FINANCIAL STRATEGY
INSTRUCTIONS TO CANDIDATES
The use of a University approved calculator is permitted during this exam.
The use of non-approved calculators is not permitted.
This paper consists of THREE written test questions (100 marks).
Answer ALL questions.
- Type the answer to each question in Word.
- Answers to each question must begin on a new page and must be clearly numbered.
- The examiner will take account of the way in which answers are presented.
- Show all relevant workings.
Question 1
Assume today’s date is 31st May 2020.
Airserv Ltd (Airserv) provides baggage handling services to European airports. Normally the company supplies staff who provide and manage baggage handling services using an airport’s existing facilities, but the company can also supply its own baggage handling systems. Airserv’s accounting year end is 31 May.
Airserv has recently received details of a potential new contract which is available at short notice with a regional airport in the UK. The airport is looking for a company to supply both baggage handling systems and staff for a period of three years from 1 June 2020 to 31 May 2023 to meet increased demand whilst a new terminal is being constructed at the airport.
The airport is offering to pay a maximum fee of £3.75 million for the three-year contract, although tenders can be submitted below this figure. The contract fee will be payable in three equal annual instalments on 31 May 2021, 31 May 2022 and 31 May 2023.
The directors of Airserv have estimated that 157,680 hours of manual labour will be worked during the three-year contract period. This labour will be specifically hired for the period of the contract only and will be paid a fixed rate of £7.50 per hour (at 31 May 2020 prices). These manual labour hours will be split evenly between the three years of the contract.
In addition, the contract would require Airserv to hire four new supervisors, who similarly would be hired for the duration of the contract only and the total cost of employing these new supervisors would be £160,000 (at 31 May 2020 prices) in each year of the contract.
To undertake this new contract, Airserv also expects to incur other incremental operating costs of £150,000 (at 31 May 2020 prices) in each of the three years of the contract.
Airserv is due to complete an existing contract in May 2020 and will be able to transfer baggage handling equipment previously used on that contract to the new contract. This equipment was originally purchased three years ago (ie, in 2017) for £3 million and as at 1 June 2019 has a tax written down value of £1,654,104. If it was not transferred to the new contract, it could be sold on 31 May 2020 for £0.75 million (in money terms).
The costs of installing this equipment in the new airport would be £40,000 payable on 31 May 2020. This cost would be treated as part of the capital cost of the equipment for tax purposes. As at 31 May 2023 it is estimated that this equipment would have negligible residual value..
Full capital allowances at a rate of 18% pa on a reducing balance basis have to date been used as soon as they were available on this equipment and the directors will continue to use such allowances in future if the equipment is retained and used on the new contract.
A balancing charge or allowance will arise on disposal of the equipment (either on 31 May 2020 or 31 May 2023).
Airserv pays corporation tax at a rate of 17% pa and all tax is paid at the end of the accounting year to which it relates.
Airserv’s directors have estimated the nominal after-tax cost of capital for the new contract to be 15% pa.
In considering the potential new contract the directors have estimated that in the years ending 31 May 2021, 2022 and 2023 inflation will be 3%, 4% and 5% pa respectively. These rates of inflation will apply to the labour (manual and supervisory) and other operating costs only.
It can be assumed that all cash flows arise at the end of the year to which they relate.
Requirements
- Working in money terms calculate the net present value of the new airport contract at 31 May 2020. Assume the contract fee is agreed at £3.75m.
(16 marks)
- Calculate and comment on the sensitivity of the net present value of the new airport contract to:
(i) total incremental labour costs (manual and supervisory); and (ii) the amount of the contract fee.
(8 marks)
- Identify the principal strengths and weaknesses of the sensitivity analysis undertaken in part b) above and suggest two ways in which its weaknesses might be addressed.
(6 marks)
- d) Describe real options and discuss whether there are any real options that may be associated with the contract.
(5 marks)
Total: 35 marks
Question 2
Rabbit Plc is a producer of bespoke children’s furniture. Demand for Rabbit’s products has been high in recent years and the directors have decided to expand by setting up a new factory. The expected cost is £100 million.
At a recent board meeting it was decided that the factory will be financed in full by a new issue of bonds.
Some directors are not happy with this financing decision and have asked you, as an ICAEW Chartered Accountant, for advice.
The directors have also asked your help in establishing the cost of capital for Rabbit to use to appraise the expansion plans. The managing director had recently been to a conference where the Capital Asset Pricing Model (CAPM) was discussed as a method of establishing the cost of equity. He wishes to understand more about the assumptions behind this model before trying to use it.
At the same conference it was also suggested that it was always better for a company to use as much debt as possible as it would increase the value of the company.
The company’s statement of financial position at 31 May 2020 shows the following equity and non-current liabilities:
£m
Ordinary £1 shares 100
Retained profit 60
9% Debentures 2023 (par value) 200
360
There is a dividend due to be paid on the 31 May 2020 of £1 per share. This is expected to grow at 4% per year for the foreseeable future. The share price is currently £14.50 (cum div).
The debentures will be redeemed at par on 31 May 2023. The 9% coupon is payable annually in arrears on 31 May and is allowable for tax purposes. The market value on 1 June 2020 is expected to be 101.5% of par (ex int).
Tax is assumed to be 17% and is not expected to change.
Requirements
- Calculate the company’s expected weighted average cost of capital at 31 May 2020.
(10 marks)
- Describe the factors that the directors need to consider when deciding between debt and equity to finance the new factory investment.
(8 marks)
- i) By making reference to the relevant theories, explain the reasoning behind the conclusion that the best approach for a company is to use as much debt as possible.
- ii) Describe the limitations of taking the above approach to financing, referring in particular to the position of Rabbit plc.
(8 marks)
- State four assumptions behind the CAPM as an approach to calculating the cost of equity.
- marks)
- Outline the five fundamental principles that you, as an ICAEW Chartered Accountant, need to follow when providing financial management advice to a client or colleague.
- marks)
Total: 35 marks
Question 3
For all parts of this question, please assume that today’s date is 30 June 2020.
Kielder plc is a UK company that supplies high-powered telescopes to customers such as universities and other research bodies that are based mainly in the US.
Kielder fabricates the telescopes in the UK from parts that are sourced mainly in the US. Although the exchange rate between £ sterling and US dollars has been relatively constant in the past few years, recent volatility in the exchange rate has encouraged Kielder to seek advice on how to hedge its currency exposure.
The following receipts and payments on exports and imports respectively are due in six months’ time:
Receipts from US based universities: $2,800,000
Payments to US based suppliers: $1,350,000
Exchange rate quotes as at today’s date are as follows:
Dollar/sterling spot rate: $1.2205 – $1.2290
3 month forward discount 0.52c – 0.71c
6 month forward discount 0.89c – 1.21c
Sterling currency options with a standard contract size of £31,250 are currently priced as follows (premiums quoted in cents per £ and payable up-front):
| Calls | Puts | ||||
| Strike price | Sept | Dec | Sept Dec | ||
| $1.22 | 4.52 | 5.76 | 0.64 1.70 | ||
| $1.24 | 3.17 | 4.33 | 1.98 3.13 | ||
| $1.26 | 1.87 | 2.90 | 3.41 4.69 |
Sterling currency futures with a standard contract size of £62,500 are currently priced as follows:
September $1.2355/£1
December $1.2470/£1
Annual interest rates for depositing and borrowing respectively are currently as follows:
Sterling 1.20% – 2.30%
Dollar 2.50% – 3.40%
Requirements
- a) Assuming that the dollar/sterling spot rate in six months’ time will be $1.2530 – $1.2615, calculate the net outcome achieved using each of the following:
- A forward market hedge
- Exchange-traded currency options (hedging to the nearest whole number of contracts) so as to achieve an outcome no worse than the current spot rate
- Currency future contracts (hedging to the nearest whole number of contracts), assuming that the Dec futures price at this point is $1.2575
- A money market hedge.
(18 marks)
In Dec 2020, Kielder will need to borrow £4.5 million for a six-month period at a fixed interest rate. The board of Kielder wants to ensure that the interest rate on the loan does not exceed 3.5% pa, with the spot rate currently at 2.8% pa. It is intended that three-month sterling traded interest rate options on futures will be used in order to hedge Kielder’s interest rate exposure.
Current prices (premiums expressed in annual % terms) for these contracts are as follows (standard contract size of £500,000):
| Calls | Puts | |||||
| Strike Price | Sep | Dec Mar | Sep | Dec Mar | ||
| 96.50 | 0.22 | 0.26 0.29 | 0.35 | 0.48 0.59 | ||
| 96.75 | 0.15 | 0.16 0.17 | 0.52 | 0.75 0.93 | ||
| 97.00 | 0.08 | 0.09 0.10 | 0.84 | 1.26 1.50 |
- b)
- Calculate the outcome of the hedge and the effective annual interest rate that will have been achieved if prices at the point the loan will be taken out are either:
- a spot interest rate of 4.5% pa and a futures price of 95.4 OR
- a spot interest rate of 2.3% pa and a futures price of 97.55.
(10 marks)
- Explain why a hedge using futures contracts may be less than 100% effective.
(2 marks)
[Total: 30 marks]
Formulae you may require:
- Discounting an annuity
The annuity factor: AF1→ n =
Where AF = annuity factor
n = number of payments
r = discount rate as a decimal
- Gordon growth model:
ke = D0(1+ g) + g
P0
Where ke = cost of equity
D0 = current dividend per ordinary share g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share
- Capital asset pricing model: rj = rf + j (rm – rf) Where rj = the expected return from security j
rf = the risk free rate j = the beta of security j
rm = the expected return on the market portfolio
- e = a 1+ D(1− T)
E
Where e = beta of equity in a geared firm
a = ungeared (asset) beta
- = market value of debt
- = market value of equity
T = corporation tax rate
Note: Candidates may use other versions of these formulae but should then define the symbols they use.
Discount Tables
| Interest | Number of | Present value of | Present value of |
| rate | years | £1 receivable at | £1 receivable at |
| p.a.
|
n
|
the end of n years
|
the end of each of n years |
| 1% | 1 | 0.990 | 0.990 |
| 2 | 0.980 | 1.970 | |
| 3 | 0.971 | 2.941 | |
| 4 | 0.961 | 3.902 | |
| 5 | 0.951 | 4.853 | |
| 6 | 0.942 | 5.795 | |
| 7 | 0.933 | 6.728 | |
| 8 | 0.923 | 7.652 | |
| 9 | 0.914 | 8.566 | |
| 10 | 0.905 | 9.471 | |
| 5% | 1 | 0.952 | 0.952 |
| 2 | 0.907 | 1.859 | |
| 3 | 0.864 | 2.723 | |
| 4 | 0.823 | 3.546 | |
| 5 | 0.784 | 4.329 | |
| 6 | 0.746 | 5.076 | |
| 7 | 0.711 | 5.786 | |
| 8 | 0.677 | 6.463 | |
| 9 | 0.645 | 7.108 | |
| 10 | 0.614 | 7.722 | |
| 10% | 1 | 0.909 | 0.909 |
| 2 | 0.826 | 1.736 | |
| 3 | 0.751 | 2.487 | |
| 4 | 0.683 | 3.170 | |
| 5 | 0.621 | 3.791 | |
| 6 | 0.564 | 4.355 | |
| 7 | 0.513 | 4.868 | |
| 8 | 0.467 | 5.335 | |
| 9 | 0.424 | 5.759 | |
| 10 | 0.386 | 6.145 | |
| 15% | 1 | 0.870 | 0.870 |
| 2 | 0.756 | 1.626 | |
| 3 | 0.658 | 2.283 | |
| 4 | 0.572 | 2.855 | |
| 5 | 0.497 | 3.352 | |
| 6 | 0.432 | 3.784 | |
| 7 | 0.376 | 4.160 | |
| 8 | 0.327 | 4.487 | |
| 9 | 0.284 | 4.772 | |
| 10 | 0.247 | 5.019 | |
| 20% | 1 | 0.833 | 0.833 |
| 2 | 0.694 | 1.528 | |
| 3 | 0.579 | 2.106 | |
| 4 | 0.482 | 2.589 | |
| 5 | 0.402 | 2.991 | |
| 6 | 0.335 | 3.326 | |
| 7 | 0.279 | 3.605 | |
| 8 | 0.233 | 3.837 | |
| 9 | 0.194 | 4.031 | |
| 10 | 0.162 | 4.192 |
