DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO.

Financial Pillar

F3 Financial Strategy
20 November 2014 Thursday Morning Session
Instructions to candidates

You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, highlight
and/or make notes on the question paper. However, you will not be allowed,
under any circumstances, to open the answer book and start writing or use
your calculator during this reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is all parts and/or subquestions).
ALL answers must be written in the answer book. Answers written on the
question paper will not be submitted for marking.
You should show all workings as marks are available for the method you use.
The pre-seen case study material is included in this question paper on pages
2 to 6. The unseen case study material, specific to this examination, is
provided on pages 8 and 9.
Answer the compulsory question in Section A on page 11. This page is
detachable for ease of reference
Answer TWO of the three questions in Section B on pages 14 to 19.
Maths tables and formulae are provided on pages 21 to 25.
The list of verbs as published in the syllabus is given for reference on page
27.
Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.
Tick the appropriate boxes on the front of the answer book to indicate which
questions you have answered.

F3 Financial Strategy

You are allowed three hours to answer this question paper.

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The Chartered Institute of Management Accountants 2014

Introduction
Y was formed in 1900. It manufactures and sells top quality confectionery. For many years, Y
has been recognised as a successful company and has become a household name particularly
throughout Europe. Its fame is built on the very high quality confectionery products it sells
through its own high street stores (some of which it owns and some which it leases). Y has just
over 3,500 employees.
All of Ys products are manufactured in its factory in the European country in which it is based
(which is in the eurozone). The products are distributed through a multi-channel network
comprising of Ys own stores and online business, franchises and retail partners. In addition, Y
has now started to supply confectionery to large retail stores and supermarkets on a contract
basis. These stores sell Ys products and also own brand label confectionery that Y
manufactures for them.
Ys product range includes a wide variety of milk, white, plain and diabetic chocolate products.
Previously Ys main sales had been chocolate products but now the company has expanded into
producing other forms of confectionery which do not contain chocolate in any form, for example
cakes and other sweets (candies). Ys customers continue to have strong regard for the quality
of its products.
Although Y exports its products throughout the world, its largest market is within Europe. Ys
customers vary from individuals to corporate clients which purchase Ys products to present to
their own clients as corporate gifts. Although individual customers buy from Ys stores,
franchises or online, corporate clients purchase goods directly from Y on a contract basis.
Business structure
Y has a simple business structure. It has a head office (which includes its corporate treasury
function) and two divisions: Direct Customer Sales (DCS), and Manufacturing and Commercial
(MC). The activities of each division are as follows:
DCS
DCS has the following sales outlets:
Ys own stores
Franchises
Online sales
MC
MC undertakes all purchasing of ingredients and manufacturing of Ys products. It then supplies
these products
internally to:
DCS for its sales through its own outlets
externally to:
Corporate clients
External retail stores and supermarkets which sell Ys products under Ys own label and
also under the stores own labels.
Both divisions are investment centres but have limited capital investment authority, for
expenditure up to EUR 10,000 per item. Major capital investments, above EUR 10,000 per item,
have to be authorised by head office.
DCS does not allow any of its outlets to make any capital investment at all without its prior
approval. Each of DCSs sales outlets is regarded as a profit centre, including online sales which
is a single profit centre in its own right. Brand development is carried out by both of the divisions.
Any brand development costs, such as promotion, above EUR 10,000 must be approved at
head office.

Financial Strategy

November 2014

The decline of high street sales has led Y to reduce the number of its stores and expand other
sales outlets. This has resulted in some staff being re-trained and re-deployed. Y currently has
just over 300 of its own stores and fewer than 200 franchises. It also has developed its own
website. This has been very popular and has enabled its international business to grow. In
addition, as internet shopping has become more popular, Y has been able to develop its online
sales business and has introduced click and collect services using its stores and franchise
businesses as the collection points.
Mission, Aim and Objectives
Ys mission statement, agreed by the Board of Directors last year is:
To delight customers by providing luxurious products which strengthen the brand.
Ys overall aim is to increase shareholder value by improving profit margins through increased
sales and reduced costs. Despite the difficult economic conditions in Europe, the chocolate
market has continued to grow in the last five years. Ys customers engage particularly with
chocolate products in response to austere economic conditions seeing them as an affordable
alternative to higher priced gifts. Y is now placing greater emphasis on trying to de-seasonalise
its sales by not being reliant on the seasonal peak sales periods. Y is encouraging customers to
buy its products throughout the year through all of its sales channels. This demands a strong
focus on developing brand awareness.
Y intends to achieve the continued development and growth of its business by meeting two
strategic objectives which are to:
1. Engage with the widest range of customers through the development of Ys markets and
products through a wide variety of sales channels. The focus of this is on the delivery of
products the customer demands, where they are required and when they are wanted.
2. Enhance the customer experience through strong and effective customer relationship
management. The focus of this is on clear and consistent branding and marketing to
encourage customer retention and loyalty all the year round.
Ys Board and Divisional Management
The Board comprises a non-executive Chairman, a newly appointed Chief Executive, the
Managing Directors of the two divisions, the Finance Director and three non-executive directors.
The company applies good corporate governance principles and practice and the Board has a
committee structure which includes an Audit Committee.
The divisional structures reflect their different activities. The Managing Director of each division
has a team comprising three divisional directors covering the functions of Finance, Human
Resources and Information Technology. In addition, the DCS division has three divisional
directors, one each responsible for Ys stores, franchises and online sales. In addition to the
divisional directors for Finance, Human Resources and IT, the MC division has three divisional
directors, one responsible for procurement, one for manufacturing and one for commercial
clients, retail stores and supermarkets. The structure for Ys Board and its divisions is presented
at Appendix 1.
Financial overview
Extracts from the statement of profit or loss for the year ended 31 December 2013 and
statement of financial position as at 31 December 2013 are shown in Appendix 2. They show
that in the last financial year, Y achieved an operating profit margin of 12% and profit after tax of
7.7%.
Despite its best efforts in heavily re-investing in the business, Ys bottom-line profit has
stagnated. The Board is concerned that the expected actual profit for the year ended 31
December 2014, when compared with the forecast, is not looking as promising as was first
thought. The Board is also mindful that some of Ys borrowings are due for re-payment in 2015.

November 2014

Financial Strategy

In response to these concerns, the Board of Directors has determined the following financial
objectives for Y:
That it should operate on a sound financial basis in order to increase profit and
shareholder value
That it should pay a regular and consistent dividend each year.
Environmental and Corporate Social Responsibility
Y aims to carry out its business with as little damage to the environment as possible and to
operate in a fair manner with regard to all its stakeholders. It is keen to ensure that each of its
suppliers adheres to high ethical and environmental standards with regard to sources of
materials and treatment of employees.
Y imports cocoa from Africa and Indonesia. Y has initiated schemes to encourage sustainable
farming of cocoa and farmers are being trained in effective agricultural methods. The
introduction of an industry approved certification programme has enabled farmers to achieve
higher levels of income from increased production and to access additional training directed at
improving their production yields. All raw materials sourced from Africa and Indonesia are priced
in US Dollars (USD).
All of Ys products contain only the ingredients listed on the packaging. The packaging also
shows nutritional content and gives advice on recommended volumes of consumption. Y tries to
ensure that the packaging used for its products is recyclable and kept as minimal as possible to
balance concerns over material usage with commercial marketing requirements.
Environmentally friendly lighting has been introduced in Ys factory which has reduced
consumption of electricity and emission of carbon dioxide.
Y has introduced annual independent health and safety audits in its factory and retail outlets. All
factory staff have undertaken food safety and health and safety in the workplace training at the
required industry standard level. Workplace benefits, such as life and medical insurance, staff
discounts and membership of local gymnasia, as well as competitive salaries and wages are
offered to all of Ys employees.
Strategic developments
In order to achieve its overall mission, aim and objectives, Y intends to expand its online channel
to increase its sales to corporate clients and external retail stores and supermarkets. These
sales yield a higher margin than that achieved through sales in Ys own high street stores. The
Board also intends to further rationalise the number of its high street stores.

Financial Strategy

November 2014

Appendix 1

STRUCTURE CHART FOR Y

Board of Directors
Non-Executive Chair
Chief Executive
Finance Director
Managing Director (DCS)
Managing Director (MC)
3 Non-executive directors

Manufacturing and Commercial

Division

Direct Customer Sales Division

Managing Director DCS

Divisional Directors of:
Finance
Human Resources
Information Technology
Ys Stores
Franchises
Ys Online Sales

November 2014

Managing Director MC
Divisional Directors of:
Finance
Human Resources
Information Technology
Procurement
Manufacturing
Corporate clients, external retail stores
and supermarkets

Financial Strategy

Appendix 2
Ys statement of profit or loss and statement of financial position
Statement of profit or loss for the year ended 31 December 2013
EUR 000
248,589
(128,523)
120,066
( 90,239)
29,827
120
( 5,008)
24,939
( 5,736)
19,203

Revenue
Cost of sales
Gross profit
Operating costs
Operating profit
Finance income
Finance costs
Profit before tax
Tax
PROFIT FOR THE YEAR

Statement of financial position as at 31 December 2013

EUR 000
ASSETS
Non-current assets
Intangible assets: goodwill
Property, plant and equipment
Total non-current assets
Current assets
Inventories
Trade and other receivables
Cash and cash equivalents
Total current assets
Total assets

2,407
158,822
161,229
44,856
21,348
12,368
78,572
239,801

EQUITY AND LIABILITIES

Equity
Share capital (EUR 0.5 shares)
Share premium
Retained earnings
Total equity

31,122
12,120
42,101
85,343

Non-current liabilities
Borrowings
Provisions for liabilities
Total non-current liabilities
Current liabilities
Trade and other payables
Provisions for liabilities
Total current liabilities
Total liabilities
Total equity and liabilities

116,484
2,294
118,778
33,936
1,744
35,680
154,458
239,801

End of Pre-seen Material

The unseen material begins on page 8
Financial Strategy

November 2014

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November 2014

Financial Strategy

SECTION A 50 MARKS
[You are advised to spend no longer than 90 minutes on this question.]
ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON
PAGE 11, WHICH IS DETACHABLE FOR EASE OF REFERENCE

Question One
Unseen
Y implemented a number of changes to the business during 2014 in an attempt to boost
revenues, including a shift in focus from selling its products through its own stores to selling
through external supermarkets. As a result, Y closed many of its own stores. It also heavily
promoted its products for sale through external supermarkets by commissioning television
adverts and paying for prominent displays at the ends of aisles and near to points of sale. There
have therefore been some large one-off costs in the first half of 2014.
The shift in business strategy has resulted in a significant increase in both the volume of goods
sold and total revenue in the first 9 months of 2014. However, there has been a negative effect
on profit margins which fell markedly. Taking the one-off costs into account, revised forecast
results for the year ending 31 December 2014 show a lower profit after tax figure than in the
previous year.
Once they were aware of the situation, the directors recognised that they had an obligation to
inform investors of revised profit after tax expectations for the year ending 31 December 2014.
Six months earlier they had indicated to the market that results for the current financial year
would be comparable with the results for 2013. In mid-October, the directors decided to issue a
public profit warning. The Finance Director was given the task of producing a best estimate of
revised expectations for 2014.
Data for Y as at 20 October 2014
The following data was collected on 20 October 2014 to enable the Finance Director to calculate
a forecast profit after tax figure for Y in respect of the year ending 31 December 2014:
Revenue is forecast to be 20% higher than in 2013.
The gross profit margin is forecast to be 38% on average during 2014.
Operating costs are assumed to be 5% higher than in 2013 due to reorganisation costs
and higher marketing costs.
The following items are assumed to remain the same as in the previous financial year:
o The corporate income tax rate (as a percentage of profit before tax).
o Finance income.
o The average interest rate charged on borrowings of 4.3%.
Borrowings are forecast to be EUR 120.22 million on 31 December 2014, which can be
assumed to be the average balance throughout 2014.
Additional data relating to the year ending 31 December 2014:
Share capital and share premium account remain unchanged since 31 December 2013.
A dividend of EUR 0.18 per share is expected to be paid in December 2014.
Note that financial data for Y for the year ended 31 December 2013 is provided on page 6 of the
preseen.

Financial Strategy

November 2014

Profit warning announcement

The profit warning was announced on 1 November 2014. At the start of the day, before the
announcement, Ys share price was EUR 3.39 per share (giving a P/E of 11.0) based upon the
markets expectation that profit after tax in 2014 would be the same as 2013. By the end of the
day the share price fell sharply by 35% in response to the profit warning announcement.
Refinancing borrowings
Y relies on bank borrowings from 30 banks. Each borrowing is arranged separately with the
bank. EUR 30 million of bank borrowings is due to be repaid in 2015 and initial refinancing
negotiations with the banks are expected to begin next month, December 2014. The Treasurer
of Y is concerned about how the profit warning might affect these negotiations.
Alternative financing schemes
The following two financing schemes are being considered as alternatives to refinancing with
bank borrowings in 2015. Either one or both schemes could be adopted.
A

Issue a scrip dividend instead of the proposed annual dividend of EUR 0.18 per share
planned to be paid before 31 December 2014.

Sell 10 retail properties for EUR 20 million in total and lease the properties back under a
10 year arrangement. It has been estimated that the present value of cash flows arising
on the sale and leaseback of the property discounted at the post tax cost of debt is minus
EUR 818,000. That is, the sale and leaseback scheme is expected to be more expensive
than retaining the properties. This appraisal was based on a forecast increase in property
values of 10% over the whole 10 year period.

The requirement for Question One is on page 11

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November 2014

Financial Strategy

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Financial Strategy

10

November 2014

Required:
(a)

Calculate:
Ys forecast profit after tax for the year ending 31 December 2014 based on the
data provided to the Finance Director.

(b)

The share price predicted by the forecast profit after tax results calculated above
and assuming Ys P/E ratio remains unchanged at 11.0.
(8 marks)

Assume you are the Finance Director and have been asked to write a report addressed to
the board of directors of Y in which you:
(i)

Advise on:

The nature of the unrecognised intangible assets that are likely to form a
significant part of Ys market value.

The risks to Ys market value of an increasing focus on the sale of products

through external supermarkets rather than Ys own stores.
(9 marks)

(ii)

Explain possible reasons why Ys share price did not move as predicted by the
result obtained in (a) above on 1 November 2014, the day the profit warning was
announced.
(5 marks)

(iii)

Advise on the key performance measures and other factors that the banks are
likely to consider when reviewing Ys refinancing request in December 2014. Your
answer should include calculations of the impact of the revised forecast on key
performance measures.
Up to 6 marks are available for calculations.
(12 marks)

(iv)

Evaluate the financing schemes A and B. Your answer should include reference to
the interrelationship between decisions concerning investment, financing and
dividends.
(13 marks)

Marks for structure and presentation:

(3 marks)
(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A
Section B begins on page 14
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November 2014

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November 2014

13

Financial Strategy

SECTION B 50 MARKS
[You are advised to spend no longer than 45 minutes on each question in this section.]

ANSWER TWO OF THE THREE QUESTIONS

Question Two
Company G is a successful IT services company formed 10 years ago. It was listed on its local
stock exchange 3 years ago. Company G has a broad customer base mainly consisting of small
and medium sized companies. Company G has achieved rapid growth in recent years by
obtaining repeat business from satisfied customers and also by acquiring other IT services
companies.
The directors of Company G have identified Company H, an unlisted company, as a possible
acquisition target. Company H has a number of large multinational clients and, in general, its
clients tend to be larger than those of Company G. If successful, the acquisition would go ahead
on 1 January 2015.
Forecast financial data for Company G and Company H as at 31 December 2014 is summarised
below:

Share capital (ordinary $1 shares)

Market share price

Company G

Company H

$150 million

$40 million

$4.90

Not applicable as unlisted.

Additional information:

If Company H were to remain an independent company, its directors estimate that

reported profit after tax would be $15 million for 2015 and then grow by 2% a year in
perpetuity.
If the acquisition were to go ahead, Company Gs directors estimate that
Company Hs profit after tax would be 5% higher for 2015 than if the company
remains an independent company and that profit after tax would then grow by 3% a
year in perpetuity.
The average ungeared cost of equity for the industry is 8%.
Both Company G and Company H are wholly equity financed.
Profit after tax can be assumed to be a good approximation of free cash flow
attributable to investors.

The directors of Company G are considering offering to purchase Company H at a price of $7.00
per share. It is estimated that transaction costs of $8 million would be payable on the acquisition
and that $2 million would be required in the first year to cover the costs of integrating the two
businesses.

Financial Strategy

14

November 2014

Required:
(a)

Calculate:

The value of Company G on 31 December 2014 before taking the possible

acquisition of Company H into account.
The value of Company H on 31 December 2014 before taking the possible
acquisition of the company by Company G into account.
The overall increase in value created by the acquisition of Company H by
Company G.
(8 marks)

(b)

(i)

Explain how value might be created by the proposed acquisition.

(4 marks)

(ii)

Advise on the challenges that Company G is likely to face in realising the potential
added value after the acquisition.
(4 marks)

(c)

Evaluate the proposed offer price of $7.00 per share for Company H from the viewpoint
of:

Company Hs shareholders.

Company Gs shareholders.
Up to 4 marks are available for calculations
(9 marks)
(Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

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November 2014

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Financial Strategy

Question Three
Company J is a listed pharmaceutical wholesaler. The company was formed 10 years ago and
has grown rapidly since then. Three years ago the company was floated on its local Stock
Exchange.
A few years ago, the company increased the proportion of debt finance following advice from
external consultants that high gearing maximises shareholder wealth. However, in the past
year there has been a deterioration in economic conditions and in liquidity available in financial
markets. Against this background, the companys high level of gearing has led to difficulty in
refinancing borrowings and issuing bonds on the capital markets. The directors have therefore
decided to take steps to reduce the companys dependency on debt finance.
The company is currently funded by:
600 million shares with a nominal value of $1.00 each.
Bank borrowings of $900 million due for repayment in 10 years.
Approximately 50% of Company Js shares are held by large financial institutions. The
remaining 50% are held by a large number of small investors. Shares are currently trading at
$1.50 per share.
The directors are discussing how best to reduce gearing. One possibility is to raise additional
equity finance by means of a rights issue and use the funds raised to repay bank borrowings.
The terms of the rights issue being considered are as follows:

Total proceeds of the issue to be $200 million if the issue is fully subscribed.
1 new share for each 3.6 shares held.
New shares to be issued at a discount of 20% to the current share price.

However, some directors have expressed concern as to whether a rights issue would be
successful at this point in time, especially if at a relatively low discount rate of 20% to the current
share price.
The following suggestions were made at a recent board meeting:

To increase the rights issue discount to 30% of the current share price but still raise
$200 million.
To consider alternative sources of finance such as preference shares or a private
placement of shares.

Financial Strategy

16

November 2014

Required:
(a)

(i)

Calculate, at a rights discount of 20% AND 30% to the current share price, the
impact of the planned rights issue and debt repayment on:

Share price.
Shareholders wealth.
Gearing (debt/(debt + equity) at market values).

Assume all shareholders take up the rights and ignore the impact of corporate
income tax and any other influences on the share price or debt.
(8 marks)
(ii)

Advise on the implications for both Company J and its shareholders of:

Proceeding with the planned rights issue and debt repayment.

The choice of rights issue discount rate.
(9 marks)

(b)

Evaluate the appropriateness of each of the following alternative sources of finance for
Company J, taking into account the current economic and financial market conditions:

Private placement of shares.

Redeemable preference shares.
(8 marks)
(Question Three = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

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November 2014

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Financial Strategy

Question Four
Company M manufactures bicycles and sells them in the wholesale market. It is considering
opening up a number of retail stores which would sell complete bicycles and spare parts. This
plan is subsequently referred to as Project X.
Forecast financial information for Company M as at 31 December 2014:
EUR million
600
200
350
300
650

Shares (EUR 1 face value each share)

Share premium account
Retained earnings
Bank borrowings at 6% interest rate
5% bonds

Additional information:

The current market share price is EUR 1.50.

The bonds are quoted at a yield of 6% and a price of EUR 92 per EUR 100 of bond.

Company M has an equity beta of 1.8 and a debt beta of 0.75.

The corporate income tax rate is 25%, payable at the end of the year in which it arises.

The risk free rate is 3% and the market premium is 4%.

Project X requires an initial investment of EUR 300 million on 1 January 2015 and is forecast to
generate annual post tax cash flows of EUR 28 million a year. For the purposes of evaluating
this project, annual cash flows should be assumed to arise at the end of the year to which they
relate and assume zero growth.
The project is eligible for a EUR 150 million 5 year loan from the government at a subsidised
interest rate of 3%. The remaining EUR 150 million required for the initial investment would be
funded by borrowings at an annual market interest rate of 5%. At the end of the 5 year loan
period, the government subsidised loan can be assumed to be replaced by a bank borrowing at
5% annual interest.
Company M has a long term gearing target which is very close to the debt/equity balance
forecast for 31 December 2014, based on market values. Although this project is being financed
using borrowings, increasing gearing, there is no intention of changing the long term gearing
target. The next time that additional funding is required, the company is likely to use equity
finance such as a rights issue in order to bring company gearing back in line with the long term
gearing target.

Financial Strategy

18

November 2014

Required:
(a)

Calculate, before taking Project X into account, Company Ms:

Geared cost of equity.
Ungeared cost of equity.
Weighted Average Cost of Capital (WACC).
(7 marks)

(b)

Calculate a value for Project X using each of the following alternative approaches:
Net present value of project cash flows based on the WACC calculated in (a)
above.
Adjusted present value, taking project financing into account.
(10 marks)

(c) Advise the directors of Company M of the validity of each of the results obtained in
part (b) above, taking all relevant factors into account.
(8 marks)
(Question Four = 25 marks)
A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

(Total for Section B = 50 marks)

End of Question Paper

Maths tables and formulae are on pages 21 to 25

November 2014

19

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Financial Strategy

20

November 2014

MATHS TABLES AND FORMULAE

Present value table

-n

Present value of 1.00 unit of currency, that is (1 + r) where r = interest rate; n = number of periods until
payment or receipt.
Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

1%
0.990
0.980
0.971
0.961
0.951
0.942
0.933
0.923
0.914
0.905
0.896
0.887
0.879
0.870
0.861
0.853
0.844
0.836
0.828
0.820

2%
0.980
0.961
0.942
0.924
0.906
0.888
0.871
0.853
0.837
0.820
0.804
0.788
0.773
0.758
0.743
0.728
0.714
0.700
0.686
0.673

3%
0.971
0.943
0.915
0.888
0.863
0.837
0.813
0.789
0.766
0.744
0.722
0.701
0.681
0.661
0.642
0.623
0.605
0.587
0.570
0.554

4%
0.962
0.925
0.889
0.855
0.822
0.790
0.760
0.731
0.703
0.676
0.650
0.625
0.601
0.577
0.555
0.534
0.513
0.494
0.475
0.456

Interest rates (r)

5%
6%
0.952
0.943
0.907
0.890
0.864
0.840
0.823
0.792
0.784
0.747
0.746
0.705
0.711
0.665
0.677
0.627
0.645
0.592
0.614
0.558
0.585
0.527
0.557
0.497
0.530
0.469
0.505
0.442
0.481
0.417
0.458
0.394
0.436
0.371
0.416
0.350
0.396
0.331
0.377
0.312

7%
0.935
0.873
0.816
0.763
0.713
0.666
0.623
0.582
0.544
0.508
0.475
0.444
0.415
0.388
0.362
0.339
0.317
0.296
0.277
0.258

8%
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215

9%
0.917
0.842
0.772
0.708
0.650
0.596
0.547
0.502
0.460
0.422
0.388
0.356
0.326
0.299
0.275
0.252
0.231
0.212
0.194
0.178

10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
0.467
0.424
0.386
0.350
0.319
0.290
0.263
0.239
0.218
0.198
0.180
0.164
0.149

Periods
(n)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

11%
0.901
0.812
0.731
0.659
0.593
0.535
0.482
0.434
0.391
0.352
0.317
0.286
0.258
0.232
0.209
0.188
0.170
0.153
0.138
0.124

12%
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322
0.287
0.257
0.229
0.205
0.183
0.163
0.146
0.130
0.116
0.104

13%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
0.376
0.333
0.295
0.261
0.231
0.204
0.181
0.160
0.141
0.125
0.111
0.098
0.087

14%
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270
0.237
0.208
0.182
0.160
0.140
0.123
0.108
0.095
0.083
0.073

Interest rates (r)

15%
16%
0.870
0.862
0.756
0.743
0.658
0.641
0.572
0.552
0.497
0.476
0.432
0.410
0.376
0.354
0.327
0.305
0.284
0.263
0.247
0.227
0.215
0.195
0.187
0.168
0.163
0.145
0.141
0.125
0.123
0.108
0.107
0.093
0.093
0.080
0.081
0.069
0.070
0.060
0.061
0.051

17%
0.855
0.731
0.624
0.534
0.456
0.390
0.333
0.285
0.243
0.208
0.178
0.152
0.130
0.111
0.095
0.081
0.069
0.059
0.051
0.043

18%
0.847
0.718
0.609
0.516
0.437
0.370
0.314
0.266
0.225
0.191
0.162
0.137
0.116
0.099
0.084
0.071
0.060
0.051
0.043
0.037

19%
0.840
0.706
0.593
0.499
0.419
0.352
0.296
0.249
0.209
0.176
0.148
0.124
0.104
0.088
0.079
0.062
0.052
0.044
0.037
0.031

20%
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
0.135
0.112
0.093
0.078
0.065
0.054
0.045
0.038
0.031
0.026

November 2014

21

Financial Strategy

Cumulative present value of 1.00 unit of currency per annum

Receivable or Payable at the end of each year for n years
Periods
(n)
1
2
3
4
5

1(1+ r ) n
r

1%
0.990
1.970
2.941
3.902
4.853

2%
0.980
1.942
2.884
3.808
4.713

3%
0.971
1.913
2.829
3.717
4.580

4%
0.962
1.886
2.775
3.630
4.452

Interest rates (r)

5%
6%
0.952
0.943
1.859
1.833
2.723
2.673
3.546
3.465
4.329
4.212

7%
0.935
1.808
2.624
3.387
4.100

8%
0.926
1.783
2.577
3.312
3.993

9%
0.917
1.759
2.531
3.240
3.890

10%
0.909
1.736
2.487
3.170
3.791

6
7
8
9
10

5.795
6.728
7.652
8.566
9.471

5.601
6.472
7.325
8.162
8.983

5.417
6.230
7.020
7.786
8.530

5.242
6.002
6.733
7.435
8.111

5.076
5.786
6.463
7.108
7.722

4.917
5.582
6.210
6.802
7.360

4.767
5.389
5.971
6.515
7.024

4.623
5.206
5.747
6.247
6.710

4.486
5.033
5.535
5.995
6.418

4.355
4.868
5.335
5.759
6.145

11
12
13
14
15

10.368
11.255
12.134
13.004
13.865

9.787
10.575
11.348
12.106
12.849

9.253
9.954
10.635
11.296
11.938

8.760
9.385
9.986
10.563
11.118

8.306
8.863
9.394
9.899
10.380

7.887
8.384
8.853
9.295
9.712

7.499
7.943
8.358
8.745
9.108

7.139
7.536
7.904
8.244
8.559

6.805
7.161
7.487
7.786
8.061

6.495
6.814
7.103
7.367
7.606

16
17
18
19
20

14.718
15.562
16.398
17.226
18.046

13.578
14.292
14.992
15.679
16.351

12.561
13.166
13.754
14.324
14.878

11.652
12.166
12.659
13.134
13.590

10.838
11.274
11.690
12.085
12.462

10.106
10.477
10.828
11.158
11.470

9.447
9.763
10.059
10.336
10.594

8.851
9.122
9.372
9.604
9.818

8.313
8.544
8.756
8.950
9.129

7.824
8.022
8.201
8.365
8.514

11%
0.901
1.713
2.444
3.102
3.696

12%
0.893
1.690
2.402
3.037
3.605

13%
0.885
1.668
2.361
2.974
3.517

14%
0.877
1.647
2.322
2.914
3.433

Interest rates (r)

15%
16%
0.870
0.862
1.626
1.605
2.283
2.246
2.855
2.798
3.352
3.274

17%
0.855
1.585
2.210
2.743
3.199

18%
0.847
1.566
2.174
2.690
3.127

19%
0.840
1.547
2.140
2.639
3.058

20%
0.833
1.528
2.106
2.589
2.991

6
7
8
9
10

4.231
4.712
5.146
5.537
5.889

4.111
4.564
4.968
5.328
5.650

3.998
4.423
4.799
5.132
5.426

3.889
4.288
4.639
4.946
5.216

3.784
4.160
4.487
4.772
5.019

3.685
4.039
4.344
4.607
4.833

3.589
3.922
4.207
4.451
4.659

3.498
3.812
4.078
4.303
4.494

3.410
3.706
3.954
4.163
4.339

3.326
3.605
3.837
4.031
4.192

11
12
13
14
15

6.207
6.492
6.750
6.982
7.191

5.938
6.194
6.424
6.628
6.811

5.687
5.918
6.122
6.302
6.462

5.453
5.660
5.842
6.002
6.142

5.234
5.421
5.583
5.724
5.847

5.029
5.197
5.342
5.468
5.575

4.836
4.988
5.118
5.229
5.324

4.656
4.793
4.910
5.008
5.092

4.486
4.611
4.715
4.802
4.876

4.327
4.439
4.533
4.611
4.675

16
17
18
19
20

7.379
7.549
7.702
7.839
7.963

6.974
7.120
7.250
7.366
7.469

6.604
6.729
6.840
6.938
7.025

6.265
6.373
6.467
6.550
6.623

5.954
6.047
6.128
6.198
6.259

5.668
5.749
5.818
5.877
5.929

5.405
5.475
5.534
5.584
5.628

5.162
5.222
5.273
5.316
5.353

4.938
4.990
5.033
5.070
5.101

4.730
4.775
4.812
4.843
4.870

Periods
(n)
1
2
3
4
5

Financial Strategy

22

November 2014

FORMULAE
Valuation models
(i)

Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity,

where P0 is the ex-div value:
d

P0 =

k pref

(ii)

Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where

P0 is the ex-div value:
d

P0 =

ke

(iii)

Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a

constant rate, g, where P0 is the ex-div value:
d1

P0 =

or

P0 =

d 0 [1 + g ]

g
ke g
Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P0
is the ex-interest value:
ke

(iv)

P0 =
or, without tax:
(v)

P0 =

i [1 t ]
k d net

i
kd

Total value of the geared entity, Vg (based on MM):

Vg = Vu + TB

(vi)

Future value of S, of a sum X, invested for n periods, compounded at r% interest:

n

S = X[1 + r]
(vii)

Present value of 100 payable or receivable in n years, discounted at r% per annum:

PV =

(viii)

[1 + r ]

Present value of an annuity of 100 per annum, receivable or payable for n years,
commencing in one year, discounted at r% per annum:
PV =

(ix)

1
1
1

n
r
[1 + r ]

Present value of 100 per annum, payable or receivable in perpetuity, commencing in

one year, discounted at r% per annum:
PV =

1
r

(x)

Present value of 100 per annum, receivable or payable, commencing in one year,
growing in perpetuity at a constant rate of g% per annum, discounted at r% per
annum:
PV =

November 2014

23

1
r g

Financial Strategy

Cost of capital
(i)

Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity,

and having a current ex-div price P0:
kpref =

d
P0

(ii)

Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current
ex-interest price P0:
kd net =

i [1 t ]
P0

(iii)

Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and

having a current ex-div price P0:
ke =

d
P0

(iv)

Cost of ordinary (equity) shares, having a current ex-div price, P0, having just paid a
dividend, d0, with the dividend growing in perpetuity by a constant g% per annum:
ke =

d1

+g

or

d 0 [1 + g ]

ke =

P0

(v)

+g

P0

Cost of ordinary (equity) shares, using the CAPM:

ke = Rf + [Rm Rf]

(vi)

Cost of ordinary (equity) share capital in a geared entity :

VD [1 t ]
VE

keg = keu + [keu kd]

(vii)

Weighted average cost of capital, k0 or WACC

WACC = ke

(viii)

VE
VD

+ k d [1 t ]

VE + VD
VE + VD

Adjusted cost of capital (MM formula):

Kadj = keu [1 tL]

(ix)

VD [1 t ]
VE
V + V [1 t ] + d

VE + VD [1 t ]
D

Regear :
g = u + [u d]

(xi)

r* = r[1 T*L]

Ungear :
u = g

(x)

or

VD [1 t ]
VE

Adjusted discount rate to use in international capital budgeting (International Fisher

effect)
1 + annual discount rate B$
1 + annual discount rate A$

Future spot rate A$/B$ in 12 months' time

Spot rate A$/B$

where A$/B$ is the number of B$ to each A$

Financial Strategy

24

November 2014

Other formulae
(i) Expectations theory:
Future spot rate A$/B$ = Spot rate A$/B$ x

1 + nominal countryB interest rate

1 + nominal countryA interest rate

where:
A$/B$ is the number of B$ to each A$, and
A$ is the currency of country A and B$ is the currency of country B
(ii) Purchasing power parity (law of one price):
Future spot rate A$B$ = Spot rate A$/B$ x

1 + countryB inflation rate

1 + countryA inflation rate

(iii) Link between nominal (money) and real interest rates:

[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]
(iv) Equivalent annual cost:
Equivalent annual cost =

PV of costs over n years

n year annuity factor

(v)

Theoretical ex-rights price:

TERP =

1
N +1

[(N x cum rights price) + issue price]

(vi) Value of a right:

Theoretica l ex rights price issue price
N

where N = number of rights required to buy one share.

November 2014

25

Financial Strategy

This page is blank

Financial Strategy

26

November 2014

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for
each question in this paper.
It is important that you answer the question according to the definition of the verb.
LEARNING OBJECTIVE
Level 1 - KNOWLEDGE
What you are expected to know.

Level 2 - COMPREHENSION
What you are expected to understand.

VERBS USED

DEFINITION

List
State
Define

Make a list of
Express, fully or clearly, the details/facts of
Give the exact meaning of

Describe
Distinguish
Explain

Communicate the key features

Highlight the differences between
Make clear or intelligible/State the meaning or
purpose of
Recognise, establish or select after
consideration
Use an example to describe or explain
something

Identify
Illustrate
Level 3 - APPLICATION
How you are expected to apply your knowledge.

Apply
Calculate/compute
Demonstrate
Prepare
Reconcile
Solve
Tabulate

Level 4 - ANALYSIS
How are you expected to analyse the detail of
what you have learned.

Level 5 - EVALUATION
How are you expected to use your learning to
evaluate, make decisions or recommendations.

November 2014

Analyse
Categorise
Compare and contrast

Put to practical use

Ascertain or reckon mathematically
Prove with certainty or to exhibit by
practical means
Make or get ready for use
Make or prove consistent/compatible
Find an answer to
Arrange in a table

Construct
Discuss
Interpret
Prioritise
Produce

Examine in detail the structure of

Place into a defined class or division
Show the similarities and/or differences
between
Build up or compile
Examine in detail by argument
Translate into intelligible or familiar terms
Place in order of priority or sequence for action
Create or bring into existence

Advise
Evaluate
Recommend

Counsel, inform or notify

Appraise or assess the value of
Advise on a course of action

27

Financial Strategy

Financial Pillar

Strategic Level Paper

F3 Financial Strategy

November 2014

Thursday Morning Session

Financial Strategy

28

November 2014