Financial

Management (FM)
March / June 2023
Examiner’s report
The examining team share their observations from the
marking process to highlight strengths and
weaknesses in candidates’ performance, and to offer
constructive advice for those sitting the exam in the
future.

Contents
General comments .............................................................. 2
Section A ............................................................................. 3
Example 1 ........................................................................ 3
Example 2 ........................................................................ 4
Example 3 ........................................................................ 4
Example 4 ........................................................................ 5
Section B ............................................................................. 6
Question 1 ....................................................................... 7
Question 2 ....................................................................... 7
Question 3 ....................................................................... 8
Question 4 ....................................................................... 8
Question 5 ....................................................................... 9
Section C ........................................................................... 10
Question 1 – Graffham Co ............................................. 10
Requirement (a)(i) – 2 marks ..................................... 11
Requirement (a)(ii) – 2 marks .................................... 12
Requirement (a)(iii) – 3 marks ................................... 13
Requirement (a)(iv) – 2 marks ................................... 14
Requirement (a)(v) – 5 marks .................................... 15
Requirement (b) – 6 marks ........................................ 16
Question 2 – Gini Co ..................................................... 18
Requirement (a) – 12 marks ...................................... 18
Examiner’s report
Requirement (b)(i) –– 2FM March/June
marks 2023
..................................... 22 1

Requirement (b)(ii) – 6 marks .................................... 22

General comments

This examiner’s report should be used in conjunction with the published March/June
2023 sample exam which can be found on the ACCA Practice Platform.

In this report, the examining team provide constructive guidance on how to answer the
questions whilst sharing their observations from the marking process, highlighting the
strengths and weaknesses of candidates who attempted these questions. Future
candidates can use this examiner’s report as part of their exam preparation, attempting
question practice on the ACCA Practice Platform, reviewing the published answers
alongside this report.

The Financial Management (FM) exam is offered as a computer-based exam (CBE).

The model of delivery for the CBE exam means that candidates do not all receive the
same set of questions. In this report, the examining team offer detailed debriefs of
selected questions from each section of the exam.

• Section A objective test questions – we focus on four specific questions that

caused difficulty in the March/June 2023 sittings of the exam.
• Section B objective test case questions – here we look at one case from section
B in detail.
• Section C constructed response questions – here we provide commentary on
two questions, providing guidance on answering these questions and where
exam technique could be improved, including in the use of the CBE functionality
in answering these questions.

Examiner’s report – FM March/June 2023 2

Section A

In this section we will look at FOUR Section A questions which proved to be particularly
difficult for candidates.

Example 1

Directive Co finances its working capital with an overdraft at a cost of 7% per year.
Its major supplier offers a discount of 0.5% for settlement of invoices after 10 days
rather than the usual 30 days.

Assume 365 days in a year.

Which statement correctly explains what Directive Co should do?

A Pay in 10 days because at 9.1% per year the benefit of the discount exceeds
the cost of the overdraft

B Pay in 30 days because at 9.1% per year the discount is more expensive than
the overdraft

C Pay in 30 days because at 6.1% per year the benefit of the discount is less
than the cost of the overdraft

D Pay in 10 days because at 6.1% per year the discount is cheaper than the
overdraft

What does this test?

 Evaluating the benefit of an early settlement discount

What is the correct answer?

 The correct answer is A

Annual benefit of taking the discount = 0.005 x 365/20 = 9.1%, this is greater than the
cost of overdraft and the discount should be taken.

The 6.1% is an incorrect calculation of the benefit of the discount 0.005 x 365/30 =
6.1%

Examiner’s report – FM March/June 2023 3

Example 2

Which TWO of the following hedging techniques can be used by an investor to

protect against a fall in interest rates?

A Money market hedge

B Interest rate collar
C Interest rate cap
D Interest rate floor

What does this test?

 The understanding of the main types of interest rate derivatives

What is the correct answer?

The correct answer is B and D

An interest rate floor is used to protect against a fall in interest rates, whereas a cap
is used to limit the maximum interest rate. A collar is a combination of a cap and a
floor and could be used to protect both against increase and decrease in interest rates.
A number of candidates selected money market hedge, although this is used for
hedging foreign exchange risk, but since interest rates are used in the calculation this
may have prompted some candidates to select this option.

Example 3

Togue Co is investigating how often it should replace its company car fleet. It is
considering replacement every two, three, four or five years. Cash flow estimates
have been compiled and the following negative NPVs have been obtained, based on
Togue Co's cost of capital of 11%:

Years to
Negative NPV
replacement
$
2 149,308
3 209,142
4 254,893
5 310,860

Using the annuity tables provided, if Togue Co adopts the optimal replacement
cycle, what will be the equivalent annual cost (to the nearest dollar)?

Examiner’s report – FM March/June 2023 4

What does this test?

 The calculation of the equivalent annual cost of a machine for a replacement

decision.

What is the correct answer?

 The correct answer is $82,170

The equivalent annual costs of each of the cycles are as follows:

2 year cycle = 149,308 / 1.713 = $87,162

3 year cycle = 209,142 / 2.444 = $85,574
4 year cycle = 254,893 / 3.102 = $82,170 (lowest)
5 year cycle = 310,860 / 3.696 = $84,107

The lowest equivalent annual cost is the optimal replacement cycle, so the answer is
$82,170.

Some candidates incorrectly gave higher equivalent annual cost figures.

Example 4

Select the type of financial market appropriate to each of the company's

needs.

Amby Co needs to convert foreign currency FOREIGN EURO

into domestic currency EXCHANGE CURRENCY
MARKET MARKET
Benji Co needs to issue new ordinary PRIMARY SECONDARY
shares CAPITAL CAPITAL
MARKET MARKET
Carlo Co needs to purchase short-term PRIMARY SECONDARY
over-the-counter derivatives MONEY MONEY
MARKET MARKET
Dill Co needs to issue new long-term loan CAPITAL MONEY
notes MARKET MARKET

What does this test?

 Understanding the role of financial markets.

What is the correct answer?

 The correct answers are: Foreign exchange market, Primary capital market,
Primary money market and Capital market
Foreign currency is sold on the foreign exchange market (euro currency market is a
loan/deposit market), new shares are sold on the primary capital market, over-the
counter derivatives are purchased on the primary market and long-term loan notes
are sold on the capital market.

Examiner’s report – FM March/June 2023 5

A number of candidates incorrectly selected secondary money market for Carlo Co,
but over-the-counter derivatives are not tradeable so are not available on the
secondary market.

Section B

Section B tests candidates’ knowledge on a number of topics in more detail than

section A, with three case questions containing five two-mark objective test
questions.

Here is an example case question on syllabus area F business valuations.

Light Co

Light Co has the following capital structure:

$m
Equity and reserves
Ordinary shares 55
9% preference shares 10
Reserves 433
498
Long-term liabilities
6% loan notes 22
8% loan notes 35
57
Current liabilities 92
Total equity and liabilities 647

The ordinary shares of Light Co have a nominal value of $0.25 per share and a
current ex dividend market price of $6.75 per share. Ordinary share prices are
expected to grow by 5%, per year, for the foreseeable future.

The 9% preference shares of Light Co are irredeemable and have a nominal value of
$1.00 per share. The cost of capital of the preference shares is 9.5%.

The 6% loan notes are irredeemable and have a nominal value of $100 per loan
note. The before-tax cost of debt of these loan notes is 7%.

The 8% loan notes are convertible, after seven years, into 15 ordinary shares of
Light Co per $100 loan note. If not converted, the loan notes will be redeemed at
nominal value after eight years. The before-tax cost of debt of these loan notes is
9%.

Light Co pays corporation tax of 25%.

Examiner’s report – FM March/June 2023 6

Question 1

What is the total market value of the 6% loan notes (to one decimal place)?

$ ____________ m

 The correct answer is 18.9

Each 6% loan note is worth $6/0.07 =$85.71

Total market value = 22m x 85.71/100 = $18.9m.

A number of candidates gave an answer of $85.7, which suggests they did not read
the question carefully and missed the requirement for the total value and possibly also
missed the m indicating that the answer is in millions.

Question 2

What is the market value of each 8% loan note?

A $94.48
B $118.20
C $131.87
D $119.38

 The correct answer is B

Conversion value = current price x seven years’ growth x number of shares at

conversion = 6.75 x 1.057 x 15 = $142.47
Market value per loan note = (8 x 5.033) + (142.47 x 0.547) = $118.20

A number of candidates incorrectly used the floor value rather than the conversion
value to get their market value or used eight years of growth in their conversion value
to get options A or D respectively.

Examiner’s report – FM March/June 2023 7

Question 3

In relation to valuing preference shares, which of the following statements is

correct?

A The market value, of an irredeemable preference share, is calculated by

multiplying the dividend by one, minus the tax rate and then dividing by the cost
of the preference shares

B Preference shares are a tax-efficient way of raising finance

C Preference shares can be difficult to value when they pay a variable rate of
dividend

D Redeemable preference shares are classed as equity in the statement of

financial position

 The correct answer is C.

The tax rate is not applied when valuing preference shares, so A is incorrect.
Preference shares are not a tax-efficient way of raising finance, so B is incorrect.
Redeemable preference shares are classed as debt in the statement of financial
position, so D is incorrect.

Leaving the correct option as preference shares can be difficult to value when they
pay a variable rate of dividend.

Question 4

In relation to practical considerations in valuing shares and businesses, which

of the following statements is correct?

A The share price of a company can rise even when it has cut its dividend

B The marketability of ordinary shares can be improved with a share buyback

scheme

C Investors will always act rationally in response to good news from a company

D Random walk theory suggests that share price movements can be forecast in
a weak form efficient market

 The correct answer is A

Market expectations of good future prospects mean that the share price of a
company can rise even when it has cut its dividend.

Option B is incorrect as a share buyback will decrease the number of issued

shares and therefore reduce marketability.

Examiner’s report – FM March/June 2023 8

Option C is incorrect as investors may not necessarily react rationally and can
overreact to either good or bad news.

Option D is incorrect as random walk theory suggests that share price movements
cannot be forecast.

Question 5

Considering behavioural finance, which of the following statements is correct?

A Behavioural finance supports the view that stock market bubbles result from
rational investment decisions

B Noise traders make investment decisions by using software to analyse real-

time share price data

C Share price anomalies do not undermine the perfect capital market theory

D The momentum effect suggests that investors can buy shares in the belief that
a recent rise in share prices will continue

 The correct answer is D

The momentum effect does suggest that investors may buy shares in the belief that
a recent rise in share prices will continue into the future.

Share price anomalies do in fact undermine the perfect capital market theory, stock
market bubbles are the result of irrational investor behaviour and noise traders make
uninformed, rather than informed, investment decisions.

Examiner’s report – FM March/June 2023 9

Section C

In this section we will look in detail at TWO constructed response questions from
different syllabus areas. The full questions and solutions have been published and
are available on the ACCA Practice Platform.

Question 1 – Graffham Co

This question is from the Business Finance (E) area of the syllabus, specifically:
Part (a)(i) tests E1(c)(i), “Identify and discuss methods of raising equity finance,
including rights issue”;
Parts (a)(ii)–(v) test E3(d)(i), “Assess the impact of sources of finance on financial
position, financial risk and shareholder wealth using appropriate measures, including
ratio analysis using statement of financial position gearing, operational and financial
gearing, interest coverage ratio and other relevant ratios” and;
Part (b) tests E1(d)(iii), “Identify and discuss methods of raising short- and long-term
Islamic finance, including Islamic financial instruments available to businesses”

Graffham Co is a company that needs to raise $18.9m of new finance and the finance
director is proposing to raise the new finance via a rights issue to existing
shareholders. The question examines the implications of this in financial terms and
also from the viewpoints of various stakeholders, namely large shareholders (who are
happy with the share issue, providing that the new project returns at least the same
operating profit margin in % terms), small shareholders (who are concerned that they
do not have the cash to pay for the new shares) and the directors (who are concerned
about current gearing levels). The question concludes with consideration of two types
of Islamic finance, a mudaraba or a musharaka contract, as alternatives to the rights
issue.

Examiner’s report – FM March/June 2023 10

Looking at each part in detail:

Requirement (a)(i) – 2 marks

(a)(i) Calculate the theoretical ex-rights price per share.

Part (a)(i) of this question specifically addressed syllabus area E1(c)(i), “Identify and
discuss methods of raising equity finance, including rights issue”.

For 2 marks, candidates were expected to be able to calculate the theoretical ex-rights
price per share (TERP) having been given the proposal of a 2 for 5 rights issue to
existing shareholders at a 25% discount to the current share price of $8.40.

Most candidates found this to be a straightforward calculation of the TERP using the
information given, with many making appropriate use of spreadsheet functionality. The
TERP is easier to calculate, and fewer errors are made, if the set-up shown in the
marking guide is used. The spreadsheet can make the calculation simpler using the
vertical format for calculating TERP:

Where errors were made, they included:

• Calculating the rights issue price at 25% i.e. $8.40 * 25% = $2.10

• Inverting the ‘2 for 5’ into an effective ‘5 for 2’

• Incorrectly using arithmetic functions when entering a long set of numbers in a

single cell, as an incorrect approach will give an incorrect answer.

For example, (2*0.75*8.4+5*8.4)/5+2 = 12.92 incorrect

Examiner’s report – FM March/June 2023 11

 Instead of

((2*0.75*8.40)+(5*8.40)/(5+2) = 7.80 correct

Requirement (a)(ii) – 2 marks

(a)(ii) Calculate the current earnings per share before investment in the
project.

Part (a)(ii) required the calculation of the company’s earnings per share (EPS) before
the new investment, thereby commencing the section of the question (the remainder
of part (a)) covering syllabus area E3(d)(i).

As per the suggested solution, the use of a logical format for the relevant part of the
income statement would be beneficial.

Unfortunately, some candidates moved straight from profit before tax and interest
(PBIT) to profit after tax (PAT) without deducting finance costs, whilst others used
PBIT for the EPS without deducting finance costs or tax. Where this occurred, it
showed a disappointing lack of knowledge as to the exact nature of earnings.

This part-question was done well overall, with marks available on own figure rule
(OFR) where workings were shown i.e. the number of shares of 7.5 million was usually
calculated correctly but as noted above, was sometimes divided into an incorrect profit
figure.

Examiner’s report – FM March/June 2023 12

Requirement (a)(iii) – 3 marks

(a)(iii) Calculate the revised earnings per share and the share price after
investment in the project, assuming the rights issue is successful.

It was important for candidates to realise that there were two parts to this requirement.
The first part repeats (a)(ii) but with the incorporation of the impact of the new
investment. The second part asks for the share price after the investment. The first
part was done better than the second part.

The revised EPS should be based on the revised PBIT with the subsequent
adjustments and the earnings raised from the rights issue. As with (a)(ii), it is important
for these types of calculations that a logical format is shown with detailed workings.

Therefore, there was an addition to PBIT of 18% x $20m = $3.6m, making the new
PBIT = $9.5m + $3.6m = $13.1m. Several candidates incorrectly used only the profit
on the new project to calculate the revised EPS.

With debt finance unchanged, finance costs stayed at $2m, but a new tax computation
was required on the profit before tax i.e. $13.1m - $2m = $11.1m. Use of a similarly
structured working from (a)(ii) was a time-efficient way of executing this computation
as well as clearly displaying the working.

The new finance was raised via a 2 for 5 share issue, thereby adding 3 million new
shares, making 10.5 million shares in total after the new investment, producing a new
EPS of $9.324m / 10.5m = $0.888.

As noted above, this was generally done well, with the common errors being consistent
with those in (a)(ii), mainly displaying a lack of understanding of the nature of earnings.

Examiner’s report – FM March/June 2023 13

Many responses, however, lacked the final step i.e., the need to calculate the share
price using the formula including the price-earnings (PE) ratio, namely:
Market price = PE x EPS.

Partly, this was due to an inability to calculate the correct PE ratio. The case scenario
was clear, “Graffham Co’s price-earnings ratio can be assumed to be unchanged by
undertaking the project.”

Given that the current share price of $8.40 per share was also stated in the case
scenario, and that an EPS of $0.84 was calculated in (a)(ii), then a PE ratio of 10 (or
its OFR equivalent) should have been computed.

The PE ratio of 10, together with the new EPS of $0.888, should have led to a new
share price of 10 x $0.888 = $8.88.

The lack of the calculation of the new share price hindered some candidates when it
came to calculate the market value of equity for the gearing ratio in part (a)(iv).

Other candidates incorrectly thought that the revised share price was the same as the
TERP.

Requirement (a)(iv) – 2 marks

(a)(iv) Calculate the current gearing and the revised gearing after investment
in the project, using market values and assuming the rights issue is
successful.

In order to address this requirement, accurate market value calculations were required
both for debt and for equity.

Before the new investment:

Debt: $25m x $110 / $100 = $27.5m

Equity: number of shares x market value per share

7.5m x $8.40 = $63m

Therefore, current gearing = $27.5m / ($27.5m + $63m) = 30.4%

Examiner’s report – FM March/June 2023 14

After the new investment:

Debt: as above, $27.5m

Equity: number of shares x market value per share
10.5m x $8.88* = $93.24m

(*Candidates using their own-figure market value per share from (a)(iii) above could
get full credit here in (a)(iv))

Therefore, revised gearing = $27.5m / ($27.5m + $93.24m) = 22.8%

Candidates, disappointingly, produced too few correct answers here, especially for
revised gearing after investment.

The formula for calculating the gearing ratio is given in the case scenario
“The current industry average gearing figure at market values, measured as ((Non-
current liabilities/(Non-current liabilities + Equity)) × 100%) is 25%”.

Using Debt / Equity instead of Debt / (Debt + Equity) was simply incorrect.

Additionally, the requirement is clear, “using market values”. Hence, calculations that
used book values scored no marks.

Two further errors were seen often in this part-question in relation to the value of
equity:
• Including retained earnings in the market value of equity;

• Using the incorrect market value per share such as the pre-investment $8.40
or the TERP of $7.80.

Requirement (a)(v) – 5 marks

(a)(v) Discuss the views of the directors, and both the small and large
shareholders, in relation to the new project and its financing.

Candidates needed to relate to the whole scenario provided in addressing this

discursive requirement and needed to structure the answer around the three
stakeholders. Good answers should take each stakeholder group’s views and discuss
the effect of the rights issue from their respective points of view.

For example, the directors’ concern was with gearing levels and whether the new
investment would result in a reduction in gearing, especially in relation to the industry
average.

Examiner’s report – FM March/June 2023 15

The calculations in (a)(iv) above show that pre-investment gearing of 30.4% was
above the industry average of 25%, but post-investment gearing of 22.8% was below
25%, thereby satisfying the directors’ main concern.

Small shareholders were concerned that they did not have the cash to pay for the new
shares. This was an opportunity for candidates to display knowledge about how
shareholders view rights issues, and about how shareholders should take some form
of action, whether it is buying the shares or, if this is not possible, selling the rights
with a subsequent comment about the implications of this, both in terms of cash raised
and dilution of their ownership percentage.

Large shareholders were concerned that the project should earn at least the same
operating profit margin as existing operations i.e. $9.5m / $45.2m = 21%. Reference
to the case scenario, where it is stated that the new project earns 18%, yielded a
straightforward mark in most cases. A supplementary comment which could have
pointed out that the new project should probably still go ahead was less frequently
seen.

The views of the directors and large shareholders seemed to have been understood
better than the views of the small shareholders, but too many responses repeated
only the content in the scenario and hence scored few, if any, marks.

Requirement (b) – 6 marks

(b) Discuss the use of a mudaraba or musharaka contract as possible

alternative sources of finance for the project.

This requirement directly addressed syllabus item E1(d)(iii), “Identify and discuss
methods of raising short- and long-term Islamic finance, including Islamic financial
instruments available to businesses”. Furthermore, the requirement specifically asks
about the use of a mudaraba E1(d)(iii)(iii), or musharaka E1(d)(iii)(v) contract.

The logical starting point of a candidate’s response was to explain the features of each
contract, as set out in the suggested solution.

For a mudaraba contract, this means a clear distinction between the sole provider of
the capital (rab al mal) and the management of the venture by Graffham Co only
(mudarib), with development into the nature of the profit-sharing arrangement, but only
the capital provider bearing any losses to the extent of the capital provided.

For a musharaka contract, this means making clear the joint venture nature of the
contract, with both the external provider and Graffham Co contributing capital, and

Examiner’s report – FM March/June 2023 16

with development into the nature of the profit- or loss-sharing arrangement and the
potential for all parties to be involved in the management of the venture.

The inability to demonstrate such knowledge was a weakness of some responses and
therefore meant that such responses could gain few, if any, marks.

Another weakness was to waste time discussing the nature of Islamic finance such as
prohibited forms of trade (in a general sense and not applied to Graffham Co) and that
interest (riba) is forbidden under Sharia law. Whilst such points may be technically
correct, they do not directly address the requirement under consideration. Therefore,
points like these gain no marks and such points consume valuable time in the exam
which could be used to develop a response more focused on the requirement.

A developed response, and therefore a response with the potential to gain the 6 marks
on offer, would take the explanations of the respective contracts and assess their
applicability as alternative sources of finance for the project under consideration by
Graffham Co. Such development could take the form of a comparison with the rights
issue proposed by the finance director with issues such as the nature of the profit-
sharing arrangement (under mudaraba) and whether the profits obtained are sufficient
to compensate for the investment required by Graffham Co’s shareholders
(musharaka) coming under discussion.

Whilst there were some good responses to part (b), too many candidates have only
superficial knowledge of this syllabus area, which will continue to be an important area
within syllabus section E on Business Finance. Future candidates should note that
good knowledge and understanding of Islamic finance is needed.

Previously published questions containing some aspects of the areas examined in

this question include Spine Co (September / December 2020), LaForge Co (March /
June 2020) and Tin Co (March / June 2018). The technical article ‘Analysing the
suitability of financing alternatives’ available as part of Financial Management’s
Technical Articles, is also of use to future candidates.

Examiner’s report – FM March/June 2023 17

Question 2 – Gini Co

This question is on investment appraisal (syllabus area D), with the following
learning outcomes being tested:

• Identify and calculate relevant cash flows for investment projects.

• Calculate the taxation effects of relevant cash flows, including the tax benefits
of tax-allowable depreciation and the tax liabilities of taxable profit.
• Calculate net present value (NPV).
• Discuss NPV’s usefulness as an investment appraisal method.
• Discuss the limitations of probability analysis in assisting investment
decisions.

Gini Co is a listed company requiring a decision on the financial acceptability of its

new product, LP500, using the investment appraisal method, net present value.

Focusing on each requirement in detail:

Requirement (a) – 12 marks

(a) Calculate the expected net present value of the LP500 project and
comment on its financial acceptability.

First, ensure that you have read the requirements and clearly identified which
syllabus area has been examined, thus quickly accessing the information provided
within the scenario. For requirement (a), it is apparent that the numerical information
provided is fundamental to the response required and, therefore, should be read
carefully, making a note of key points such as the fact that the selling price, variable
costs, and incremental fixed costs are expressed in current price terms.

You must read the question carefully and carry out the workings related to the NPV
cash flow separately. For the computation of the net present value cash flow, it is
important that you approach this correctly. Starting with the detailed workings and
once they are completed, you can build the net present value cash flow table quite

Examiner’s report – FM March/June 2023 18

quickly using the spreadsheet. The following section discusses in detail specific
issues that were noted:

• Expected value: Using the scenario for Gini Co, the potential outcomes for the
variable cost and their associated probabilities are used to calculate the
expected value of the variable costs. This can be done using the spreadsheet
(see Working 1). The expected value of the variable cost is $54.

Please note that in order to display the formulae used the = at the start of
each formula has been omitted. The exam spreadsheet software does require
the use of the = to construct a formula.

• Inflation: The subsequent workings should be for the effect of inflation on the
selling price per unit, variable cost per unit, incremental fixed costs, and
working capital, as these values are shown in current prices. Therefore, it is
appropriate to begin inflation in year 1. Note other examples in the past that
have stated these values in ‘year 1 price terms’, where it is inappropriate to
apply the inflation factor to the year 1 figure (see Examiner’s report
March/June 2022). You must be vigilant of the inflation rates as different cash
flow elements will be inflated at different rates. It might be a good idea to visit
the technical article ‘The effect of inflation on cash flows’ available as part of
Financial Management’s Technical Articles.

Using the selling price per unit as an example to demonstrate the inflated or nominal
values calculation (see Working 2).

Examiner’s report – FM March/June 2023 19

 • Initial investment and working capital: Candidates must recognise that initial
investment and initial working capital amounts are shown as outflows in year
0 and not in year 1.

• Tax allowable depreciation: The area that still causes candidates problems is
the calculation of tax allowable depreciation (TAD) and tax allowable benefits.
Candidates must identify whether tax allowances are granted on a reducing
balance or a straight-line basis and whether the tax is payable immediately or
in arrears. Ensure that they can calculate tax savings using different tax
regimes. For Gini Co, the question is clear in stating “tax is payable at the end
of the year following the year to which it relates” and that the company can
claim TAD “at a rate of 25% per year on a reducing balance basis” (see
Working 3).

• Working capital: The investment in working capital was given as $100,000 at

the beginning of the project and, therefore should be shown as an outflow in
year 0. The working capital should be shown after the tax figures as they do
not have any tax impact. Some candidates added it to taxable profit and
therefore affected the tax liability figures, for which no mark was awarded.

Examiner’s report – FM March/June 2023 20

 • Residual value: The residual value was given in nominal terms, and hence the
impact of inflation has been reflected in this figure. The usual assumption is
that the asset is disposed of on the last day of the last year of the project, and
hence the cash inflow is shown in year 4. Some candidates showed the
residual value in year 0 or year 5 and as cash outflow, for which no marks
were awarded. Some candidates added the residual value to taxable profit ,
affecting the tax liability figure in year 5, for which no mark was awarded.

It is important to calculate the taxable profits and tax liabilities separately before
calculating the project's net cash flow to avoid confusion and summation errors.
Once the relevant and incremental cash flows have been determined, they should be
discounted using an appropriate rate. In Gini Co’s case, the question gave the
nominal after-tax weighted average cost of capital of 12%, and therefore, the
incremental cash flow discounting should be conducted using 12%. Candidates
should know that this may not always be given and may require calculation. For
example, if it is before tax, then the tax element has to be removed.

• The present values are found by multiplying the total net nominal cash flows
by the discount factors shown at 12%
• The NPV is calculated as the sum of the present values calculated less the
initial investment and the initial working capital. However, you can use the net
present value formula (see Working 4). Candidates using the NPV formula
must do so correctly. The NPV formula computes the sum of the PVs from
year 1 onwards. To execute the computation correctly, the year 0 cash
outflows must be added separately (see Working 4). I strongly emphasise that
you must show all workings, otherwise marks cannot be awarded if the final
figure is incorrect.

The formula to be applied to calculate NPV for this appraisal is as follows

=NPV(12%,D6:H6)+D12+D13

Finally, it is important to not ignore the element of the requirement to comment on

the financial acceptability, which should be based on the calculated figure; for
example, the project should be accepted if the NPV is positive, i.e., greater than
zero.

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In this case, this is an expected NPV based on a variable cost per unit which is not a
possible outcome. This means that there is a 40% chance of a higher variable cost
per unit, which would mean a lower NPV and could mean a reduction in shareholder
wealth.
Requirement (b)(i) – 2 marks

(b)(i) Briefly discuss how your decision in part (a) will help Gini Co achieve
its primary objective.

Since Gini is a listed company, the objective should be to maximise shareholders’

wealth. Since there are two marks available, this should indicate that there are two
different points to be made. Candidates could state the company’s objective of
maximising shareholders’ wealth and that a positive net present value would add
value and increase shareholders’ wealth. For candidates who had a negative net
present value in part (a), marks were awarded for explaining that rejection of the
project is necessary as it would reduce shareholder wealth. Very few responses
emphasised the use of the expected value of the variable cost per unit, and it is
possible that the positive net present value may not be achievable.

Requirement (b)(ii) – 6 marks

(b) (ii) Discuss THREE limitations of using probability analysis in deciding

whether or not to proceed with the LP500.

Limitations need to be accurately stated. For example, saying that an expected value
does not account for the range of values is incorrect, as all values are considered.
However, expected values do not account for those who are risk-averse or risk
seekers as it is a weighted average. That is, there is a 20% chance that the variable
cost per unit could be $70, some $16 above the expected value, which may be
unacceptable to risk-averse investors.

Although some good points were made in discussing the limitations of probability
analysis, the responses lacked development of each issue. Generic points such as
“it’s complex” are not creditworthy. Some candidates mistakenly referred to
profitability indices. The question did refer to the development of the product LP500,
so to obtain full marks, the answer should ideally reference the scenario.

For both (b)(i) and (ii), the requirement was “discuss,” and therefore, short bullet
points do not address the requirement. It is important to set out each limitation as a
heading and then provide a meaningful discussion and any illustrations related to the
LP500.

You must read the requirements carefully as some candidates provided benefits of
probability analysis instead. There were 6 marks available here, and three limitations
were required. Therefore, there would be one mark for an explanation of the
limitation and one mark for further development of the limitation.

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