PROFESSIONAL LEVEL EXAMINATION

TUESDAY 14 MARCH 2017

(2½ hours)

FINANCIAL MANAGEMENT
This paper consists of three questions (100 marks).

1. Ensure your candidate details are on the front of your answer booklet. You will be given
time to sign, date and print your name on the answer booklet, and to enter your
candidate number on this question paper. You may not write anything else until the
exam starts.

2. Answer each question in black ballpoint pen only.

3. Answers to each question must begin on a new page and must be clearly numbered
Use both sides of the paper in your answer booklet.

4. The examiner will take account of the way in which answers are presented.

5. When the assessment is declared closed, you must stop writing immediately. If you
continue to write (even completing your candidate details on a continuation booklet), it
will be classed as misconduct.

A Formulae Sheet and Discount Tables are provided with this examination paper.

IMPORTANT

Question papers contain confidential You MUST enter your candidate number in this
information and must NOT be removed box.
from the examination hall.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN WORK

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1. You should assume that the current date is 28 February 2017

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 2017

£’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 2017

£’000
Ordinary share capital (£1 shares) 12,500
Retained profits 11,286
23,786
7% debentures (redeemable July 2019 to December 2020) 20,300
44,086

The market values of Sentry’s ordinary shares and debentures on 28 February 2017 are:

Ordinary shares £3.44 (cum div)

7% debentures £111% (cum int)

The £20 million required would be raised on 1 March 2017 by either:

1. A rights issue at £2.50 per ordinary share or
2. An issue of 8% debentures at par, redeemable in 2023

You have been asked by the directors to assume the following for the year to 28 February
2018:
 Sales will increase by 20%
 The contribution to sales ratio will remain unchanged
 Fixed costs will increase by £2 million pa
 The current level of dividends per share will be maintained
 Corporation tax will remain at 17%

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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

1.1 For both the rights issue and the debenture issue, prepare forecast income
statements for Sentry for the year to 28 February 2018. (6 marks)

1.2 For both the rights issue and the debenture issue, calculate Sentry’s forecast

 EPS figure for the year to 28 February 2018 and

 Gearing ratio (book value of long-term borrowings/long-term funds) as at
28 February 2018. (6 marks)

1.3 For the rights issue only, calculate the increase in annual sales required for the year
to 28 February 2018 in order that Sentry’s EPS figure remains the same as in the
current year. (6 marks)

1.4 Making reference to your calculations in 1.1, 1.2 and 1.3 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)

1.5 Discuss Matthew Girvan’s proposal that dividends should be cut, making reference to
relevant theories. (6 marks)

1.6 Discuss the ethical issues for Jenna Helier that would be caused by Roger Smyth’s
suggestion. (3 marks)

Total: 35 marks

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2. 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.

2.1 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 2017 or on 31 March 2019, 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 2017 prices)
Year to 31 March 2018 £7.2m £1.3m
Year to 31 March 2019 £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 2019. The annual
lease cost is fixed and is payable on 1 April. If the factory is closed on 31 March 2017 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 2017 prices) £1.4m £1.2m
Allocated head office costs pa (at 31 March 2017 prices) £1.6m £1.3m

Working capital

The London factory has a working capital balance on 31 March 2017 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.

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Tax allowable London factory closure payments

Closure payments if closure is on 31 March 2017 £1.6m

Closure payments if closure is on 31 March 2019 (at 31 March 2019 prices) £2.3m

London factory machinery

Machinery tax written down value at 1 April 2016 £3.1m

Resale value of machinery at 31 March 2017 £1.7m
Resale value of machinery at 31 March 2019 (at 31 March 2019 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. 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 2018 2%

Year to 31 March 2019 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 2017

(2) 31 March 2019

and use these to calculate the net present value at 31 March 2017 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)

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2.2 Investment priorities at the Manchester factory

The Manchester factory has a capital expenditure budget of £15 million for the financial year
to 31 March 2018. 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)

2.3 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

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3. You should assume that the current date is 31 March 2017

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 ten days’ time.

Both of these contracts are due to be settled in three months’ time on 30 June 2017. 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 2017:

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 2017 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.

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Requirements

3.1 For Issue 1, show the net sterling payment for the four possible strategies under
consideration, assuming that on 30 June 2017 the spot exchange rate will be:

(a) €1.1875 – 1.1960/£

(b) €1.2745 – 1.2860/£

(11 marks)

3.2 For Issue 1, with reference to your calculations in 3.1 above, advise STL’s board
whether it should hedge against movements in the value of the euro. (8 marks)

3.3 For Issue 2, assuming that on 1 July 2017 LIBOR will be:

(a) 4% pa

(b) 6% pa

calculate the annual interest rate payment if STL chooses an FRA, an option or no
hedging instrument and advise STL’s management as to its best strategy. (7 marks)

3.4 Explain briefly how FRAs differ from interest rate futures. (4 marks)

Total: 30 marks

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