proposal. In the third part, for three marks,
candidates were asked to explain real options and to identify a real option that could apply to the
DCL scenario. The final part, for five marks, asked candidates to outline the potential risks that the
company could face were it to expand its existing operations into China and India.
Most candidates scored well on the NPV calculation. Errors made by weaker candidates included
inflating sales figures already given in money terms and inflating costs a year too early/late. In
addition, many candidates included interest costs when they were covered by the WACC and
included depreciation which isn’t a cashflow. Regarding the tax charge, a common error made was
the taxing of capital and working capital flows. Some candidates started WDAs a year too late. The
working capital calculation was difficult, and many candidates inflated the working capital increments
rather than the balances. Finally, some candidates inflated the discount rate, which was already given
in money terms.
In part two, reasonable marks were earned by most candidates, as expected. Weaker candidates
were too brief and often excluded comments on probability.
In part three, it was observed that candidates continue to be poor at defining what is meant by ‘real
options’ despite the number of times this has been examined in recent exams. There was a clear
requirement for the identification of one option that could apply in the scenario. Weaker candidates
gave two or more or picked an inappropriate one such as abandonment or delay.
The final part was generally well done.

65 Jackett Clarke Travel plc

Marking guide Marks

65.1 Forecast income statement:

Sales 1
Variable costs 1
Fixed costs 1
Interest (.5 mark for rights issue and 1.5 marks for debt issue) 2
Tax 1
Dividends (2 marks for rights issue and 1 mark for debt issue) 3
Marks Available 9
Maximum 9
65.2 EPS and gearing ratio:
EPS calculation (1 mark for rights issue and 1 mark for debt issue) 2

368 Financial Management ICAEW 2021

 Gearing ratio (1.5 marks for rights issue and 1.5 marks for debt issue) 3
Marks Available 5
Maximum 5
65.3 Debt vs Equity discussion:
Current EPS 1
Current gearing 1
Discussion of issues 5
Marks Available 7
Maximum 7
65.4 TERPS
Calculation 2
Reasons for differences between the theoretical and actual ex-right price 4
Marks Available 6
Maximum 6
65.5 Efficient market theories
Chartist approach 1
Explanation of EMH 4
Marks Available 5
Maximum 5
65.6 Ethics
Insider trading is illegal
Explanation of ICAEW ethical principles (integrity, objectivity, professional
behaviour)
Marks Available 0
Maximum 3
Total 35

Developing your ACA Professional Skills

This question is from the first part of the Financial Management syllabus and focuses on the
different financing options available to a company. The key to demonstrating professional
skills in this question is being able to apply your technical knowledge efficiently and work
logically through each requirement. The company needs to raise £7 million to expand its
operations overseas and you are asked to assess whether the finance should be raised via a
rights issue or a debenture issue. This question then progresses to tests your ability to apply
different technical skills to this practical situation.

Assimilating and using information

One of the professional skills assessed in the ACA exams considers your ability to evaluate the
relevance of information provided. The first two requirements ask you to compare the use of a
rights issue and a debenture issue to finance the expansion, you therefore need to be able to
identify from the scenario what information is relevant to each of the financing options when
you prepare the two income statements.

Structuring problems and solutions

The first two requirements involve some detailed, time pressured calculations. It is therefore
important that you adopt a good structure to preparing the forecast income statements under
each of the financing options to enable you work clearly through the calculations in the time

ICAEW 2021 September 2019 exam questions 369

 available. Your ability to handle basic calculations such as earnings per share and gearing will
be important here.

Applying judgement
In the exam you need to be able identify assumptions or faults in arguments and exercise
ethical judgment. These skills are important when answering the final two requirements of this
question. When addressing the sales director’s views on the company’s share price you
should make reference to the efficient market hypothesis and behavioural finance to support
your answer. In the final requirement you should use the ICAEW ethical framework to help you
to identify the legal and ethical issues arising from the scenario.
In requirement three you are asked to discuss the implications for Jackett’s shareholders from
choosing either debt or equity finance to fund the expansion. From the information provided
in the question it may not be initially obvious which source of finance is preferable. Look for
information in the scenario on areas such as shareholder reaction, issue costs, servicing costs
and impact on control. When discussing the implications for Jackett’s shareholders, it is also
important that you make reference to your calculations performed in the first two
requirements.

Concluding, recommending and communicating

In each of the requirements you need to apply your technical knowledge to support your
reasoning and conclusions. Addressing each requirement with a logical course of action
based on your evaluation of the matters raised in the scenario will demonstrate that you can
make evidence-based recommendations which can be justified by reference to supporting
data and other information.

65.1 Stewart – Income Statement for the year to 30 September 20Y0

Rights issue Debt issue

£’000 £’000
Sales 52,200 52,200
Variable costs (28,710) (28,710)
Fixed costs (11,000) (11,000)
Profit before interest and tax 12,490 12,490
Interest (W1) (805) (1,155)
Profit before tax 11,685 11,335
Taxation (17%) (1,986) (1,927)
Profit after tax 9,699 9,408
Dividends paid (W2) (3,000) (2,400)
Retained profit 6,699 7,008

WORKINGS
(1) Interest

W1 Rights Debt
£’000 £’000
Current interest cost 805 805
Extra interest cost (£7m × 5%) 0 350

370 Financial Management ICAEW 2021

 W1 Rights Debt
£’000 £’000
Total interest cost 805 1,155

(2) Dividend

Rights Debt
W2 £’000 £’000
Current dividend (16m × £0.15) 2,400 2,400
Extra dividend ([16m/4] × £0.15) 600 0
Total dividend 3,000 2,400

65.2

Rights Debt
£’000 £’000
Earnings per share £9,699/20,000 £0.485
£9,408/16,000 £0.588
Current debt 11,500 11,500
Extra debt 0 7,000
New total debt 11,500 18,500

Current long-term funds 36,250 36,250

Extra funds raised 7,000 7,000
Retained profit 20Y0 6,699 7,008
Current long-term funds 20Y0 49,949 50,258

Gearing ratio £11,500/£49,949 23.0%

£18,500/£50,258 36.8%

65.3

Current EPS £7,694/16,000 £0.481

Current gearing £11,500/£36,250 31.7%

Other points for consideration by shareholders:

• The EPS will be higher with an issue of debt, but gearing will be higher as well, which
increases financial risk.
• Interest cover (currently 12.5 [£10,075/£805]) will be lower if the debt issue is chosen (10.8),
but it will increase with a rights issue (15.5). In both cases the cover figure is sufficient.
• A rights issue could lead to a dilution of control for the shareholders.
• An issue of debt issue could give a tax shield advantage.
• An equity issue would be more expensive.
• The existing debt is due to be repaid 20Y1 – this has cash flow implications for the company
in the near future.
• The board’s attitude to risk is important.
65.4

ICAEW 2021 September 2019 exam questions 371

 Current market capitalisation 16,000 £2.58 £41,280
Rights issue 4,000 £1.75 £7,000
Totals 20,000 £2.41 £48,280
So theoretical ex-rights price = £2.41

Reasons for differences between the theoretical and the actual ex-rights market price:
• The project NPV is not included in the ex-rights price
• Information released by Jackett regarding the use of funds raised
• Additional information re Jackett or the market
• Market expectations regarding the expansion
• Level of take up of rights issue
• General market conditions
• Events (macro) – eg, interest rates
• Events (micro) – eg, new managers at the company
• Events (industry) – eg, takeovers
• A rights issue might give a negative signal and a lowering of the market value
• Level of market efficiency
65.5 Michael Ayres is, wrongly, proposing a Chartist approach to share prices. He is assuming that
the market is not efficient at all and that prices follow pre-set patterns.
The Efficient Market Hypothesis (EMH) posits that there are no patterns to share prices. Markets
have no memory. Past prices have no influence on future prices. Efficiency means that shares
cannot be bought cheaply and then sold quickly at a profit. Share prices are “fair” and
investment returns are those expected for the risks undertaken. When share prices, at all times,
rationally reflect all available information, the market in which they are traded is said to be
efficient. In efficient markets investors cannot make consistently above-average returns other
than by chance.
There are three levels of market efficiency: weak form, semi strong form and strong form.
Behavioural finance is an alternative view to the EMH. This considers investors’ irrational
tendencies, leading to a weakening of market efficiency.
65.6 Legal – this is insider trading so is illegal.
Ethics - you are an ICAEW Chartered Accountant. The ICAEW’s ethical guidance includes:
• A member should behave with integrity – ie, be honest and truthful. The member’s advice
and work should not be influenced by the interests of other parties.
• A member should strive for objectivity in all professional and business judgements – ie,
there should be no bias, conflict of interest or undue influence of others.
• A member should behave professionally – ie, avoid any action that discredits the
profession.
Ann Baker’s request would be counter to all three of these elements of the ethical guidance.

Examiner’s comments
This question had the lowest percentage mark on the paper. A considerable proportion of
candidates scored less than a pass mark (55%) in this question.
This was a six-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus and there was also a small section with an ethics element to it.
In the scenario, the candidate (an ICAEW Chartered Accountant) was employed in the finance team
of Jackett, a UK-listed travel agency and tour operator. Currently, Jackett arranges flights and
package holidays in Europe and North America. The company’s board was keen to explore the
implications of expanding its operations into South East Asia and Australia. This would cost an initial
£7 million, to be raised via a rights issue or a debenture issue. Jackett’s board had commissioned a
market research report. Candidates were given the key financial implications noted in the report.

372 Financial Management ICAEW 2021

 The first part was worth nine marks and required candidates to calculate the next year’s profit figures
under the two alternative funding methods. Using these figures, candidates were required in the
second part, for five marks, to calculate the amended earnings per share figures and gearing ratios.
The third part was worth seven marks. It asked candidates to make use of their calculations and
discuss the implications for Jackett’s shareholders of the company using equity or debt to raise the
£7 million required. For six marks, the fourth part required candidates to: calculate the theoretical ex-
rights price that would arise with the equity issue; and, explain why this might be different to the
actual ex-rights price. The fifth part was worth five marks and it tested, via the scenario, candidates’
understanding of the efficient market theory. Finally, for three marks, the sixth part tested, via the
scenario, candidates’ understanding of ethical guidance.
In the first part many candidates scored full marks (nine). Weaker candidates failed to calculate the
extra interest (new debt) correctly – this was simply 5% of £7 million. Also, with the dividend
calculation, a common failing was the maintenance of a constant payout ratio rather than dividend
per share as specified in the question.
There were very mixed responses to the second part. A small minority of candidates continue to
calculate EPS using retained earnings. Many candidates could not calculate the gearing ratios
correctly. Errors included: the use of market values when book values were required; using
debt/equity when debt/debt+equity was specified; not including the share premium account when
issuing new shares; and, not including retained earnings in the equity book value.
The third part was, overall, disappointing, as most candidates did not calculate the current year EPS
and gearing, and so had nothing meaningful to compare their figures with. A significant number of
candidates wasted time going through the M&M and traditional capital structure theories when they
were not required.
In part four, most candidates could calculate the theoretical ex-rights price correctly, but a significant
minority couldn’t because they used the nominal value of the existing and/or new shares. Many
candidates were too brief in explaining why the actual price might be different to the theoretical
price in a four-mark requirement.
The fifth part was also disappointing. Many candidates asserted that the employee was using weak
form efficiency as he’d identified patterns in share price movements, yet in their explanation of weak
form efficiency they stated that this couldn’t be done. Few identified that the employee was
promulgating the Chartist theory.
The final part was, generally, done well.

66 Barratt Waters Shine plc

Marking guide Marks

66.1 (a) Hedging strategies:

Forward contract spot rate 1
Plus contract discount .5
Arrangement fee .5
Forward contract sterling amount .5
MMH – amount to borrow 1
Convert at spot 1
Sterling value 1
Option – November put option 1
Use option .5
Option premium .5
Sterling value .5
Marks Available 8
Maximum 8

ICAEW 2021 September 2019 exam questions 373

 (b) Advice on hedge:
Sterling receipt at spot rate 1
Discussion 5
Marks Available 6
Maximum 6
(c) Forwards compared to futures:
Forward contract 1.5
Currency future 1.5
Marks Available 3
Maximum 3
66.2 (a) FTSE hedge outcome:
Sell futures 1
Number of contracts 1
Rounded number of contracts .5
Loss in 3 months 1
Futures position – change 1
Gain on future 1
Net decrease in portfolio value .5
Marks Available 6
Maximum 6
(b) Reason not 100% effective:
Basis risk 1
Rounding contracts 1
Marks Available 2
Maximum 2
66.3 LIBOR Hedge:
Total cost (a) and (b) .5
Exercise option (.5 mark for each rate) 1
Total cost (a) and (b) .5
Annual cost (1 mark for each rate) 2
Discussion 1
Marks Available 5
Maximum 5
Total 30

Developing your ACA Professional Skills

This question is from the second part of the Financial Management syllabus and focuses on
managing financial risk. It covers a number of the more complex technical areas of the
syllabus including hedging currency risk using a forward contract, MMH and OTC option,
hedging portfolio risk using index futures and hedging interest rate risk using an interest rate
option. To demonstrate your professional skills in this question it is key that you are able to
apply your technical knowledge efficiently and work logically through each requirement.
Approaching each of the three tasks separately will help you to focus on the relevant technical
knowledge needed to answer each requirement. For example, Task 1 focuses on managing
currency risk, Task 2 focuses on managing portfolio risk and Task 3 focuses on managing
interest rate risk. Breaking the question down into three separate tasks and focuses on one
task at a time will avoid you becoming overwhelmed with the volume of technical information.

374 Financial Management ICAEW 2021

 Assimilating and using information
One of the professional skills assessed in the ACA exams considers your ability to evaluate the
relevance of information provided. Questions covering hedging will include an abundance of
information. It is therefore important that you can identify the relevant information needed
from the scenario to allow you to calculate the impact of the hedging strategy stated in the
requirement. This is particularly important for Task 1 where lots of information is provided on
currency and interest rates. Highlight on your screen the relevance of the data provided in the
scenario and show clear workings for each of the three currency hedging strategies.
It is always vital to read the requirements carefully to ensure that you extract the relevant
information from the scenario to answer the question. This is especially the case in the final
task where the requirement specifies that the interest option had already been taken out, so it
is not relevant to evaluate whether or not the option should be used.

Structuring problems and solutions

In the exam you are expected to be able to use structured information to identify evidence
based solutions. A structured approach is especially important in tasks 1 and 2 to ensure that
the calculations are performed efficiently.

Applying judgement
Market rates change regularly, therefore the outcome predicted from a hedging strategy is
simply an estimate at a point in time and will change as underlying variables such as currency
and interest rates change. It is worth making this point when advising the board which
hedging strategy to use. Demonstrating the application of professional scepticism and critical
thinking by showing awareness of the drawbacks of the hedging techniques used will add
value to your answer.

Concluding, recommending and communicating

In each of the requirements you need to apply your technical knowledge to support your
reasoning and conclusions. Addressing each requirement with a logical course of action
based on your evaluation of the matters raised in the scenario will demonstrate that you can
make evidence-based recommendations which can be justified by reference to supporting
data and other information. When answering the first requirement it is important to remember
that the amount is not expected to be received until three months’ time therefore a
recommendation based solely on the spot rate is not appropriate.

66.1
(a) Forward contract (FC)

AP 22,400,000
46.98
46.85 + 0.13 = 46.98 £476,799

AP 22,400,000
AP 1,000,000
Fee = 22.4 × £260 (£5,824)

£470,975

Money market hedge (MMH)

ICAEW 2021 September 2019 exam questions 375

 AP 22,400,000
1.015
Borrow AP = AP 22,068,966

AP 22,068,966
46.85
Convert @ spot = £471,056

Lend @ UK £471,056 × 1.009 = £475,295

Option
Selling AP’s, so a November put option

AP 22,400,000
46.05
Use option £486,428

AP 22,400,000
AP 1,000,000
Premium = 22.4 × £740 (£16,576)
£469,852

(b) Sterling receipt at spot rate = AP 22,400,000/46.85 = £478,122

• Summary of range of sterling receipts from hedging.
• MMH gives highest receipt, but it’s a fixed amount.
• Current spot rate gives high receipt, but the forward rate suggests a strengthening of
sterling against the peso. This would be bad news for Barratt, an exporter.
• Management’s attitude to risk is important.
• General points about various hedging techniques.
(c) A forward contract is a binding agreement to buy/sell a specified quantity of one currency
in exchange for another item for settlement at a future date and at a price agreed today.
Forward contracts are not always easily available.
A currency future is a standardised exchange-traded contract to buy/sell a quantity of one
currency in exchange for another for notional delivery at a set date in the future. The
contracts cannot be tailored to the user’s exact requirements. There may be hedge
inefficiencies – rounding of contracts and basis risk (pricing differences between spot and
futures markets). Limited currency availability.
66.2
(a) Barratt concerned about an index fall, so sell futures .

Portfolio value £8,350,000

Futures price 7,115

Price/index point × 10
Value/contract = 71,150

No of contracts £8,350,000/71,150 = 117.4

376 Financial Management ICAEW 2021

 Rounded to 117

In three months’ time £

Closing portfolio value (£8,350,000 × 7055/7130) 8,262,167
Opening portfolio value (8,350,000)
Loss in value (87,833)

Futures position
Sell at 7,115
Buy at (7,055)
Change 60
×
No of contracts 117
×
£10
Gain on future 70,200
Net decrease in portfolio value (£17,633)

(b) The hedge will not be 100% efficient because of:

• basis risk; and,
• rounding contracts
66.3

(a) (b)
LIBOR 3.5% 5.5%
plus 1.5% 1.5%
Total cost 5.0% 7.0%

Option cost 5.3% 5.3%

Exercise option? NO YES

Rate 5.0% 5.3%

Premium 1.0% 1.0%
Total cost 6.0% 6.3%

Borrowed £12,500,000 £12,500,000

× ×
6.0% 6.3%
Annual cost £750,000 £787,500

ICAEW 2021 September 2019 exam questions 377

 (a) (b)
Note: Annual cost of no hedge (at 5% & 7% pa) £625,000 £875,000

• At low interest rates, it’s better not to hedge.

• At high interest rates, it’s better to hedge.
• The option premium is expensive.
• What is the board’s attitude to risk?

Examiner’s comments
This question had the second highest percentage mark on the paper. The majority of candidates
achieved a “pass” standard in this question.
This was a five-part question which tested the candidates’ understanding of the risk management
element of the syllabus.
In the scenario, the company (Barratt) is a UK-listed manufacturer of pharmaceuticals. Candidates,
again, were employed in the finance team and were asked to work through three tasks and advise
senior management accordingly. Part one considered the first task – foreign exchange hedging for a
large export contract. Part one (a) was worth eight marks and asked candidates to calculate the
sterling receipt for the export contract using three different hedging techniques. In part one (b), for
six marks, candidates were required to advise the board whether it should hedge against exchange
rate movements for the contract in question. Part one (c) asked candidates to compare forward
contracts and futures as hedging techniques. The second part was worth eight marks and considered
the second task – using FTSE100 index futures to hedge the value of Barratt’s investment in a
portfolio of UK shares. The third part, for five marks, considered the final task – the implications of
taking out an interest rate option. Barratt was borrowing a large amount from its bank at a variable
rate. Candidates had to prepare calculations of the costs of hedging the interest charges and advise
the board.
In part (a) of the first part most candidates scored well. Common errors were: adding, rather than
deducting, fees and premiums; using the wrong interest rates in an MMH; and, using a call rather
than a put.
In part (b) of the first part there were some very good answers, but many candidates asserted doing
nothing as using the current spot rate produced the highest income, despite the money not being
received for three months. The discussion section for weaker candidates was often very brief.
In part (c) of the first part most candidates produced satisfactory answers.
In the second part most candidates scored adequately on the index futures calculations. Common
errors were: using the wrong price to calculate the number of contracts; not specifying the need to
sell first; and, miscalculating the new portfolio value and the profit on the futures contracts. Most
candidates identified correctly why the hedge would be inefficient, but weaker candidates rolled the
two separate reasons into one.
In the final part there was much variation in the marks. This was due to many candidates not reading
the question carefully enough. It specified that the interest option had already been taken out,
whereas many candidates answered as if that decision was still to be made.

378 Financial Management ICAEW 2021

 December 2019 exam questions
67 Packaging Innovations plc

Marking guide Marks

67.1 NPV annual income:

Sales 3
Contribution 1
Selling and admin 1
Fixed production costs 1
Rent 1
Sale to management 2
Tax on profit 1
Working capital 2
Plant and Machinery 1
Tax saved on WDA’s 2
Discount factors 1
NPV 1
Ignore R&D and centrally allocated costs 1
Decision and reason 1
Marks Available 19
Maximum 19
67.2 Sensitivity to sales volume
Contribution 1
Price 1
Tax 1
Discounting 1
Conclusion 1
Marks Available 5
Maximum 5
67.3 Revised NPV
Adjustment for sale to management 1
Revised NPV 1
Marks Available 2
Maximum 2
67.4 Real options
Definition and reference to the context of Pi’s project NPV 2
Example of how real options could be applied 2
4
67.5 Sustainability objective
Definition and application 2
Impact on shareholder wealth 1
Marks Available 3
Maximum 2
67.6 Ethical issues

ICAEW 2021 December 2019 exam questions 379

 Marking guide Marks

Conflict of interest 1
Explanation 2
Marks Available 3
Maximum 3
Total 35

Developing your ACA Professional Skills

The key to demonstrating professional skills in the first part of this question is being able to
apply your technical knowledge efficiently. Investment appraisal questions are time pressured
therefore it is important that you have a good logical approach that you can apply accurately
and efficiently. In the remaining requirements you are asked to do a number of things
including the application of sensitivity analysis, identification of a real option attached to the
investment and a discussion of the ethical issues raised. Your answer therefore requires you to
combine a number of different technical skills in a practical situation.

Assimilating and using information

You need to interpret the information provided in the scenario correctly. Some of the cash
flows need to be inflated while others remain constant. The real cost of capital is given,
indicating that you will need to adjust it to the money cost of capital using the Fisher formulae
and then apply a ‘with inflation’ approach to the NPV. The question provides you with the
number of batches to be sold each month so make sure you assimilate the information
correctly to include the correct figures for yearly sales and costs.

Structuring problems and solutions

One of the professional skills assessed in the ACA exams considers your ability to use
structured information to make evidence-based solutions.
Using a standard NPV proforma can help to produce quick and efficient analysis. When
preparing an NPV you must only include those cash flows that are relevant to the decision.
When reading the scenario, you therefore need to be able to identify any cash flows that are
not relevant to the investment (eg, research costs, allocated fixed costs). It is important that
you note in your answer the reason for excluding these cash flows so that you can gain credit
for your thought process.

Applying judgement
In the fourth requirement you are asked to explain what is meant by real options and to
discuss one real option applicable to the project. Make sure that you select an appropriate
real option that is relevant to the information given in the scenario (ie, not abandon or delay
options).

Concluding, recommending and communicating

As long as you answer the question set, you will have demonstrated that you can present
analysis and recommendations in accordance with instructions. However, addressing each
requirement with a logical course of action based on your evaluation of the matters raised in
the scenario will also demonstrate that you can make evidence-based recommendations
which can be justified by reference to supporting data and other information. In the final

380 Financial Management ICAEW 2021

 requirement it is important that you make appropriate use of the language of ethics to
communicate effectively the ethical issues arising from the project.

67.1
0 1 2 3
£000s £000s £000s £000s
Sales (W1) 9,576.00 10,849.61 12,292.61
Cost of sales (6,703.20) (7,594.73) (8,604.82)
Contribution 30% 2,872.80 3,254.88 3,687.78

Selling and admin (1,500.00) (1,560.00) (1,622.40)

Fixed production costs (300.00) (300.00) (300.00)
Rent (200.00) (206.00) (212.18)
Sale to management 7,375.56
Taxable cash flows (200.00) 866.80 1,182.70 9,140.95
Tax 34.00 (147.36) (201.06) (1,553.96)
Working capital (W2) (1,900.00) (252.70) (286.31) 2,439.01
Plant and machinery (2,000.00) 250.00
Tax saved on WDA (W3) 61.20 50.18 41.15 144.97
Total cash flows (4,004.80) 516.93 736.48 10,420.96
PV factors at 10%
((1.07 × 1.024) – 1) 1.00 0.91 0.83 0.75
PV (4,004.80) 469.89 608.34 7,826.14
NPV 4,899.56

The project is positive and should be accepted which will improve s/h wealth.
The research and development costs and centrally allocated costs are a sunk costs and should
not be included.

WORKINGS
(1) Sales
T1 3 × 266 × 12 = 9576
T2 9576 × 1.10 × 1.03 = 10849.61
T3 10849.61 × 1.1 × 1.03 = 12292.61
(2) Working capital

Increment
£000s £000s
T0 (1,900.00) (1,900.00)
T1 (2,152.70) (252.70)
T2 (2,439.01) (286.31)
T3 2,439.01

ICAEW 2021 December 2019 exam questions 381

 (3) Capital allowances

Cost/WDV C.A Tax

£000s £000s £000s
t0 2,000.00 360.00 61.20
t1 1,640.00 295.20 50.18
t2 1,344.80 242.06 41.15
t3 1,102.74
t3 Sale (250.00) 852.74 144.97

67.2 Sensitivity to Sales volume

1 2 3
£000s £000s £000s
Contribution 2,872.80 3,254.88 3,687.78
Price 7,375.56
Tax (488.38) (553.33) (1,880.77)
2,384.42 2,701.55 9,182.57
PV factors at 10% 0.909 0.826 0.751
PV 2,167.44 2,231.48 6,896.11

Total PV 11,295.03
Sensitivity 4899.56/11295.0 43%

Not very sensitive to sales volume changes

67.3 7375.56(1 – 0.17) × 0.751 = 4597.41
4899.56 – 4597.41 = 302.15
67.4 NPV analysis only considers the cash flows related directly to the project. However there are
options associated with a particular project which outweigh the conventionally calculated NPV
so a negative NPV project may be acceptable once the value of any options is added.
In Pi’s case without selling to the management team the project has a small positive NPV of
302.15 and is risky. However real options might make it more acceptable.
Even though the Ecopacks project has a small NPV without selling to the management team it
has a Follow-on option in this growing market. Therefore by launching the Ecopacks project PI
will have later opportunities to launch further versions, which could be highly profitable.
Candidates might also mention and discuss Growth options, which will be awarded marks.
67.5 The sales director’s comments are not in line with PIs objectives regarding sustainability.
Companies are to act ethically in relation to the impact they have on the environment and PI
needs to take into account sustainability in its decisions and actions. PI also has a corporate
responsibility to take the needs of their wider stakeholders into account. If Pi does this it may
end up improving shareholder wealth by having a positive effect on its economic
performance.
67.6 There is a clear conflict of interest in Chan setting the price that his management team should
buy the Ecopacks project at from PI. Chan should be acting on behalf of the shareholders of PI
and ensuring that he is maximising their wealth.
If he is involved in setting the price he is not action professionally and not being objective. He
would not be acting with Integrity and there is a self-interest threat.
Chan should take no part in setting the price at which his team could buy the Ecopacks project
from PI.

382 Financial Management ICAEW 2021

 Examiner’s comments
Most of the attempts at the NPV were good however common errors were: Not stating why the
research costs should be ignored ie, that they are sunk costs; not stating the reason why 50% of the
fixed costs should be ignored ie, that they are centrally allocated; inflating cash flows when it is
stated that they remain constant; incorrect timing of cash flows; inflating the net cash flows by the
general level of inflation; not using the Fisher formulae to calculate the nominal cost of capital and
merely adding the general level of inflation to the real cost of capital; discounting money net cash
flows by the real cost of capital. Using one month’s volume and not multiplying by 12.
Some candidates attempted to calculate sensitivity using units (rather than £ contribution), going as
far as taxing them and discounting them. Other, common, errors were: calculating sensitivity using
sales rather than contribution; ignoring tax; inverting the sensitivity calculation; inadequate narrative
and not stating whether the project is or is not sensitive to changes in volume.
Part 3 was generally ok with follow through from part 1. However some candidates wasted time by
recreating the whole NPV minus the sale to management.
Poor definitions of real options across the board with hardly any reference to the answer to part 3.
Too many abandon and delay choices, which were not appropriate given the scenario of the
question.
Part 5 was generally well answered.
In part 6 there was a lack of the language of ethics, also many candidates did not mention the conflict
of interest.

68 Wizard plc

Marking guide Marks

68.1 Dividend growth rate

Growth 20X5 to 20X9 1
Growth 20X7 to 20X9 1
Discussion 2
3
68.2 (a) WACC
Ke using CAPM 1
Kd using IRR 4
Market values 1
WACC 1
Marks Available 7
Maximum 7
(b) Ke using DVM 2
Marks Available 2
Maximum 2
68.3 APV
Change in risk 2
Explanation of APV and application to scenario 3
Marks Available 5
Maximum 4
68.4 Cost of equity
Calculation 2
Discussion of risk and application to the scenario 3
Marks Available 5

ICAEW 2021 December 2019 exam questions 383

 Marking guide Marks

Maximum 5
68.5 Gearing ratio and interest cover
Gearing ratio and interest cover without the project 1
Gearing ratio and interest cover without the project 2
Marks Available 3
Maximum 3
68.6 Reaction of shareholders
Discussion of gearing ratio 2
Discussion of interest cover 2
Reaction of shareholders 3
Marks Available 7
Maximum 6
68.7 Dividend policy
Constant pay-out ratio 1
Growth is important 3
Dividend irrelevancy and practical issues 3
Marks Available 7
Maximum 5
Total 35

Developing your ACA Professional Skills

In this question you are asked to make a presentation at the next board meeting covering a
number of things including the use of APV, the impact of debt finance on certain ratios and
stakeholders and the company’s current dividend policy. The question is split into six detailed
requirements, you need to work through each of these requirements logically, applying the
relevant technical knowledge to each of them. Requirements one, two, four and five involve
some detailed, time-pressured calculations. It is therefore important that you manage your
time effectively and lay out your workings clearly. You are then asked to discuss the likely
reactions of both shareholders and the capital markets of financing the purchase entirely by
debt finance. It is important that your discussion is based on your calculations but also the
industry data provided in the scenario. The remaining requirements cover a number of
different technical areas asking you to advise on the use of APV and the appropriateness of
the company’s dividend policy. The question comes from the first part of the Financial
Management syllabus focusing on the different financing options available to a company and
tests your ability to apply different technical skills to a practical situation.

Assimilating and using information

Requirements two and four ask you to calculate WACC and cost of equity under a number of
different scenarios. In requirement two you need to calculate WACC and Ke ignoring the
proposed acquisition of the new company, you are asked to calculate Ke using both CAPM
and the DVM. You therefore need to carefully select the correct information from the question
to use with each formula. In requirement four, you need to calculate the cost of equity to be
used when appraising the purchase of the new company using an APV approach. Think
carefully about what type of beta factor you should use in the CAPM formula to make sure that
you incorporate the correct risk needed for this type of appraisal.

384 Financial Management ICAEW 2021

 Structuring problems and solutions
In requirement 6 you are asked to discuss the likely reactions of both the shareholders and the
capital market to the purchase of the new company being financed entirely by debt. You are
specifically asked to use your calculation prepared in requirement five (gearing and interest
cover ratios) and also the industry data provided in the scenario. This will demonstrate your
ability to use a range of data types and sources to inform analysis and decision making.

Applying judgement
In the exam you need to be able to identify assumptions or faults in arguments and exercise
ethical judgment. For example, in task 1 the use of a high dividend growth rate (11.7%) should
have been criticised for relating to an unrepresentative time period.

Concluding, recommending and communicating

In each of the requirements you need to apply your technical knowledge to support your
reasoning and conclusions. Addressing each requirement with a logical course of action
based on your evaluation of the matters raised in the scenario will demonstrate that you can
make evidence-based recommendations which can be justified by reference to supporting
data and other information. This applies particularly to the final two requirements.

68.1 Growth 20X5 – 20X9 (141/119)(1/4) – 1 = 4.33%

Growth 20X7 – 20X9 (141/113)(1/2) – 1 = 11.70%
The 11.70% growth of dividends from 20X7 to 20X9 is distorted by the fall in 20X7 and
increase in 20X9 and this period is unlikely to be representative.
It is more appropriate to take a longer term view of past dividend growth and it is advisable to
use the 4.33% growth in dividends from 20X5 to 20X9. Although this figure is also distorted by
the sharp increase in 20X9.
68.2
(a) ke using the CAPM = 2 + 0.79 × 7 = 7.53%
kd

Time Cash flow Factors at PV Factors at PV

5% 10%

£ £ £

0 (93) 1 (93) 1 (93)

1–4 4 3.546 14.18 3.170 12.68

4 100 0.823 82.30 0.683 68.30

3.48 (12.02)

YTM = 5 + ((3.48/(3.48 + 12.02))5) = 6.12%

Kd = 6.12 (1 – 0.17) = 5.08%
Market values:
The number of shares in issue = 1,400m (140/0.10)
Equity 1,400m × £4.79 = £6,706m
The total market value of debt = 1,375 × 0.93 = £1,279 (rounded)
WACC = (7.53 × 6706 + 5.08 × 1279)/(6706 + 1279) = 7.14%
(b) ke using the dividend growth model

ICAEW 2021 December 2019 exam questions 385

 Dividends per share = £141m/1,400 = 10p
ke = ((10 × 1.0433)/479) + 0.433 = 6.51%
68.3 To use the current WACC to appraise the Merlin purchase would be inappropriate since the
gearing in particular (as well as the systematic business risk) is going to materially change, the
new capital values are needed for a new WACC but equity requires the NPV which requires the
WACC and a circular argument ensues. Instead the project should be appraised using
Adjusted Present Value (APV).
In the APV technique the base case cash flows are discounted using an all equity discount rate
to produce the base case present value. The base case present value is then adjusted by the
present value of the financing side effects such as the tax shield on debt interest. For example
in the Merlin project that would be the present value of the tax saved on interest paid on the
new debentures. Issue costs are then deducted.
68.4 The all equity discount rate should reflect the systematic (business) risk of Wizard’s
diversification into the hotel industry. Unlike unsystematic risk, systematic risk can not be
diversified away. It is the risk to which all companies are exposed, although individual
companies carry different amounts of this systematic risk. Examples of systematic risk are:
Interest rate changes; Oil price fluctuations; Changes in Government.
Spell Hotels plc is a pure hotel operating company and its equity beta reflects the systematic
risk of Wizard’s diversification. However the equity beta reflects Spell Hotel’s financial risk and
this must be stripped out by calculating the asset beta. This asset beta can then be used in the
CAPM to calculate an all equity discount rate that can be used in the APV evaluation of the
Merlin project.
De-gearing the Spell Hotels equity beta =
0.92 = ßa (1 + (1050(1 – 0.17))/1950) = 0.64
ke = 2 + 0.64 × 7 = 6.48%
68.5 Gearing without the Merlin project = 1279/6706 = 19.7%
Gearing with the Merlin project = (1279 + 735)/6706 = 30%
Interest cover without the Merlin project = 395/55 = 7.18 times
Interest cover with the Merlin project = 395/(55 + 735 × 0.05) = 4.30 times
68.6 With the project Wizard’s gearing at 19.7% will increase from a little over the industry average
of 18% to 30%, which is the industry maximum.
With the project Wizard’s interest cover of 7.18 times will decrease form a little over the
industry average of 7 times to 4.30 times which is approaching the industry minimum of 4
times.
The financial markets and shareholders may not be encouraged by these changes and they
will need to have information about the profitability of the Merlin purchase. If their reaction is
favourable then these financial ratios may improve after the purchase and moves into
profitability.
68.7 It can be seen from the calculating the dividend payout ratio that Wizard is employing a
dividend policy of keeping the payout ratio constant over the last five years at 50%. This means
that dividends will rise and fall with profits.
Most listed companies attempt to keep dividends at a level where they can give some growth
each year and so it would seem that Wizard’s current dividend policy is inappropriate for a
listed company. However this will depend on the shareholder base and what they prefer.
However Modigliani and Millar in their Dividend Irrelevancy Theory stated that the pattern of
dividends over time is irrelevant in determining shareholder wealth. The further stated that
dividends should only be paid when there are no positive NPV projects to invest in. However
practical issues are that dividends are important signals to the financial markets and also there
is a clientele effect and different shareholders will have different preferences in terms of
income and taxation.

386 Financial Management ICAEW 2021

 Examiner’s comments
In part one it was disappointing to see that a lot of candidates could not calculate compound growth
rates correctly, even with the correct figures in the formulas. Also the incorrect number of years was
often used. Also the commentary on which growth rate to use was poor with many candidates
picking the distorted figure of 11.7%.
Answers to part two were often weak. Common errors were: Incorrect computation of ke when using
the CAPM; no tax deducted from kd; incorrect IRR computations; picking the wrong discount and
annuity factors in the IRR computation; incorrect market values, often confusing the number of zeros
between the market value of debt and equity; fudging figures where an unrealistic result was
obtained ie, In DVM 223% stated as 2.23%; incorrect result for ke when using DVM despite correct
numbers in the formula.
In part three there were poor explanations of why APV should be used with little mention of the fact
that the project would be finance entirely by debt. Quite poor descriptions of the main elements of
the APV technique. Although there were some very good answers.
Answers to part four were often weak common errors were:
Picking the incorrect equity beta; lack of precision in ungearing the equity beta; gearing up the asset
beta and using this to calculate the cost of equity to be used in APV; few comments on systematic
risk; few valid examples of systematic risk.
There were many good answers to part six but poorer candidates reverted to capital structure theory
when it was not asked for.
Part seven was generally well answered.

69 Moon Sport Ltd

Marking guide Marks

69.1 (a) Hedging strategies:

Forward rate 1.5
Forward contract sterling amount .5
MMH – amount to invest 1
Convert at spot 1
Sterling value 1
Option – call option .5
Use option .5
Option premium 1
Option premium with interest 1
Sterling value 1
Marks Available 9
Maximum 9
(b) Advice on hedge:
Sterling receipt at spot rate 1
Discussion 8
Marks Available 9
Maximum 8
69.2 (a) Bitcoin outcome
09.00 Receipt 1
10.00 Sales proceeds .5
11.00 Sales proceeds .5

ICAEW 2021 December 2019 exam questions 387

 Marking guide Marks

Marks Available 2
Maximum 2
(b) Advise on accepting Bitcoins
Volatility 1
Hedging 1
Marks Available 2
Maximum 2
69.3 (a) LIBOR Hedge:
Total cost 1
Marks Available 1
Maximum 1
(b) Sell March futures 1
Number of contracts 1
Futures outcome 2
Interest cost 1
Total cost 1
Marks Available 6
Maximum 6
(c) Explanation
Basis risk 1
Number of contracts 1
Marks Available 2
Maximum 2
Total 30

Developing your ACA Professional Skills

This question is from the second part of the Financial Management syllabus and focuses on
managing financial risk. It covers a number of the more complex technical areas of the
syllabus including hedging currency risk, Bitcoin price risk and interest rate risk. To
demonstrate your professional skills in this question it is key that you are able to apply your
technical knowledge efficiently and work logically through each requirement. Approaching
each of the three tasks separately will help you to focus on the relevant technical knowledge
needed to answer each requirement. For example, task 1 focuses on managing currency risk
using a forward contract, MMH and an OTC option, task 2 asks you to assess the impact of
accepting the payment in Bitcoins rather than sterling and task 3 focuses on managing
interest rate risk using interest rate futures. Breaking the question down into three separate
tasks and focussing on one task at a time will allow you to avoid becoming overwhelmed with
the volume of technical information.

Assimilating and using information

One of the professional skills assessed in the ACA exams considers your ability to evaluate the
relevance of information provided. Questions covering hedging will include an abundance of
information. It is therefore important that you can identify the relevant information needed
from the scenario to allow you to calculate the impact of the hedging strategy stated in the
requirement. This is particularly important for task 1, where lots of information is provided on

388 Financial Management ICAEW 2021

 currency and interest rates. Think carefully about the following when attempting this
requirement:

(1) Adjustments to be made to account for the premium on the forward contract
(2) Selecting and time apportioning the correct interest rates for the MMH
(3) Selecting the correct type of option and making an appropriate exercise or abandon decision
You might find it helpful to highlight the relevant data on your screen when working through
each hedging strategy.

Structuring problems and solutions

In the exam you are expected to be able to use structured information to identify evidence-
based solutions. A structured approach is especially important in tasks 1 and 3 to ensure that
the calculations are performed efficiently.

Applying judgement
In the exam you are expected to be able to use critical thinking. This is particularly important
in task 1 as you are asked to explain the advantages and disadvantages of each hedging
technique and advise the board as to which technique is most beneficial. It is important that
you avoid simply stating the advantages and disadvantages, to display this skill effectively you
must explain the relative advantages and disadvantages of each technique to Moon Sport
Ltd. You need to analyse both the financial and non-financial data provided in the scenario
when giving your advice. The calculations in the first requirement are obviously important,
however you should also consider other features of each of the three hedging strategies and
how they apply to the foreign currency payment due in four months’ time. It is important that
you provide a valid recommendation based on your calculations and discussion.

Concluding, recommending and communicating

In each of the requirements you need to apply your technical knowledge to support your
reasoning and conclusions. Addressing each requirement with a logical course of action
based on your evaluation of the matters raised in the scenario will demonstrate that you can
make evidence-based recommendations which can be justified by reference to supporting
data and other information. This is particularly important in tasks 1 and 2 as you are asked to
advise the board on an appropriate strategy for hedging its currency risk and whether it
should accept the payment for the building in either sterling or Bitcoins. When making your
recommendation, ensure that you explain why you have chosen that particular strategy.

69.1
(a) The forward rate is: $/£ 1.3097 (1.3156 – 0.0059)
This is result in a sterling payment of: $1,550,000/$1.3097 = £1,183,477
Using the money markets, Moon will invest in $, buy $ at the spot rate and borrow in £.
Invest $1,550,000/(1 + 0.027 × 4/12) = $1,536,174
Buy $ spot $1,536,174/$1.3156 = £1,167,660
Borrow in £ to give total cost £1,167,660 × (1 + 0.041 × 4/12) = £1,183,618
Over the counter option. Using a call option to buy $:
Exercise price $1.3200. If spot is $1.3080 exercise the option.
The option premium is $1,550,000 × £0.03 = £46,500.
The premium with interest is £46,500 × (1 + 0.041 × 4/12) = £47,136
The sterling payment will be ($1,550,000/$1.3200) + £47,136 = £1,221,378
(b) The forward contract = £1,183,477
The money market hedge = £1,183,618

ICAEW 2021 December 2019 exam questions 389

 The OTC option = £1,221,378
No hedge = $1,185,015 (1,550,000/1.3080)
The forward contract and money market hedge lock Moon into an exchange rate. The
option however protect Moon against the downside risk of the £ weakening more than
expected against the $ and allow for the upside potential of the $ weakening against the
£, however the option premium is expensive.
In addition to the above some specific advantages and disadvantages include:
Forwards:
Tailored specifically for Moon
However there is no secondary market.
Money market hedge:
The money market hedge is more difficult to arrange than a forward contract and might
use up Moon’s credit lines.
OTC currency options:
There is no secondary market
It is unlikely that the $ is going to weaken against the £ and, even if it did, it is unlikely to
weaken enough to cover the cost of the option premium, therefore it is not recommended
that the company use OTC foreign currency options. The forward contact and money
market hedge are both better than the spot rate, however the forward is the cheapest. It is
recommended that Moon use a forward contract to hedge the forex. Attitude to risk can
also be mentioned.
69.2
(a) 09.00 The receipt in Bitcoin will be = B182.93
10.00 Sale proceeds = £501,283 (182.93 × 2,740.30). A gain of £1,283.
11.00 Sale proceeds = £493,625.63 (182.93 × 2,698.44). A loss of £6,374
(b) It can be seen from the calculations in (a) above that in a matter of only two hours the
volatility of the price of Bitcoins is high moving from either a gain of £1,283 to a loss of
£6,374.
Unless Moon can hedge the risk of the Bitcoin price moving against it, it is not
recommended that the company accepts payment in Bitcoins. Attitude to risk can also be
mentioned.
69.3
(a) If LIBOR remains at 0.9% Moon will pay 4.9% interest, which is a total cost of:
£91,140 (1,240,000 × 0.049 × 18/12)
(b) Using interest rate futures to hedge Moon will SELL March futures at 98.80.
The number of contracts = 14.88 (1,240,000/500,000 × 18/3) Round to 15 contracts.

LIBOR 1.5% 0.75%

LIBOR + 4% 5.5% 4.75%

Futures sold at 98.80 98.80

Futures bought at 98.30 99.00

Gain (Loss) 00.50 (00.20)

Futures total position Gain £1,875,000 × 0.5% = Loss £1,875,000 × 0.2% =

15 × £500,000 × 3/12 = £9,375 £3,750
£1,875,000

Interest cost £1,240,000 × 5.5% × 18/12 £1,240,000 × 4.75% ×

= £102,300 18/12 = £88,350

390 Financial Management ICAEW 2021

 Total cost £92,925 (102.300 – 9,375) £92,100 (88,350 + 3,750)

(c) The interest cost of the loan if LIBOR remains constant is £91,140. In both cases where
LIBOR increase or decreases the interest cost is more at £92,925 and £92,100 respectively.
The reason why the hedge is not perfect is twofold namely:
• The number of contracts – Because the contracts are a standard size it is not possible to
hedge a perfect amount and the number of contracts will have to be rounded.
• Basis risk – The price of futures will normally be different from the spot price on any
given date. This difference is called the basis. The effect of basis is to prevent hedges
from being 100% efficient.

Examiner’s comments
Responses to part one (a) of the question were mainly good but common errors were: for the
forward contract using the incorrect exchange rate and adding instead of deducting the forward
premium; for the money market hedge choosing the incorrect interest rates, incorrect
apportionment of the annual interest and using the incorrect spot rate; for the OTC option choosing
the put rather than the call, picking the call and using the put premium; not taking account of the
interest on the option premium, treating the OTC option as a traded option and incorrect exercise or
abandon decisions.
Some good responses to part one (b) but some of the errors that poorer candidates made include:
just stating advantages and disadvantages; not showing the result of not hedging; not considering
the direction of currencies shown by the forward premium; no recommendation.
Part two was mostly fine but some candidates used £ × £ (price × rate), which was clearly incorrect.
In part three (a) it was disappointing to see that some candidates could not calculate 18 month’s
interest on a loan.
Part three (b) was generally ok but common errors included: Incorrect number of contracts, often 2 or
3 instead of 15; buying initially instead of selling; can not calculate 0.5% and 0.2% of the futures gain
or loss; can not calculate the interest cost ie, taking the full 18 months into account.
Part three (c) was generally ok.

ICAEW 2021 December 2019 exam questions 391

392 Financial Management ICAEW 2021
 March 2020 exam questions
70 Engavon plc

Marking guide Marks

70.1 Hedging strategies

Forward rate 1
Forward contract sterling amount 1
MMH – amount to borrow 1
Convert at spot 1
Sterling value 1
Option – June call option 1
Number of contracts 1
Option premium 2
Abandon/Exercise 1
Total profit from the option 1
Sterling value 3
14
70.2 Advice on hedge
Sterling receipt at current spot rate 1
Sterling receipt at spot rate on 30/6/20YO 2
Summary & discussion 6
Marks Available 9
Maximum 7
70.3 Forward rate
Calculation of forward rate 3
Discussion of theory 2
Marks Available 5
Maximum 5
70.4 Economic risk
Definition of economic risk 1
Discussion of imports and exports 1.5
Currency movements 1.5
Marks Available 4
Maximum 4
Total 30

70.1 Forward contract

A$
Spot rate 1.8585
plus: Forward contract discount 0.0117
1.8702
£

ICAEW 2021 March 2020 exam questions 393

 Translation of A$ –
A$2.9m/1.8702 1,550,636
plus: Arrangement fee A$2.9m/
× £10/1,000 (29,000)

£1,521,636

Money Market Hedge

A$2.9m A$2.9m
A$2,852,92
1 + (6.6%/4) 1.0165
Borrow A$ now 7
A$2,852,927/1.8
Convert at spot rate 585 £1,535,070

Sterling invested at 3% pa (£1,535,070) × [1 + (3%/4)] £1,546,583

Traded Option
Engavon will buy £ so it is a June call option

A$2.9m 1,557,465
No of contracts 1.8620 10,000 156 contracts
156 × $.0274 ×
Cost of option 10,000 $42,744
$42,744
1.8495 £23,111

Spot rate at 30/6/20 1.8345 1.8810

Bought for (1.8620) (1.8620)
(Loss)/Profit (0.0275) 0.0190
Abandon Exercise
156
×
10,000
×
Contracts 0.0190
Total profit A$29,640
A$ A$
2,900,000 2,900,000
Sum due from customer 0 29,640
plus: Profit 2,900,000 2,929,640
£ £
At relevant spot rate 1,580,812 1,557,491
less: Cost of option (23,111) (23,111)
Sterling receivable 1,557,701 1,534,380

70.2

Spot rate at
Current spot 1/4/20 A$2.9m £1,560,39

394 Financial Management ICAEW 2021

 1.8585 8

Spot rate at A$2.9m A$2.9m

30/6/20 1.8345 1.8810
£1,541,7
£1,580,812 33

SUMMARY STERLING COSTS £

3-month spot (weak £) 1,580,812
Current spot 1,560,398
Traded option (weak £) 1,557,701
MMH 1,546,583
3-month spot (strong £) 1,541,733
Traded option (strong £) 1,534,380
Forward contract 1,521,636

A weakening £ would favour Engavon – an exporter. The best outcome is the 3-month spot
rate, ie, do nothing (the other 3-month spot rate gives a sterling receipt that is 2.5% lower). The
traded option (weak £) gives the best hedged outcome.
The forward contract (A$ discount) suggests that sterling will strengthen.
MMH and FC give fixed amounts - what is the management’s attitude to risk? Staff time and
costs will be incurred if Engavon hedges.
Other general points on the three hedging methods.
70.3

Av A$ rate (3mos)
= Av discount given in
Av sterling rate (3mos)
Av spot rate x Av f’wd rate qn.

1.01475
1.00875
=
1.8540 x 1.8650 0.01095 OK

Theory: Interest rate parity (IRP) links currency & money markets.
Money market interest rates explain difference between forward and spot rates
No gain can be made on interest rates of different currencies
70.4 Economic risk: Engavon’s value = PV future of future cash flows. These may be adversely
impacted by forex movements.
Asia Pacific exports eg, in A$
EU imports and exports – either net receipt or payment in €
So, currencies (A$ & €) could both move adversely against sterling – A$ weakens and, (if a net
payment in euros). € strengthens.

Examiner’s comments
This question had the lowest percentage mark on the paper. However, the majority of candidates
scored a “pass” mark (55%) in this question.
This was a four-part question which tested the candidates’ understanding of the risk management
element of the syllabus.
In Part one most candidates scored well on the forward contract (FC) and MMH calculations. Errors
made by weaker candidates included the wrong rate for the FC, subtracting, not adding, the FC

ICAEW 2021 March 2020 exam questions 395

 discount, adding, not subtracting, the FC fee. A small number of candidates worked out two answers
for the FC (from the two spot rates) and will have scored zero. With the MMH the most common error
was to use the wrong (i) number of months or (ii) interest rates. For the sterling traded currency
options, it was very pleasing to see a fair number of good scripts. Overall, however, as expected, this
section proved to be a key discriminator. Many candidates failed to provide sufficient workings and
so will have lost marks. Also it was quite common to see candidates using only two decimal places,
rather than four, in their calculations. This, again, will have cost them marks. Quite a few candidates
chose put, rather than call, options and then, subsequently, made the wrong abandon/accept
decision. Typical smaller errors noted were: (i) the use of the current spot price rather than exercise
price when calculating the number of contracts, (ii) the calculation of A$ premium using A$2.9m
rather than the number of contracts just calculated, (iii) not recognising that the premium was in A$
and then not converting or converting at wrong rate. Many candidates lost marks because they
exercised the option, but then then treated it as an OTC, rather than a traded, option.
Overall part two was done well and many candidates were able to link theory to the scenario and
provide useful advice.
In part three too few candidates were able to explain IRP adequately. Weaker scripts used annual
rather than quarterly rates and didn’t use averages, where necessary. Marks were lost if a candidate
failed to explain whether IRP held up in the scenario.
Part four, overall, was poor. Too few candidates were able to explain what economic risk is,
concentrating, wrongly, on political, physical and/or transaction factors. A lot of candidates wasted
time on how to protect against economic risk, which wasn’t the question.

71 AOS Energy plc

Marking guide Marks

71.1 (a) WACC

WACC using DVM
Cost of equity using DVM 4
Cost of preference shares 1
Cost of irredeemable debt 2
Cost of redeemable debt 5
Market values 2
WACC 2
Marks Available 16
Maximum 16
(b) WACC using CAPM
Cost of equity using CAPM 1
WACC 1
Marks Available 2
Maximum 2
71.2 DVM compared to CAPM
Explanation of DVM to calculate Ke 2
Explanation of CAPM to calculate Ke 3
Marks Available 5
Maximum 5
71.3 Use of WACC
Discussion of calculations 1
Assumptions of using WACC 3

396 Financial Management ICAEW 2021

 Marking guide Marks

Conclusion 1
Marks Available 5
Maximum 4
71.4 APV
Explanation of APV 3
Applicable to purchase decision 2
Marks Available 5
Maximum 4
71.5 Portoflio effect
Spread risk 1
Investors normally fully diversified 1
Application to unlisted company 2
Marks Available 4
Maximum 4
Total 35

71.1
(a) Cost of equity (ke)
Latest dividend (d0) £5.125m/20.5m = £0.25

£5.125m
£4.428m
Dividend growth rate = = 1.1574 over 5 years so 1.15741/5–1 = 3% pa
Ex div market value per share = (£4.20 – £0.25) £3.95

(d1) (£0.25 × 1.03)

MV
+g (£3.95)
+ 3%
Cost of equity (ke) 9.51%

d £0.06
Cost of preference
MV £1.33
shares (kp) 4.51%
Cost of
(i−t) (£4 × 83%)
irredeemable debt
MV £102
(kdi) 3.25%

Cost of redeemable debt (kdr)

Year Cash Flow 5% factor PV 1% factor PV

0 (98) 1.000 (98.000) 1.000 (98.000)
1–3 3 2.723 8.169 2.941 8.823
3 100 0.864 86.400 0.971 97.100
NPV (3.431) NPV 7.923

IRR = 5% – (4% × (3.431/(3.431 + 7.923))) = 3.79%

less: Tax at 17% (3.79% × 83%) = 3.15%
WACC

ICAEW 2021 March 2020 exam questions 397

 Total MV’s

£m £m Cost × weighting WACC

9.51% ×
Equity (20.5m × £3.95) 80.975 80.975/98.560 7.81%
Pref. Shares (4.3m × 4.51% ×
£1.33) 5.719 5.719/98.560 0.26%
Irredeemable debt 3.25% ×
(£5.1m × 1.02) 5.202 5.202/98.560 0.17%
Redeemable debt 3.15% ×
(£6.8m × 0.98) 6.664 6.664/98.560 0.21%
17.585 0.64%
Total market value 98.56 8.45%

(b)

Cost of equity (ke) using the CAPM

Expected market return 8.70%
less: Expected risk-free return (2.60%)
Expected risk premium 6.10%
Applying EP’s beta to the risk premium 1.30 × 6.1% 7.93%
plus: Expected risk-free return 2.60%
Cost of equity (ke) 10.53%

WACC

Total MV’s

£m £m Cost × weighting WACC

10.53% ×
Equity (20.5m × £3.95) 80.975 80.975/98.560 8.65%
Pref. Shares (4.3m × 4.51% ×
£1.33) 5.719 5.719/98.560 0.26%
Irredeemable debt 3.25% ×
(£5.1m × 1.02) 5.202 5.202/98.560 0.17%
Redeemable debt 3.15% ×
(£6.8m × 0.98) 6.664 6.664/98.560 0.21%

17.585 0.64%
98.56 9.29%

71.2 DVM – shareholders benefit from owning a share by (i) receiving dividends into the future and
(ii) a capital gain on the value of the shares. The PV of these benefits creates the current price
of the shares. This share price is determined by expected future dividends discounted at the
investor’s required rate of return (ke)
CAPM – specific/unsystematic risk can be diversified away by investors, so it’s assumed that
investors are rational and that they have a diversified portfolio. Systematic risk can’t be
diversified away – macro-economic factors. A company’s beta is calculated from the
performance of its share price against the market average and is taken as a measure of the
market’s view of the risk attached to the security in question. The higher the perceived risk,
then the higher the beta figure and thus the higher the equity return required by investors.

398 Financial Management ICAEW 2021

71.3 WACC (DVM) = 8.5%, CAPM = 9.3%. Bank loan = 10.5%, which exceeds both of these so both
WACCs likely to rise.
Three assumptions re maintaining WACC:
(1) Historic debt/equity unchanged – NO. Extra gearing via loan (30% of current Total Mkt
Value (£98.56m). The 10.5% bank loan is expensive – is AOS’ gearing deemed too high?
(2) Systematic business risk unchanged – possibly, although different technology. Is sea
technology riskier? The two companies might have different cost structures and break-
even points. Pentmarine might have higher business risks and higher beta.
(3) Finance not project-specific – OK
It would be unwise to use 8.5% or 9.3% as the discount rate. AOS should be discounting using
a risk-adjusted WACC that includes the cost of the new debt.
71.4 Adjusted Present Value (APV)
AOS’ increased gearing (£30 million in extra borrowings) is likely to alter the company’s WACC.
To find AOS’ new WACC requires the new MV of its shares. However this requires the NPV of
the proposed investment in Pentmarine to be known, which needs the new WACC. To avoid
this circular argument one could use the APV technique to appraise the Pentmarine purchase.
This technique:
(1) Calculates a base case value at ungeared cost of equity
(2) Calculates the PV of the tax shield arising from the extra debt
(3) Adjusts for issue costs
Add 1, 2 and 3 to give APV – if positive then proceed with investment.
71.5 A portfolio of investments helps to spread risk.
Investors can usually spread risk themselves – they don’t need managers to do it for them.
However Pentmarine is not listed and shareholders might not be able to buy shares in sea-
based energy. Increasing the renewable industry investments might be OK for investors,
subject to changes in business risks. Do AOS managers know how to run a wave power
business?
There may be synergies which shareholders can’t achieve for themselves, but the companies
can.

Examiner’s comments
This question had the highest percentage mark on the paper. A considerable majority of candidates
scored a “pass” mark (55%) in this question.
This was a six-part question that tested the candidates’ understanding of the investment decisions
element of the syllabus.
In part one (a) many candidates scored full marks. Errors were most common with the calculation of
(i) the dividend growth rate, (ii) the IRR for the cost of redeemable debt, (iii) using the par value of
shares/debt rather than market value.
In part one (b) most CAPM calculations scored full marks.
Part two was done poorly. Too few candidates were able to explain how the two models calculate the
cost of equity.
There were some very good, well-argued answers to part three. Weaker scripts, typically, only looked
at one aspect of the Pentmarine purchase, ie, systematic risk, and ignored the vast change in gearing.
Most candidates scored well in part four. Others were vague about the “base case” and having to use
keu, some subtracted the tax shield and many ignored issue costs.
Part five was reasonably answered. Weaker scripts, typically, only dealt with the reduction in
unsystematic risk.

ICAEW 2021 March 2020 exam questions 399

72 Greene & Banks plc

Marking guide Marks

72.1 (a) NPV

Close on 20Y1
P&M sale .5
P&M tax 1
Factory sale .5
Factory tax .5
Bristol sales .5
Bristol variable costs 1.5
Fixed costs 1.5
Redundancy costs .5
Tax on profits 1
Discount factors .5
NPV .5
Close on 20Y3
P&M sale .5
P&M tax 1.5
Factory sale .5
Factory tax .5
Shop sales .5
Variable costs 1.5
Fixed costs 1.5
Redundancy costs .5
Tax on profits 1
NPV .5
Marks Available 17
Maximum 17
(b) Advise on closure date 1
Marks Available 1
Maximum 1
72.2 Advise on closure date
NPV difference 1
Tax 1
Discount 1
Current factory sales price 1
Sales price required 20Y3 1
Marks Available 5
Maximum 5
72.3 Real options
Explanation of real options 2
Application to decision 2
Marks Available 4
Maximum 4

400 Financial Management ICAEW 2021

72.4 Sensitivity analysis & Simulation
Sensitivity analysis: strengths & weaknesses 3
Simulation: strengths & weaknesses 3
Marks Available 6
Maximum 5
72.5 Ethical issues
Confidentiality 3
Integrity 1
Professional behaviour 1
Marks Available 5
Maximum 3
Total 35

72.1
(a)

20Y0 20Y1 20Y2 20Y3

CLOSE 20Y1 Y0 Y1 Y2 Y3
£ £ £ £
P&M sale 900,000
P&M tax (W2) (27,200)
Factory sale 7,700,000
Tax on sale
(17% × £7.7m) (1,309,000)
Bristol sales 1,280,000 1,360,000
Bristol variable
costs (W1) (599,270) (649.459)
Fixed costs (W1) (332,928) (339,587)
Redundancy (2,000,000)
Tax on profits
(W4) 340,000 (59,126) (63,062)

Total Cash
Flows 0.000 5,630,800 288,676 307,892
8% discount
factor 1.000 0.926 0.857 0.794

PV 0.000 5,189,119 247,395 244,466

NPV 5,680,980

20Y0 20Y1 20Y2 20Y3

CLOSE 20Y3 Y0 Y1 Y2 Y3
£ £ £ £
P&M sale 780,000
P&M tax (W3) 22,644 18,568 (48,012)
Factory sale 8,200,000

ICAEW 2021 March 2020 exam questions 401

 20Y0 20Y1 20Y2 20Y3
CLOSE 20Y3 Y0 Y1 Y2 Y3
£ £ £ £
Tax on sale
(17% × £8.2m) (1,394,000)
Shop sales 1,220,000 1,250,000
Variable costs
(W1) (698,108) (729,581)
Fixed Costs
(W1) (208,080) (212,242)
Redundancy (2,150,000)
Tax on profits
(W5) (53,348) 313,110

Total Cash
Flows 0.000 22,644 279,032 6,009,276
8% discount
factor 1.000 0.926 0.857 0.794

PV 0.000 20,968 239,130 4,771,365

NPV 5,031,463

The NPV is higher with a closure date of 31/3/Y1 and so this should be chosen. This will
lead to a greater increase in shareholders’ wealth.

WORKINGS
(1) Variable and fixed costs

20Y2 20Y3
£’000 £’000
CLOSE 20Y1
Sales (£’000) 1,280 1,360
VCs 45% 45%
VCs (£’000) (576.000) (612.000)
VCs Inflated (£’000) (599.270) (649.459)
FCs (£’000) (320.000) (320.000)
FCs Inflated (£’000) (332.928) (339.587)
CLOSE 20Y3 1,220 1,250
Sales (£’000) 55% 55%
VCs (671.000) (687.500)
VCs (£’000) (698.108) (729.581)
VCs Inflated (£’000) (200.000) (200.000)
FCs (£’000) (208.080) (212.242)

402 Financial Management ICAEW 2021

 (2) P&M tax close 20Y1

20Y1 20Y2 20Y3

£’000 £’000 £’000
WDV b/f 740.000
Sale proceeds 900.000
Balancing
charge (BC) (160.000)

Tax on BC 27.200

(3) P&M tax close 20Y3

£’000 £’000 £’000

WDV b/f 740.000 606.800 497.576
WDA (18%) (133.200) (109.224) 282.424
WDV/sale 606.800 497.576 780.000
Tax on WDA 272.644 18.568 (48.012)

(4) Tax on profits close 20Y1

£’000 £’000 £’000

Bristol sales 1,280,000 1,360,000
Bristol variable
costs (W1) (599.270) (649.459)
Fixed Costs
(W1) (332.928) (339.587)
Redundancy (2,000,000)
Taxable profit –
Close 20Y1 (2,000,000) 347,802 370,954

Tax due on
profit (@17%) 340.000 (59.126) (63.062)

(5) Tax on profits close 20Y3

£’000 £’000 £’000

Shop sales 1,220.000 1,250.000
VCs (W1) (698.108) (729.581)
Fixed Costs
(W1) (208.080) (212.242)
Redundancy (2,150.000)
Taxable profit –
Close 20Y3 0 313.812 (1,841.823)

Tax due on
profit (@17%) 0 (53.348) 313.110

(b) The NPV is higher with a closure date of 31/3/Y1 and so this should be chosen. This will
lead to a greater increase in shareholders’ wealth.
72.2

ICAEW 2021 March 2020 exam questions 403

 NPV 20Y1 5,680,980
NPV 20Y3 (5,031,463)
NPV difference 649,517
Tax adjustment (@17% rate) £649,517/83% 782,551
Discount adjustment to year
3 £782,551/0.794 985,580

Extra cash flow to “break-

even” 985,580
Current factory sale price
20Y3 8,200,000

Factory sale price required

20Y3 9,185,580

72.3 NPV analysis only considers cash flows related directly to a project. However, a project with a
negative NPV could be accepted for strategic reasons. This is because of (real) options
associated with a project that outweigh the negative NPV. In other words, there is extra value in
a project that needs to be considered and evaluated.
Greene’s board could decide to abandon its plans to rationalise. For example, Brexit might
affect dairy prices and it could then be worth keeping the regional factories open. Greene has
a put option to sell the regional factories at a price known today. If Brexit pushes prices up
then the company could abandon its plans. If prices go down it can sell after one year or three.
The sale of the factory may cause a problem – is there a signed contract with Sharpe?
If candidates mention a delay option (eg, option to close in two years rather than one), they
should note that beyond 20Y3 would cause a problem with Sharpe.
72.4 Sensitivity analysis
It facilitates subjective judgment (by management for example)
It identifies areas critical to the success of a project, eg, sales volume, materials price
It is relatively straightforward
But
It assumes that changes to variables can be made independently
It ignores probability
It does not point to a correct decision
Simulation
More than one variable at a time can be changed
It takes probabilities into account
But
It is not a technique for making a decision
It can be time consuming and expensive
Certain assumptions that need to be made could be unreliable
72.5 You are employed by Greene and are party to confidential information which, if made public,
could influence the market price of Greene’s shares.
An ICAEW Chartered Accountant should assume that all unpublished information about a
prospective, current or previous client’s or employer’s affairs, however gained, is confidential.
That information should then:
• Be kept confidential
• Not disclosed, even inadvertently such as in a social environment
• Not be used to gain personal advantage
In addition an ICAEW Chartered Accountant should:

404 Financial Management ICAEW 2021

 • act with integrity – ie, avoid self-interest; and
• be aware of his/her professional behaviour – comply with laws, don’t damage the
reputation of the profession.

Examiner’s comments
This question had the second highest percentage mark on the paper. A good majority of candidates
scored a “pass” mark (55%) in this question.
Candidates, as expected, found part one very testing and it was good discriminator. There were
some really good answers. Quite a few candidates scored 100%, which was very impressive.
Common errors made were: (i) incorporating both closure dates into one NPV, (ii) only doing one
year of cash flows for the 20Y1 closure, (iii) inflating fixed costs, but not variable costs, (iv) ignoring
redundancy costs, (v) not taxing sales income and/or redundancy costs, (vi) inflating “money” cash
flows and/or the discount rate, (vii) adding £500,000 to the £8.2 million factory price.
Part two was another good discriminator. Many candidates scored full marks here, but the weakest
scripts failed to answer this section at all.
Responses to part three were, overall, disappointing. This topic has been examined regularly
recently, but there were too many poor definitions of real options. Also many candidates chose an
inappropriate option by not focussing on the board’s plans, ie, closure.
Part four was done well and a majority of candidates scored full marks.
Part five was done well and a majority of candidates scored full marks.

ICAEW 2021 March 2020 exam questions 405

406 Financial Management ICAEW 2021
Appendices
408 Financial Management ICAEW 2021
Formulae
Formulae you may require:
Discounting an annuity
The annuity factor:

[1− ]
1 1
AF1 -n = r (1 + r)n

Where AF = annuity factor

n = number of payments
r = discount rate as a decimal

Dividend growth model:

Do(1 + g)
ke = Po
+g

Where ke = cost of equity

D0 = current dividend per ordinary share
g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share

Capital asset pricing model: rj = rf + ßj (rm – rf)

Where rj = the expected return from security j
rf = the risk free rate
ßj = the beta of security j
rm = the expected return on the market portfolio

D(1−T)

β =β
(1 + E )
Where βe
e a

= beta of equity in a geared firm

βa = ungeared (asset) beta
D = market value of debt
E = market value of equity
T = corporation tax rate
Note: Candidates may use other versions of these formulae but should then define the symbols they
use.

ICAEW 2021 Appendix 409

410 Financial Management ICAEW 2021
Discount tables
Interest rate p.a. Number of years Present value of £1 Present value of £1
receivable at the end receivable at the end of
of n years each of n years

r n
[1− ]
1 1
r (1 + r)n

1% 1 0.990 0.990

2 0.980 1.970

3 0.971 2.941

4 0.961 3.902

5 0.951 4.853

6 0.942 5.795

7 0.933 6.728

8 0.923 7.652

9 0.914 8.566

10 0.905 9.471

5% 1 0.952 0.952

2 0.907 1.859

3 0.864 2.723

4 0.823 3.546

5 0.784 4.329

6 0.746 5.076

7 0.711 5.786

8 0.677 6.463

9 0.645 7.108

10 0.614 7.722

10% 1 0.909 0.909

2 0.826 1.736

3 0.751 2.487

4 0.683 3.170

5 0.621 3.791

6 0.564 4.355

7 0.513 4.868

8 0.467 5.335

9 0.424 5.759

ICAEW 2021 Appendix 411

 Interest rate p.a. Number of years Present value of £1 Present value of £1
receivable at the end receivable at the end of
of n years each of n years

r n
[1− ]
1 1
r (1 + r)n

10 0.386 6.145

15% 1 0.870 0.870

2 0.756 1.626

3 0.658 2.283

4 0.572 2.855

5 0.497 3.352

6 0.432 3.784

7 0.376 4.160

8 0.327 4.487

9 0.284 4.772

10 0.247 5.019

20% 1 0.833 0.833

2 0.694 1.528

3 0.579 2.106

4 0.482 2.589

5 0.402 2.991

6 0.335 3.326

7 0.279 3.605

8 0.233 3.837

9 0.194 4.031

10 0.162 4.192

412 Financial Management ICAEW 2021