F3 Financial Strategy

Post Exam Guide

May 2011 Exam

F3 FINANCIAL STRATEGY
Examiner’s general comments

The overall performance in the May exams showed a marked improvement over recent previous diets.
This improvement was observed in both home and overseas centres. Question 1 in particular was
generally very well answered, especially the calculations for part (ai). The greatest weakness in answers to
this compulsory question was part (c) where many candidates provided poor understanding of real options
and/or did not fully address the question asked. The structure and presentation of figures in this question
also presented a challenge for many candidates.

The most popular of the optional questions was Question 4, which gained the highest marks. No question
was noticeably avoided by candidates.

A summary of candidates’ performance on each of the optional questions is given below:

Question 2
This was the most poorly attempted question and many candidates demonstrated weak knowledge of the
question topics (dividend policy and IPOs) and/or inability to apply their knowledge to the question
scenario.

Question 3
Candidates continue to struggle to answer questions on leasing and often fail to understand how to apply
tax relief in the different scenarios. The use of an incorrect discount rate, or rates, was also a common
error.

Question 4
This question was generally answered satisfactorily although some candidates failed to understand the
need to ungear and regear the beta or, if they did recognise the need, failed to do so correctly.

In a narrative section where the marking guide says “up to 2 or 3 marks are available for each valid point”,
0.5 marks are awarded for a bullet point, 1 mark for some attempt at (correct and valid) discussion, rising to
2 marks for good discussion of the point and, if available, 3 marks where candidates have also provided
appropriate illustrative examples.

Where marks are shown for calculations, the mark shown is the maximum available assuming all
calculations are correct. Some credit is given for recognition of correct approach and understanding even if
the numbers are not correct.

The published solutions are intended as a guide only. Marks are also awarded for other valid comments
made by candidates that might not be mentioned in the marking guide or the published solutions.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

SECTION A – 50 MARKS
COMPULSORY

Question One

Required:

Assume that you are the Management Accountant of the Snacks Division and have been asked to write a
Report addressed to the Divisional Board of the Snacks Division of F plc that will assist it in deciding
whether or not to proceed with the proposed product launch. In your report you are required to:

(a) Ignoring the abandonment option:

(i) Calculate the NPV for the project as at 1 January 2012 for Scenarios A and B individually as
well as the overall total expected NPV.
(13 marks)

(ii) Calculate the payback period for the project for each of Scenarios A and B.
(4 marks)

(iii) Interpret your results from (a)(i) and (a)(ii).

(6 marks)

(b) Evaluate whether or not the project should be abandoned on 1 January 2013 if Scenario B occurs.
(8 marks)

(c) Advise how real options and other strategic financial issues might influence the initial investment
decision.
(12 marks)

(d) Recommend, with reasons, whether or not to proceed with the proposed product launch on
1 January 2012.
(4 marks)

Additional marks available for structure and presentation: (3 marks)

(Total for Question One = 50 marks)

Rationale

Question One concerns the investment appraisal of a proposed project to launch a new line of chocolate bars in a
foreign market. It includes the complication of uncertainty in terms of future cash flows and the evaluation of an
opportunity to abandon the project before the end of its life.

This question examines learning outcomes in syllabus sections A and C.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Suggested Approach

Part (a)(i)
Firstly identify relevant cash flows and calculate exchange rates.
For each outturn scenario, schedule cash flows according to currency and convert net total euro cash flows into
British pounds. Then calculate tax cash flows and total cash flows by year and then discount and aggregate across
years to give a net total NPV for the project. Finally, apply given probabilities to the NPV result obtained for each
individual Scenario to obtain an overall expected NPV.

Part (a)(ii)
To calculate the payback period for each Scenario, first calculate the net investment. Then schedule net cash flows
per year and tabulate cumulative cash flow figures to determine the payback period. Use interpolation techniques to
obtain an answer that falls between two year ends.

Part (a)(iii)
Interpret your results – see key points listed in the markscheme below and in the suggested solutions.

Part (b)
Firstly identify the relevant remaining cash flows for the project and also the abandonment cash flows from 1 January
2013 onwards. Discount the project cash flows and then the abandonment cash flows back to 1 January 2013 and
compare the results obtained.

Part (c)
Consider real options first and then other relevant strategic issues.

Part (d)
Conclude with a recommendation, weighing up the arguments for and against proceeding with the project.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Marking Guide Marks

Part (a)(i) - Calculate NPVs - 13 marks

Scenario A NPV Distribution centre (incl residual value) 1.0

Growing EUR cash inflows and
calculating FX rates and convert to GBP correctly 2.5
Market research and launch (excluding sunk cost) 1.0
Growing GBP cash outflows 0.5
Tax calculations 2.0
Discounting and overall NPV 1.0
8.0

Scenario B NPV Revised growing EUR cash inflows 1.0

Computing cash flows 1.0
Discounting and overall NPV 1.0
3.0

Calculate expected NPV Apply probabilities to individual results in (a)(i) 2.0

Maximum part (a)(i) 13 marks

Part (a)(ii) - Calculate payback periods - 4 marks

Using correct base cash flows 2.0

Subsequent calculations– 1 mark each for A & B 2.0
4.0

Maximum part (a)(ii) 4 marks

Part (a)(iii) - Interpret your results in parts (a)(i) and (a)(ii) - 6 marks

Key issues: 6.0

• Review NPV results
incl implication of negative NPV for Scenario B
• Review payback results
• Danger of basing decisions on expected values
• Reliability of the results

Maximum part (a)(iii) 6 marks

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Post Exam Guide
May 2011 Exam

Part (b) - Evaluate whether or not to abandon the project on 1 January 2013 – 8 marks

Calculation
• Appropriate base figures 2.0
• Balancing charges (including timing delay) 2.0
• Sales proceeds(GBP 5.7m) 1.0
5.0
Conclusion
Explain whether or not project would be abandoned 3.0

Maximum part (b) 8 marks

Part (b) - Advise how real options and other strategic financial issues might
influence the initial investment decision. – 12 Marks

Real options: up to 8.0

• Abandonment (up to 3 marks)
• Follow on option (up to 3 marks)
• Wait option – competitor risk

Other key issues: up to 8.0

• Ability of the business to support additional finance
• Impact on shareholder returns
• Impact on gearing
• Risk appetite

Other minor issues:

• Sensitivity up to 4.0
• FX
• Country risk / political risk
• Economic climate
• Commodity prices / inflation

Maximum for part (c)

12 marks

Part (d) - Recommendation – 4 marks

Recommendation Summarise reasons for and against proceeding

Conclude with recommendation

Maximum part (d)

4 marks
Additional marks available for structure and presentation
3 marks
(1 for headings, 1 for purpose, 1 for tabulated calculations where appropriate)

Total maximum for question 1 50 marks

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Examiner’s Comments

This question was generally answered well, especially the calculations in part (ai). Main
weaknesses in this part of the question were:

■ Inability to set up the NPV calculations with the GBP/EUR conversions and the assumptions about
cost and revenue growth, with some candidates combining EUR and GBP figures directly.

■ Treating the scenarios like separate projects and so not highlighting the problem with using expected
values.

In part (aii) very few candidates were able to calculate payback correctly, which is astonishing
in a final level paper.

Most candidates made a reasonable attempt at part (b) although some ignored it completely.

Part (c) was generally poorly answered, with many candidates discussing all types of strategic
options whereas the question required discussion of strategic financial options.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

SECTION B – CHOICE OF TWO QUESTIONS FROM THREE

25 MARKS EACH QUESTION

Question Two
Required:

(a) Evaluate the current dividend policy of HJK.

(6 marks)

(b) (i) Describe the process involved in an IPO.

(3 marks)

(ii) Advise on the potential risks with an IPO and what action can be taken to minimise such
risks.
(4 marks)

(c) Discuss the concerns of the Directors regarding the possible implications of becoming a listed
company on dividend, financing and investment strategies and the interrelationship between
them.
(12 marks)

(Total for Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Rationale

Question 2 focuses on the implications of a planned IPO on a given company. It requires candidates to explain the
processes and risks involved with an IPO and to also consider the possible impact on the company’s current dividend
policy, financing strategies and investment strategies.

The question examines learning outcomes in syllabus sections A and B.

Suggested Approach

Part (a)
• Examine the historic dividend figures provided and identify the current dividend policy.
• Identify alternative dividend policies and compare and contrast the features of each.

Part (b)(i)
• Discuss the process involved in an IPO.

Part (b)(ii)
• Consider the potential problems and risks involved in an IPO.
• Discuss what action can be taken to minimise such risks.

Part (c)
Consider each of: dividends, financing and investment in turn, explaining and advising the directors how an IPO
might affect each of these three policy areas, and concluding by examining the interrelationship between them.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Marking Guide Marks

Part (a) – Evaluate the current dividend policy – 6 marks

Calculations
• Dividend payout as % of profit
• Dividend payout as % of profit not required for acquisitions 2.0

Identify the current dividend policy

• Identify 50% payout of available profits
• Subject to minimum payout of EUR 2 million 2.0

Evaluate the current policy

• Stable dividend (pros and cons)
• Dividend linked to profits before acquisitions (pros and cons) 4.0

Maximum part (a) 6 marks

Part (b)(i) – Describe the process of an IPO – 3 marks

Key Points
• Through issuing house which underwrites the issue
• Issuing house acquires shares and offers to public
• Offer to public either at fixed price or by tender

Maximum part (b)(i) 3 marks

Part (b)(ii) – Advise on the problems and risks with an IPO – 4 marks

Key points

• Failure to sell all shares => underwrite issue

• Issue over-subscribed => set price at appropriate level, take professional advice

Maximum part (b)(ii) 4 marks

Part (c) – Discuss possible implications of listing on three specified policy areas – 12 marks

Dividend policy
• Signalling effect for listed companies
• Accountability to shareholders => consider shareholder expectations
• Additional market value for stable growing dividend levels

Financing strategies
• Greater accessibility of financing
• Possibility of raising funds on capital markets

Investment strategies
• Market scrutiny of investment decisions and impact on share price
• Greater levels of investment may be possible given more sources of finance

Interrelationship between them

Maximum part (c) 12 marks

Total maximum for question 2 25 marks

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Examiner’s comments

Discussion of the dividend policy, IPO process and consequences of listing for a private, family-owned
and managed business was surprisingly poor, even though this was a straightforward question where
candidates could have gained good marks. Most candidates were able to identify the current dividend
policy but many failed to recognise that HJK was a family company and thus the dividend policy was
likely to reflect that. Many candidates actually discussed the policy as if HJK were already listed. Part (b)
was reasonably well answered – as was part (c).

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Question Three

Required:

(a) Calculate the present value, as at 1 July 2011, of the cash-flows associated with each of the
three alternative financing methods under consideration.
(13 marks)

(b) Recommend, with reasons, which of the three alternative financing methods should be chosen.
(8 marks)

(c) Discuss how an immediate change in government policy to improve tax depreciation allowances
on equipment used in low carbon emission technology would impact on the decision. No further
calculations are required.
(4 marks)

(Total for Question Three = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Rationale

This question concerns a company that was a “spin-off” from a university. It now works with large manufacturing
companies on the reduction of carbon emissions. It is planning to purchase specialist equipment at a cost of $50
million and is evaluating three financing methods.

The question examines learning outcomes in syllabus section B.

Suggested Approach

Part (a)
Calculate the PV of each of the alternative financing methods, using the post-tax cost of borrowing as the
discount rate.

Part (b)
■ Recommend the most appropriate method, recognising that the one with the lowest PV might not be
the best choice in the circumstances of the scenario.

■ Provide reasons for your choice/recommendation.

Part (c)
Discuss the key factors as shown in the marking guide.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Marking Guide Marks

Part (a) – 13 marks

Alternative 1 - Outright purchase

 Purchase cost and tax relief 2.0
 Maintenance and tax relief 2.0

Alternative 2 - Finance lease

 Tax relief on depreciation and interest 2.0
 Lease payment 2.0
(no tax relief and no interest cash flows)
 Maintenance and tax relief 1.0

Alternative 3 – Operating lease

• Lease payment after tax relief 2.0
(overall discounting marks)

Discounting and NPV 2.0

(marks awarded across all 3 methods)

Maximum part (a) 13 marks

Part (b) – 8 marks

Key issues
• Finance lease (cheapest)
• Uncertainty over maintenance costs
(none with operating lease)
• Obsolescence risk (none with operating lease)
• Accounting disclosure (none with operating lease)

Maximum part (b) 8 marks

Part (c) – 4 marks

Key issues
 Adequacy of profits to absorb extra tax allowances
 Extent to which finance lease is reduced
 Recalculate NPV on new basis – sensitivity analysis

Maximum part (c) 4 marks

Total maximum for question 25 marks

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Examiner’s comments

The main weaknesses in answers to this question were:

Part (a)
■ Failure to see that this was a cash flow problem, with a requirement to determine the present value of
the cash outflows associated with each of the financing options (non-cash items were often included).

■ Computing the implied interest on the finance lease option, even though the question had already
provided the relevant figures.

■ Adopting a simplistic view of picking the option that resulted in the lowest PV of cash outflows without
exploring other relevant issues like the potential to avoid obsolescence costs under the operating lease
option.

Part (b)
Providing a very brief recommendation, or no recommendation at all or omitting supporting reasons.

Part (c) was generally poorly answered.

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F3 Financial Strategy
Post Exam Guide
May 2011 Exam

Question Four

Required:

(a) Calculate:

(i) XX’s existing cost of equity.

(1 mark)
(ii) XX’s existing weighted average cost of capital (WACC).
(2 marks)

(iii) A suitable WACC for the Specialist Division based on proxy YY, adjusted for XX’s gearing.
(5 marks)

(b) (i) Calculate a range of values for the Specialist Division based on the different methods
suggested by Directors A, B and C (but not Director D).
(5 marks)

(ii) Discuss the validity of the methods suggested by each of the four Directors A, B, C and D.
(8 marks)

(iii) Advise XX on an appropriate price for the purchase of the Specialist Division.
(4 marks)

(Total for Question Four = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

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F3 Financial Strategy
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Rationale

Question 4 concerns the valuation of a division of a larger company. Candidates are required to calculate a range of
values using different valuation methods and different bases for each approach. A discussion is required regarding
the validity of each approach and an appropriate purchase price.

The question examines learning outcomes in syllabus sections B and C.

Suggested Approach

Part (a)
■ Calculate XX’s existing cost of equity using CAPM.
■ Adjust XX’s cost of debt for tax and then use this cost of debt, together with the cost of equity calculated above,
to calculate XX’s WACC.
■ Ungear and regear YY’s beta.
■ Calculate an adjusted cost of equity based on this adjusted beta and using CAPM.
■ Recalculate a WACC using this adjusted cost of equity.

Part(b)(i)
Present a range of values, starting with the asset figures provided in the question.
Then use the earning valuation model to calculate the value of the division based on each WACC calculated in part
(a) above.

Part (b)(ii)
Discuss the validity of each valuation method in turn

Part (b) (iii)

Conclude by advising an appropriate purchase price.

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Post Exam Guide
May 2011 Exam

Marking Guide Marks

Part (a) – 8 marks

Calculations
• XX’s cost of equity 1.0
• XX’s WACC 2.0
• Ungear and regear YY’s beta 3.0
• Calculate adjusted cost of equity 1.0
• Calculate adjusted WACC 1.0

Maximum part (a) 8 marks

Part (b)(i) – 5 marks

Calculations
 Earnings valuation using XX’s WACC 2.0
 Earnings valuation using adjusted WACC 2.0
 Asset values 1.0

Maximum part (b)(i) 5 marks

Part (b)(ii)– 8 marks

Key points:
• Asset values not appropriate (intellectual capital and earning capacity ignored)
• Limitations of using XX’s WACC (difference in risk profile)
• Limitations of using adjusted WACC (appropriateness of proxy)
• Problems with identifying earnings and cost of equity for valuation on that basis

Maximum part (b)(ii) 8 marks

Part (b)(iii)– 4 marks

Advice on price
• Lowest price and range of acceptable prices from part (b)(ii)
• Start negotiations at the lower end of the range

Maximum part (b)(iii) 4 marks

Total for question 4 25 marks

Examiner’s comments

Parts (a) and b(i) were very well answered on the whole. Answers to part b(ii) were often too brief and failed to
recognise the key issues.

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