PART 3

WEDNESDAY 16 JUNE 2004

QUESTION PAPER
Time allowed 3 hours
This paper is divided into two sections
Section A

BOTH questions are compulsory and MUST be

answered

Section B

TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normal

distribution tables are on pages 8, 9, 10 and 11

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination
hall

The Association of Chartered Certified Accountants

Paper 3.7

Strategic Financial
Management

Section A BOTH questions are compulsory and MUST be attempted

1

The board of directors of Wurrall plc has requested the production of a four-year financial plan. The key assumptions
behind the plan are:
(i)

Historically, sales growth has been 9% per year. Uncertainty about future economic prospects over the next four
years from 20052008 however implies that this growth rate will reduce by 1% per year after the financial year
2005 (e.g. to 8% in 2006). After four years, growth is expected to remain constant at the 2008 rate.

(ii) Cash operating costs are estimated to be approximately 68% of sales.

(iii) Tax allowable depreciation for the past few years has been approximately 15% of the net book value of plant and
machinery at year end. This is expected to continue for the next few years.
(iv) Stocks, debtors, cash in hand and other creditors are assumed to increase in proportion to the increase in sales.
(v) Investment in, and net book value of, plant and machinery is expected to increase in line with sales. No
investment is planned in other fixed assets other than a refurbishment of buildings at an estimated cost of
40 million in late 2007.
(vi) Any change in interest paid as a result of changes in borrowing may be assumed to be effective in the next year.
Wurrall plans to meet any changes in financing needs, with the exception of the repayment of the fixed rate loan,
by adjusting its overdraft.
(vii) Wurrall currently pays 7% per annum interest on its short-term borrowing.
(viii) Corporation tax is expected to continue at its present rate over the next four years.
(ix) For the last few years the companys dividend policy has been to pay a constant percentage of earnings after tax.
No changes in this policy are planned.
(x) Wurrall has borrowed extensively from the banking system, and covenants exist that prevent the companys
gearing (book value of total loans to book value of total loans plus equity) exceeding forty percent for a period of
more than one year.
(xi) The companys managing director has publicly stated that both profits before tax and Wurralls share price should
increase by at least 100% during the next four years.
Summarised financial accounts of Wurrall plc:
Profit and loss account for the year ended March 2004
million
1,639
(1,225)

414
(152)

262
(57)

205
(62)
(80)

63

Turnover
Operating costs before depreciation
EBITDA
Tax allowable depreciation
EBIT
Net interest payable
Profit on ordinary activities before tax
Tax on ordinary activities (30%)
Dividends
Amount transferred to reserves

Balance sheet as at 31 March 2004

million
Fixed assets
Land and buildings
Plant and machinery (net)
Investments1

310
1,012
32

Current assets
Stocks
Debtors
Cash in hand and short-term deposits

448
564
20

Creditors: amounts falling due within one year:

Short term loans and overdrafts
Other creditors

230
472

Creditors: amounts falling due after one year:

Borrowings (8% fixed rate)2

1,354

1,032

(702)

(580)

1,104

Capital and reserves

Called up share capital (10 pence par)
Reserves

240
864

1,104

The investments yield negligible interest

Borrowings are scheduled to be repaid at the end of 2006 and will be refinanced with a similar type of loan in
2 2006.

The companys current share price is 210 pence, and its weighted average cost of capital is 11%.
Required:
(a) Produce pro forma balance sheets and profit and loss accounts for each of the next four years. Clearly state
any assumptions that you make.
(12 marks)
(b) Critically discuss any problems or implications of the assumptions that are made in each of points (i) to (iv)
and point (ix) in the question.
(8 marks)
(c) Using free cash flow analysis, evaluate and discuss whether or not the managing directors claims for the
future share price are likely to be achievable. (The operating cash flow element of free cash flow may be
estimated by: EBIT(1-t) plus depreciation.)
(10 marks)
(d) Using financial ratios or other forms of analysis, highlight any potential financial problems for the company
during this period. Discuss what actions might be taken with respect to these problems.
(10 marks)
(40 marks)

[P.T.O.

Assume that it is now 1 July. Polytot plc has received an export order valued at 675 million pesos from a company
in Grobbia, a country that has recently been accepted into the World Trade Organisation, but which does not yet have
a freely convertible currency.
The Grobbian company only has access to sufficient $US to pay for 60% of the goods, at the official $US exchange
rate. The balance would be payable in the local currency, the Grobbian peso, for which there is no official foreign
exchange market. Polytot is due to receive payment in four months time and has been informed that an unofficial
market in Grobbian pesos exists in which the peso can be converted into pounds. The exchange rate in this market
is 15% worse for Polytot than the official rate of exchange between the peso and the pound.
Exchange rates:
Spot
3 months forward
1 year forward

$/
15475 15510
15362 15398
15140 15178

Official spot rate

Grobbian peso/
15630

Official spot rate

Grobbian peso/$
9820

Philadelphia SE /$ options 31,250 (cents per

CALLS
Sept
Dec
March
Sept
15250 295 335 365
200
15500 180 225 265
330
15750 090 140 180
490
16000 025 075 110
675

pound)
PUTS
Dec March
325 435
460 575
625 735
805 915

/$ Currency futures (CME, 62,500)

September 15350
December 15275
Assume that options and futures contracts mature at the relevant month end.
Required:
(a) Discuss the alternative forms of currency hedge that are available to Polytot plc and calculate the expected
revenues, in sterling, from the sale to the company in Grobbia as a result of each of these hedges. Provide
a reasoned recommendation as to which hedge should be selected.
(17 marks)
(b) The Grobbian company is willing to undertake a countertrade deal whereby 40% of the cost of the goods is paid
for by an exchange of three million kilos of Grobbian strawberries. A major UK supermarket chain has indicated
that it would be willing to pay between 50 and 60 pence per kilo for the strawberries.
Discuss the issues that Polytot should consider before deciding whether or not to agree to the countertrade.
(6 marks)
(c) The Grobbian company has asked for advice in using the Euromarkets to raise international finance.
Required:
Provide a briefing memo for the company discussing the advantages of the Euromarkets, and any potential
problems for the Grobbian company in using them.
(7 marks)
(30 marks)

Section B TWO questions ONLY to be attempted

3

The finance director of Zendeck plc is considering how to finance a major new expansion of existing activities. The
investment will cost 40 million and is expected to last for five years.
The companys current capital structure is:
million
34
56
15
82

Medium-term floating rate loans

11% debentures redeemable July 2007
Issued ordinary shares (50 pence par value)
Reserves
Other information:
(i)

The companys current share price ex-dividend is 478 pence, and debenture price ex-interest is 10780. Each
debenture is redeemable at its par value of 100.

(ii) Issue costs of externally financed equity are expected to be 65% of the total raised. There needs to be a
minimum issue of 20 million, otherwise issue costs increase substantially.
(iii) Issue costs of new debentures are estimated to be 35%.
(iv) The equity beta of Zendeck is 115.
(v) The current dividend per share is 364 pence and dividends have grown by approximately 4% per year for the
last three years.
(vi) The risk free rate is 35% per year and the market return is 11% per year.
(vii) The corporate tax rate is 30%.
(viii) Zendeck wishes to maintain its current capital structure.
Required:
(a) Estimate the cost of capital of the new investment:
(i)

If internal sources of equity are used (retained earnings), and debt finance is raised by a 75% floating
rate bank loan with negligible issue costs;

(ii) If external sources of debt (new debentures issued at par of 100) and equity are used. New equity may
be assumed to be issued at the current market price. Comment upon your findings and state clearly any
assumptions that you make.
(11 marks)
(b) Discuss whether or not the techniques used in part (a) could be applied to unlisted companies.

(4 marks)
(15 marks)

[P.T.O.

The board of directors of Chancit plc is concerned that two of its divisions appear to be significantly less successful
in their capital investments than the companys other divisions. Investment ideas are normally generated by senior
divisional managers, and then approved or rejected by the main board. An external consultant has suggested that the
divisions performance might be related to the attitude to risk of senior divisional managers. The consultant has tested
such attitude and produced tables of equal satisfaction under different risk/return conditions, for both of the divisions
managers.
Division 1
Expected NPV
1,000,000 with certainty
80% chance of 13m, 20%
60% chance of 18m, 40%
40% chance of 25m, 60%
20% chance of 30m, 80%
10% chance of 40m, 90%
Division 2
Expected NPV
1,000,000 with certainty
85% chance of 13m, 15%
75% chance of 18m, 25%
50% chance of 25m, 50%
35% chance of 30m, 65%
20% chance of 40m, 80%

chance
chance
chance
chance
chance

chance
chance
chance
chance
chance

of
of
of
of
of

of
of
of
of
of

700,000
300,000
100,000
(100,000)
(200,000)

Risk ()
0
024
074
108
124
126

700,000
300,000
100,000
(100,000)
(200,000)

Risk ()
0
021
065
120
Not yet estimated
Not yet estimated

Required:
(a) Analyse the data in the tables and discuss the possible implications of the data for the success of these two
divisions investments.
(8 marks)
(b) Discuss what actions the board of directors of Chancit might take in response to your findings in (a).
(3 marks)
(c) Discuss any possible problems with the method of analysis used in (a).

(4 marks)
(15 marks)

Folter plc has short-term equity holdings in a number of companies that it considers might be future take-over targets.
The equity market has recently been very volatile, and the finance director is considering how to protect the equity
portfolio from adverse market movements, in case some of the holdings need to be sold, at short notice, by the end
of October.
The finance director is particularly concerned about 2 million shares that are currently held in Magterdoor plc. The
shares are trading at 535 pence.
Assume that it is now 1 June and that option contracts mature at the month end.
LIFFE Traded options (1,000 shares)

500
550

July
375
165

CALLS
October
525
240

January
605
340

July
120
210

PUTS
October
245
510

January
350
600

Required:
(a) Illustrate how Folter plc might use traded options to protect against a fall in the share price of Magterdoor
plc. Assuming that Folter has to sell the shares at the end of October at a price of 485 pence, evaluate the
outcome of the hedge(s).
(4 marks)
(b) Assume that the option delta of Magterdoor is 047. Illustrate how a delta neutral hedge might be used to
protect against price movements of the shares of Magterdoor. Comment upon any practical problems of using
a delta hedge for this purpose.
(4 marks)
(c) Discuss the reasons why the January 550 call option premium is not the same as the intrinsic value of the
option.
(4 marks)
(d) The managing director of Folter suggests increasing its holding in Magterdoor from 2% to 6% of that
companys issued shares. Discuss briefly the advantages and disadvantages of this strategy.
(3 marks)
(15 marks)

(a) Discuss the reasons for the existence of the global debt problem. Explain briefly what is meant by financial
contagion and how financial contagion might affect the global debt problem.
(7 marks)
(b) Explain the main attempts that have been made to resolve the global debt problem and how governments
might try to limit financial contagion.
(8 marks)
(15 marks)

[P.T.O.

Formulae Sheet

E( r j ) = r f + E( rm ) r f j

Ke (i)

D1
+g
(ii)
P0
WACC Keg

E
D
+ Kd (1 t )
E+D
E+D

Dt
or Keu 1

E + D
2 asset
portfolio

p = a2 x 2 + b2 (1 x ) 2 + 2 x (1 x ) p ab a b
Purchasing
power parity

a = e

i f i uk
1 + i uk

D(1 t )
E
+ d
E + D(1 t )
E + D(1 t )

Call price for a European option = Ps N( d1) Xe rT N( d 2 )

d1 =

1n ( Ps / X ) + rT

+ 0.5 T

d 2 = d1 T
Put call parity PP = PC PS +XerT

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[P.T.O.

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10

Standard normal distribution table

000

001

002

003

004

005

006

007

008

009

00
01
02
03
04

00000
00398
00793
01179
01554

00040
00438
00832
01217
01591

00080
00478
00871
01255
01628

00120
00517
00910
01293
01664

00160
00557
00948
01331
01700

00199
00596
00987
01368
01736

00239
00636
01026
01406
01772

00279
00675
01064
01443
01808

00319
00714
01103
01480
01844

00359
00753
01141
01517
01879

05
06
07
08
09

01915
02257
02580
02881
03159

01950
02291
02611
02910
03186

01985
02324
02642
02939
03212

02019
02357
02673
02967
03238

02054
02389
02703
02995
03264

02088
02422
02734
03023
03289

02123
02454
02764
03051
03315

02157
02486
02794
03078
03340

02190
02517
02823
03106
03365

02224
02549
02852
03133
03389

10
11
12
13
14

03413
03643
03849
04032
04192

03438
03665
03869
04049
04207

03461
03686
03888
04066
04222

03485
03708
03907
04082
04236

03508
03729
03925
04099
04251

03531
03749
03944
04115
04265

03554
03770
03962
04131
04279

03577
03790
03980
04147
04292

03599
03810
03997
04162
04306

03621
03830
04015
04177
04319

15
16
17
18
19

04332
04452
04554
04641
04713

04345
04463
04564
04649
04719

04357
04474
04573
04656
04726

04370
04484
04582
04664
04732

04382
04495
04591
04671
04738

04394
04505
04599
04678
04744

04406
04515
04608
04686
04750

04418
04525
04616
04693
04756

04429
04535
04625
04699
04761

04441
04545
04633
04706
04767

20
21
22
23
24

04772
04821
04861
04893
04918

04778
04826
04864
04896
04920

04783
04830
04868
04898
04922

04788
04834
04871
04901
04925

04793
04838
04875
04904
04927

04798
04842
04878
04906
04929

04803
04846
04881
04909
04931

04808
04850
04884
04911
04932

04812
04854
04887
04913
04934

04817
04857
04890
04916
04936

25
26
27
28
29

04938
04953
04965
04974
04981

04940
04955
04966
04975
04982

04941
04956
04967
04976
04982

04943
04957
04968
04977
04983

04945
04959
04969
04977
04984

04946
04960
04970
04978
04984

04948
04961
04971
04979
04985

04949
04962
04972
04979
04985

04951
04963
04973
04980
04986

04952
04964
04974
04981
04986

30

04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

This table can be used to calculate N(di), the cumulative normal distribution functions needed for the Black-Scholes
model of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above
from 05.

End of Question Paper

11