Examiner’s report – FM September/December 2020 1

Financial

Management (FM)

Sept / Dec 2020

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 ............................................................................. 2

Example 1 ........................................................................ 3

Example 2 ........................................................................ 3

Example 3 ........................................................................ 4

Example 4 ........................................................................ 5

Conclusion ....................................................................... 5

Section B ............................................................................. 6

Question 1 ........................................................................ 6

Question 2 ........................................................................ 7

Question 3 ........................................................................ 7

Question 4 ........................................................................ 8

Question 5 ........................................................................ 9

Section C ........................................................................... 10

Spine Co ........................................................................ 10

Requirement (a) – 10 marks ....................................... 10

Requirement (b) – 5 marks ......................................... 12

Requirement (c) – 5 marks ......................................... 13

Crocket Co ..................................................................... 14

Requirement (a)(i) - 4 marks ...................................... 14

Requirement (a)(ii) - 6 marks ..................................... 15

Requirement (b) – 4 marks ......................................... 16

Requirement (c) – 6 marks ......................................... 16

Examiner’s report – FM September/December 2020 2

General comments

This examiner’s report should be used in conjunction with the published

September/December 2020 sample exam which can be found on the ACCA Practice

Platform.

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 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.

• Section A objective test questions – four specific questions that caused difficulty in these exam sessions.

• Section B objective test case questions – one whole objective test case to illustrate the types of questions candidates can expect to receive in this section of the exam.

• Section C constructed response questions – guidance on what was done well and where candidate performance could be improved from the published exam questions.

Section A The objective test questions in Section A ensure a broad coverage of the syllabus, and so all areas of the syllabus need to be carefully studied, as all learning outcomes can be tested in this part of the examination. Candidates preparing for the examination are therefore advised to work through as many objective test questions as possible, reviewing carefully to see how correct answers are derived in areas where they experience difficulty. The following questions are reviewed with the aim of giving future candidates an indication of the types of questions asked which have caused difficulty and guidance on dealing with such exam questions. Example 1 is numerical and tests the calculation of NPV. Example 2 is a question testing knowledge of working capital investment as well as risk and return. Example 3 is numerical and tests rights issues. Example 4 is a question testing knowledge of interest rate hedging.

Examiner’s report – FM September/December 2020 3

Example 1 A company is appraising a three-year project which requires an initial outlay on 1 January 20X4 of $30,000. The project is expected to give the following cash inflows on 31 December of each year: 20X4 $10,000 20X5 $20,000 20X6 $25,000 All of the above cash flows are before taking account of specific annual inflation of 5% per year. The real cost of capital is 4% and the nominal cost of capital is 14%. Using a nominal approach and the discount tables provided, what is the NPV of the project on 1 January 20X4 (to the nearest dollar)? The correct answer is $15,701 Year 1 PV = 10,000 x 1.05 x 0.877 = $9,209 Year 2 PV = 20,000 x 1.052 x 0.769 = $16,957 Year 3 PV = 25,000 x 1.053 x 0.675 = $19,535 NPV = 9,209 + 16,957 + 19,535 - 30,000 = $15,701 (Note: Other answers which differ due to roundings applied, would also be marked as correct)

Example 2 Which of the following is/are true? (1) A conservative working capital investment policy implies a higher proportion of

permanent current assets to fluctuating current assets (2) Long-term finance is generally cheaper than short-term finance A 1 only is correct B 2 only is correct C 1 and 2 are correct D 1 and 2 are incorrect The correct answer is D. A conservative working capital investment policy refers to a higher amount invested in working capital. It does not relate to the proportions of permanent to fluctuating current assets so statement 1 is incorrect. Long-term finance is not generally less expensive than short-term finance; it is more expensive as it is riskier for the lender, so statement 2 is also incorrect.

Examiner’s report – FM September/December 2020 4

Example 3 Simon Co is planning a 1 for 4 rights issue. The value of rights has been calculated as $0.40 per existing share. Simon Co's market price is currently $7.00 per share. What is the theoretical ex rights price (TERP) per share and the rights issue price per share?

The correct answers are: TERP $6.60 Rights issue price $5.00 TERP is the market price before the rights issue less the value of a right per existing share = $7.00 – $0.40 = $6.60. The issue price can be calculated from the TERP by subtracting the value of a right. The value of a right can be calculated by multiplying the value of a right per existing share by the number of shares needed for one right. Value of a right = 4 x $0.40 = $1.60 So the rights issue price is $6.60 – $1.60 = $5.00

Examiner’s report – FM September/December 2020 5

Example 4 Which TWO of the following statements concerning the interest rate risk management method of smoothing are true? A The debt portfolio will consist of a mixture of fixed and floating rate debt B Interest payments will still increase if the interest rate rises C Investments with a fixed cash flow will be financed with fixed rate debt D Full benefit will be obtained from a fall in interest rates E The net effect will be an interest payment which is fixed overall The correct answers are A and B. Smoothing is holding a balanced mix of both fixed and floating rate debt. This will reduce the effects of an interest rate change but not eliminate it completely, so interest payments will still increase following a rise in rates, therefore statements A and B are correct. Full benefit will not be obtained from a fall in rates due to the fixed element of the debt portfolio. Financing fixed cash flow investments with fixed rate debt is a matching strategy, not smoothing.

Conclusion Candidates should read the question carefully and follow the instructions on how to answer the question. For example, if a question asks the candidate to select two correct statements, then marks can only be awarded if two statements have been selected. There is no partial marking, so an answer which only selects one statement will be awarded no marks. A candidate who selects three statements will also receive no marks. In addition, when answering a number entry question, candidates must ensure they are entering their answer in the correct format as stated in the requirement. If a number is being requested in millions, there will be an ‘m’ after the number entry box. If a candidate puts a full answer of say 13000000 in the box rather than 13, this will be marked as incorrect. If there is no format specified, answers may be given as an integer or to one or two decimal places. The exam system is configured to allow any correct answer, under these formats, to be awarded the available marks.

Examiner’s report – FM September/December 2020 6

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 the topic of risk management.

Question 1 What type of exchange rate risk would Marigold Co experience with the $100,000 loss in its consolidated financial statements? A Economic B Translation C Transaction D Political The correct answer is B. Translation risk is the gain/loss arising from the retranslation of a foreign subsidiary's results.

Examiner’s report – FM September/December 2020 7

Question 2 If Marigold Co uses the forward market to hedge the MS receipt, what amount will be received (to the nearest $)? The correct answer is $269,663. The appropriate forward rate is 1.1125 MS per $1. MS 300,000 / 1.1125 = $269,663

Question 3

Borrowing rate pro-rated for three months = 4% x 3/12 = 1% Amount to borrow = MS300,000 / 1.01 = MS297,030 Amount to deposit = MS297,030 / MS1.1250 = $264,027

Examiner’s report – FM September/December 2020 8

Question 4 Marigold Co is now considering the use of an option to hedge the currency risk on the MS receipt. Its bank has offered an over-the-counter option with an exercise price of MS1.1250 per $. Which TWO of the following statements concerning the option are TRUE? A The option will be more expensive to set up compared with either the forward

contract or money market hedge

B An imperfect hedge will result as the option will be for a standard amount of currency and only a whole number of contracts may be used

C If the $ was to strengthen against the MS, Marigold Co is likely to be worse off by using the option compared to either the forward contract or money market hedge

D Using an option hedge will mean that Marigold Co is obligated to exercise the option in three months irrespective of the spot rate on the day

The correct answers are A and C. Payment of the option premium upfront will make the option the more expensive means of hedging. A strengthening of the $ will result in a worse spot rate than the exercise price, forcing exercise of the option. This, along with the premium cost will mean that Marigold Co will be worse off than if they had used the other instruments which offer better rates than even the exercise price. Standard contract sizes only apply to tradable options, not over-the-counter options which will be tailored to the needs of the customer.

Examiner’s report – FM September/December 2020 9

Question 5 Marigold Co is unsure whether to use a forward contract or a money market hedge and is comparing the relative advantages and disadvantages of the two. Which of the following statements is true? A The forward contract has the advantage of being tailored precisely to Marigold

Co's requirements but the money market hedge will be a standardised instrument resulting in an imperfect hedge

B The forward contract will result in Marigold Co receiving the dollar equivalent of the MS receipt in three months' time, whereas the money market hedge will provide Marigold Co with dollar receipts today

C The forward contract will result in the effective rate of exchange being fixed whereas the money market hedge will allow Marigold Co to benefit from favourable movement in the exchange rate

D Marigold Co will be obligated to fulfil the forward contract in three months' time whereas the money market hedge could be traded on an exchange to another party before settlement

The correct answer is B. A money market hedge will bring the cash translation forward and will therefore provide $ today which could be spent rather than deposited. The forward contract will not do this, as it will be settled at the set future date.

Examiner’s report – FM September/December 2020 10

Section C

Spine Co

Spine Co shares similarities with recent questions examined on the Business Finance section of the syllabus (Section E); specifically, part (a) has similar elements to Tin Co from March / June 2018.

Requirement (a) – 10 marks

This requirement addressed syllabus area E3d(i), which says candidates should be able to ‘assess the impact of sources of finance on financial position, financial risk and shareholder wealth using appropriate measures’. This syllabus area is designated as level 2, ‘application and analysis’, which is a step up from level 1, ‘knowledge and comprehension’. Many candidates failed to demonstrate an intellectual level that reached level 2. The requirement asked candidates to ‘evaluate’ the options and candidates were presented with various pieces of financial information in the scenario. It’s therefore difficult to perceive how the question can be answered fully without reference to such information. Some candidates chose to ‘discuss’ debt and equity in quite a generic way, with little or no reference to the scenario. A clear strategy to answering such a question is necessary and a structured approach is recommended. This means that candidates should clearly show the financial effect of financing by debt and then separately the financial effect of financing by equity. A justified recommendation can then be made. Most candidates were able to compute the increased profit before interest and tax (PBIT), although, as with other computations, it is disappointing to see basic errors of arithmetic, for example, errors of magnitude where a 20% rise was processed as 2%.

Examiner’s report – FM September/December 2020 11

Under the debt financing option, interest is certain to rise, and the scenario clearly stated that the finance charges (interest) on the new $15,000,000 of loan notes will be at 8%. It is difficult to see why any other interest rates would be used. Once again, errors of arithmetic arose, instead of 8% x $15,000,000 = $1,200,000 being included, there were examples of $120,000 and other errors of magnitude and/or decimal points. Both the increased PBIT and the increased finance charges will affect the profit before taxation (PBT) and therefore the taxation charge. The corporation tax rate is clearly stated, and a quick check will show the company currently pays $3,840,000 in taxation out of $12,800,000 of PBT, exactly 30%. Therefore, the new taxation charge will be based upon the new PBT i.e. 30% x $14,208,000 = $4,262,400. The revised profit after taxation (PAT) under the debt option is therefore $9,945,600. A source of error here was adding after-tax additional interest payments to current before-tax interest payments, in calculating revised finance costs. This suggests both carelessness and lack of familiarity with the format of financial statements. Furthermore, some candidates were incorrect to simply apply a 20% increase to the PAT. Once the revised earnings (PAT) figure has been calculated, the impact upon various measures can be assessed. Increased earnings will result in a change in earnings per share (EPS). Under the debt option, the number of shares has remained the same at 12,000,000, thereby resulting in a rise in EPS from $0.747 per share to $0.829 per share. This demonstrates that the earnings available for distribution to shareholders has risen, thereby increasing the likelihood of higher dividend payments. Whilst this looks at the option from the perspective of shareholders’ income, it is also important to look from the perspective of shareholders’ wealth. Using the current EPS of $0.747 per share, it is possible to calculate Spine Co’s price/earnings ratio (PER), given the current share price of $6.25, i.e. $6.25 / $0.747 = 8.37 times. Then, using this PER, the company’s revised share price can be calculated, i.e. 8.37 x $0.829 = $6.94 per share, thereby giving rise to a capital gain of $6.94 - $6.25 = $0.69 per share. Looking at the equity financing option, there will be no change to the current finance charges (as given in the scenario), but the PBT will change as a result of the increased PBIT, and therefore the taxation charge will also rise proportionately, giving revised earnings of $10,785,600. Under this option new shares are issued under a 1 for 4 rights issue, i.e. ¼ of 12,000,000 shares = 3,000,000 new shares. This will change the EPS to $10,785,600 / 15,000,000 shares = $0.719 per share, a fall from the original EPS of $0.747 per share. The change in EPS will also affect the share price by using the PER, i.e. 8.37 x $0.719 = $6.02 per share. It is, however, inappropriate to compare this forecast share price to the current share price of $6.25 per share since a rights issue has taken place with a resultant theoretical ex-rights price (TERP) of $6.00 per share, thereby giving rise to a capital gain of $6.02 - $6.00 = $0.02 per share.

Examiner’s report – FM September/December 2020 12

Whilst many candidates could calculate the TERP, some incorrectly claimed that the TERP was the share price after investing the rights issue funds, when in fact the TERP is the share price after the cash has been raised but before it has been invested, and/or also incorrectly claimed that shareholders would be unhappy with the rights issue because it would lead to a fall in the share price to the TERP, when in fact, the TERP is a wealth-neutral share price, resulting from shareholders transferring some of their cash wealth into share wealth. The TERP can then be used, as above, to assess any capital gain or loss arising from the investment. Part (a) bears comparison to part (a) of past question Tin Co, but with the respective requirements being broken down to differing extents. In Section C of the examination, candidates are expected to be able to perform a financial evaluation, involving application and analysis, without necessarily being guided step-by-step.

Requirement (b) – 5 marks

The requirement here was to explain and discuss the relationship between systematic and unsystematic risk, as per syllabus area E2a(ii). This requirement produced a wide range of responses, with some candidates gaining full marks. Better answers recognised that the relationship between systematic and unsystematic risk depended upon portfolio diversification, with systematic risk being ‘undiversifiable risk’ and unsystematic risk being ‘diversifiable risk’ (this is the approach taken in an article on the ACCA website). In some answers, systematic risk was referred to as ‘market risk’ and unsystematic risk was referred to as ‘specific risk’. Candidate responses that adopted an investor perspective for discussing portfolio diversification had a straightforward route to discussing the relationship between diversifiable and undiversifiable risk, whereas answers that attempted to discuss diversification from a corporate perspective often strayed into a discussion of risk hedging that did not address the question requirement and that overemphasised internal risk relative to external risk. As has been stated about other questions in previous Examiner’s Reports, some answers were too brief for the marks on offer. However, even where answers were more substantial, marks could not be awarded due to candidates wandering off the point, for example by discussing financial risk and business risk, or by discussing the relationship between equity beta and asset beta. Weaker answers failed to mention portfolio diversification at all and focused instead on describing systematic and unsystematic risk, often very briefly and with little else added to the discussion. Candidates must recognise that a requirement worth five marks needing them to ‘explain and discuss’ should yield more than brief points, sometimes comprising sentences of fewer than six words and/or where the technical discussion is weak. A surprisingly high number of candidates made no response to the requirement.

Examiner’s report – FM September/December 2020 13

Requirement (c) – 5 marks

The requirement here was to discuss the assumptions made by the capital asset pricing model (CAPM) as required in Section E of the Financial Management syllabus (E2a(iv)). The assumptions made by the CAPM are clearly set out in an article on the ACCA website, in study texts, and as illustrated by the suggested solution. These assumptions lend themselves to a focused and well-structured answer. Whilst there were some good responses, many answers showed limited understanding of this syllabus area. Too often, responses were irrelevant to the requirement e.g. how to calculate a project-specific discount rate, or written in a general way about CAPM with no attempt to discuss the assumptions made by the CAPM, often taking instead individual aspects of the CAPM and describing them incorrectly as assumptions, e.g. the CAPM assumes that betas can be ungeared and regeared. Candidates need to be able to apply and analyse such models within the syllabus. Question requirements need to be addressed directly rather than an approach which suggests candidates write all that they know about a topic in the incorrect expectation that it will score sufficient marks. A surprisingly high number of candidates, as in part b above, made no response to the requirement.

Examiner’s report – FM September/December 2020 14

Crocket Co

This question addressed several areas within section D of the syllabus, Investment Appraisal, by considering three independent investment decisions being considered by Crocket Co.

Requirement (a)(i) - 4 marks

Part (a) (i) required candidates to calculate the NPV of an investment project, including

the effects of specific inflation of sales and costs. Most candidates scored high marks

on this question.

Where full marks were not awarded, a number of errors were encountered:

• Not applying inflation at all to sales and cost values or using incorrect inflation rates

for them;

• Inflation of sales and costs for one year only, such that the sales revenue figure for

year 4 was incorrectly calculated as $612,000 * 1.04 = $636,480. This occurred

fairly often and suggests a lack of understanding of inflation

• Inflation and use of the Year 1 figures only such that the sales revenue figure for

year 4 was incorrectly calculated as $725,000 * 1.04^4 = $848,147

• Using total capital available, $5,000,000, as the initial investment, rather than the

specified amount of $1,500,000

• Spreadsheet errors, such as incorrect summation and errors in formulae. One such

error is deducting the initial investment figure when it has already been entered as

a negative figure, thereby giving an incorrect NPV due to the ‘double negative’

e.g. $2,061,000 – ($1,500,000) = $3,561,000

Examiner’s report – FM September/December 2020 15

• Failing to use spreadsheet functionality at all, for example entering calculated

values in cells rather than in-cell calculations, so that computations could not be

checked, and method marks could not be awarded.

This final point is of high importance. Method marks cannot be awarded where

markers cannot see how the figures have been computed. Candidates must present

their work as they would in the professional work environment, for example in

presenting to a company director or accounting practice partner, by appropriately

labelling workings and displaying the detail behind figures.

Requirement (a)(ii) - 6 marks

Part (a)(ii) tested candidates’ ability to evaluate investment decisions under single-period capital rationing, via the calculation of profitability indexes for six divisible investment projects, two of which were mutually exclusive. Candidates who were familiar with the evaluation process of calculating profitability indexes (PI), ranking projects by PI, allocating funds according to PI, and investing partial funds in a proportion of divisible projects, were able to obtain good marks here. It is important that the detail of the scenario is read and understood. There was some evidence that this was lacking here. For example, projects C and E were mutually exclusive. This was sometimes ignored, or incorrectly treated as meaning that they must be undertaken together, such that C and E were combined and treated as a one investment package. A further example of a misunderstanding of the detail of the scenario was in respect of divisible projects. Incorrect approaches here included the failure to use the remaining funds in a proportionate way for the next ranked project e.g. in the suggested solution $725,000 remains after 100% of projects D, F and E are undertaken, and so 72.5% of project A can be invested in ($725,000 / $1,000,000) yielding a further 72.5% * $390,000 = $282,750. Some candidates incorrectly took an indivisible approach to the projects, for example by calculating NPVs of different combinations of projects, thereby wasting a lot of valuable time. Other errors encountered included:

• Ranking projects by absolute NPV, rather than by profitability index

• Calculating profitability index as investment/NPV, rather than NPV/Investment,

and therefore ranking the projects in completely the reverse order to the correct

one.

As per the comments on part (a)(i), it is of the utmost importance for candidates to show their workings, and to use the cell formulae functionality to perform calculations, so that markers can follow the logic of a candidate’s response.

Examiner’s report – FM September/December 2020 16

Requirement (b) – 4 marks

Here, candidates were required to explain the approach that the company should use to determine the optimum replacement cycle for the fleet of cars, and many answers gained full marks by correctly explaining the equivalent annual cost (EAC) approach by including explanations of relevant cash flows, the calculation of the present value (PV) of each cycle, the conversion of the PV into the EAC via the correct use of the annuity factor and, finally, the correct decision rule. Some candidates failed to gain good marks by not providing enough detail in the explanation such as describing a range of cash flows without explaining the need to use a present value approach and/or lacking precision, for example writing ‘NPV of the cars’ rather than ‘PV of the relevant costs of the replacement cycle’. Furthermore, some candidates incorrectly believed that EAC is calculated by dividing the NPV of a cycle by the length of the cycle in years. As with any requirement to ‘explain’, candidates need to write in enough detail in relation to the marks on offer. For example, one sentence or two short bullet points are highly unlikely to score more than one mark. Careful study of the suggested solutions for requirements such as this and also the technical article on the ACCA website give good guidance as to the amount of detail required to gain the marks on offer.

Requirement (c) – 6 marks

This requirement asked for a description of two approaches for dealing with inflation in relation to an investment decision where both specific inflation rates and a general inflation rate were available. This addresses syllabus area D2a. A detailed technical article on this syllabus area has been published on the ACCA website, and a detailed numerical illustration of the concept was demonstrated in the published question Pinks Co from the Sample March June 2019 questions. The suggested solution to Crocket Co displays the detail required for the six marks on offer, including a recommendation in relation to investment decision 3 for Crocket Co, which needs to consider the circumstances faced by this company namely that the inflation rates affecting the various cash flows will be uncertain and will differ from the general rate of inflation. Many answers were clear that the presence of specific inflation meant that a nominal terms approach to calculating the NPV was required. Nonetheless, some candidates incorrectly believed that the real approach ignored inflation. The real terms approach discounts real cash flows with a real cost of capital,

Examiner’s report – FM September/December 2020 17

and real cash flows might need to be calculated by inflating cash flows using specific inflation rates, then deflating the resulting nominal cash flows by the general rate of inflation. The article mentioned above addresses this in detail. A part-question such as this needs a structured response. Weaker responses often lack such structure and terms are sometimes used in a ‘scattergun’ approach in the hope that something will ‘stick’ and score a mark or two. Such an approach displays uncertainty surrounding the meaning of the terms. For example, there was some evidence of confusion between deflation and discounting when discussing real and nominal cash flows. Whilst recognising that candidates are under time pressure in the examination, taking a minute or so to plan an answer by placing sub headings on the screen (note the sub headings in bold in the suggested solution) will prove beneficial in giving a flow to the answer and can help to check that the requirement is being addressed. Some candidates did not gain marks in part (c) by discussing concepts, often at length, that did not address the requirement. Examples of concepts that scored no marks included discussing inflation in very general terms such as in relation to macroeconomic policy or discussing probability analysis, sensitivity analysis, and the relative merits of NPV and IRR. This is evidence that some candidates simply ‘rote-learn’ the suggested solutions to previously published questions and reproduce them in their examination, rather than addressing the actual requirement.