PROFESSIONAL LEVEL AND STAGE EXAMINATION

WEDNESDAY 11 SEPTEMBER 2013

(2½ hours)

FINANCIAL MANAGEMENT
This paper consists of THREE written test questions (100 marks).

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

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

3. 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.

4. 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 2013. All rights reserved.

ICAEW\263\S13 Page 1 of 8
1. Arleyhill Redland plc (AR) is a UK listed manufacturer of domestic kitchen equipment. AR’s
directors are planning to expand and update the company’s product range through a mixture
of organic growth and the acquisition of smaller competitors. These plans would require an
additional £12 million of funding (to be raised in September 2013) and you, as a project
analyst at AR, have been asked to prepare working papers to aid the directors’ decision as to
which source of finance to use. AR’s financial year ends on 31 August and extracts from its
most recent management accounts are shown below:

Income Statement for the year to 31 August 2013

£’000
Sales 54,400
Variable costs (32,640)
Fixed costs (8,200)
Profit before interest 13,560
Debenture interest (930)
Profit before tax 12,630
Taxation (@ 21%) (2,652)
Profit after tax 9,978
Dividends (1,728)
Retained profit 8,250

Balance Sheet at 31 August 2013

£’000
Ordinary share capital (£1) 28,800
Revenue Reserves 30,850
6% debentures 15,500
75,150

Total assets less current liabilities 75,150

Market research commissioned by AR’s directors has estimated that the £12 million of
additional funding would increase annual turnover from September 2013 by one fifth and that
this expansion of the company’s operations would also lead to an additional £0.5 million of
annual fixed costs. The directors also expect AR’s contribution to sales ratio to remain
unchanged. Two methods of raising the additional funding have been suggested:

(i) a rights issue at £2.50 per share or,

(ii) an issue of 7% debentures at par.

The most recent board meeting was held on 2 September 2013 and an extract from the
minutes of that meeting is shown here:

“Martin Cotham (Finance Director) suggested that AR should raise the

£12 million via a rights issue. The current share price is £3.10. If the issue was
priced at £2.50 per share, he thought this was sufficient a discount to be
attractive to shareholders and should guarantee a successful outcome. He said
it’s also good as it reduces AR’s gearing and so will send the shareholders a
positive message. He felt if, after the rights issue, AR could get its share price up
above its current level, even if it’s only a £0.20 per share increase, then the rights
issue looks like the best method.”

Copyright © ICAEW 2013. All rights reserved. Page 2 of 8

 “Amy Wills (Managing Director) said that we should issue more debentures as
(i) the rights issue will dilute the value of AR’s shares and (ii) AR is not making
enough use of the tax shield. She also said that a rights issue might upset the
shareholders, as, if they can’t afford it and don’t take up the rights, they would
lose money. The debentures would also put less pressure on AR to maintain
annual dividend levels and, thereby, maintain investors’ confidence in us. A
slightly higher coupon rate of 7% would make the debentures more attractive
than those currently in issue. She also said we should consider other types of
debt such as convertibles and loan stock with warrants.”

Requirements

(a) Aside from the factors already identified by Martin Cotham and Amy Wills, outline the
other factors that should be considered by a company contemplating a rights issue as a
means of raising finance. (4 marks)

(b) Using the market research estimates above, and assuming that AR’s dividend per share
remains unchanged, prepare AR’s forecast Income Statement for the year to 31 August
2014 if it uses:

(i) a rights issue at £2.50 per share; or

(ii) an issue of 7% debentures at par

to raise the £12 million of additional funding required. (9 marks)

(c) Calculate AR’s earnings per share for the year to 31 August 2013 and, for both
financing methods, its estimated earnings per share for the year to 31 August 2014.
(5 marks)

(d) Calculate AR’s gearing ratio (in book and market value terms) on 31 August 2013 and
similarly, for both financing methods, its gearing ratio on 31 August 2014. You should
assume that on 31 August 2014 AR’s ordinary share price is £3.30 per share and that
its debentures are quoted at par on 31 August 2013 and 31 August 2014. (8 marks)

(e) Using the calculations undertaken in parts (b), (c) and (d), advise AR’s directors of the
key issues to consider when deciding whether to raise the required funds via a rights
issue or a debenture issue. (5 marks)

(f) Explain the differences between convertible loan stock and loan stock with warrants.
(4 marks)

(35 marks)

Copyright © ICAEW 2013. All rights reserved. Page 3 of 8

2. Air Business Limited (ABL) is a UK airline company that offers flights between London and
European cities. All six of its aircraft are four-seaters and the company offers an exclusive
travel service for business customers. ABL has a financial year end of 30 September and has
been trading since 1992. Historically it has not tried to compete with cheaper competitors.
However, the company has now endured two years of stagnant sales.

ABL’s board is considering changing its business strategy. It will reduce ticket prices and, to
accommodate the expected increase in demand, buy three larger aircraft to replace two of its
existing aircraft. You work in ABL’s finance team and have been asked to help the board with
their decision regarding this proposed investment. You have been given the following
information:

Life of investment

You have been informed that, because of the volatility of the airline market, the board wishes
to set a three-year time limit on this investment appraisal.

Sales and costs

Table 1 below (with notes) is a summary of recent and estimated sales and costs prepared
by ABL’s management accounting team:

Table 1

Current strategy Proposed strategy

Sales & costs Annual sales & costs
(year to 30 September 2013) (three years to 30 September 2016)
25% Fixed 22% Fixed
Sales margin costs Profit Sales margin costs Profit
£’000 £’000 £’000 £’000 £’000 £’000 £’000 £’000
4,150 1,038 (50) 988 7,350 1,617 (90) 1,527

Notes:

1. “% margin” represents the contribution to sales ratio.

2. All figures in Table 1 are in 30 September 2013 prices.

3. Sales and costs, in 30 September 2013 prices, can be assumed to remain constant for
the next three years if no change in strategy occurs.

Copyright © ICAEW 2013. All rights reserved. Page 4 of 8

 Capital expenditure

On 30 September 2013 ABL will purchase three larger aircraft for £1 million each.
Management estimates that these would have a trade-in value of £200,000 each
(in 30 September 2016 prices) on 30 September 2016.

These three new aircraft will replace two of its existing aircraft, which have a current tax
written down value of zero and will be traded in for £380,000 each on 30 September 2013.

The aircraft 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 aircrafts’ written down value for tax purposes and their
disposal proceeds will be treated by the company either:

(i) as an additional tax relief, if the disposal proceeds are less than the tax written down
value, or

(ii) as a balancing charge, if the disposal proceeds are more than the tax written down
value.

Working capital

ABL currently has a working capital investment of £140,000 on 30 September 2013. The
proposed strategy is expected to increase this to £220,000 on 30 September 2013 and any
incremental working capital will be fully recoverable on 30 September 2016.

Inflation

ABL’s sales, costs and working capital are all expected to increase in line with the general
rate of inflation, which is estimated at 5% pa.

Taxation

ABL’s directors wish to assume that the corporation tax rate will be 21% 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 ABL uses a money cost of capital of 8% pa.

Other information

Unless otherwise stated, all cash flows occur at the end of the relevant trading year.

In addition to this investment appraisal, ABL’s directors are aware that there have been a
number of takeovers and mergers in the airline industry in the past three years. They are
concerned that the company might be the subject of a takeover bid and wish to explore how
they could make use of Shareholder Value Analysis to value the company.

Copyright © ICAEW 2013. All rights reserved. Page 5 of 8

 Requirements

(a) Calculate the net present value of the proposed investment in the three new aircraft on
30 September 2013 and advise ABL’s directors whether they should proceed with the
investment. (16 marks)

(b) Calculate the sensitivity of your advice in part (a) to:

(i) changes in the estimated trade-in value of the new aircraft at 30 September 2016.
(4 marks)

(ii) changes in the estimated incremental annual profits arising from the new strategy.
(5 marks)

(c) Explain the theory underpinning the Shareholder Value Analysis method of valuing a
business and advise ABL’s directors as to what extent your calculations in part (a)
above could be used to calculate a valuation of ABL using this method were it to be
subject to a takeover bid. (10 marks)

(35 marks)

Copyright © ICAEW 2013. All rights reserved. Page 6 of 8

3a. You should assume that it is now 30 September 2013

Clifton Bernard Limited (CB) is a UK engineering firm and specialises in the building of
cranes. It has a financial year end of 30 September. Much of CB’s trade is in Europe - its
main suppliers are based in Germany and a major customer is based in Italy.

CB has two large contracts due for settlement at the end of December 2013 and, because of
the scale of these contracts, its board is considering whether or not to hedge against the
possibility of an adverse move of sterling against the euro before the end of 2013. Details of
the two contracts are shown below:

Receipt due from Italian customer on 31 December 2013 €2.600m

Payment due to German supplier on 31 December 2013 €3.350m

You work for CB and have been asked to advise the board on the implications of hedging
these two contracts. The information below in Table 1 has been gathered on
30 September 2013:

Table 1

Spot rate (€/£) 1.2080-1.2170

Relevant over the counter (OTC) currency option, exercise price (€/£) 1.2070
Three month forward contract – premium (€/£) 0.0025-0.0020
OTC currency option cost (per euro converted) £0.025
Forward contract arrangement fee (per euro converted) £0.008
Euro interest rate (borrowing) 3.6% pa
Euro interest rate (lending) 2.8% pa
Sterling interest rate (borrowing) 4.4% pa
Sterling interest rate (lending) 3.4% pa

Requirements

(i) Using the information above, and assuming that the spot rate on 31 December 2013 will
be:

1. either €1.1850 - €1.1940/£

2. or €1.2570 - €1.2660/£

Calculate CB’s net sterling payment if it uses the following to hedge its foreign
exchange transaction risk:

 a forward contract

 a money market hedge

 an over-the-counter currency option. (11 marks)

(ii) Advise CB’s directors of the implications of hedging or not hedging its foreign exchange
transactions on 31 December 2013, showing supporting calculations. (8 marks)

(iii) Explain the concept of interest rate parity with reference to the information available in
Table 1 above. (5 marks)
PLEASE TURN OVER

Copyright © ICAEW 2013. All rights reserved. Page 7 of 8

3b. In June 2009, CB borrowed £6.3 million at a variable rate of LIBOR plus 2.5% pa to finance
the construction of a large new factory. This loan is set to mature in June 2016 and CB’s
directors are keen to explore the possibility of an interest rate swap. CB’s bank has advised
them that Montpelier Neville Industrials plc (MNI) has a similar sized loan with an interest rate
of 5% pa. MNI is seeking a variable rate and could borrow at a variable interest rate of LIBOR
plus 1.5% pa whilst the best fixed rate available to CB is 6.5% pa. LIBOR on 30 September
2013 is 5% pa.

Requirement

Suggest a swap arrangement that would be equally fair to both CB and MNI (setting the
variable leg of the swap at LIBOR) and, based on the current LIBOR, show the difference in
total annual interest payable by CB if the swap goes ahead. (6 marks)

(30 marks)

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