J22 FM Student Mark Plan

Professional Level – Financial Management – June 2022
MARK PLAN AND EXAMINER’S COMMENTARY
The marking plan set out below was that used to mark this question. Markers were encouraged to use
discretion and to award partial marks where a point was either not explained fully or made by implication.
More marks were available than could be awarded for each requirement. This allowed credit to be given for a
variety of valid points which were made by candidates.
Question 1
Total marks: 30
General comments
The scenario of the question is that a company is importing goods from Switzerland and has also raised a
loan over a ten-year period.
Task One: Hedging foreign currency exchange rate (forex) risk
a. Requires candidates to calculate the sterling cost of a payment in CHF using various techniques to
hedge its forex risk.
b. Requires candidates to explain the advantages and disadvantages of the hedging techniques used in
a. and advise the finance director on whether the company should hedge its forex risk and, if so, which
method to use.
Task two: An explanation of interest rate parity
Requires candidates to provide an explanation of interest rate parity and, using the data in task one,
prepare calculations which show whether interest rate parity is holding.
Task three: Arranging an interest rate swap
a. Requires candidates to demonstrate how the interest rate swap would be implemented.
b. Requires candidates to explain two advantages of entering into an interest rate swap.
1.1 (a)
Forward contract:
The forward rate is 1.2324 – 0.0084 = CHF/£1.2240
The sterling payment is 500,000/1.2240 = £408,497
Money market hedge:
Deposit in CHF 500,000/(1 + 0.03 x 4/12 )= CHF495,050
Buy spot CHF495,050/1.2324 = £401,695
Borrow in £ so the total cost is: 401,695 x (1 + 0.06 x 4/12) = £409,729
OTC option:
Use Call options to buy CHF with and exercise price of CHF/£1.2238
Premium 500,000 x £0.03 = £15,000
If the spot price on 31 October 2022 is CHF/£1.2230 the option would be exercised
and CHF bought at CHF/£1.2238
Exercise of options: 500,000/1.2238 = 408,563
The total cost will therefore be:

408,563 + 15,000 = £423,563
Copyright © ICAEW 2022. All rights reserved Page 1 of 10

Many candidates scored full marks on the calculations and those that didn’t made some or all of the usual
errors (wrong spot, adding premium, 3-month interest rates not 4, wrong pair of interest rates, put not
call).
Total possible marks 10

Maximum full marks 10
1.1 (b)
£
Forward contract 408,497
Money market hedge 409,729
OTC option 423,563
No hedge 500,000/1.2230 408,831
Both the forward contract and money market hedge lock Chocoholic into an exchange rate.
General advantages and disadvantages include:
Forward contacts are tailored specifically for the company. However, they are legally binding and there is
no secondary market.
Money market hedges are tailored specifically for the company. However, they use up the company’s
credit lines.
OTC option
The option allows Chocoholic to take advantage of the upside potential of the £ strengthening against
CHF. However, there is no secondary market and also the premium is expensive, which makes the OTC
option unattractive.
The forward market indicates that the £ is weakening against the CHF (which is bad for importers) and it is
unlikely that the OTC option would become attractive in the next four months. It is recommended that
Chocoholic continue to use either forward contracts or money market hedges. In this case the forward
contract which is slightly cheaper.
The written section was generally well answered.

1.2
The principle of interest rate parity links the currency and money markets. Money market interest rates
explain the difference between forward rates and spot rates. Differences between rates cannot be
exploited to make risk free gains (CIA).
In this case CHFs are at a premium and the link between the premium and interest rates can be
demonstrated as follow:
Middle rates:
Spot CHF/£1.2328 ((1.2324 + 1.2332)/2)
Interest rates
CHF 3.5 ((4 + 3)/2)
£ 5.5 ((6 + 5)/2)
The middle forward rate = (1.2328 x (1 + 0.035x4/12))/(1 + 0.055 x 4/12) = 1.2247
This results in a premium of CHF0.0081 (1.2328 – 1.2247)
The middle forward contract premium = CHF0.0081 ((0.0084+ 0.0078)/2)

Therefore, interest rate parity is holding.
Many candidates can’t explain what IRP is or undertake the correct calculations (eg not using average 4
month rates or not using 1 + the interest rate in the calculations).

1.3 (a)
Chocoholic Alp Differentials

Fixed rates 5% 4% 1.0%
Floating rates SONIA + 3.5% SONIA + 3% 0.5%
Net differential 0.5%
This net differential will be shared 0.25% each
The interest rates that can be achieved through the swap are:
Chocoholic Alp
Fixed market rate 5.00% ----
Floating market rate ---- SONIA + 3.00%
Less the differential 0.25% 0.25%
4.75% SONIA + 2.75%

Rates achieved through the swap
Cash flows would typically be SONIA from Alp to Chocoholic and 1.25% fixed from Chocoholic to Alp.
Those candidates who identified the difference between the differences usually did well, those that didn’t
often struggled. Some candidates added the differences together rather than netting them off.

1.3 (b)
The advantages to Chocoholic of an interest rate swap include:
• The arrangement costs are significantly less than terminating an existing loan and taking out a new
one.
• Interest rate savings are possible either out of the counterparty or out of the loan markets by using the
principle of comparative advantage.
• They are available for longer periods than the short-term methods of hedging such as FRAs, futures
and options.
• They are flexible since they can be arranged for tailor-made amounts and periods. Also they are
reversible.
• Obtaining the type of interest rate, fixed or floating, that the company wants.
• Swapping to a fixed interest rate for Chocoholic will assist in cash flow planning.
Most candidates could identify 2 valid advantages of swaps.


Question 2
Total marks: 35
General comments
The scenario of the question is that a company is raising finance to fund a project to manufacture
previously bought it products.
1. Requires a WACC computation and the calculation of the cost of equity using different models.
2. Requires a cost of equity computation for the company to reflect the risk of the new project.
3. Requires gearing computations assuming different ways to finance the project.
4. Requires a discussion and recommendation of which of the funding methods is most appropriate
for the company.
5. Requires a description of the EMH and when details of the project should be announced.
6. The sixth part of the question considers an ethical and legal problem.
2.1
(a) Ke = 2 + 0.32 x 7 = 4.24%
Kd using the RATE ss function
The YTR of the 4% debentures, which mature in five years' time
Using the RATE function the inputs are:
Number of payments (5 x 2) 10
Six month coupon (4 /2) 2
Price (106 - 2) -104
Redemption 100
Annual YTM using the RATE fn (2 x 1.56%) 3.13%
Tax rate 25%
Kd = YTM (1-t) 2.35%
Market values:
Equity
Number of shares = 47/0.1 = 470m
Market value = 470 x 0.67 = £314.9 m
Debt 39 x 1.04 = £40.56 m
WACC = (4.24 x 314.9 + 2.35 x 40.56)/(314.9 + 40.56) = 4.02%
(b) Growth = (3/2.75)^(1/4) = 2.2%
Ke = (3(1.022)/67) + 0.022 = 6.78%

• A sizeable minority didn’t identify that the market premium for risk was provided so calculated the ke
incorrectly.
• The cost of debt was very variable but some got full marks and many scored 4 out of 4.5. A minority
had difficulty identifying the 6 monthly interest payment (using £4 instead of £2) or forgot to double the
6 monthly cost using the RATE function.
• Many candidates used 5 years instead of 4 to calculate the dividend growth and wasted time on a
WACC calculation that wasn’t asked for.

2.2
De-gear the plastic bottle manufacturing company’s beta equity:
0.50 = Ba (1+ (25x0.75)/75)) . Ba = 0.40
Re-gear using Wilton’s gearing:
Be = 0.40 (1+ (40.56 x 0.75)/314.9). Be = 0.44
Ke = 2 + 0.44 x 7 = 5.08%
Ke increases from 4.24% to 5.08%. The new cost of equity, 5.08%, reflects the systematic business risk
of the project as is shown by the increase in the Be from 0.32 to 0.44. This new Ke compensates the
equity shareholders for the increase risk of the project. The systematic financial risk remains constant as
gearing is unchanged.
The degearing/regearing calculations were generally done well but the explanations were often poor –
telling the marker what they were doing rather than why they were doing it. Many identified systematic
business risk simply as systematic risk ignoring the fact that financial risk is also systematic. Many wasted
time on a WACC calculation that wasn’t asked for.

2.3
(a) Current gearing 40.56/314.9 = 12.9%
(b) All debt
The value of equity will now be: 65p x 470m = £305.5m

The value of existing debt will now be: 40.56 x 98/104 = £38.22m
(38.22+ 40)/ 305.5 = 25.6%
(c) All equity 40.56/(314.9 + 40) = 11.4%
The gearing calculations were variable – some used book values when told in the question (twice) to use
market values, some added the retained earnings to the MV of the equity and many ignore the analyst’s
comments on movements in the debt and equity values if debt alone was used for the finance.


2.4
If Wilton finances the project entirely from equity the gearing ratio will fall from its existing figure of 12.9%
to 11.4%. This is a decrease but still keeps gearing between the average of 15% and minimum of 10%
levels in the sector. The shareholders and markets should not be too worried about this change and this
is reflected in the fact that the analyst predicts no change in the price of both Wilton’s debentures and
shares. A negative reaction by shareholders might have indicated that they feel the company is under
geared.
If the project is financed entirely from debt the gearing ratio will rise from its existing figure of 12.9% to
25.6%. This is a significant increase and is more than the maximum of 22% in the sector. The markets
and shareholders would not be happy about this increase and this is reflected in the decline in the price of
both Wilton’s debentures and shares as predicted by the analyst.
It is recommended that either equity or a combination of debt and equity finance be raised for the project.
The industry gearing data may be less relevant as Wilton is diversifying away from its current activities –
the gearing of the bottle manufacturing industry is also relevant.
Project NPV is ignored for all equity and all debt gearing calculations.
Comments were average at best on the funding decision.
Total possible marks 10.5

2.5
Weak form efficiency – share prices reflect information about past price movements.
Semi-strong from efficiency – share prices incorporate all publicly available information (published
accounts, press releases, dividends, new products etc.,)
Strong form efficiency – share prices reflect all available information, whether or not it has been
published.
For alternative (1) to be a reality the market would have to be semi-strong form efficient. i.e. as soon as
the announcement is made, and the market reacts favourably, the share price would rise.
Generally, answers were good. However, some candidates did not refer to the announcement.

2.6
Acting on alternative (2) regarding the announcement would be insider trading and illegal.
The finance director should act with integrity and display professional behaviour with regard to the
suggestion made by the board and he should advise the board accordingly.
Generally, answers were good.


Question 3
Total marks: 35
General comments
The scenario of the question is that a company wishes to divest itself of a subsidiary.
1. Requires a valuation of the subsidiary using different methods.
2. Requires a discussion regarding the valuation techniques in the first part of the question.
3. Requires a comparison of methods that can be used for the company to divest itself of the subsidiary.
4. Requires a reasoned recommendation of how the company should divest itself of the subsidiary.
3.1
All workings in £’000.
Using Flaky as the comparative for P/E and EV
Averages are calculated using the ss function

P/E Multiple
Average earnings after tax = £6,376.
The value of the shares = 6,376 x 10.1 = £ 64,398.
EV multiple
Average EBIT (PBI) = £9,002
Average Depreciation and amortisation = £288
EBITDA 9,002 + 288 = £9,290
Enterprise value 9,290 x 9.5 = £88,255
The value of the shares = EV + Cash and cash equivalents – long term debt = 88,255 + 5,000 – 10,000 =
£83,255
Net Assets
Historic £76,170
NRV of assets 76,170 – 64,860 + 115,000 + 1,000 + 100 = £127,410

Less £4m disposal costs = £123,410
SVA using FCF
Results from the ss function

Worst case FCF for the years ended 30 June:
2022 2023 2024 2025 2026 2027

£'000 £'000 £'000 £'000 £'000
FCF 5500 5665 5835 6010 6190 6376
£'000
PV of FCF 30/06/2023 to 30/06/2027 at 8% 23908

Terminal value (PV of FCF beyond 30/06/2027)

(6376x1.02/0.08-0.02)/1.08^5 73770
Add cash and cash equivalents 5000
Less long-term loans -10000
The value of
equity 92678
Best case FCF for the years ended 30 June:
2022 2023 2024 2025 2026 2027

£'000 £'000 £'000 £'000 £'000
FCF 5500 5830 6180 6551 6944 7360
£'000
PV of FCF 30/06/2023 to 30/06/2027 at 8% 26009
Terminal value (PV of FCF beyond 30/06/2027)
(7360.24x1.04/0.08-0.04)/1.08^5 130241
Add cash and cash equivalents 5000
Less long-term loans -10000
The value of equity 151250
(Note: The terminal value is based on 2027 FCF to two decimal places)
• Many ignored the instruction to average.

• A sizeable minority didn’t identify Flaky as the most appropriate comparator.
• A small minority couldn’t identify earnings or EBITDA.
• Many did long calculations to come to the book value given already in the BS. Most ignored the disposal
costs in the NRV.
• Most candidates couldn’t calculate the PV for 2023-2027 despite the prepopulated spreadsheet telling
them that was what was needed. Terminal value calculations were poor and no workings from most
meant no marks on these 2 calculations.

3.2
For both the P/E and enterprise value methods:
How comparable is Flaky to Arrowsmith? (Size, debt, activities etc)

Is it reasonable to use the average of the past five years results to base the valuations, particularly since
the average is distorted by the 2018 results? (Should use maintainable future figures)
Both are based on earnings however accounting policies can be used to manipulate earnings figures
The P/E method is useful for growth companies and reflects the industry sentiment regarding a particular
sector. Using Flaky may not be appropriate since its p/e ratio reflects the market sentiment towards that
particular company. It may be more appropriate to use an industry sector average.
Enterprise Value/ excludes the affect of the way in which the company is financed. It excludes CAPEX
and therefore you can compare companies in the same industry that have different levels of CAPEX.
However, the method is simplistic and a lot of information from many value drivers is distilled into a single
number.
Assets methods do not take into account the earning potential of the assets and ignores goodwill. The
balance sheet values do not always reflect the realisable values of the assets. Even when the assets are
revalued there is no guarantee that the assets can be sold for the NRV estimates. Closure and
redundancy costs are estimates.

Shareholder value analysis evaluates future free cash flows and is more representative of the true value
of a company. However, the method relies upon assumptions that might be unrealistic. Such problems
include: estimating future growth rates for the primary period and the terminal value; setting the time
horizon; calculating the discount rate.
For EV/NRV/SVA
Assumed book value and market value/redemption value of debt are the same.
The answers consisted largely of text book advantages and disadvantages with very few showing any
professional scepticism (2018 out of line, optimistic growth way above performance in last few years).

3.3
A liquidation
In a liquidation the assets would be sold and after paying any expenses and settling the liabilities any net
proceeds would be distributed to Scafell. In Arrowsmith’s case, if the assets can be sold for the revalued
amounts the shareholders would share in the net proceeds.
A major disadvantage of liquidation is that there is no opportunity to participate in any future growth.
A sale as a going concern
Scafell would receive cash for the shares of Arrowsmith and again would not be able to participate in any
future growth potential. However, Arrowsmith’s results have been erratic and it may be difficult to find a
buyer for the company.
A spin-off
Arrowsmith would cease to be a subsidiary of Scafell and have its own corporate identity. The
shareholders of Scafell would own shares in both Scafell and Arrowsmith. The original shareholders of
Scafell could therefore participate in any future growth of Arrowsmith. There is the potential to float
Arrowsmith on a market.
Candidates were asked to compare and contrast liquidation, sale and spin off not discuss which value
belonged to which method. Some still think ‘going concern’ means closure within 12 months. Almost all
candidates had no real idea of what a spin-off is despite the learning materials.

3.4
The range of values is:
£’000
P/E multiple 64,398
Enterprise value multiple 83,255
Liquidation 123,410
SVA worst case scenario 92,678
SVA best case scenario 151,250
If Arrowsmith is sold the sale proceeds range between £64,398 and £151,250 million.
The eventual sale proceeds would depend on the negotiations between the Scafell and any potential
buyer. Similarly if Arrowsmith is spun-off any issue price would depend on the market appetite for the
shares.

The SVA valuation using the best case scenario growth estimates is probably unrealistic given
Arrowsmith’s historic growth in EBIT from 2019 to 2022, which is 2% (2018 excluded since it appears to
be abnormally high)
(EBIT growth 3√(8724/8210) – 1 = 2%)
Ignoring the SVA best case scenario valuation, a liquidation results in a substantially higher amount than
either selling or a spin-off it would be sensible to liquidate Arrowsmith. However, the sale proceeds are
not certain since it is possible that the assets might have to be sold for less than their estimated values
(they are high street shops and high streets are in decline).
Answers to this section were generally poor. Some candidates did not refer to the range of values at all.
Many said ignore liquidation as shareholders would get nothing despite their NRV figure.


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What are the advantages and disadvantages of hedging foreign currency exchange rate risk?

What are the advantages and disadvantages of hedging foreign currency exchange rate risk?

What is interest rate parity and how does it relate to the scenario provided?

What is interest rate parity and how does it relate to the scenario provided?

Professional Level – Financial Management – June 2022

MARK PLAN AND EXAMINER’S COMMENTARY

Task One: Hedging foreign currency exchange rate (forex) risk

Task two: An explanation of interest rate parity

Task three: Arranging an interest rate swap

The forward rate is 1.2324 – 0.0084 = CHF/£1.2240

The sterling payment is 500,000/1.2240 = £408,497

Money market hedge:

Deposit in CHF 500,000/(1 + 0.03 x 4/12 )= CHF495,050

Buy spot CHF495,050/1.2324 = £401,695

Borrow in £ so the total cost is: 401,695 x (1 + 0.06 x 4/12) = £409,729

Premium 500,000 x £0.03 = £15,000

The total cost will therefore be:

Copyright © ICAEW 2022. All rights reserved Page 1 of 10

Total possible marks 10

General advantages and disadvantages include:

The written section was generally well answered.

Total possible marks 7

The middle forward rate = (1.2328 x (1 + 0.035x4/12))/(1 + 0.055 x 4/12) = 1.2247

This results in a premium of CHF0.0081 (1.2328 – 1.2247)

The middle forward contract premium = CHF0.0081 ((0.0084+ 0.0078)/2)

Copyright © ICAEW 2022. All rights reserved Page 2 of 10

Therefore, interest rate parity is holding.

Total possible marks 5

Chocoholic Alp Differentials

4.75% SONIA + 2.75%

Total possible marks 4

The advantages to Chocoholic of an interest rate swap include:

Most candidates could identify 2 valid advantages of swaps.

Total possible marks 4

Copyright © ICAEW 2022. All rights reserved Page 3 of 10

3. Requires gearing computations assuming different ways to finance the project.

(a) Ke = 2 + 0.32 x 7 = 4.24%

Kd using the RATE ss function

The YTR of the 4% debentures, which mature in five years' time

Using the RATE function the inputs are:

Tax rate 25%

Kd = YTM (1-t) 2.35%

Debt 39 x 1.04 = £40.56 m

WACC = (4.24 x 314.9 + 2.35 x 40.56)/(314.9 + 40.56) = 4.02%

(b) Growth = (3/2.75)^(1/4) = 2.2%

Ke = (3(1.022)/67) + 0.022 = 6.78%

Copyright © ICAEW 2022. All rights reserved Page 4 of 10

Total possible marks 11

De-gear the plastic bottle manufacturing company’s beta equity:

0.50 = Ba (1+ (25x0.75)/75)) . Ba = 0.40

Re-gear using Wilton’s gearing:

Be = 0.40 (1+ (40.56 x 0.75)/314.9). Be = 0.44

Total possible marks 6

(a) Current gearing 40.56/314.9 = 12.9%

(b) All debt

The value of equity will now be: 65p x 470m = £305.5m

(38.22+ 40)/ 305.5 = 25.6%

(c) All equity 40.56/(314.9 + 40) = 11.4%

Total possible marks 4

Copyright © ICAEW 2022. All rights reserved Page 5 of 10