November 2008 Examinations Strategic Level Paper P9 Management Accounting - Financial Strategy Question Paper 2 Examiners Brief Guide to the Paper 19 Examiners Answers 21 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com/students) from February is a Post Examination Guide for the paper which provides much valuable and complementary material including indicative mark information. The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher.

The Chartered Institute of Management Accountants 2008

http://www.cimaglobal.com/students

Financial Management Pillar Strategic Level Paper

P9 Management Accounting Financial Strategy

19 November 2008 Wednesday Morning Session

Instructions to candidates

You are allowed three hours to answer this question paper.

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during the reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or sub-questions). The question requirements are highlighted in a dotted box.

ALL answers must be written in the answer book. Answers or notes written on the question paper will not be submitted for marking.

Answer the ONE compulsory question in Section A on pages 2 to 5.

Answer TWO of the four questions in Section B on pages 8 to 15.

Maths Tables and Formulae are provided on pages 17 to 21.

The list of verbs as published in the syllabus is given for reference on page.

Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.

Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

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P9 2 November 2008

SECTION A 50 MARKS [the indicative time for answering this Section is 90 minutes] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One KEN is a property development company located in country A whose currency is A$. KEN specialises in the construction of domestic housing in country A and is listed on the local stock exchange. KEN has been highly successful in recent years and has built a strong reputation based on high build quality and meeting deadlines. However, in recent months house prices have fallen and interest rates have risen, making it harder to sell houses, even at significantly lower prices. Domestic housing construction project One of KENs current projects is the construction of 300 houses. This project has been planned in three distinct phases, each in a self-contained plot of land. Good progress has been made with the development since work began in 2006. The position at 1 January 2009 is expected to be as follows:

Phase 1 80 houses Construction completed and all houses sold and occupied.

Phase 2 100 houses 30 houses were sold in 2008 Remaining 70 houses in this Phase to be actively marketed in 2009

Phase 3 120 houses Planning approval obtained but no construction work or marketing begun at

1 January 2009

Forecast figures for 2009-2011: 2009 2010 2011 House sales (number of houses) Phase 2 70 - - Phase 3 - 80 40 Cost of running the sales office (A$) Salaries and other staff costs 100,000 140,000 80,000 Other 30,000 30,000 30,000

November 2008 3 P9

Other financial information on the domestic housing project: The forecast average selling price per house BEFORE the recent fall in house prices

was as follows: o Phase 2: A$350,000 o Phase 3: A$400,000 However, due to the recent fall in house prices in country A, the forecast average selling prices listed above are considered to be overstated by 20% on unsold houses at 1 January 2009.

A 10% deposit is received on agreeing a house sale and the selling price is agreed at this stage. The remaining 90% is due on completion a year later.

Construction costs are, on average, 60% of the forecast selling price. 70% of the construction costs are incurred in the year in which the sale is agreed and 30% are incurred in the following year. These costs already take into account government estimates of inflation and are not expected to be affected by the recent fall in house prices. Construction costs should therefore be calculated on the forecast selling prices before the recent fall in house prices.

All sales office costs forecast for 2009 relate to Phase 2 and forecast costs for 2010 and 2011 relate to Phase 3.

Business tax is 30% on profits and capital gains, payable one year in arrears.

All cash flows should be assumed to arise at the end of the year. Strategic choices for KEN The fall in house prices has created potential liquidity problems for KEN and KEN is considering what its strategic response should be at this time. The following strategies are being considered: Strategy 1: Abandon Phase 3 and sell the land Strategy 2: Merge with another property development entity Strategy 1: Abandon Phase 3 of the domestic housing project If KEN were to abandon Phase 3 of the project, the land would be sold and the sales office staff would be made redundant. All this would be expected to take place at the end of 2009. Phase 2 of the project would continue as planned since KEN is already committed to completing this phase of the project. The land for Phase 3 was purchased in 2006 at a cost A$25 million without planning permission. Planning permission was obtained in 2006 at a cost of A$100,000 and the land could be sold in 2009, with planning permission, for A$44 million. It is estimated that it would cost A$60,000 to make the sales office staff redundant at the end of 2009. Normal running costs and salaries would be paid up to the end of 2009, at which point the sales office would be closed. Strategy 2: Merger KEN has also been approached by another property development entity located in country A that is interested in merging the businesses. Discussions are still at a very early stage but KEN is interested in investigating this possibility further. Investment appraisal KEN uses DCF to evaluate investments at an after-tax nominal discount rate of 12%.

P9 4 November 2008

Required:

(a) For Phase 2 of the project, calculate the fall in after-tax sales receipts in each of the years 2009 and 2010 as a result of the fall in house prices. Ignore the time value of money.

(4 marks)

(b) Discuss the industry, economic and market factors that affect KENs business cash flows and liquidity and funding issues.

(6 marks)

(c) Explain the role of the treasury function in liquidity management, and funding management.

(6 marks) (d) Assume you are the Finance Director of KEN and write a report to the Board

of Directors of KEN on the strategic choices facing KEN at this time.

Your report should address the following issues:

Strategy 1: (i) Calculate the net present value of the Phase 3 cash flows AFTER the

fall in house prices and compare this with the net present value of the cash flows associated with selling the land.

(17 marks) (ii) Advise whether or not to proceed with Strategy 1. As part of your

answer discuss what other real options are available to KEN, and what other factors should be taken into account.

(7 marks) Strategy 2: (iii) Identify and explain the possible reasons why KEN might consider a

merger at this time and the potential problems with such a merger.

(7 marks) Additional marks for structure and presentation in part (d) (3 marks)

(Total for Question One = 50 marks)

November 2008 5 P9

SECTION B 50 MARKS

[the indicative time for answering this Section is 90 minutes]

ANSWER TWO ONLY OF THE FOUR QUESTIONS Question Two BG is a privately-owned transport entity based in country B, which has the euro () as its currency. BG had revenue in the last financial year of 65 million and earnings of 145 million. The directors of the entity, who are also the major shareholders, have been evaluating the replacement of a number of vehicles, which will be purchased in country C, which has the C$ as its currency. BG has a number of customers based in country C. The vehicles will have a capital cost of C$16 million and the directors expect these new vehicles to provide after-tax cash flow benefits (including tax depreciation benefits) of 160,000 each year. Cash flows beyond five years are ignored by BG in all its investment decisions. The vehicles are estimated to have a resale value at the end of five years of 15% of the original purchase price. BG is currently all-equity financed. Some directors believe this should continue and the new vehicles should be financed with a rights issue (that is, they are prepared to inject more capital into the business themselves). However, the Chief Executive has