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Examiners reportDB1

June 2011

General Comments

The format of the examination remained unchanged from previous examination. Thus, Section A consisted of

twenty objective test questions that were divided equally between the Financial Strategy and the Risk

Management elements of the examination paper. Section B consisted of three questions relating to the Financial

Strategy element and Section C consisted of three questions relating to the Risk Management element.

Candidates were required to attempt all questions in Section A and a total of three questions from Sections B and

C, including at least one from Section B and one from Section C. This report deals with the performance of

candidates in Sections B and C of the examination paper.

Specific Comments

Question One

The first question in Section B was an investment appraisal problem. This was a popular question which was, on

the whole, well answered. The first part required candidates to prepare calculations showing the net present

value and internal rate of return of a project. Many candidates were well prepared for calculating the net present

value and marks awarded were often high. Calculating the internal rate of return, however, posed more problems

and some candidates struggled when carrying out the interpolation necessary to derive an approximate figure.

The second part of the question required candidates to comment on the recommendation to abort the project.

Most candidates managed to make the point the net present value was positive and the internal rate of return

was higher than the cost of capital, therefore acceptance of the project would enhance shareholder wealth. Few,

however, mentioned the fact that the margin of safety of the project was not high and that the reliability of

underlying estimates should be checked before a final decision is made.

The final part of the question required candidates to comment on the two methods of investment appraisal used

in the first part of the question and to explain which, if any, is superior. Although most candidates managed to

describe the basic features of each of the two methods, few managed to identify the flaws in the internal rate of

return method. This method ignores the scale of the investment and gives priority to projects with a higher

percentage rate of return. It is, therefore, not directly concerned with maximising the absolute wealth of

shareholders. The internal rate of return method also has difficulty in dealing with projects that have

unconventional cash flows.

Question Two

This question concerned a business that is considering the acquisition of another business in a different industry.

This was not a very popular question and, although some candidates managed to score high marks, the general

standard of answers was not high. The first part of the question required a brief discussion of the case for and

against business diversification through acquisition. Most candidates managed to make the point that it can

result in greater stability of cash flows, which may, in turn, help the business to survive over the longer term.

Few, however, raised the issue as to whether diversification by a business will provide benefits to shareholders

that they cannot achieve more cheaply themselves by holding a diversified portfolio of investments.

The second part of the question required various calculations to be carried out that were connected to the

proposed acquisition. These calculations were sometimes carried out well with a few candidates scoring

maximum marks. However, the majority struggled with the rate of exchange for the shares of the two companiesand the total number of shares that needed to be issued to finance the takeover. This second part carried more

than half the total marks of the question and so a poor attempt at this part usually meant a low mark overall.

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The final part of the question required a discussion of the advantages and disadvantages of shareholders in a

target company receiving the bid consideration in the form of cash rather than shares. Most candidates made a

reasonable attempt at this part and were able to make some useful points.

Question Three

Question three was concerned with the effect of competing financing options on the returns to shareholders. The

first part of the question required candidates to undertake various calculations to demonstrate the differential

effect of equity and debt when used to finance the expansion of a business. Most candidates were able to

calculate the likely impact on future income and earnings per share under the two different sources of finance

without much difficulty. They were often unable, however, to calculate the level of gearing associated with each

option. The main problem was usually in deriving the total equity for use in the gearing formula.

The second part of the question required candidates to calculate the level of operating profit at which the level of

earnings per share would be the same under each financing option. This proved to be beyond the reach of many

candidates and a significant number did not even attempt this part. Fortunately for these candidates, it did not

carry a large number of marks and so it was still possible to gain reasonable marks for the question as long as

the remaining parts were answered well.

The third and final part of the question required candidates to evaluate each of the financing options from the

perspective of an existing shareholder. Although most managed to make a few points, the general standard of

discussion was not high. The issue of risk and return was rarely mentioned in relation to each financing option

and the problem of dilution of shareholder control was too often ignored.

Question Four

This question was concerned with the views of Modigliani and Miller (MM) concerning the capital structure

debate. It was clear that candidates were generally ill prepared for this type of question. It proved to be an

unpopular choice and marks awarded were generally low. The first part of the question required candidates to

outline the views of MM concerning capital structure. This was rarely well answered, although a few managed to

score high marks. It was disappointing to see such a lack of preparation for such a question. The views of MM on

capital structure are an important element of the syllabus and the question posed was very straightforward.

Candidates were only required to outline the MM views.

The second part of the question required candidates to identify two limiting assumptions of the MM (including

taxes) viewpoint. This was often better answered than the first part but only carried a small proportion of the total

marks available.

The final part required candidates to calculate the equilibrium price of a share in a company based on the MM

(including taxes) view. This was a more demanding part and, given the performance of candidates in the previous

two parts, it was not surprising to find that it was either answered badly or was left unanswered.

Question Five

Question five was concerned with currency risk. This type of question is rarely a popular choice although it does

attract a small group of candidates with a good understanding of the topic. As a result some of the scores for this

question were very high.

The first part of the question required candidates to show the effect of three different options for dealing with

currency risk. The first option was to use a forward exchange contract. Most managed to make a reasonable

attempt at this part, although dealing with the premium created problems for some. The second option was touse a currency option and, again, some floundered when dealing with the premium. The final option was to do

nothing and most managed to calculate the financial effect of this option.

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