Financial Management Pillar Strategic Level Paper

25 November 2009 Wednesday Morning Session

Instructions to candidates You are allowed three hours to answer this question paper. 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 the 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). The question requirements are highlighted in a dotted box. ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking. Answer the ONE compulsory question in Section A on pages 2 to 5. The question requirements are on page 5, which is detachable for ease of reference. Answer TWO of the four questions in Section B on pages 8 to 12. Maths Tables and Formulae are provided on pages 15 to 19. These pages are detachable for ease of reference. The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper. 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.

TURN OVER

The Chartered Institute of Management Accountants 2009

P9 Financial Strategy

P9 Management Accounting Financial Strategy

SECTION A 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE

Question One
T Industries Background information T Industries provides a variety of goods and services to the construction industry. Its main areas of operation include building construction, repairs and renovations, consultancy and design planning services. Its main market is in the UK but it also operates in countries in the Euro zone. Its shares are quoted on a recognised Stock Exchange. The entity has been highly profitable in the past but revenue and profit margins have suffered in the past year as a consequence of the economic downturn and increased costs of complying with ever changing building regulations in the countries in which it operates. However, the poor economic situation has provided opportunities. Some of T Industries competitors have ceased trading and it has picked up some of their business. Also, its long term debt is repayable in nine months time and falling interest rates mean it should be able to re-finance at more favourable terms. Financial objectives T Industries has two financial objectives: 1 To increase EPS year on year 2 To improve shareholder value, as measured by growth in dividends and increase in share price, by an average of 8% per annum over a rolling 5 year period. These objectives have been achieved each year over the past 9 years but the directors believe they now need to be reviewed. Acquisition opportunity A specific opportunity is the acquisition of L Products, an entity in a related but not identical business whose shares are listed on the UKs Alternative Investment Market (AIM). Its share price has fallen 40% over the past 5 months and it has recently announced it will not pay a dividend in the coming financial year. This acquisition would broaden T Industries business base and provide access to technical expertise that is a scarce resource. However, it is likely to be a hostile bid at the initial approach and T Industries directors are aware other entities might be viewing L Products as a potential takeover target. T Industries' financial advisors have produced estimates of the expected future growth in earnings. The forecast growth rates are based on publicly available information and assume both entities continue to operate independently and that dividend policy, capital structure and risk characteristics remain unchanged. Annual percentage growth rates in earnings. T Industries L Products Financial year to 30 June 2010 Financial year to 2011 Years 2012 onwards 0 +3 +4 -5 + 10 +2.5

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Even if the bid succeeds, T Industries directors believe it would be difficult to improve on the forecast earnings in either entity in 2010 or 2011 but from 2012 onwards they are confident that they will be able to obtain growth in L Products earnings equivalent to their own projected growth rate of 4%. They also believe that by re-financing the combined debt of the group and by lowering its overall business risk they can obtain a group cost of equity of 10% from 2012 onwards. Extracts from both entities Balance Sheets as at 30 June 2009 T Industries millions ASSETS Non-current assets (NBV) Land and buildings Plant and equipment Current assets: Inventory and accounts receivable Cash and cash equivalents L Products millions

435 250 685 120 25 145 830

125 87 212 95 0 95 307

EQUITY AND LIABILITIES Equity Issued share capital (nominal value 1)* 120 Issued share capital (nominal value 25 pence)* Retained earnings 210 Total equity Non Current Liabilities Current liabilities *All Authorised Share Capital is in issue. Other financial information Earnings for year to 30 June 2009 (m) Dividends declared for year to 30 June 2009 (m) Share price as at 30 June 2009 (pence) Share price as at today, 25 November 2009, (pence): Beta co-efficient

15 55 330 450 50 830 70 220 17 307

65.0 26.0 885 670 1.17

22.5 11.4 620 375 n/a

No beta is available for L Products. The beta of a larger, quoted entity in a similar line of business is 1.4. This entity has a debt ratio (debt:debt + equity) of 40%. Assume a debt beta of 0.2. Assume both entities debt is quoted at par.

The requirement for Question One is on page 5, which is detachable for ease of reference

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Required:
(a)
Calculate for T Industries and for L Products as independent entities: (i) The P/E ratio and current market capitalisation (3 marks) (ii) The cost of equity using the CAPM (6 marks) (iii) Estimated value using the discounted cash flow method (5 marks) Notes The expected return on the market is 9% and the expected return on the riskfree asset is 3%. Assume earnings equal net cash flows. Ignore taxation in your calculations. Use sensible roundings throughout your answer. (b) Calculate the increase in value generated by combining the two businesses assuming the acquisition goes ahead and: The present value of the two entities cash flows up to and including 2011 is as you have calculated in part (a)iii The present value of the combined group cash flows from 2012 onwards is as explained in the scenario (growth in earnings of 4% and a cost of equity of 10%). (5 marks) (c) Assume you are T Industries Finance Director. Write a report for review by the entitys Board which includes the following: (i) Discussion and advice on the range of values within which T Industries should be prepared to negotiate. Include in your discussion brief comments on how share prices are determined and how the stock market might assess the value of the two entities. Conclude your discussion here with a recommendation of an opening bid for L Products expressed as a price per share. (12 marks) (ii) Discussion and recommendation on the most appropriate method of financing the bid, taking into account the possible effect on risk and earnings and other key factors. Assume that the two alternative methods under consideration are a share exchange or the issue of new debt. Include any calculations you consider appropriate to support your discussion. (8 marks) (iii) Discussion and evaluation of the implications of the proposed acquisition for the achievement of T Industries current financial objectives in the context of the current economic environment of low and falling interest and inflation rates. Include in your discussion an evaluation of how financing and dividend policies could be adapted to assist in the achievement of Ts objectives. (8 marks) Note: If you have been unable to complete the calculations for parts (a) and (b) of the question, make sensible assumptions in your answer for part (c). Structure and presentation: (3 marks) (Total for Question One = 50 marks)

Section B starts on the page 8

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Section B starts on the next page

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SECTION B 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER TWO ONLY OF THE FOUR QUESTIONS

Question Two
Gregory Gregory, a listed entity based in Europe, provides private medical care through private hospitals. Additional funds are required to fund the construction of a new medical support unit. This was already public knowledge in August 2009 A rights issue was announced in a press statement on 1 September 2009. Ordinary shares are to be issued at a discount of 20% on market price and the issue is expected to raise a total sum of 29.3million. Gregory already has 40million 1 ordinary shares in issue. The share price on 1 September 2009 before the press statement was released was 458 cents. Mr X holds 200,000 1 ordinary shares in Gregory and is wondering whether or not to take up the rights being offered.

Required:
(a)
(i) (ii) Calculate the number of ordinary shares to be issued under the rights issue.

(2 marks)
Calculate the theoretical ex-rights price .

(3 marks) (iii)
(iv) Calculate the expected trading price for the rights.

(2 marks)
Evaluate and discuss the impact of the rights issue on the personal wealth of shareholder Mr X for each of the following three alternative responses to the rights offer: does not take up the rights takes up the rights sells just enough rights to provide the funds needed to purchase the remaining rights

(10 marks)

Question 2 continues on the opposite page

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George George, a competitor of Gregory, is also based in Europe and operates in the medical services industry. It has been highly successful in recent years and has accumulated a large amount of surplus cash representing 10% of total equity value. It now wishes to return this surplus cash to shareholders. Gearing is defined as net debt to net debt plus equity where net debt is debt after deduction of surplus cash. Current market values: Debt Surplus cash Equity million 37 7 70

The entity is considering the best method to achieve the return of surplus cash to the shareholders, preferably also reducing the cost of capital but not changing the balance of share ownership. The two main methods being considered are: (i) share repurchase (ii) one-off special dividend

Required:
(b)
Compare and contrast the advantages to George of each of the two proposed methods of returning surplus cash to shareholders and recommend which of these methods George should use. (8 marks) (Total for Question Two = 25 marks)

Section B continues on the next page

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Question Three
Horatio is a manufacturing entity based in the UK. It is considering installing energy efficient equipment at its plant in the UK at a capital cost of 10 million. The new equipment is estimated to have a useful life of nine years. However, it involves the use of new technology that has largely only been tested in laboratory conditions. Therefore the introduction of this equipment carries significant risks. The project to install this new energy efficient equipment has been evaluated using the entitys WACC but the Finance Director is concerned that this may not be the most appropriate approach in view of the high risks involved. Three alternative sources of finance for the new equipment are being considered as follows: Alternative 1 Irredeemable 5.5% preference shares to be issued at a price of 1.20 per 1 share. Alternative 2 A 9-year bond with an annual coupon of 4%, issued at par and redeemable at 110 per 100 nominal. Alternative 3 A 5-year bond denominated in US dollars, issued and redeemed at par and expected to be quoted at a low dollar yield to maturity of 2.8% on the issue date. The US dollar is expected to strengthen against the British pound by 2.5% per annum. Assume business tax of 35% is payable one year after the year in which it is incurred.

Required:
(a)
(i) Calculate the cost of debt for each of the THREE alternative sources of finance listed above. Accurate calculations are required for Alternatives 1 and 2 but only an estimate of the equivalent yield in British pounds is required for Alternative 3. (10 marks) Discuss the advantages and disadvantages of each alternative source of finance in the context of Horatio and recommend which should be selected. (7 marks)

(ii)

(b)
For TWO of the following THREE methods, explain how each could be used to incorporate risk in NPV calculations and advise to what extent each would be useful to Horatio when evaluating the proposed project: decision trees risk-adjusted discount rate certainty equivalents (8 marks) (Total for Question Three = 25 marks)

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Question Four
Claudia is based in Asia and is considering installing a new computer system in order to upgrade the web-based sales system to bring it in line with that of Claudias main competitors. The cost of $10 million is payable up front but the new system will take a full year to implement. Increased pre-tax operating earnings of $770,000 a year are expected from year 2 onwards indefinitely to reflect increased operational efficiencies and increased revenue from web-based sales. Claudia is currently funded by ordinary shares and an irredeemable bond as follows: Nominal value Market value 20 million ordinary shares $1 each $2.50 each 5.4% irredeemable bond $33 million trading at par Additional debt finance of $10 million will be taken out (also at 5.4%) if the project is approved. Additional information: Cost of equity is 6.2% The project is not expected to have any impact on either the current cost of equity or the cost of debt. The share price is expected to react very quickly on announcement of the project to reflect the anticipated NPV of the project. Business tax is payable and refundable at 35% in the year in which it is incurred. No tax depreciation allowances can be claimed Assume earnings equal net cash inflow Cash flows arise at the end of a year

Required:
(a)
Calculate the current WACC of Claudia (before taking the project into account). (3 marks)

(b)
Evaluate the project using the current WACC calculated in part (a). (4 marks)

(c)
Calculate the post-project WACC for Claudia after adjusting for the NPV of the project and the increased debt, and discuss your results. Discuss and advise whether the pre-project WACC was an appropriate discount rate for Claudia to use in this scenario. (6 marks)

(d)
Discuss the key factors that Claudia should take into account in respect of this project when: (i) assessing customer requirements (ii) drawing up an implementation plan (12 marks) (Total for Question Four = 25 marks) TURN OVER

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Question Five
Dominique is a multinational group. The head office and parent entity are based in Country D which uses currency D$. The group runs a chain of supermarkets both in Country D and in neighbouring countries. Dominique sources its supplies from its home country D, neighbouring countries and also from some more distant countries. Dominique is funded by a mix of equity and long-term borrowings. The borrowings are largely floating rate bonds denominated in D$. Proposed new project The proposed new project is to open a number of new supermarkets in Country T, a neighbouring country, which uses currency T$. Market research has already been undertaken at a cost of D$ 0.3 million. If the proposed project is approved additional logistics planning will be commissioned at a cost of D$ 0.38 million payable at the start of 2010. Other forecast project cash flows: Initial investment on 1 January 2010 Residual value at the end of 2014 Net operating cash inflows 2010 2011 and 2012 2013 and 2014 T$ million 150 T$ million 40 T$ million 45 growing at 20% a year from 2010 levels growing at 6% a year from 2012 levels

Additional information: On 1 January 2010, the spot rate for converting D$ to T$ is expected to be D$1 =T$ 2.1145. Dominique has received two conflicting exchange rate forecasts for the D$/T$ during the life of the project as follows: Forecast A Forecast B A stable exchange rate of D$1 = T$2.1145 A devaluation of the T$ against the D$ of 5.4% a year

Business tax is 20% in Country T, payable in the year in which it is incurred. Tax depreciation allowances are available in Country T at 20% a year on a reducing balance basis All net cash flows in Country T are to be remitted to Country D at the end of each year An additional 5% tax is payable in Country D based on remitted net cash flows net of D$ costs but no tax is payable or refundable on the initial investment and residual value capital flows.

The project is to be evaluated, in D$, at a discount rate of 12% over a five year period.

Required:
(a)
Calculate and discuss the D$ NPV of the project cash flows as at 1 January 2010 using each of the two different exchange rate scenarios, Forecast A and Forecast B. Briefly advise Dominique whether or not it should proceed with the project. (18 marks)

(b)
Discuss the likely impact of changes in exchange rates and tax rates on the performance of the Dominique group as a whole and how this is likely to influence the financial strategy of the group. No further calculations are required. (7 marks) (Total for Question Five = 25 marks)

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End of Question Paper Maths Tables & Formulae are on pages 15-19

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MATHS TABLES AND FORMULAE

Present value of 1.00 unit of currency, that is (1 + r)-n 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 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

Present value table

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

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

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Cumulative present value of 1.00 unit of currency per annum

1(1+ r ) n Receivable or Payable at the end of each year for n years r

8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818 9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129 10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514

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 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046

2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351

3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878

4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590

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 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470

7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594

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 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963

12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469

13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025

14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623

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 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929

17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628

18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353

19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101

20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870

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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: P0 =
ke d1

or

P0 =

d 0 [1 + g ] ke

(iv)

Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P0 is the ex-interest value: P0 =
i [1 t ] k d net

or, without tax: (v) Total value of the geared entity, Vg (based on MM):

P0 =

i kd

Vg = Vu + TBc
(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest:

S = X[1 + r]n
(vii) Present value of 100 payable or receivable in n years, discounted at r% per annum:
1

PV =

[1 + r ]

(viii)

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 =

1 1 1 n r [1 + r ]

(ix)

Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:
1

PV =
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:
1

PV =

r g

FORMULAE CONTINUE ON THE NEXT PAGE

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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 =
(ii)

d P0

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

kd net =
(iii)

i [1 t ] P0

Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

ke =
(iv)

d P0

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 =
(v)

d1 P0

+g

or

ke =

d 0 [1 + g ] P0

+g

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

ke = Rf + [Rm Rf]
(vi) Cost of ordinary (equity) shares in a geared entity (no tax):

keg = k0 + [ko kd] VD E

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

keg = keu + [keu kd]

(viii) Weighted average cost of capital, k0:

VD [1 t ] VE

k0 = keg
(ix) Adjusted cost of capital (MM formula):

VD VE V + V + k d V + V E D E D
or r* = r[1 T*L]

Kadj = keu [1 tL]

In the following formulae, u is used for an ungeared and g is used for a geared : (x)

u from g, taking d as zero (no tax): u = g

VE VE + VD
VD + VE

(xi)

If d is not zero:

u = g

VE VE + VD

V D

(xii)

u from g, taking d as zero (with tax): u = g

VE VE + VD [1 t ]

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(xiii)

Adjusted discount rate to use in international capital budgeting using interest rate parity:

1 + annual discount rate C$ 1 + annual discount rate euro

Exchange rate in 12 months' time C$/euro Spot rate C$/euro

Other formulae
Interest rate parity (international Fisher effect): Forward rate US$/ = Spot US$/ x
1 + nominal US interest rate 1 + nominal UK interest rate

Purchasing power parity (law of one price): Forward rate US$/ = Spot US$/ x
1 + US inflation rate 1 + UK inflation rate

Link between nominal (money) and real interest rates: [1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]

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]

Value of a right: Value of a right = or

Theoretica l ex rights price issue price N

Rights on price issue price N+1

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

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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
1 KNOWLEDGE What you are expected to know.

VERBS USED
List State Define

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

2 COMPREHENSION What you are expected to understand.

Describe Distinguish Explain Identify Illustrate

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

3 APPLICATION How you are expected to apply your knowledge.

Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate

To put to practical use To ascertain or reckon mathematically To prove with certainty or to exhibit by practical means To make or get ready for use To make or prove consistent/compatible Find an answer to Arrange in a table

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

Analyse Categorise Compare and contrast Construct Discuss Interpret Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between To build up or compile To examine in detail by argument To translate into intelligible or familiar terms To create or bring into existence

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

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

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Financial Management Pillar

Strategic Level Paper

P9 Management Accounting Financial Strategy

November 2009

Wednesday Morning Session

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