Financial Pillar

F3 – Financial Strategy
25 November 2010 – Thursday 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

F3 – Financial Strategy
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 sub-
questions).

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 7. 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.

 The Chartered Institute of Management Accountants 2010

DEF Airport

Pre-seen case study

Overview
DEF Airport is situated in country D within Europe but which is outside the Eurozone. The local
currency is D$. It is located near to the town of DEF. It began life in the 1930s as a flying club
and was extended in 1947, providing scheduled services within central Europe. A group of four
local state governments, which are all in easy reach of the airport (hereafter referred to as the
LSGs), took over the running of the airport in 1961. The four LSGs are named North (NLSG),
South (SLSG), East (ELSG) and West (WLSG). These names place their geographical location
in relation to the airport. In the early 1970s flights from the airport to European holiday
destinations commenced with charter flights operated by holiday companies. In 1986, the first
transatlantic flight was established and the airport terminal building was extended in 1987.

By 1989 the airport was handling 500,000 passengers per year which is forecast to increase to
3.5 million for both incoming and outgoing passengers in the current financial year to 30 June
2011. The airport mainly serves holidaymakers flying to destinations within Europe and only 5%
of the passengers who use the airport are business travellers.

DEF Airport was converted into a company in 1990 and the four LSGs became the
shareholders, each with an equal share. The company is not listed on a stock exchange. The
airport has undertaken extensive development since 2000, with improvements to its single
terminal building. The improvements have mainly been to improve the airport’s catering
facilities and to increase the number of check-in desks. There has also been investment in the
aircraft maintenance facilities offered to the airlines operating out of the airport.

Governance
The Board of Directors has four Executive directors: the Chief Executive, the Director of
Facilities Management, the Finance Director and the Commercial Director. In addition there is a
Company Secretary and a Non-Executive Chairman. In accordance with DEF Airport’s Articles
of Association, the Non-Executive Chairman is drawn from one of the four LSGs. The Non-
Executive Chairman is the sole representative of all four LSGs. The Chairmanship changes
every two years with each of the four LSGs taking turns to nominate the Chair.

The four LSGs have indicated that they may wish to sell their shareholdings in the airport in the
near future. If any LSG wishes to sell its shares in the airport it must first offer them to the other
three LSGs. Any shares that are not purchased by the other LSGs may then be sold on the
open market. A local investment bank (IVB) has written to the Chairman expressing an interest
in investing in the airport in return for a shareholding together with a seat on the Board.

Mission statement
The Board of Directors drew up a mission statement in 2008. It states “At DEF Airport we aim
to outperform all other regional airports in Europe by ensuring that we offer our customers a
range of services that are of the highest quality, provided by the best people and conform to the
highest ethical standards. We aim to be a good corporate citizen in everything we do.”

DEF Airport development plan

The Board of Directors produced a development plan in 2009. The Board of Directors consulted
with businesses in the area and followed central government airport planning guidelines. It was
assumed that the views of other local stakeholders would be represented by the four LSGs
which would feed comments to the Board through the Chairman.

The plan relates to the development of DEF Airport and its forecast passenger growth for the
next two decades. The Board proposed that future development of the airport will be phased
and gradual in order to avoid unexpected consequences for the local communities and industry.

November 2010 2 Financial Strategy

Strategic objectives
The following strategic objectives have been established in the development plan:

1. Create a planning framework which enables DEF Airport to meet the demands of the
forecast passenger numbers;
2. Reduce to a minimum the visual and audible impacts of the operation of the airport on
the local environment;
3. Ensure that the airport is financially secure;
4. Improve land based access to the airport;
5. Minimise the pollution effects of the operation of the airport.
6. Maintain / increase employment opportunities for people living close to the airport.

By the year ending 30 June 2015, DEF Airport is expected to support about 3,000 local jobs
and have a throughput of 5 million passengers per year, an increase of 1.5 million from the 3.5
million passengers forecast for the current financial year ending 30 June 2011. In order to
accommodate the forecast increased number of passengers and attain the development
objectives, it will be necessary for the airport to extend its operational area to the east of the
land it currently occupies.

Financial objectives
Extracts from DEF Airport’s forecast income statement for the year ending 30 June 2011 and
forecast statement of financial position as at that date are presented in the Appendix. The four
LSGs have made it clear to the Board of Directors that the airport must at least achieve
financial self-sufficiency. The financial objectives of the airport are to ensure that:

1. The airport does not run at a loss;

2. All creditors are paid on time;
3. Gearing levels must not exceed 20% (where gearing is defined as debt to debt plus
equity) and any long-term borrowings are financed from sources approved by the four
LSGs.

Corporate Social Responsibility

A key feature of DEF Airport’s development plan is to develop “Sustainable Aviation” initiatives
in order to reduce the effects of flying on the environment. One effect on the environment is that
the airport is subject to specific planning restrictions affecting flights between the hours of 11
p.m. (2300 hours) and 7 a.m. (0700 hours) to reduce aircraft noise. Flights are permitted
between these times, but must be specially authorised. Typically, flights between these times
would be as a result of an emergency landing request.

A leading international consultancy, QEG, which specialises in auditing the corporate social
responsibility (CSR) issues of commercial enterprises, has offered to provide a CSR audit to
DEF Airport free of charge. QEG is based in the USA and hopes to expand by offering its
services to European enterprises.

DEF Airport’s competitors

TUV Airport is located about 100 kilometres away from DEF Airport and serves a highly
populated industrial city. The Board of Directors of DEF Airport considers TUV Airport to be its
main competitor. There are another three competing airports within 80 kilometres of DEF
Airport. TUV Airport purchased one of these three competitor airports and subsequently
reduced services from it in order to reduce the competitive threat to itself.

Airlines
Airlines are keen to negotiate the most cost effective deal they can with airports. DEF Airport
applies a set of standard charges to airlines but is aware that some of its competitor airports
have offered inducements to airlines in order to attract DEF’s business.

Airlines across the world are facing rising fuel and staff costs as well as strong competition from
within the industry. There has been an overall increase in customer demand for air travel in
recent years and low-priced airlines have emerged and are threatening the well-established,

Financial Strategy 3 November 2010

traditional airlines. Consequently, the traditional airlines have begun to cut the number of
destinations to which they fly.

There are several low-priced airlines that serve DEF Airport’s competitors, but only one, S, also
operates out of DEF Airport. S is exploring ways in which it might increase its flights to and
from DEF Airport.

DEF’s Board of Directors has been approached by a North American airline that wishes to
operate services from DEF Airport. This airline specialises in flights for business and first class
passengers. However, this airline insists that it would pay DEF Airport in US$. This is contrary
to the airport’s policy of accepting payment only in D$, which is the local currency.

Analysis of revenue by business segment

The forecast split of total revenue of D$23.4 million by business segment for the current
financial year ending 30 June 2011 is:
%
Aviation income 48
Retail concessions at the airport 20
Car Parking 15
Other income 17
(Other income includes income from property rentals, and other fees and charges.)

DEF Airport offers discounts for prompt payment.

Aviation income
In addition to the standard charges, which are set out below, there is a range of surcharges
which are levied on airlines for such items as “noisy aircraft” (charged when aircraft exceed the
Government limits for acceptable noise levels), recovery of costs and expenses arising from
cleaning or making safe any spillages from aircraft and extraordinary policing of flights (for
example, arrests made as a result of anti-social behaviour on aircraft).

Standard charges made by DEF Airport to the airlines:

Charges per aircraft

Landing charges – large aircraft: D$300
Landing charges – medium aircraft: D$170

Parking charges for the first two hours are included in the landing charge. Thereafter, a charge
of D$200 per hour is imposed for each large aircraft and D$250 per hour for each medium
aircraft. The parking charge is lower for large aircraft because they take at least two hours to
clean and refuel, so they almost always have to pay for an hour’s parking, and also because
there is less demand for the parking areas used for large aircraft. Medium aircraft tend to take
off again within one hour of landing. Approximately 10% of medium sized aircraft landings
result in the airline incurring parking charges for one hour. This is normally either because their
scheduled departure time requires them to park or because of delays imposed by air traffic
restrictions, technical malfunctions or problems with passengers.

Charges per passenger

Passenger Load:

Flights to European destinations: D$1.60 per departing passenger

Flights outside Europe: D$4.00 per departing passenger

Passenger security D$1.20 per passenger arriving or departing

November 2010 4 Financial Strategy

Retail concessions
DEF Airport provides the facilities for a range of shops, bureau de change (dealing in foreign
exchange currency transactions for passengers), bars and cafes for the budget conscious
passenger.

DEF Airport has a monopoly in the provision of retail concessions and therefore faces no
competition.

Car parking
Car parking is an important source of DEF Airport’s revenue. The airport has extended its own
car parking facilities for customers over recent years. Car parks occupy a large area of what
was green belt land (that is land which was not previously built on) around its perimeter. The
land was acquired by the airport specifically for the purpose of car parking. A free passenger
bus service is provided to take passengers to and from the car parks into the airport terminal
building.

Competitors have established alternative car parking facilities off-site and provide bus services
to and from the airport’s terminal. The parking charges made by the competitors are lower than
those levied by the airport. Competitor car park operators offer additional services to
passengers, such as car maintenance and valeting, which are undertaken while the car is left in
their care.

DEF Airport does not have a hotel on its premises. There is a hotel within walking distance of
the airport which offers special rates for passengers to stay the night before their flight and then
to park their cars at the hotel for the duration of their trip.

Other income
This heading contains a mixture of revenue streams. The Commercial Director reported that
some have good growth prospects. Property rental income is likely to decline though as there
has been much building development around the airport perimeter.

DEF Airport security

Passengers and their baggage are required to go through rigorous security checks. There is a
fast track service provided which can be accessed by all passengers at an extra charge. This is
intended to speed up the security process. However, on some occasions this leads to
passengers on the normal route becoming frustrated because they are required to wait in
lengthy queues to pass through the security checks. Airport security staff are required by law to
search all departing passengers and their baggage for suspicious or dangerous items. On the
very rare occasions that they discover anything they report their concerns to the police. There
are always several police officers on patrol at the airport at any given time and so the police
can respond to any report very quickly.

In addition to passenger and baggage screening, DEF Airport security staff are responsible for
the security of parked aircraft and airport property. They do this primarily by monitoring all
arriving and departing vehicles and their drivers and by monitoring the many closed circuit
television cameras that cover the airport.

The airport has had a good record with regard to the prevention of theft from passenger
baggage. This is frequently a serious matter at other airports, but DEF Airport has received very
few complaints that baggage has been tampered with. DEF Airport’s Head of Security regards
the security of baggage as very low risk because of this low level of complaints.

The Head of Security at DEF Airport was appointed to his current role in 1990, when the airport
was very much smaller than it is today. He was a police sergeant before he joined the airport
staff. Immediately before his appointment he was responsible for the front desk of DEF town’s
main police station, a job that involved managing the day-to-day activities of the other police
officers on duty. He was happy to accept the post of Head of Security because the police
service was starting to make far greater use of computers. He had always relied on a
comprehensive paper-based system for documenting and filing reports.

Financial Strategy 5 November 2010

The Head of Security is directly responsible for all security matters at DEF Airport. In practice,
he has to delegate most of the actual supervision of staff to shift managers and team leaders
because he cannot be expected to be on duty for 24 hours per day or to manage the security
arrangements in great detail while administering the security department. The overall
responsibilities of the Head of Security have not been reviewed since his appointment.

Strategic options
The Board of Directors is now actively considering its strategic options which could be
implemented in the future in order to meet the strategic objectives which were set out in the
airport’s development plan.

November 2010 6 Financial Strategy

 APPENDIX 1

Extracts of DEF Airport’s forecast income statement for the year ending 30 June
2011 and statement of financial position as at 30 June 2011

Forecast income statement for the year ending 30 June 2011

Note D$000

Revenue 23,400
Operating costs 1 (25,450)
Net operating loss (2,050)
Interest income 70
Finance costs (1,590)
Corporate income tax expense (130)
LOSS FOR THE YEAR (3,700)

Forecast statement of financial position as at 30 June 2011

D$000
ASSETS
Non-current assets 150,000
Current assets
Inventories 400
Trade and other receivables 9,250
Cash and cash equivalents 3,030
Total current assets 12,680
Total assets 162,680

EQUITY AND LIABILITIES

Equity
Share capital 2 17,700
Share premium 530
Revaluation reserve 89,100
Retained earnings 23,200
Total equity 130,530

Non-current liabilities
Long term borrowings 3 22,700
Current liabilities
Trade and other payables 9,450
Total liabilities 32,150
Total equity and liabilities 162,680

Notes:

1. Operating costs include depreciation of D$5.0 million.

2. There are 17.7 million ordinary shares of D$1 each in issue.
3. The long-term borrowings comprise a D$6.3 million loan for capital expenditure which
is repayable on 1 July 2015 and D$16.4 million owed to the 4 LSGs. This has no fixed
repayment schedule and is not expected to be repaid in the next year.

End of Pre-seen Material

The unseen material begins on page 8
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Financial Strategy 7 November 2010

SECTION A – 50 MARKS
[You are advised to spend no longer than 90 minutes on this question]
ANSWER THIS QUESTION

Question One
Unseen case material
Background

Today’s date is 25 November 2010.

The Directors of DEF Airport have recently received information that TUV Airport, a competitor
airport located approximately 100 kilometres from DEF, is interested in acquiring the company.

TUV Airport is privately owned and has the overall financial objective of maximising shareholder
wealth. Its strategic objectives support this financial objective by focussing on opportunities for
growth, both internally and by expansion through acquisition.

The Directors of DEF Airport have informed the four LSGs about the potential takeover bid and
the Directors and the LSGs have been discussing the implications of the sale of their shares to
TUV Airport. On the one hand, the potential takeover bid appears quite attractive because
running the airport has proved to be very challenging in recent months due to a global
economic downturn. On the other hand, the LSGs are reluctant to give up direct control over
local air transport and the interest income received on funds which the LSGs advanced to DEF.

The most likely date for the proposed takeover is considered to be 1 July 2011.

DEF Airport’s forecast financial statements for the year ending 30 June 2011 are set out in the
pre-seen material on page 7. Financial and strategic objectives can be found on page 3.

Financial information for DEF Airport

Forecast revenue for the year ending 30 June 2011 can further be analysed by business
segment as follows:
% D$ million
Aviation income 48 11.23
Retail concessions 20 4.68
Car parking 15 3.51
Other income 17 3.98
TOTAL 100 23.40

Forecast total operating costs for the year ending 30 June 2011 are D$25.45 million.

Years ending 30 June 2012 and 30 June 2013

• The total number of passengers is estimated to be 3.5 million in the year ending
30 June 2011 and to grow by 5% in the year ending 30 June 2012 and then by 8% in
the year ending 30 June 2013.
• Aviation income should be assumed to be directly related to the number of passengers.
The average aviation income per passenger in the year ending 30 June 2011 is
forecast to be D$3.21 and this is expected to increase at a rate of 4% a year in each of
the years ending 30 June 2012 and 30 June 2013.
• Car parking income should be assumed to be directly related to the number of
passengers. The average car parking income per passenger is forecast to be D$1.00
in the year ending 30 June 2011 and this is expected to increase at a rate of 10% a
year in each of the years ending 30 June 2012 and 30 June 2013.

November 2010 8 Financial Strategy

 • Retail concessions and other income are expected to increase by 7% a year in each of
the years ending 30 June 2012 and 30 June 2013 and are not dependent on passenger
numbers.
• Operating costs excluding depreciation are expected to increase by 4% a year in
each of the years ending 30 June 2012 and 30 June 2013. Operating costs are not
dependent on passenger numbers.
• Depreciation is expected to remain constant at D$5 million in each of the years ending
30 June 2012 and 30 June 2013. No capital expenditure or disposals of non-current
assets are planned for either of these two financial years.
• Working capital is expected to remain constant.
• The interest rate payable on borrowings is 7%. No repayments of long-term borrowings
are due in each of the years ending 30 June 2012 and 30 June 2013. Interest of 4% is
received on cash and cash equivalents. Interest should be calculated on the opening
balances of borrowings and cash and cash equivalents in each year.
• Corporate income tax is charged at 30% on taxable profits and is paid at the end of the
year in which the taxable profit arises. No tax refunds are available on losses for tax
purposes as these are carried forward to be offset against future taxable profits.
• Tax depreciation allowances are available on a reducing balance basis at a rate of 25%
per annum. On 1 July 2011, the opening balance of non-current assets that qualify for
tax depreciation allowances can be assumed to be D$3 million.
• Operating cash flows can be assumed to equate to operating profit or loss after
adjusting for the non-cash items specified above.

Year ending 30 June 2014 onwards

For the financial years ending 30 June 2014 to 30 June 2016, assume annual profits after tax of
D$6 million, D$8 million and D$9 million respectively and that these are equivalent to cash
flows.

For the year ending 30 June 2017 onwards, assume annual profits after tax (that is, cash) grow
by 5% a year in perpetuity.

Valuation of DEF Airport

The Directors of DEF Airport consider 11% to be an appropriate after tax discount rate to use in
discounting future cash flows. All cash flows should be assumed to arise at the end of the year.

In the event of the acquisition going ahead, TUV Airport is expected to be able to benefit from a
one-off synergistic benefit of D$3 million (after tax) in the year ending 30 June 2012. It pays
corporate income tax at a rate of 30% and expects to be able to obtain tax relief on any future
losses for tax purposes arising from DEF Airport by offsetting against taxable profits elsewhere
in the group in the same year.
.

The requirement for Question One is on page 11 which is

detachable for ease of reference

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Financial Strategy 9 November 2010

 This page is blank

November 2010 10 Financial Strategy

Required:

(a) Construct, for each of the financial years ending 30 June 2012 and 30 June 2013:

• A forecast of the net cash flow for the year;

• A statement of opening and closing balances for cash and cash equivalents
and long term borrowings.
(13 marks)

(b) Assume you are an external consultant engaged by the Board to prepare a report on the
factors that need to be considered should a takeover bid be received from TUV Airport.

Write a report addressed to the Board in which you:

(i) Calculate a range of values for DEF Airport as at 1 July 2011. Discuss your
results and advise on an appropriate valuation for use in negotiations with
TUV Airport.

(Up to 7 marks are available for calculations)

(14 marks)

(ii) Explain the main differences in the financial objectives of public and private sector
organisations, illustrating your answer by reference to the stated financial
objectives of both DEF Airport and TUV Airport.

(8 marks)

(iii) Discuss the strategic implications of the proposed sale of the business for the
LSGs and also for each of the other major stakeholder groups. Advise the LSGs
whether or not to negotiate a sale of the business to TUV Airport.

(12 marks)

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

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A
Section B starts on page 14

TURN OVER

Financial Strategy 11 November 2010

 Section B starts on page 14

November 2010 12 Financial Strategy

 Section B starts on page 14

TURN OVER

Financial Strategy 13 November 2010

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

ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH

Question Two
Today’s date is 25 November 2010.

GUC provides gas utility products and services in South America. Its functional currency is P$.
The Board is considering raising additional finance to provide capital for future acquisitions.

Three alternative sources of finance are being considered:

1) New equity by means of a rights issue at a 15% discount to current share price.
2) A five year bond with a yield of 0.5% below the industry average yield for comparable bonds.
3) A convertible bond issued at par with a coupon rate of 3%. The bond would be
convertible into ordinary shares in five years’ time at the ratio of 11 ordinary shares per
P$100 nominal of the bond.

Extracts from the financial statements of GUC for the year ended 30 September 2010 and other
relevant financial information are shown below:

• Revenue P$4,500 million

• Earnings P$ 864 million
• Number of equity shares in issue (par value 50 cents) 785 million
• Share price as at 30 September 2010 P$8.20
• Share price as at 25 November 2010 P$7.70
• Industry average P/E ratio 8.4
• Gearing ratio (debt:debt+equity, current market values) 34%
• Industry average gearing ratio 45%
• Corporate income tax rate 30%

GUC forecasts that the share price will grow in line with the expected growth in earnings and
dividends of 6% per annum. The yield to maturity for bonds without conversion rights, issued
by utility companies of similar size to GUC, is currently 6.5%

The shareholder profile is as follows:

Institutions (such as pension funds etc) 72%

Small individual non-employee investors 15%
Employees and directors 13%

November 2010 14 Financial Strategy

Required:

(a) Calculate:

(i) GUC’s current cost of equity

(ii) The gross yield to maturity of the convertible bond up to and including
conversion, assuming the convertible bond is issued on 25 November 2010.

State any assumptions made.

(10 marks)

(b) Evaluate the THREE alternative methods of finance being considered by GUC and
advise which method might be most appropriate.

(15 marks)

(Total for Question Two = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

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Financial Strategy 15 November 2010

Question Three

PEI is a privately-owned college of higher education in the UK. It competes directly with other
private and government-funded schools and colleges. The college directors are considering two
investment opportunities that would allow the college to expand in the UK (known as Projects A
and B) and a third opportunity to set up a satellite training centre in a foreign country (known as
Project C). Ideally, it would invest in all three projects but the company has only GBP 25 million
of cash available (where GBP is British Pounds). PEI currently has borrowings of
GBP 50 million and does not wish to increase indebtedness at the present time. PEI’s shares
are not listed.

The initial capital investment required (on 1 January 2011) and likely net operating cash inflows
arising from the investments in each project are as follows.

Initial
Investment
GBPmillion Net Operating Cash inflows (after tax)

Project A 15.50 GBP 1.75 million each year from year 1 indefinitely.
Project B 10.20 GBP 1.15 million in year 1, and GBP 3.10 million a year in years 2 to 7.
Project C 9.50 A$ 9.30 million each year for years 1 to 5.

Notes:

1. The projects are not divisible.

2. Project B has a residual value of GBP 2.5 million. The other projects are expected to
have no residual value.
3. Projects A and B are to be discounted at 8%. The Finance Director considers that a GBP
discount rate of 9% is more appropriate for Project C as it carries slightly greater risk.
4. The GBP/A$ exchange rate is expected to be GBP/A$ 2.00 on 1 January 2011 (that is,
GBP 1 = A$ 2.00). The A$ is expected to weaken against GBP by 1.5% per annum for
the duration of the project.
5. Assume cash flows, other than the initial investment, occur at the end of each year.

November 2010 16 Financial Strategy

 Required:

(a)
(i) Calculate the NPV and PI of each of the THREE projects based on the
GBP cash flows.
(8 marks)

(ii) Evaluate your results and advise PEI which project or combination of
projects to accept.

(7 marks)

(b) Explain the alternative method of evaluating Project C using an A$ discount rate,
illustrating your answer with a calculation of an appropriate A$ discount rate.

(4 marks)

(c) Discuss the key financial factors, other than the NPV decision, that should be
considered before investing in a project located in a foreign country rather than
the home country.
(6 marks)

(Total for Question Three = 25 marks)

A REPORT FORMAT IS NOT REQUIRED FOR THIS QUESTION

Section B continues on the next page

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Financial Strategy 17 November 2010

Question Four

ADS operates a number of large department stores based in a developed country in Asia. Its
shares are listed on an Asian stock exchange. It has shown year-on-year growth in earnings
and dividends every year since it became a listed company in 2000. Some years have shown
better growth than others but even in a relatively poor year earnings in real terms have been
higher than in the previous year. It is currently all-equity financed. Approximately half of its
shareholders are institutional investors; the other half is made up of large holdings by the
original founding family members and small investors including many employees of ADS.

The directors of ADS are proposing to raise A$250 million to invest in new, smaller stores. This
investment will carry similar risk to ADS’s current business. It is proposed that the investment
will be financed by an issue of an undated bond carrying 5% interest pre-tax. This rate is
deemed to reflect the returns required by the market for the risk and duration of the bond.
Some of the directors are reluctant to agree to debt finance as they think it will lower the value
of equity and this might be a matter of concern for shareholders. The investment is planned for
the end of 2010.

The following information is relevant:

• Earnings for ADS are forecast to be A$127.1 million in 2011. This forecast assumes
that the new stores are already fully operational at the start of 2011. From the year
2012 onwards, earnings are expected to increase at a rate of 4% per annum
indefinitely.
• The corporate income tax rate is 25%. This is not expected to change.
• The cost of equity for ADS as an all-equity financed company is 9%.
• There are 300 million shares in issue, currently quoted at A$8.50.

One of ADS’s directors has recently read an article about company valuation and the
differences between Modigliani and Miller (MM) models and the ‘traditional’ view.

November 2010 18 Financial Strategy

Required:

(a) Discuss:

• How the MM models, both with and without corporate taxes, differ from the
‘traditional’ view of the relationship between gearing and cost of capital.
Accompany your discussion with appropriate graphical illustrations.

• The limitations of MM models in ‘real world’ situations.

(10 marks)

(b)

(i) Calculate the value of ADS’s equity using discounted cash flow techniques,
assuming that the new stores are financed by equity.

(2 marks)

(ii) Calculate, assuming that the new stores are financed by the undated bond and
using the MM model with corporate taxes, the following:

• The value of ADS’s equity;

• The expected cost of equity;
• The weighted average cost of capital (WACC).

(6 marks)

(c) Explain your results in (b) above and advise the directors whether their concern
about lowering the value of equity is valid.

(7 marks)

(Total for 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 – 25

Financial Strategy 19 November 2010

 Maths Tables and Formulae are on Pages 21 – 25

November 2010 20 Financial Strategy

 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 Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Financial Strategy 21 November 2010

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 
Periods Interest rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods Interest rates (r)

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

November 2010 22 Financial Strategy

 FORMULAE

Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P 0 is the ex-
div value:
d
P0 =
k pref
(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P 0 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
P 0 is the ex-div value:
d1 d 0 [1 + g ]
P0 = or P0 =
ke −g ke −g
(iv) Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P 0 is the ex-interest
value:
i [1 − t ]
P0 =
k d net

i
or, without tax: P0 =
kd

(v) Total value of the geared entity, V g (based on MM):

V g = V u + 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 1⋅00 payable or receivable in n years, discounted at r% per annum:

1
PV = n
[1 + r ]

(viii) Present value of an annuity of 1⋅00 per annum, receivable or payable for n years, commencing in one
year, discounted at r% per annum:

1 1 
PV = 
r 
1−
n 
[1 + r ] 
(ix) Present value of 1⋅00 per annum, payable or receivable in perpetuity, commencing in one year,
discounted at r% per annum:

1
PV =
r

(x) Present value of 1⋅00 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

Financial Strategy 23 November 2010

 Cost of capital
(i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current
ex-div price P 0 :
d
k pref =
P0

(ii) Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price P 0 :
i [1 − t ]
k d net =
P0
(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div
price P 0 :
d
ke =
P0

(iv) Cost of ordinary (equity) shares, having a current ex-div price, P 0 , having just paid a dividend, d 0 , with the
dividend growing in perpetuity by a constant g% per annum:

d1 d 0 [1 + g ]
ke = +g or ke = +g
P0 P0
(v) Cost of ordinary (equity) shares, using the CAPM:
k e = R f + [R m – R f ]ß

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

VD [1 − t ]
k eg = k eu + [k eu – k d ] VE

(vii) Weighted average cost of capital, k 0 or WACC

 VE   VD 
WACC = k e
  + k d [1 − t ]  
VE + VD  VE + VD 
(viii) Adjusted cost of capital (MM formula):

K adj = k eu [1 – tL] or r* = r[1 – T*L]

(ix) Ungear ß:

 VE   VD [1 − t ] 
ßu = ßg
V + V [1 − t ]  + ß d V + V [1 t ] 
 E D   E D
− 

(x) Regear ß:
VD [1 − t ]
ß g = ß u + [ß u – ß d ] VE

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

1 + annual discount rate B$ Future spot rate A$/B$ in 12 months' time

=
1 + annual discount rate A$ Spot rate A$/B$
where A$/B$ is the number of B$ to each A$

November 2010 24 Financial Strategy

Other formulae

(i) Expectations theory:

1 + nominal countryB interest rate

Future spot rate A$/B$ = Spot rate A$/B$ x
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):

1 + countryB inflation rate

Future spot rate A$B$ = Spot rate A$/B$ x
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:

PV of costs over n years

Equivalent annual cost =
n year annuity factor

(v) Theoretical ex-rights price:

1
TERP = [(N x cum rights price) + issue price]
N +1

(vi) Value of a right:

Theoretica l ex rights price − issue price

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

Financial Strategy 25 November 2010

 This page is blank

November 2010 26 Financial Strategy

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 VERBS USED DEFINITION

Level 1 KNOWLEDGE
What you are expected to know. List Make a list of
State Express, fully or clearly, the details of/facts of
Define Give the exact meaning of

Level 2 COMPREHENSION
What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning or
purpose of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something

Level 3 APPLICATION
How you are expected to apply your knowledge. Apply Put to practical use
Calculate Ascertain or reckon mathematically
Demonstrate Prove with certainty or to exhibit by
practical means
Prepare Make or get ready for use
Reconcile Make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table

Level 4 ANALYSIS
How are you expected to analyse the detail of Analyse Examine in detail the structure of
what you have learned. Categorise Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct Build up or compile
Discuss Examine in detail by argument
Interpret Translate into intelligible or familiar terms
Prioritise Place in order of priority or sequence for action
Produce Create or bring into existence

Level 5 EVALUATION
How are you expected to use your learning to Advise Counsel, inform or notify
evaluate, make decisions or recommendations. Evaluate Appraise or assess the value of
Recommend Advise on a course of action

Financial Strategy 27 November 2010

 Financial Pillar

Strategic Level Paper

F3 – Financial Strategy

November 2010

Thursday Morning Session

November 2010 28 Financial Strategy