F3 – Financial Strategy - CIMA

1 Financial Strategy 1 May 2014 Strategic Level Paper F3 Financial Strategy May 2014 examination Examiner s Answers Question One Suggested Approach In part (a), first identify the key issues and then discuss each one in turn. In part (b)(i), first calculate the cost of equity and the post tax cost of debt. The cost of equity can be obtained using the CAPM formula and the post tax cost of debt can be calculated from the interest cost given by deducting tax of 30%. Next calculate the market value of equity based on the number of shares in issue (obtained from the pre-seen Financial data) multiplied by the share price provided in the question. The final piece of data required to complete the WACC calculation is the value of debt which can again be obtained from the Financial statements provided in the pre-seen material.

2 In part (b)(ii), use discounted cash flow (DCF) analysis to calculate the value of Smart Bathrooms as at 30 June 2014. This can be achieved by scheduling sales revenues over the 10 year period and then calculating gross margin. Fixed costs are then deducted and a net pre-tax cash flow obtained. Deduct tax at 30% from this amount and then discount at the WACC calculated in part (b)(i) plus 2% risk adjustment. Rationale Question One tests the ability to evaluate strategic Financial objectives from the viewpoint of the shareholder. It also tests the ability to value a division and understand the impact of a significant fall in value that necessitates an impairment charge on both performance measures and company value. Dividend policy is also examined, testing the understanding of how best to deploy surplus cash, with particular focus on the payment of a special dividend.

3 Question One tests syllabus areas A1(b) & (c), A2(d), B1(c) and C1(a). May 2014 2 Financial Strategy In part (b)(iii), consider the effect of a material impairment charge of GBP 80 million on P plc s latest Financial statements as provided in the pre-seen material. Calculate key performance measures before and after such an impairment charge and comment on the effect of the impairment charge. Finally, divide the impairment charge by the number of shares in issue to obtain an estimate of the likely impact on the share price. In part (c)(i), consider the impact of a special dividend payment on P plc s key stakeholders, including any signalling effect. Consider each in turn, classifying each point as either an advantage or disadvantage of paying a special dividend. Finally, for part (c)(ii), identify possible alternative uses of surplus cash and evaluate each in turn in the context of P plc.

4 Report to the Board of P Plc Re: Strategic Objectives, Impairment of Goodwill and Special Dividend From: Finance Director Date: 22 May 2014 Purpose of Report (a): Impact of strategic objectives 1 and 2 on shareholder wealth Objective 1: To be the market leader in the regions of the world in which P plc operates Having a substantial market presence creates economies of scale and synergistic benefits (from all business units sharing the same storage warehouses and distribution networks together with shared IT, personnel and finance departments). This has a direct impact on profitability and therefore shareholder wealth. Being the market leader in a market means that P plc has the potential to benefit from economies of scale to a greater extent than any of its rivals. That is, shareholders of P plc have the possibility of receiving above average market returns and greater returns than shareholders in rival companies.

5 However, revenue or volume targets must not be confused with profit targets. Poor performing units should not be retained simply in order to maintain market share. It is profit rather than revenue that is significant in terms of shareholder wealth. This report will address the following matters: The impact of strategic objectives on shareholder wealth. The potential charge for goodwill impairment and its impact on investor assessment of P plc s performance. Advice regarding a proposed special dividend and other possible reasons for either deploying or retaining surplus cash. Financial Strategy 3 May 2014 Objective 2: To deleverage P plc by disposing of business units or individual retail outlets which do not contribute sufficiently to the aim of P plc becoming market leader or are failing to meet minimum performance targets.

6 Modigliani and Miller s capital structure theory proposes that a high gearing level is required in order to maximise shareholder wealth. Higher gearing increases the tax benefit on debt and leads to higher returns to shareholders, albeit at higher risk. There is therefore a risk that deleveraging P plc could lead to the opposite effect, that is, such a policy could lead to a reduction in shareholder wealth. However, other factors are relevant. The company struggled to source debt finance during the credit crunch and is seeking to reduce dependence on debt finance to increase Financial resilience. Long term survival and hence lower risk are also highly valuable to shareholders. In the current economic downturn, the optimal level of gearing may well be lower than in earlier, less turbulent economic times.

7 (b)(i) Calculation of P Plc s WACC Ke = + (4% x ) = Pre tax Kd = , so post tax Kd = x = Ve = GBP x 500 million shares = GBP 4,250 million Vd = GBP 1,000 million Ve + Vd = GBP 5,250 million (= GBP 4,250 milion + GBP 1,000 million) So WACC = (GBP 4,250 / GBP 5,250) + (GBP 1,000 / GBP 5,250) = That is, approximately 6%. Examiner s note: Alternative approaches such as the use of the MM formula were also accepted. (b)(ii) Estimate of the fall in value of Smart Bathrooms Value on 31 December 2013 : GBP million Value on 30 June 2014: Year 1 2 3 4 5-10 Units sold (grow at 3% then 0%) 8,200 8,446 8,699 8,960 8,960 Unit selling price (grow at 2% then 0%) (GBP) GBP 000 GBP 000 GBP 000 GBP 000 GBP 000 Sales value 1,066 1,120 1,177 1,237 1,237 Gross profit margin of 45% Fixed costs ( ) ( ) ( ) ( ) ( ) Taxable profit Profit after tax of 30% DF at 8% (6% WACC+2% risk adjustment) (= ) Present value 1, May 2014 4 Financial Strategy Therefore total present value of post-tax cash flow as at 30 June 2014 = GBP 1,954,800.

8 The difference in the valuations is GBP 345,200 ( = GBP 2,300,000 - GBP 1,954,800). This represents the value of the impairment adjustment required to value the goodwill associated with Smart Bathrooms. (b)(iii) Advice on the possible effect of an impairment charge of the order of GBP 80 million. Impact on performance measures Reduced earnings and EPS. Reduced ROCE and return on assets (since the impact on return is more significant than the impact on capital employed or assets). Increase in gearing (due to fall in equity), but only a very minor change as GBP 80 million is small in relation to total capital employed of GBP 5,250 million. Impact on DPS will depend on company policy. This is only an accounting charge and does not affect cash this year, so the dividend payment could remain unchanged.

9 Impact on share price Theoretically, shareholder wealth would fall by the value of the impairment charge. This is likely to exert downward pressure on the share price of at least the value of the impairment charge divided by number of shares in issue. Indeed, the share price may well already reflect a likely impairment charge and, indeed, a fall in the value of business units developed by internal growth, if the market has been following the industry carefully and already recognises that P plc s performance is likely to be adversely affected by deteriorating market conditions or over ambitious expansion plans. The fall in share price could, however, be much greater if investors consider that there is an increased risk of further impairment charges in future years. Share prices are based on the present value of future earnings/free cash flow and therefore look beyond current year results.

10 The actual fall in value will largely depend on whether this is considered to be a one-off charge or not. (c) (i) Advice on special dividend Arguments in favour If P plc has no immediate or foreseeable use for the cash, it should be returned to investors so that they can put it to better use. A one-off special dividend returns cash to investors faster than an increase in regular dividends. P plc has the cash available to support the payment of a special dividend now. The impairment charge is solely an accounting entry, it does not affect cash. Cash reserves of GBP 418 million are sufficient to accommodate both the interim normal dividend (GBP 55 million = 500 million shares x GBP ) and the special dividend (GBP 350 million). After paying both dividends, cash of GBP 13 million would remain (where GBP 13 million = GBP 418 million GBP 55 million GBP 350 million).