PROFESSIONAL STAGE APPLICATION EXAMINATION

WEDNESDAY 12 JUNE 2013

(2½ 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 2013. All rights reserved.

1. ProBuild plc (ProBuild) runs a network of builders’ merchants in northern England. The
company has a small subsidiary, Cabin Ltd (Cabin) that hires out various types of portable
cabin used on building sites. In recent years, Cabin’s performance (relative to that of
ProBuild’s core business) has been disappointing and the directors of ProBuild have decided
that they should focus resources on their core operations and dispose of Cabin.

Having advertised the business for sale, ProBuild has now been approached by the directors
of Brixham plc (Brixham) with an offer to buy Cabin on 31 December 2013. Brixham has
agreed, in principle, to pay ProBuild the net present value (as at 31 December 2013) of the
projected incremental net cash flows of Cabin over the four-year period to 31 December
2017.

You have been asked by Brixham’s directors to calculate an appropriate purchase price
using the following information which has been provided by ProBuild and verified by
independent accountants:

(1) All cash flows can be assumed to occur at the end of the relevant year unless otherwise
stated.

(2) Inflation is expected to average 2% pa for all costs and revenues.

(3) The real discount rates applicable to the appraisal of this investment are:

2014: 5%
2015: 6%
2016: 7%
2017: 7%

(4) During the past five years, Cabin’s annual revenue (at 31 December 2013 prices) has
been extremely volatile, having peaked at £2 million in one year, whilst falling to a low of
£1.2 million in another year.

(5) During the past five years, Cabin’s variable costs have been similarly volatile, being as
low as 25% of annual revenue in one year, whilst having been as high as 30% of annual
revenue in another year. There has been no direct correlation between annual revenue
and variable costs during the past five years.

(6) It has been estimated that under Brixham’s ownership, annual fixed costs will be
£0.6 million (at 31 December 2013 prices), including a share of Brixham’s existing head
office costs equal to £0.25 million.

(7) Working capital equal to 8% of Cabin’s annual revenue for that year must be in place by
the start of the year concerned and, for the purposes of the calculation of a purchase
price, it can be assumed to be released in full on 31 December 2017.

(8) Cabin has an existing commitment (which Brixham would have to honour as a condition
of its purchase of Cabin) to make a substantial investment of £1.5 million in new plant
and equipment on 31 December 2013. This equipment is expected to have a useful
working life of four years, at which time it is estimated that it will be disposed of for a
sum of £100,000 (at 31 December 2017 prices).

Copyright © ICAEW 2013. All rights reserved. Page 2 of 6

This new plant and equipment will attract capital allowances of 20% pa on a reducing
balance basis commencing in the year of purchase and continuing throughout Brixham’s
ownership of the equipment. A balancing charge or allowance will arise on disposal of the
equipment on 31 December 2017.

It can be assumed that sufficient profits would be available for Brixham to claim all such tax
allowances in the year they arise. It can also be assumed that the corporation tax rate will be
28% for the foreseeable future, and that tax payments will occur at the end of the accounting
year to which they relate.

Requirements

(a) Using money cash flows, calculate the net present values at 31 December 2013 of the
Cabin business for both the ‘worst case’ and ‘best case’ scenarios. (17 marks)

(b) Distinguish between the terms ‘uncertainty’ and ‘risk’ in the context of investment
decision-making and describe how the directors of Brixham might adjust the
calculations made in part (a) from calculations made under conditions of uncertainty to
calculations made under conditions of risk. (6 marks)

(c) Explain what is meant by the term ‘real options’ and suggest two real options that might
be relevant to Brixham’s purchase of Cabin. (6 marks)

(29 marks)

Copyright © ICAEW 2013. All rights reserved. Page 3 of 6

2. Assume that the current date is 30 June 2013.

Brampton plc (Brampton) is a large company in the UK agricultural market, principally

involved in the production of crops for both the brewing and food sectors. The business has
grown rapidly in recent years through the acquisition of numerous farming businesses.

As this growth has gathered pace, the finance director has become increasingly concerned
by the potential negative impact of interest rate movements on the company, which has
never previously hedged its exposure to interest rate risk.

Forecast cash position

As the company accountant, you have recently produced a forecast of average cash
balances for the company’s next financial year which illustrates the extremely seasonal
nature of its business, as evidenced by the following projected average cash balances for
each half of the next year:

1 October 2013 – 31 March 2014 £40 million borrowing

1 April 2014 – 30 September 2014 £70 million cash deposit

The finance director has now asked you to explore how either interest rate options or forward
rate agreements might be used to manage the company’s interest rate risk.

Three-month interest rates are currently 3.25% pa. You have been able to obtain the
following information at the close of business on 30 June 2013:

Sterling Interest Rate Options on 3-month Futures Contracts

Standard Contract Size £500,000
Premiums in annual % terms

Strike price Calls Puts

Sept Dec March Sept Dec March
96.75 0.53 0.74 0.81 0.42 0.69 0.79

Forward Rate Agreements

Term Rate (% pa)

3v6 3.00
3v9 2.91
6v9 2.72
6v12 2.68
9v15 2.55

It can be assumed that both deposits and borrowings attract the same rate of interest.

Three scenarios

The finance director has requested that you analyse matters in relation to three specific
scenarios:

1. No change in the current three-month interest rate during the next financial year;
2. An increase in the three-month interest rate to 5.00% pa for the next financial year;
3. A decrease in the three-month interest rate to 1.50% pa for the next financial year.

Copyright © ICAEW 2013. All rights reserved. Page 4 of 6

Futures

The finance director has also mentioned that he understands that interest rate futures can
achieve the same effect as forward rate agreements, although he has no experience of using
interest rate futures in practice.

Requirements

(a) For each of the three specific scenarios in turn, calculate Brampton’s net interest
received or paid, for each half year and for the full year, if the company chooses to:

(i) remain unhedged;

(ii) use interest rate options;
(iii) use forward rate agreements. (20 marks)

(b) Identify for the finance director how hedging interest rate exposure using interest rate
futures differs from hedging using forward rate agreements. (7 marks)

(27 marks)

PLEASE TURN OVER

Copyright © ICAEW 2013. All rights reserved. Page 5 of 6

3. Bayton plc (Bayton) is a listed automotive engineering company and is currently planning to
increase its production capacity through a significant investment in a new factory. Bayton’s
finance director is proposing to finance the project with long-term funding in the form of a mix
of new equity and new 5% irredeemable debentures.

The finance director is currently considering the issue of the cost of capital for this particular
investment project as he considers the company’s existing weighted average cost of capital
(WACC) to be the appropriate discount rate to use in appraising the proposed investment.

He has obtained the following up to date information:

- the company has 130 million £1 ordinary shares in issue, which are currently
trading at 250p per share;
- an annual dividend of 13.6p per share has just been paid which compares with an
annual dividend of 10.0p per share paid four years ago;
- the company has £125 million of 4% redeemable debentures in issue, which are
currently trading at £98 per £100 of debentures and they are redeemable at par in
five years’ time.

The finance director wishes to assume that the corporation tax rate will be 28% for the
foreseeable future.

Bayton’s managing director has, however, expressed some concerns regarding the proposed
financing of the new factory. The managing director feels that the company should use only
debt to finance its future projects in order to maximise the wealth of shareholders. He feels
that the finance for this latest project should be raised solely through a new issue of 5%
irredeemable debentures and that the debenture interest rate of 5% should, therefore, be the
appropriate discount rate to use in appraising the new investment.

The production director, on the other hand, cannot understand why the company should be
concerned about the cost of capital when it has access to retained profits, as they have no
cost.

Requirements

(a) Calculate Bayton’s existing WACC on the basis of the information provided. (6 marks)

(b) Describe the difficulties that Bayton might encounter when attempting to calculate its
WACC. (7 marks)

(c) Critically evaluate the suggestions of the finance director, the managing director
and the production director, in respect of both the method of financing and the
cost of capital. (11 marks)

(24 marks)

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