PROFESSIONAL LEVEL EXAMINATION

MARCH 2016
Mock Exam 1

FINANCIAL MANAGEMENT

ANSWERS

Copyright ICAEW 2016. All rights reserved.

BLANK PAGE

2 of 20
Question 1
Marking guide
Marks
1.1 Calculations 7
Assumptions/explanations ( each) to max 2
Basis of weightings 1
11
1.2 1 mark per valid point max 7
1.3 Explanation 1
CAPM equation 1
Strengths/weaknesses 4
6
1.4 Traditional theory 2
M&M theory 2
Effect in practice 1
5
1.5 1 to 1 marks per valid point 6
Total 35

1.1 WACC
28.8
g= 3 1 = 7.0%
23.5

ke =
D0 (1 + g) + g = 28.8 (1.07)
+ 0.07 = 0.1617 = 16.17%
P0 2.10 160

kd = IRR of relevant cash flows from the company's perspective.

Consider a 100 nominal value block of loan stock.
Cash DF PV DF PV
T Narrative flow @ 5% @ 5% @ 10% @ 10%
0 Market value (97.00) 1.000 (97.00) 1.000 (97.00)
1-3 Interest, gross 7.20 2.723 19.61 2.487 17.91
3 Redemption 105.00 0.864 90.72 0.751 78.86
13.33 (0.23)
13.33 (10 5)
Pre-tax kd = IRR ~
5+ = 9.92%
13.33 + 0.23
Post-tax kd = 9.92% (1 0.21) = 7.84%
8
kp = = 9.41%
0.85

WACC =
(MV
equity k e ) + (MV
debt ) (
k d + MVpref k p )
MVequity + MVdebt + MVpref

MVequity = 160m 2.10 = 336m

3 of 20
 MVdebt = 67m 97/100 = 64.99m
MVpref = 12m 0.85 = 10.2m
(336m 16.17%) + (64.99m 7.84%) + (10.2m9.41% )
=
(336m + 64.99m +10.2m )
= 14.69%
Assumptions/explanations
The formula for ke assumes that future growth in dividends will be constant.
The use of 7% for the growth rate assumes that past growth will be continued
in the future.
In the kd calculation it has been assumed that the annual cash flows are
allowable deductions for tax and that there is no delay on the tax relief.
Tax is assumed to remain at 21% for the next three years.
That the current share price is fair and not distorted by short-term market
factors.
That the dividend valuation model is valid.
Basis of weightings
Both costs of capital (ke, kp and kd) and the WACC have been calculated using
current ex-dividend (ex-interest) market values, rather than balance
sheet/nominal values.
This is to ensure that a current market cost of finance is determined, rather
than an historic cost. Ideally a future WACC is needed to discount future
project cash flows, and the current WACC based on current market rates is
the best estimate for this.
Marks
Calculations 7
Note. Give full credit for alternative answers obtained from using different,
appropriate discount rates.
For each assumption/explanation mark each max 2
For basis of weightings and explanation 1
1.2 Criticisms
The existing company WACC reflects the company's current gearing level and its
existing ke, kp and kd. The ke in turn reflects the shareholders' risk perception of
the company's existing activities.
Thus the existing WACC is only suitable for project appraisal if the following apply.
The project has the same business risk as the company's existing activities, so
that overall business risk is unchanged.

4 of 20
 The project is financed by a mixture of debt and equity, so as to leave the
company's gearing unaltered.
New debt can be issued at the same cost as the existing loan stock.
These conditions may be relaxed if the project is small, as business risk and
gearing do not change much and/or if finance is deemed to come out of the 'pool'
so any change in gearing is seen to be short-term. However, in this case Oxfield is
to undertake a 'major' investment, so the above three concerns must be
addressed.
The size of the investment may be such that a public issue of shares would be
required for equity finance. These new shareholders may have a different risk
perception of the company and project than existing shareholders, so the company
ke would change, again invalidating the existing WACC.
Marks
For each point made 1
Maximum 7
1.3 CAPM
CAPM could have been used to estimate a project-specific ke if the project
activities were different from that of the company. This could then have been used
to calculate a project-specific WACC.
The method for this would have been as follows.
Find a listed company with activities similar to those of the project.
Look up its beta factor.
Adjust for gearing if necessary.
Put into the CAPM equation: Project ke = rf + (rm rf)
Note. rf could be calculated by looking at yields on Government gilts.
rm could be calculated by looking at movements on the FT all share index.
The model's strengths and weaknesses include the following.

5 of 20
 Strengths Weaknesses
Gives a risk-adjusted discount rate Only appropriate for well-diversified
specific to the project's activities, so shareholders.
useful where a company is
diversifying.
Books of betas are readily available. Published betas are calculated by looking
at past share price movements. The
discount rate is thus of limited use for
future project appraisal.
Many analysts and business managers
have moved to calculating a fundamental
beta. This is based on the risk-return
relationship, ie, where a companys cash
flows are subject to greater risk, then the
required return should be higher. The
main disadvantage is that adjustment for
risk is subjective and lacks precision.
Difficult to find a similar listed company.

Marks
Explanation 1
Equation 1
Strengths/weaknesses 4
1.4 WACC and gearing
There are two theories linking a company's WACC and its gearing ratio.
The traditional theory of gearing proposes a 'U' shaped WACC curve. This is
because as debt is introduced into the capital structure, the WACC will fall,
because initially the benefit of cheap debt finance more than outweighs an
increase in the cost of equity. As gearing increases, higher returns will be
demanded by equity holders and this will start to outweigh the benefit of cheap
debt finance, and the WACC will rise. The optimal gearing level is where the
value of equity plus debt is maximised.

6 of 20
 Cost of capital

k equity

WACC

k
debt

Debt
G1 Gearing =
Equity

Thus if Oxfield is already at its optimal gearing level, G1, then any change in
gearing will cause the WACC to increase. If Oxfield is not already at optimal
gearing, then were the change in gearing to move it closer to G1 the WACC
would drop, but if further away from G1 the WACC would rise.
Modigliani and Miller (M&M) with tax
M&M predicted that with corporation tax, but without personal tax, firms should
gear up as much as possible.
Cost of capital

k equity

WACC

k
debt

Debt
Gearing =
Equity

Thus if Oxfield were to increase its gearing its WACC would drop, and a fall in
gearing would increase the WACC.
In practice the impact of a change in gearing would depend on market
reaction.

7 of 20
 Debt
Oxfield's current gearing level =
Equity

67m 97/100
=
160m 2.10

64.99
=
336

= 0.19, or 19% in terms of market values

This appears low and therefore implies that an increase in gearing would
reduce WACC.
If Oxfield were to move to a gearing level higher than the industry average, the
WACC could increase as the company is perceived as being more risky.
Marks
Traditional theory of gearing and WACC 2
M&M theory of gearing and WACC 2
Effect of gearing on WACC in practice 1
1.5 Covenants used by suppliers of debt finance can be divided into four main
categories:
Restrictions on issuing new debt
These usually prevent the issue of new debt with a superior claim on assets
unless the existing debt is upgraded to have the same priority, or unless the firm
maintains a minimum prescribed asset backing. Restrictions on asset rentals,
leasing, and sale and leaseback are also often used.
Restrictions on dividends
Dividend growth is usually required to be linked to earnings. Repurchase of equity
(effectively a dividend) is also often restricted.
Restrictions on merger activity
Debt covenants may prohibit mergers unless post-merger asset backing of loans
is maintained at a minimum prescribed level.
Restrictions on investment policy
Covenants employed include restrictions on investments in other companies,
restrictions on the disposal of assets, and requirements for the maintenance of
assets. This is usually considered to be the most difficult aspect for creditors to
monitor.
Contravention of these agreements will usually result in the loan becoming
immediately repayable, thus allowing the debenture holders to restrict the size of
any losses.
1 to 1.5 marks per well explained point
Maximum 6 marks

8 of 20
Question 2
Marking guide
Marks
2.1 1 mark per valid point on overdrafts up to maximum of 2
1 mark per valid point on term loans up to a maximum
of 2
4
2.2 Correct contracts 2
Premium 1
Case (a) 2
Case (b) 2
7
2.3 Correct FRA 1
Case (a) 2
Case (b) 2
6
2.4 Demonstration of how a 0.1% benefit can arise 2
What happens to Sprint 2
What happens to Deauville 2
7
2.5 Benefits 3
Risks 3
6
Total 30

2.1 Overdrafts
Strictly repayable on demand, and this introduces additional risk.
The company only needs to pay interest on the amount outstanding each day.
This could be a major advantage of overdraft financing because there is
unpredictability about how much finance is needed.
Almost certainly overdrafts will be offered at variable rates, so there is a risk
that interest rates will rise during the period of the overdraft. Of course, interest
rates could fall giving benefit to Deauville.
Difficult to hedge as borrowed amount and periods vary.
Overdrafts tend to be more expensive (ie higher interest rates) than term
loans.
Term loan
Certainty in repayment date and terms.
Might not be needed for the whole term, though surplus cash could be
deposited to partially offset the cost if the full loan was not needed.
Capable of being hedged.

9 of 20
 If the company has to take out a new loan to repay the old loan at the end of
its term, the interest rate offered could be much higher if rates have risen.
Marks
Per valid point 1
Maximum 4
2.2 The company needs to borrow 10 million and wants to guard against interest rate
rises (which cause the future price to drop). Therefore, the company would buy put
options.
Which contract: June (the loan starts in June)
Number of put options required: 10m/0.5m 6/3 = 40 contracts
Strike price: 100 6 = 94
Premium: June puts at 94 = 0.24% pa
Cost of the options = 40 0.24% 500,000 3/12 = 12,000
Case (a)
Strike price = 94 (right to sell at this price)
Closing price = 93.6 (can buy at this price)
Profit on trade = 0.4% therefore exercise the option
Total gain = 0.4% 500,000 3/12 40 = 20,000

Borrow at spot for six months 10m 6/12 6.2% (310,000)
Gain on option 20,000
Option premium (12,000)
Net cost of borrowings (302,000)
Case (b)
Option would not be exercised (no point buying at 94.3 to sell at 94)

Borrow at spot 10m 6/12 5.5% (275,000)
Option premium (12,000)
(287,000)
Marks
Set up 2
Calculation of premium 1
Descriptions (2 marks each) 4

10 of 20
2.3 The company is borrowing from month 3 to month 9, so needs to use the 3 v 9
FRA. The company is borrowing, so will be quoted the higher rate: 5.99
(a) Interest rates have risen so the bank will pay Deauville plc:

FRA receipt = 10m (6.2% 5.99%) 6/12 10,500
Interest at 6.2% = 10m 6.2% 6/12 (310,000)
((299,500)
(b) Interest rates have fallen so Deauville plc must pay the bank:

FRA payment (5.99% 5.5%) 10m 6/12 (24,500)
Interest at 5.5% = 10m 5.5% 6/12 (275,000)
(299,500)
In both cases, the company is paying, in net terms, the equivalent of a 5.99%
interest rate. ((299,500/10,000,000) (12/6) = 0.0599)
Marks
Correct FRA 1
Descriptions each case up to 2 5
2.4 Deauville Sprint
(prefers fixed) (prefers variable) Difference
Can borrow at a fixed rate of 6% 5.70% 0.3%
Can borrow at a variable rate of LIBOR + 1.6% LIBOR + 1.4% 0.2%
Difference between differences 0.1%
Sprint is offered better rates for both fixed and variable rate loans, but has a
greater advantage in the fixed market. The companies will do better if Sprint
makes use of this comparative advantage by borrowing at a fixed rate; Deauville
should borrow at the variable rate.
So each borrows 10m for six months.
Sprint borrows at the fixed rate of 5.7%
Deauville borrows at variable rate LIBOR + 1.6% = 5.5% + 1.6% = 7.1%
There is 0.1% to gain between them, compared to normal borrowing.
Deauville pays Sprints fixed interest of 5.7% instead of paying 6% if it had
borrowed fixed itself.
Sprint pays Deauvilles variable interest of 7.1% instead of paying 6.9% if it had
borrowed variable itself.
To benefit equally, Deauville should end up paying 6.0 0.05 = 5.95% and Sprint
should end up paying 6.9 0.05 = 6.85%. A transfer of interest from Deauville to
Sprint of 0.25% is needed so that:
Deauville pays: 5.7 + 0.25 = 5.95% (0.05% less than 6%)
Sprint pays 7.1 0.25 = 6.85% (0.05% less than 6.9%)

11 of 20
 (Alternative presentations/methods acceptable)
Marks
Showing advantages of swap 2
Description of effect on Sprint 2
Description of effect on Deauville 2
2.5 Benefits
Enable a switch between fixed and floating rate to hedge interest rate risk.
Low arrangement costs, typically less than terminating an old loan and taking
a new one.
Achieve cash flow schedule desired (fixed/floating) at a better rate than could
be achieved alone due to the theory of comparative advantage.
Available for long periods (several years).
Not standardised, so can be tailored to business needs with respect to amount
and period.
Risks
Counterparty risk: the counterparty may default on payments, usually covered
by intermediary.
Market risk: rates may move unfavourably after entering the position leaving
the net borrowing cost uncompetitive.
Swaps are relatively complex transactions and there is a risk that the swap
activity might lead to financial statements of the parties involved being
misleading.
Marks
For each point identified (give credit for other valid points) 1
Maximum (up to 3 for benefits and 3 for risks) 6

12 of 20
Question 3
Marking guide
Marks
3.1 (a) Dividend yield 1
Earnings 1
Assets 1
(b) Dividend growth calculations/explanations 3
6
3.2 (a) Explanations and limitations (1 mark per point, to 6
maximum)
(b) Reasons for valuation (1 to 1.5 marks per point, to 5
maximum)
Suggested figure 1
12
3.3 Information requested (1 mark per point, to maximum) 8
3.4 Business plan contents (1 to 1.5 marks per point, to 9
maximum)
Total 35

3.1 (a) Dividend yield based valuation (dividend/dividend yield = share price) =
0.05/0.0307 = 1.6287 per share.
P/E based valuation = 2.8m 15.2 = 42.56m in total = 4.256 per share.
Net assets based valuation = 11.3m + (10.2m 8.6m) = 12.9m in total =
1.29 per share.
(b) Using the dividend valuation model (d1/Ke g), valuation = (0.066/(0.12
0.08)) = 1.65 per share.
Dividend growth will distort a dividend based valuation which considers current
dividend only. Therefore it is essential to estimate a sustainable medium/long-
term dividend growth rate. However, the market average dividend yield will
itself reflect investors' expectations of future growth potential.
Using the estimated growth rate of 8% gives only a slightly higher valuation of
1.65 per share than that achieved in part (a) above. Changing the growth rate
will change the valuation, potentially quite significantly. For example,
increasing the growth rate by only 1 percentage point to 9% would increase
the share value by 1/3 to 2.20.
Marks
(a) For each calculation (by dividend yield, P/E ratio, assets) 3
(b) Calculation 1
For explanations 2

13 of 20
3.2 (a) Reasons for difference in the valuations and limitations of the
calculations
The P/E based valuation gives the highest valuation, as this method takes into
account all profits available for distribution to shareholders (rather than just
actual distributions) and also incorporates growth potential.
The dividend yield valuation method is based on current dividends, rather than
projected future dividends, although the low dividend yield may reflect
investors' expectations of future growth potential. The dividend valuation
model, using a projected future long-term growth rate in dividends gives a
similar value.
In both the dividends-based and earnings-based valuations in 3.1 above, the
calculations are based on industry average yields rather than reflecting the
specific characteristics of Bon Chic.
'General retailers' operate on a dividend cover of 2.12 as opposed to 5.6
(2.8/0.5) for Bon Chic (BC). The higher level of reinvestment in BC is likely to
lead to high dividend growth and a higher equity value.
The assets-based valuation method considers just the carrying or market
value of reported assets and effectively ignores both future profits and sources
of value (such as staff loyalty) which are not recognised in the statement of
financial position.
Bon Chic is a high growth company so when the effects of future potential
profits are excluded from the value imputed to the assets the result is likely to
be a significant undervaluation.
Generally in the fashion industry one would not expect high investment in
tangible assets and reported asset values would be expected to understate
value in these circumstances. In particular, the Bon Chic brand will not be
included in the statement of financial position.
All the valuation techniques employed are only as good as the data available.
Specific problems include the appropriateness of the figures given. 'General
retailers' will include a wide variety of companies, many with different risk and
growth prospects to the fashion sector, and as noted above, this is likely to
distort the dividends- and earnings-based valuations.
Asset values, although considered 'fair' by the directors, would need to be
verified. The value of inventory and receivables in particular should be verified
current assets are growing both in absolute terms and as a percentage of
sales revenue the recoverability of receivables and the realisable value of
inventory should not be overestimated.
Marks
For each reason/limitation 1
Maximum 6

14 of 20
 (b) Maximum price to be offered
The following points should be considered:
The above valuations relate to the existing share capital. If there is an
issue of new shares, then ownership of existing shareholders may be
diluted.
The company has very high growth prospects and the asset based
approach in particular effectively ignores this. Earnings based valuations
which include an allowance for growth via the PE ratio are likely to be
more suitable.
General stock market conditions should also be considered given recent
volatility of equity markets. The company must be wary of tendering a high
price in case the market falls soon afterwards.
Given the above arguments an earnings based approach would seem the
most sensible valuation and a figure in the region of 4.26 per share would
seem a suitable maximum. If BC has better growth prospects than average
and does not appear to expose investors to high risk, then an even higher
figure may be justified.
Marks
For each valid point made 1
To maximum 5
For suggesting a reasonable figure (consistent with calculations in 3.1)) 1
Maximum 6
3.3 Further information required
Long-term growth in sales revenue and profits.
The contractual position of the design team. In this area quality design is vital
for future growth. If the design team were lost future profits may be threatened.
The contractual position of the two founders. It is important that they remain
with the business so that their creative input can add value and so as to avoid
competition.
Details of the relationship with manufacturers they could be vital for future
success.
Details of the company's cash flow position (current and projected). Given
such rapid growth overtrading is a risk.
The reason why the venture capitalist wishes to liquidate its investment.
More details on the plans for European expansion, particularly any market
research available and the attractiveness of the BC brand in Europe.
The risk associated with new business expansion abroad is likely to increase
costs and risks as well as providing opportunity for increased profits.
Details of the performance of the existing business by segment, in particular
the performance of the mail order business.

15 of 20
 Details of the property owned or leased by BC.
Details of the internal control systems in the company (to analyse risk).
The reason for the investment institution purchasing the shares. Although it is
unlikely to be as a first step to ultimate control, if it is, questions of synergy and
value of assets will assume greater importance.
More detail on the make up of the 'general retailers' section companies to see
how comparable they are with BC.
Any market research available on the fashion sector, likely growth rates, the
value of the BC brand etc.
Marks
For each valid point made 1
Maximum 8
3.4 A suitable business plan should contain the following:
Executive summary a one-page summary which allows the reader to grasp
the nature and purpose of the European expansion.
History and background this provides a context for decisions and describes
how the expansion idea has developed.
Mission statement and objectives the mission statement shows how the
business wants to be seen and objectives show what the business wants to
achieve in both the short and long term.
Products or services this includes products and services provided as well as
any differentiating factors for the company along with any planned future
development of the products or services.
Market information this section includes lots of information about the market
including demographic description and competitor comparisons.
Resources employed, management and operations this describes key
people including management, premises used and a broad description of how
goods or services are provided.
Financial information this information will support the business plan and
should include sensitivity or what if analysis on the European expansion.
Action plan this is a list of the main actions required to implement the
European expansion.
Appendices these are used to contain detailed information that support the
contents of the main report.
Marks
For each valid point made 1 or 1
Maximum 9

16 of 20
BLANK PAGE

17 of 20
BLANK PAGE

18 of 20
BLANK PAGE

19 of 20
ICAEW
Metropolitan House
321 Avebury Boulevard
Milton Keynes
MK9 2FZ
www.icaew.com