BUSINESS FINANCE DECISIONS

Suggested Answer & Marking Key

Certified Finance and Accounting Professional Examination – Winter 2023

A.1 (a) Pay back: Cumulative

Cashflows
cashflows
---------- £ in '000 ----------
Initial investment (1,500)
Year 1 132 (1,368)
Year 2 (W-1) 374 (994)
Year 3 634 (360)
Year 4 672 312
Payback period is 3 years and 6 months (360/672)
W-1: After tax operating cash profit Year 1 Year 2 Year 3 Year 4 Year 5
------------------- £ in '000 -------------------
Expected gross profit (W-1.1) 676 1,055 1,462 1,521 1,582
Variable operating costs (100) (156) (216) (225) (234)
Fixed lease costs (400) (400) (400) (400) (400)
176 499 846 896 948
Tax 25% (44) (125) (212) (224) (237)
After tax operating cash profit /
Cashflows 132 374 634 672 711

W-1.1: Expected gross profit Year 1 Year 2 Year 3 Year 4 Year 5

Average revenue per cover (£) 50 50 50 50 50
Expected gross profit per cover (50%)
(£) A 25 25 25 25 25
Number of covers per week B 500 750 1,000 1,000 1,000
Number of weeks per year C 52 52 52 52 52
Inflation D 1.04 1.042 1.043 1.044 1.045
Expected gross profit (£ in '000)
(A×B×C×D) 676 1,055 1,462 1,521 1,582
Accounting rate of return:
ARR = Average accounting profit ÷ Average investment
225,000 (1,123,000(W-2)÷5)
=
800,000[(1,500,000+100,000)÷2]
ARR = 28%

W-2: Annual profit Year 1 Year 2 Year 3 Year 4 Year 5 Total

-------------------------- £ in '000 --------------------------
After tax operating cash
profit 132 374 634 672 711 2,523
Depreciation
(£1,500,000 – £100,000)÷5 (280) (280) (280) (280) (280) (1,400)
Annual profit (148) 94 354 392 431 1,123

NPV: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

--------------------------- £ in '000 ---------------------------
After tax operating cash
profit 132 374 634 672 711
Investment (1,500)
Scrap 100
(1,500) 132 374 634 672 811
DF 10% 1 0.9091 0.8264 0.7513 0.6830 0.6209
PV (1,500) 120 309 476 459 504
NPV = £368,000
Page 1 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

Sensitivity in respect of sales volume:

Year 1 Year 2 Year 3 Year 4 Year 5
--------------------------- £ in '000 ---------------------------
Gross profit 676 1,055 1,462 1,521 1,582
Variable operating costs (100) (156) (216) (225) (234)
Operating contribution 576 899 1,246 1,296 1,348
Tax 25% (144) (225) (312) (324) (337)
After tax contribution 432 674 934 972 1,011
DF 10% 0.9091 0.8264 0.7513 0.6830 0.6209
PV 393 557 702 664 628

PV of contribution margin = £2,944,000

Sensitivity = 368 ÷ 2,944 = 12.5%

Project sensitivity
Sales volume would need to fall by only 12.5% and the project would not yield a positive net
present value.

The company operates many restaurants and so the sales volume estimates, which are drawn
from global historic data, are likely to be realistic. However, the average will be adversely
affected by outlier data.

It would be useful to know the standard deviation or range of covers across all the restaurants.
This would enable a better understanding of whether existing individual restaurants do have
average covers that are 12.5% below the global average.

Sensitivity of 12.5% is unlikely to be sufficient to prevent the project appraisal process from
progressing to phase two.

Summary
The opportunity has satisfied all aspects of the first phase of analysis:

Investment in London
Key metric Target
restaurant
Payback 3 years 6 months 4 years
ARR 28% 20%
NPV £368,000 >£0

This demonstrates financial viability.

(b) Non-financial considerations

In addition to the financial viability the board will need to evaluate the opportunity in respect
of non-financial considerations:

Business strategy
Firstly, the board should agree that the opportunity is in line with the overall business strategy.

This opportunity is an example of market development, that is taking the existing product to
a new geographical market. This is consistent with the historic position of the company and
so is likely to be in line with the business strategy.

Political
Operating in a different country introduces risk as the government in that country may take
actions that reduce the profits, or the ability to access the profits. An example might be a
restriction on dividend payments.

Page 2 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

The board should consider the operating environment and the government’s receptiveness to
foreign direct investment (FDI). It may be that there are incentives for overseas investors.

In addition, an assessment of the stability of the government in England.

The legal framework will differ from that in Pakistan. Lack of knowledge here would expose
Bacalt to fines and negative publicity. Bacalt must ensure that they are familiar with local laws,
in particular in relation to food safety and hygiene.

Economic
It would be useful to understand the current economic climate in England (and the UK).
Increasing and/or high levels of inflation in the UK will potentially lead to the GBP devaluing
against the PKR, or vice versa if Pakistan rates are higher.

The current economic climate will also determine the likely success of the restaurant venture;
cost of living pressures are likely to make more expensive dining (at £50 per cover) less
desirable, so the cashflow projections may need to be revised. A poor economic outlook would
suggest that there is a credible risk of generating a negative NPV.

Social
This is the first restaurant to be opened in London. It would be useful to conduct research to
test the market and to see whether the food served by Bacalt will be popular with the British
consumers.

It would also be prudent to look at the competitive landscape to see whether this market is
already catered for.

Real options
When evaluating an opportunity, a company should consider the value of the real options that
the investment will bring.

There are three types of real options:

Further investment
This is the first investment in England. As such, there are many local factors that will not be
familiar to Bacalt. Mistakes will, inevitably, be made. However, after the initial investment,
the company will have a greater understanding of the local market. This local knowledge can
be used as the basis for further expansion in England, thus bringing additional opportunities
for investment.

This additional value is not typically included in the financial analysis but should be included
in the decision-making process.

Abandon the investment

The company typically commits to five-year leases when establishing a new restaurant. This
presents less risk than acquiring freehold buildings, however, the business is still committed
for five years.

It might be more suitable to introduce flexibility into the leases, because a lease providing the
opportunity to break the agreement after two years would make it easier to withdraw if the
plans did not turn out as expected. Such a lease therefore provides a hidden value to Bacalt.

Wait before investing

When evaluating the stability of the government in England (and the UK), Bacalt may
consider that there is a lack of stability, for example if the outcome of forthcoming government
elections is uncertain.

Page 3 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

In such circumstances as this, it might be appropriate to delay the decision until after the
elections. This would enable more certainty in the predictions and aid the decision-making
process. By waiting, Bacalt avoids incurring unnecessary costs that could have been avoided.

Overall recommendation
The project has satisfied all of the requirements of the first stage of financial appraisal and so
should now be considered in more detail under the phase two methodology.

This will include a more detailed analysis of both the financial and non-financial implications
and, if possible, an estimated value attributable to any relevant real options.

A.2 (a) Suitable discount rate

As Malahro is diversifying into a new industry, the current cost of capital is not suitable.

The cost of capital reflects the business and financial risk faced by shareholders and so the new
industry means that the business risk will change.

In this situation, it is common to take the beta value from a company in the new industry,
FPK, and adjust this so that it reflects the gearing ratio of the investing company, Malahro.

This enables the calculation of a revised cost of equity, which can be used to determine the
overall cost of capital suitable for appraising the new project.

This is demonstrated as follows:

Degear FPK βEG

E
βA = βEG ×
E + D(1 − t)
2
= 1.5 × = 1.107
2 + 1(1 − 0.29)

Regear βA to get Malahro βEG

E
βA = βEG ×
E + D(1 − t)
4
1.107 = βEG ×
4 + 1(1 − 0.29)
1.107 = βEG × 0.8493
βEG = 1.30

Cost of equity using CAPM

Ke = Rf + β  (Rm – Rf)
Ke = 7 + 1.30  (15 – 7)
Ke = 17.4%

Cost of debt
Kdt = Rf (1–t)
Kdt = 7  ( 1 – 0.29)
Kdt = 5.0%

Weighted average cost of capital (WACC)

(Ke × E) + (Kdt × D)
WACC =
E+D
(17.4% × 4) + (5.0%× 1)
WACC =
5
WACC = 14.9%

Page 4 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

(b) Outright purchase:

Cashflows Discount factor Present Value
Time Description
Rs. in '000 5%[7(1-0.29)] Rs. in '000
0 Investment (28,000) 1 (28,000)
1 Tax saved on tax depreciation 2,030 0.9524 1,933
7,000(28,000×25%) × 29%
2 Tax saved on tax depreciation 914 0.9070 829
3,150(28,000×75%×15%) × 29%
3 Tax saved on tax depreciation 776 0.8638 671
2,678(3,150×85%) × 29%
4 Tax saved on tax depreciation 660 0.8227 543
2,276(2,678×85%) × 29%
5 Tax saved on disposal 2,928 0.7835 2,294
10,096(2,800–12,896(WDV))×29%
5 Scrap 2,800 0.7835 2,194
(19,536)

PV of costs of outright purchase = Rs. 19.5 million

Lease:
Discount Present
Cashflows
Time Description factor Value
Rs. in '000 5% Rs. in '000
0–4 Lease payments (6,000) 4.546 (27,276)
1–5 Tax relief on lease payments 1,740 4.329 7,532
(6,00029%)
(19,744)

PV of leasing = Rs. 19.7 million

Recommendation:
The present value of the costs for each alternative is very similar, outright purchase being
Rs. 19.5 million compared with the Rs. 19.7 million for leasing. As such, either approach
could realistically be selected.

It is worth noting that the outright purchase final cost is not guaranteed as the actual scrap
value may be different in five years’ time.

Given the closeness of the costs, the board should consider other practical factors as part of
their decision, for example with leasing there is no need to identify a buyer for the scrap in five
years’ time.

Page 5 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

A.3 (a) NPV

X-ray machine in China
Time 0 1 2 3 4 5
Operations ---------------------------- ¥ in '000 ----------------------------
Sales (W-1) 8,160 16,646 33,959 51,957 70,661
Variable costs (40% of sales) (3,264) (6,658) (13,584) (20,783) (28,264)
Fixed costs (W-2) (1,938) (2,081) (2,335) (2,381) (2,760)
Operating profit pre tax 2,958 7,907 18,040 28,793 39,637
Chinese tax 25% (740) (1,977) (4,510) (7,198) (9,909)
Operating cash profit after tax 2,218 5,930 13,530 21,595 29,728
Terminal value (29,728 × 5) 148,640
Investment
Outlay (10,000) 0 (10,000) 0 (10,000) 0
Tax saved on capital
allowances 2,500 0 2,500 0 2,500 0
Working capital (W-3) (4,000) (4,000) (2,000) (3,000) (2,000) 0
Total cash flows (11,500) (1,782) (3,570) 10,530 12,095 178,368
Exchange rate PKR:CNY
(W-4) 35 37 39 42 44 47
---------------------------- Rs. in '000 ----------------------------
Cash flows remitted to
Pakistan (402,500) (65,934) (139,230) 442,260 532,180 8,383,296
Additional Pakistan tax (W-5) 14,000 (4,378) 3,265 (30,307) (33,076) (74,518)
Total cash flows (388,500) (70,312) (135,965) 411,953 499,104 8,308,778
Discount rate 12% 1 0.8929 0.7972 0.7118 0.6355 0.5674
Present value (388,500) (62,782) (108,391) 293,228 317,181 4,714,401
NPV Rs. '000 4,765,137

W-1: Sales
Time 0 1 2 3 4 5
Sales units 10 20 40 60 80
Selling price per unit in T0
terms ¥ 800,000 800,000 800,000 800,000 800,000
Inflation 1.02 1.022 1.023 1.024 1.025
Monetary value ¥ '000 8,160 16,646 33,959 51,957 70,661

W-2: Fixed cost

Time 0 1 2 3 4 5
Fixed costs
Per annum in T0 terms 1,900,000 2,000,000 2,200,000 2,200,000 2,500,000
Inflation 1.02 1.022 1.023 1.024 1.025
Monetary value ¥ '000 1,938 2,081 2,335 2,381 2,760

W-3: Working capital needed

Time 1 2 3 4 5 6
¥ '000 4,000 8,000 10,000 13,000 15,000 15,000
Time 0 1 2 3 4 5

¥ '000 4,000 4,000 2,000 3,000 2,000 0

(It is assumed that working capital investment is already in nominal figures)

W-4: Exchange rate

Time 0 1 2 3 4 5
CNY: PKR 1: 35 37 39 42 44 47
Inflation in China 2%
Inflation in Pakistan 8%
1+id
sr = s0 ×
1+if
Predicted exchange rate
(1.08×35)÷1.02
Page 6 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

W-5: Additional Pakistan tax

Time 0 1 2 3 4 5
Operating profit ¥ '000 0 2,958 7,907 18,040 28,793 39,637
Capital investments ¥ '000 (10,000) 0 (10,000) 0 (10,000) 0
Taxable profit in ¥ '000 (10,000) 2,958 (2,093) 18,040 18,793 39,637
Exchange rate 35 37 39 42 44 47
Taxable profit in Rs. '000 (350,000) 109,446 (81,627) 757,680 826,892 1,862,939
Additional tax at 4%
(29% – 25%) Rs. '000 14,000 (4,378) 3,265 (30,307) (33,076) (74,518)
Note. Costs incurred for market research are not relevant, they are a sunk cost.

MRI machines manufactured in Karachi

Operations 0 1 2 3 4 5
------------------------------ Rs. in '000 ------------------------------
Sales (W-1) 1,512,000 1,632,960 5,290,790 5,714,054 6,171,178
Variable costs (55% of sales) (831,600) (898,128) (2,909,935) (3,142,730) (3,394,148)
Fixed costs (W-2) (108,000) (116,640) (188,957) (204,073) ( 220,399)
Operating profit pre tax 572,400 618,192 2,191,898 2,367,251 2,556,631
Tax 29% (165,996) (179,276) (635,650) (686,503) (741,423)
Operating cash profit after tax 406,404 438,916 1,556,248 1,680,748 1,815,208
Terminal value (1,815,208×5) 9,076,040
Investment
Outlay (500,000) (500,000) (500,000) 0 0 0
Tax saved on capital allowances 145,000 145,000 145,000 0 0 0
Working capital (W-3) (320,000) (120,000) (120,000) 0 0 0
Total cash flows (675,000) (68,596) (36,084) 1,556,248 1,680,748 10,891,248
Discount rate 12% 1 0.8929 0.7972 0.7118 0.6355 0.5674
Present value (675,000) (61,249) (28,766) 1,107,737 1,068,115 6,179,694
NPV Rs. '000 7,590,531

Workings:
W-1: Sales
Time 0 1 2 3 4 5
Sales units 5 5 15 15 15
Selling price per unit in T0
terms Rs. '000 280,000 280,000 280,000 280,000 280,000
Inflation 1.08 1.082 1.083 1.084 1.085
Monetary value Rs. '000 1,512,000 1,632,960 5,290,790 5,714,054 6,171,178

W-2: Fixed costs

Time 1 2 3 4 5
Per annum in T0 terms Rs. '000 100,000 100,000 150,000 150,000 150,000
Inflation 1.08 1.082 1.083 1.084 1.085
Monetary value Rs. '000 108,000 116,640 188,957 204,073 220,399

W-3: Working capital needed

Time 1 2 3 4 5 6
Rs. in '000 320,000 440,000 560,000 560,000 560,000 560,000
Time 0 1 2 3 4 5
Cash flow Rs. '000 320,000 120,000 120,000 0 0 0
(It is assumed that working capital investment is already in nominal figures)

Note. Costs incurred for product research are not relevant, they are a sunk cost.

Page 7 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

(b) Capital rationing

Both projects generate a positive NPV and so both will increase shareholder wealth.

Total funds
Time X ray in China MRI in Karachi Funds available
needed
-------------------------------- Rs. in '000 --------------------------------
0 -388,500 -675,000 -1,063,500 900,000
1 -70,312 -68,596 -138,908 150,000
2 -135,965 -36,084 -172,049 100,000
3 411,953 1,556,248 No limit
4 499,104 1,680,748 No limit
5 8,308,778 10,891,248 No limit
Cash flows 8,625,058 13,348,564

Let X = the proportion invested in the expansion of X-ray machines

M = the proportion invested in the production of MRI machines

X,M ≤ 1 -------- Eq 1
X,M ≥ 0 -------- Eq 2

Capital at T=0 388,500 X + 675,000 M ≤ 900,000 -------- Eq 3

Capital at T=1 70,312 X + 68,596 M ≤ 150,000 -------- Eq 4
Capital at T=2 135,965 X + 36,084 M ≤ 100,000 -------- Eq 5

Objective function

Maximise NPV = 4,765,137 X + 7,590,531 M ------ Eq 6

Workings to support the graph:

Capital at T=0 [i.e. Eq 3]
When X = 0, M = 900,000/675,000
X = 0 , M = 1.3
When M = 0, X = 900,000/388,500
X = 2.3, M=0

Capital at T=1 [i.e. Eq 4]

When X = 0, M = 150,000/68,596
X = 0, M = 2.2
When M = 0, X = 150,000/70,312
X = 2.1, M=0

Capital at T=2 [i.e. Eq 5]

When X = 0, M = 100,000/36,084
X = 0, M = 2.8
When M = 0, X = 100,000/135,965
X = 0.7, M=0

Let NPV = 6,000,000 ------ [i.e. Eq 6]

X=0 M = 6,000,000/7,590,531
When M = 0, X = 6,000,000/4,765,137
X = 1.3, M = 0.8

Page 8 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

The maximum position is achieved at the intersection of the following two constraints:
M = 1, and capital at time 2.
135,965 X + 36,084 M = 100,000

When M = 1
135,965 X + 36,084 = 100,000
135,965 X = 63,916
X = 0.47

Therefore, the optimal investment strategy is for the MRI machine investment to be completed
in full and for 47% of the X-ray machine investment in China. The overall NPV and increase
in shareholder wealth will be:

Rs. in '000
MRI manufacture 7,590,531
47% of X-ray manufacture (4,765,137×47%) 2,239,614
9,830,145

Page 9 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

A.4 (a) Report to the board of directors

Valuation of Xon

This report provides a range of values that can be used in the negotiation for the purchase of
Xon.

The company has seen disappointing results recently such that the latest financial statements
show an operating loss. Valuations based on the current year performance are therefore not
possible, and so forecast results for the year ended 30 June 2024 have been used instead.

The following valuations have been produced.

Valuations Latest results Forecast results
------------------------- $ in '000 -------------------------
Net asset valuation (W-1) 13,570 14,044
PV of cash flows 0 6,583
PE multiple 0 5,688

Net asset valuation

Due to recent poor performance, the net asset position is currently higher than valuations
based on earnings and cash flows.

This valuation is based on the book value of assets and so may not reflect the current value of
the company assets.

There may be intangible assets that are not reflected within the financial statements and so the
true value could be higher.

It would be useful to consider the authors currently contracted to work with the publisher and
assess their popularity and earnings potential.

This valuation does not attribute any value to future earnings, and these may improve in the
future.

It would be useful to gain additional information on the current value of the assets owned by
Xon.

Workings

W-1: Statement of financial position extract Actual Forecast

Year ended Year ended
30 June 2023 30 June 2024
-------------- $ in '000 --------------
Share capital ($1) 1,000 1,000
Retained profits 13,044
12,570 (12,570+474(W-2))
13,570 14,044

W-2: Statement of profit or loss extract Year ended Year ended

30 June 2023 30 June 2024
-------------- $ in '000 --------------
Operating (loss)/profit (5,500) 1,000
Interest (400) (400)
(5,900) 600
Corporate tax 21% (0) (126)
(Loss)/Profit after interest and tax (5,900) 474

Page 10 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

Earnings valuation
Yepple is in the same industry as Xon and so it would be appropriate to use Yepple’s PE ratio
to estimate the potential value of Xon.

It is realistic to assume that the shareholders of Yepple would expect similar returns from Xon
as it is in the same industry and under the same management.

The PE multiple is applied to the after tax profit expected in the first year. This is based on
projections by Xon and may be different to the expectations of Yepple.

Workings
PE ratio Yepple 12
Earnings (forecast) (W-2) $474,000
Market value of equity (12  $474,000) $5,688,000

Present value of cashflows

This report assumes that the predicted Year 1 earnings can be used as an approximation of
Year 1 cashflows.

A suitable discount rate should reflect the risk of the cashflows and so Yepple’s asset beta
reflects the correct business risk for Xon.

The beta should however be adjusted to reflect the financial risk of the debt within Xon’s
capital structure.

The board has suggested that cashflows can be assumed to grow at 5% per annum. Yepple
may have different projections for growth which would alter the valuation significantly.
Yepple are also unlikely to accept Walmor’s projections and will carry out their own due
diligence on the figures.

The computation below assume 5% growth in perpetuity.

Regear Yepple βA
14
0.730 = βEG ×
14+4(0.79)
0.730 = βEG × 0.816
βEG = 0.90

Cost of equity = Rf + β(Rm-Rf)

Cost of equity = 5% + (0.9  (13% – 5%)) = 12.2%
Estimated growth = 5% per annum in perpetuity
d1
Market value equity = Ke −g
Rs. 474,000 (𝐖−𝟐)
Market value equity =
0.122 − 0.05

Market value equity = Rs. 6,583,333

Recommendation
The highest valuation is based on the net asset value of Xon and so represents a realistic
minimum as a breakup of the company would generate income of approximately $10 million.

Page 11 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

(b) Managing exchange rate risk

Money market hedge

Invest USD $10,000,000 / 1.01{1+(4%3/12)} $ 9,900,990

Purchase USD at the spot rate $ 9,900,990

Borrow in Pakistan (June spot rate) Rs. 230 : $1 Rs. 2,277,227,700
Interest on the borrowing 7%  3/12 = 1.75% Rs. 39,851,485

Equivalent cost in September Rs. 2,317,079,185

OTC Options
Buying USD, so a CALL option is needed. There are two strike prices to choose from:

------------------------- Rupees -------------------------

Strike price 227 233
Buy $10 million at the strike price 2,270,000,000 2,330,000,000
Option premium 60,000,000 40,000,000
Total cost 2,330,000,000 2,370,000,000

Recommendation
The lowest overall cost is achieved through money market hedge.
The option is also flexible in that, if the spot rate on the day is more favourable or the purchase
does not take place due to some unforeseen reason, the option can simply lapse meaning the
only cost to Walmor is the option premium.

A.5 (a) Report

Suitable Debt for Redd Ltd
Prepared for the board of directors
Prepared by An Accountant
Date June 2023

Introduction
Redd is currently 100% equity financed and so, to date, has not taken advantage of lower cost
debt finance. All the debt options suggested will benefit from tax relief on the interest paid.

This report considers the respective cost and suitability of three different debt finance
alternatives.

Summary of costs
Redeemable debentures 8.9% (W-1)
Convertible debentures 8.6% (W-2)
Bank loan 5.0% (W-3)

Redeemable debentures
This is the most expensive finance, and it will need to be repaid in five years’ time.

Realistically, this will be replaced by newly issued debt finance.

An issue of redeemable debt would be straight forward because Redd is already listed on the
Pakistan Stock Exchange.

Convertible debentures
The convertible debentures have a slightly lower cost than the redeemable debentures. The
lower coupon rate of 8% is expected given the potential return on conversion in eight years’
time.
Page 12 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

The calculations assume that the historic share price growth of 5% will continue for the next
eight years. In the absence of other information, this is a realistic assumption, however if the
actual growth differs the cost estimate may change significantly.

Convertible debentures are often issued as delayed equity for companies that might struggle to
raise equity at the current time. This delayed equity may dilute the control for the existing
shareholders.

Redd does not want to introduce more equity for this reason, this finance is not recommended.

Bank loan
The cheapest form of finance is the secured bank loan.

The loan is secured on the head office building and includes loan covenants. If the loan
covenants are not satisfied, Redd would be in breach of the terms and the bank may demand
immediate repayment of the loan.

If Redd was unable to do this, the bank could take ownership of Redd’s head office building.

This presents some risk for Redd. The board would need to ensure that appropriate controls
were in place to monitor and take appropriate action to avoid the covenants being breached.

The board should prepare financial models that predict the values of the ratios.

Redd is currently all equity; the resulting gearing could be low though this will depend on the
target gearing ratio. If gearing is still low, interest cover is likely to be high.

The current ratio would need to be determined and the board should satisfy themselves that
this will be manageable in the future.

The term of the bank loan is ten years, which is significantly longer than the term of the
redeemable debt. There is potential for interest rates to fall, in which case Redd could be tied
into higher rates for several years.

This could be managed through arranging a SWAP agreement if necessary.

Similarly, the fixed loan does protect Redd from any increases in interest rates.

Recommendation
The bank loan is the cheapest finance available to Redd and this is recommended provided
the board is satisfied that the debt covenants will not be breached for the duration of the loan.

W-1: Redeemable debentures

Time Description Cashflow (Rs.) DF 5% PV (Rs.) DF 10% PV (Rs.)
0 Investment (10,000) 1 (10,000) 1 (10,000)
1–5 Interest net of tax 710 4.329 3,074 3.791 2,692
10,00010%(1–0.29)
5 Redemption value 11,000 0.784 8,624 0.621 6,831
1,698 (477)

1,698
IRR = 5% + × (10% − 5%)
1,698 + 477
IRR = 8.9%

Page 13 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

W-2: Convertible debentures

Time Cashflow Rs. DF 5% PV (Rs.) DF 10% PV (Rs.)
0 Investment (10,000) 1 (10,000) 1 (10,000)
1–8 Interest net of tax 568 6.463 3,671 5.335 3,030
10,0008%(1–0.29)
8 Conversion value 12,930 0.677 8,754 0.467 6,038
(2,586 (W-1) × 5) 2,425 (932)
2,425
IRR = 5% + × (10% − 5%)
2,425 + 932
IRR = 8.6%

Conversion value
W-1: Expected future market price in eight years [1,750×(1+0.05 (W-1.1))8] ⇒ Rs. 2,586

W-1.1: Using historic growth rate

3 1,750
1+g= √ ⇒1 + g = 1.05 ⇒ g = 5.00%
1,510

Assume the growth rate continues, in eight years’ time, investors should choose between
redemption at Rs. 10,000, and conversion to five shares.
The expected conversion value in eight years is: (2,586×5) ⇒ Rs. 12,930
Therefore, conversion is expected (but not guaranteed) to be preferable.

W-3: Bank loan

Kdt = Rf (1 – t)
= 7  ( 1 – 0.29)
Kdt = 5.0%

(b) Hedging
FRA
3/12 is the correct FRA as it represents a nine-month loan that commences in three months’
time.
Interest rate in three months’ time 4% 2.5%
--------------------- £ ---------------------
Interest on loan with Bank 45,000 33,750
£1,000,000(4%+2%)9÷12) £1,000,000(2.5%+2%)9÷12)
(Receipt from)/Payment to FRA Bank (5,250) 6,000
£1,000,0000.7%(4%–3.3%) £1,000,0000.8%(3.3%–2.5%)
(9÷12) (9÷12)
Effective interest cost 39,750 39,750
Effective interest rate (3.3% + 2%) 5.3% 5.3%

Futures
STIRS £500,000 for 3 months
Rs. 1,000,000 for 9 months
Hedge =
Rs. 500,000 for 3 months

1,000,000 × 9
Number of contracts = 500,000 × 3
= 6 contracts

The relevant contracts are the September dated ones.

Interest rates in three months' time: 4% 2.5%

Sell September dated futures 1 June 96.80 96.80
Close out at estimated September dated futures price
1 September (W-1) 95.95 97.45
Gain / (Loss) 0.85 (0.65)
Page 14 of 15
 BUSINESS FINANCE DECISIONS
Suggested Answer & Marking Key
Certified Finance and Accounting Professional Examination – Winter 2023

Overall position 4% 2.5%

--------------------------- £ ---------------------------
Interest on loan with Bank 45,000 33,750
£1,000,000  (4% + 2%)  9÷12) £1,000,000  (2.5% + 2%)  9÷12)
(Gain) /Loss on futures hedge (6,375) 4,875
(6  £500,000  3 ÷ 12  0.85%) (6  £500,000  3 ÷ 12  0.65%)
Effective interest cost 38,625 38,625
Effective interest rate
(£38,625÷£1,000,000  12÷9) 5.15% 5.15%

W-1:
Underlying interest rate for September dated futures at 1 June 2023 [100 – 96.8] 3.20%
SONIA rate 1 June 2023 3.00%
Basis 20 points
Time to expiry 4 months
Time to expiry at 1 September 2023 1 month
Estimated basis at 1 September 2023 (20/4) 5 points

Expected SONIA 1 September 2023 4% 2.5%

Expected underlying interest rate for futures 4.05% 2.55%
Expected price at 1 September 2023 95.95 97.45
(100 – 4.05) (100 – 2.55)

Options
Purchase September dated PUT options
Interest rate on 1 September 2024 4% 2.5%
Exercise the option Yes No
Strike price / SONIA on 1 September 3.00% 2.50%
Risk premium 2.00% 2.00%
Option premium paid in June 0.40% 0.40%
Effective interest rate 5.40% 4.90%

Note. In all hedges, the credit risk premium of 2% is assumed to be constant. Greenly cannot
hedge against this changing.

Conclusion and summary of effective rates

SONIA 4% 2.5%
FRA 5.30% 5.30%
Futures 5.15% 5.15%
Options 5.40% 4.90%

The FRA and futures hedge are both ‘fixing’ hedges, though the final outcome of the futures
hedge will not be known until the contract is settled.

The option provides the overall lowest cost as this allows Greenly to take advantage of lower
rates if SONIA falls.

Options are expensive however, and this is reflected in the overall highest cost if SONIA rises.

(The End)

Page 15 of 15