PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 12 DECEMBER 2012

(2 hours)

FINANCIAL MANAGEMENT
This paper consists of FIFTEEN objective test (OT) questions (20 marks) and THREE written
test questions (80 marks).

1. Ensure your candidate details are on the front of your answer booklet.

2. Answer each question in black ball point pen only.

Objective Test Questions (1 15)

3. Record your OT responses on the separate answer sheet provided: this must not be
folded or creased. Your candidate details are printed on the sheet.

4. For each of the FIFTEEN OT questions there are four options: A, B, C, D. Choose the
response that appears to be the best and indicate your choice in the correct box, as
shown on the answer sheet.

5. Attempt all questions: you will score equally for each correct response. There will be no
deductions for incorrect responses or omissions.

Written Test Questions (1 3)

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

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

A Formula 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

Copyright ICAEW 2012. All rights reserved. Page 1 of 7

1(a) 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 30 September 2012

Profit before interest and tax 1,080,000

Interest (180,000)
Profit before tax 900,000
Tax (28%) (252,000)
Profit after tax 648,000

Dividends declared and paid:

Preference dividend 43,200
Ordinary dividend 180,000

Balance sheet at 30 September 2012

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
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 2011: 440,000

Year ended 30 September 2010: 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.

Copyright ICAEW 2012. All rights reserved. Page 2 of 7

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. Cerns directors wish to assume that for the foreseeable future the corporation tax rate
will be 28%.

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. Fentons directors have confirmed that if an acquisition goes ahead,
they will purchase the debentures at their market value and Fentons bank has agreed to buy
the preference shares at their market value. Cerns directors have sought your advice as an
external consultant.

Requirements

(i) 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)

(ii) Comment on the values you have calculated and any issues you think should be
brought to the attention of Cerns directors. (4 marks)

(iii) Identify the motives that might lie behind Fentons possible acquisition of Cern.
(4 marks)

PLEASE TURN OVER

Copyright ICAEW 2012. All rights reserved. Page 3 of 7

1(b) 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
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, Cerns directors
are reconsidering their current replacement policy with a view to maximising the present
value of the companys 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 Cerns directors how often they should replace the processing
machine. (10 marks)

(31 marks)

Note: Ignore inflation and taxation when answering part (b).

Copyright ICAEW 2012. All rights reserved. Page 4 of 7

2. The finance director of Liteform plc (Liteform) has been asked to calculate a discount factor
for use in appraising all the firms potential investment projects in the forthcoming year. He
has gathered the following information, which he has passed on to you, the firms finance
manager, with the request that you use the information provided to calculate the firms
weighted average cost of capital, which will then be used as the required discount factor.

1. The current cum-dividend price of a Liteform ordinary share is 4.58 and an annual
dividend of 1,134,000 is due to be paid in the near future. Dividends have represented
a constant proportion of profits after interest and tax over the last few years.

2. The current price of the firms loan stock is 85.10 per 100 of stock. The loan stock is
redeemable in ten years time at a premium of 5% compared to the nominal value of the
loan stock. Annual interest on the loan stock has just been paid.

3. The current rate of corporation tax is 28% and the current basic rate of income tax is
20%.

4. Extracts from Liteforms most recent financial statements:

000
Issued ordinary share capital (1 shares) 4,200
Retained profits 9,159
Shareholders funds 13,359
7% loan stock 1,819
15,178

000
Profit after interest and tax 2,106
Dividend 1,134
Retained profit for the year 972

Requirements

(a) Using the information provided, calculate Liteforms weighted average cost of capital
(WACC). (10 marks)

(b) Discuss the underlying assumptions and weaknesses of the approach you have
employed in calculating the cost of equity in part (a). (8 marks)

(c) Discuss any reservations you may have regarding the use of the WACC as a discount
factor in appraising Liteforms potential investment projects next year. (5 marks)

(23 marks)

Copyright ICAEW 2012. All rights reserved. Page 5 of 7

3 (a) The finance director of Sunwin plc (Sunwin) is a trustee of the firms employee pension fund.
The vast majority of the funds assets are currently invested in a portfolio of FTSE 100
shares. It is 1 December 2012 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 funds portfolio of shares is
5.6 million. The FTSE 100 index stands at 5,000 on 1 December 2012 and the directors
wish to protect the current value of the portfolio. The trustees have obtained the following
information as at 1 December 2012:

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

Requirement

Demonstrate how FTSE 100 index options can be used by the trustees to hedge the pension
funds exposure to falling share prices and show the outcome if, on 31 December 2012, the
portfolios value:

(i) rises to 6.608 million and the FTSE index rises to 5,900;
(ii) falls to 4.592 million and the FTSE index falls to 4,100. (8 marks)

Copyright ICAEW 2012. All rights reserved. Page 6 of 7

3 (b) It is 1 December 2012 and Sunwins board of directors has recently agreed to purchase
machinery from a UK supplier on 28 February 2013. The firms cash flow forecasts reveal
that the firm will need to borrow 4 million on 28 February 2013 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 or traded interest rate options on futures to hedge against the firms 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 2012 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.

Requirements

(i) 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 2013, the spot rate of interest is 4.5% pa and the
March interest rate futures price has fallen to 95. (6 marks)

(ii) 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 2013:

(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)

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

(26 marks)

Copyright ICAEW 2012. All rights reserved. Page 7 of 7