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Question 1

Assume the date is 31 December 2022.

NewTech plc (NT) is an engineering company based in the UK. NT is considering whether to
build an electric vehicle battery recycling plant (the ‘CleanUp project’). The board of NT has
asked its finance department to evaluate the CleanUp project using net present value (NPV)
analysis.

The CleanUp project involves NT buying used electric vehicle batteries and testing them for
their quality. Batteries with some remaining life will be recycled and sold as power packs for
electric vehicle recharging. Batteries with no remaining life will be ground down to extract raw
materials which will be sold to battery manufacturers. NT’s research and development
department has estimated that 25% of the used batteries that it buys will have no life left.

The board of NT is aware that a large German vehicle manufacturer is also proposing to build
and open an electric vehicle battery recycling plant by December 2026.

With increasing numbers of electric vehicles sold, the availability of used batteries is likely to
increase rapidly in the next four years. NT appointed a firm of analysts in November 2022, at
a cost of £0.1 million, to estimate the number of batteries that it could buy in the four years to
31 December 2026. The estimates are shown in the pre-populated spreadsheet. The
analysts also estimated the following selling prices for the four years to 31 December 2026:

• The average selling price of a power pack for electric vehicle recharging will be £6,500
and will remain constant.

• For the year to 31 December 2023, the average selling price of the raw materials
extracted from ground down batteries will be £500 per battery. However, raw material
prices are expected to fall and this price will reduce by 10% pa in the three years to 31
December 2026.

Pre-populated spreadsheet

Based on the volume and selling price information provided by the analysts, a trainee
accountant from NT’s finance department produced a draft schedule of cash flows (which can
be found in the pre-populated spreadsheet) for the NPV analysis. However, the trainee was
uncertain how to deal with the raw materials selling price, labour costs and fixed production
overheads.

Information relating to the schedule produced by the trainee is as follows:

• Processing costs (battery purchases, recycling and grinding down) are 70% of total
revenue.

• Labour costs represent the total cost of labour to process the used batteries. NT’s
existing workforce has some spare capacity and will be used to process 20% of the used
batteries purchased for the four years to 31 December 2026. All staff will be paid at the
same rate, and labour costs do not vary with sales revenue.
• Fixed production overheads include the depreciation of the new equipment. The
equipment will be depreciated on a straight-line basis over its four year life. The
remaining fixed production overheads are all incremental costs related to the CleanUp
project.

• All revenues and costs are expressed in money terms.

• Unless otherwise indicated, assume that all operating cash flows occur at the end of the
relevant year.

• The figures provided are arithmetically correct.

Additional information required to complete the NPV calculation

• The CleanUp project will be launched onto the market with a marketing spend on 31
December 2022 of £1 million.

• The CleanUp project will be evaluated assuming an initial life of four years. On 31
December 2026, there is the possibility of NT selling the CleanUp project to a
management buyout (MBO) team. However, if the German vehicle manufacturer opens its
battery recycling plant it is likely that the MBO will not go ahead and NT will then have to
consider its choices regarding the CleanUp project. The estimated pre-tax selling price
would be two times the contribution in the year to 31 December 2026.

• The new equipment will attract 18% (reducing balance) capital allowances in the year of
expenditure and in every subsequent year of ownership by the company, except in the
final year. At 31 December 2026, the difference between the equipment’s written down
value for tax purposes and its disposal proceeds will be treated by the company as either:

(1) a balancing allowance if the disposal proceeds are less than the tax written down
value; or

(2) a balancing charge if the disposal proceeds are more than the tax written down value.

• On 31 December 2022, the project will require an investment in working capital of £5

million which will increase at the start of each subsequent year in line with total revenue.
Working capital will be fully recoverable on 31 December 2026.

• Assume that the rate of corporation tax will be 25% for the foreseeable future and that tax
cash flows arise in the same year as the cash flows that give rise to them.

• A suitable money cost of capital to appraise the CleanUp project is 12% pa.

Requirements

1. Using the pre-populated spreadsheet provided and assuming the sale to the MBO
team goes ahead:

• Revise the cash flows prepared by the trainee accountant as necessary and
complete the NPV calculation for the CleanUp project on 31 December 2022.
 • Explain any revisions that you have made to the trainee’s figures and advise NT on
whether to proceed with the CleanUp project. (17 marks)

2. Ignoring the effects on working capital, calculate and comment on the sensitivity of the
NPV of the CleanUp project to changes in total revenue if the sale to the MBO team:

• goes ahead; and

• does not go ahead. (7 marks)

3. State the disadvantages of sensitivity analysis and explain how simulation might be a
better way to assess the risk of the CleanUp project. (4 marks)

4. Identify two real options that are available to NT on 31 December 2026 as an

alternative to the sale of the CleanUp project to the MBO team. (4 marks)

5. Explain how shareholder value analysis (SVA) could be used to evaluate the CleanUp
project. (3 marks)
Total: 35 marks
Question 2

Assume the date is 31 December 2022.

StartUp plc (SU) is a furniture retailer and is listed on the London Stock Exchange. SU would
like to diversify its activities and has identified an online retailer of clothing, HighFashion Ltd
(HF), as a takeover target.

Information regarding HF

• The head office of HF is in the UK, but its day-to-day operations and manufacturing plant
are in an overseas country that, due to widespread dissatisfaction with its government,
has experienced some political unrest.

• Adverse reports in the UK press claim that HF may be keeping its costs down by
exploiting lower safety standards and cheap labour in its overseas manufacturing plant.

• The value of HF will be determined by discounting its free cash flows at an appropriate
weighted average cost of capital (WACC).

• You are the Finance Director of SU and an ICAEW Chartered Accountant. You have
been asked by the SU board to advise on the takeover of HF and its potential impact on
SU.

The following information is available:

• On 31 December 2022, SU has in issue:

- 200 million ordinary shares with a market value of 300p each (ex-div).

- 2 million 6% (semi-annual coupon) debentures each with a nominal value of £100 and
a market value of £105% (cum-interest). These debentures are redeemable in six
years’ time.

• SU has an equity beta of 1.25 on 31 December 2022.

• The finance to purchase HF can be raised in such a way as to leave SU’s existing
gearing (measured as debt:equity by market values) unchanged after the acquisition of
HF.

• An appropriate equity beta, for a company that operates in HF’s industry, is 1.59 with a
debt:equity ratio (by market values) of 3:7.

• The debt proportion of the HF purchase consideration will be raised by a new issue of 4%
(semi-annual coupon) debentures, redeemable at par in ten years’ time.

• If the purchase of HF goes ahead, the overall equity beta of SU will consist of 60%
furniture retailing and 40% clothing retailing.

• The market return is expected to be 7% pa and the risk-free rate 2% pa.

• Assume that the rate of corporation tax will be 25% for the foreseeable future.
• SU’s total dividends for the past five years ending 31 December are shown in the chart
below:

Total Dividend
20
18
16
14
12
£m

10
8
6
4
2
0
2018 2019 2020 2021 2022
Year to 31 December

Note: Due to the one-off sale of some assets, the total dividend for the year ended 31
December 2022 includes a special dividend of £4 million

Requirements

1. Ignoring the purchase of HF, calculate SU’s cost of equity at 31 December 2022 using:
• the dividend valuation model (dividend growth should be estimated using the earliest
and latest dividend information as appropriate); and (3 marks)

• the CAPM (1 mark)

2. Comment on the suitability of using the dividend growth rate you have calculated in 1.
above to calculate the cost of equity of SU. (3 marks)

3. Using the CAPM, calculate SU’s current WACC at 31 December 2022, ignoring the
purchase of HF. (6 marks)

4. Using the CAPM, estimate the risk adjusted WACC that SU should use to discount HF’s
free cash flows. Explain why this WACC is different to SU’s current WACC that you
have calculated in 3. (7 marks)

5. Calculate the overall equity beta of SU and the WACC of the enlarged company, if the
purchase of HF goes ahead. Explain briefly whether this overall WACC could be used to
evaluate future projects in the enlarged company. (5 marks)

6. Using the gross redemption yield of SU’s existing 6% debentures, calculate the issue
price of the new 4% debentures that form the debt proportion of the finance required to
purchase HF. Discuss whether it is appropriate to use the gross redemption yield of
SU’s existing 6% debentures to arrive at the issue price. (4 marks)

7. Explain how political risk could potentially affect HF. (3 marks)

8. Identify and explain the ethical issues for you as an ICAEW Chartered Accountant
regarding the purchase of HF. (3 marks)
Total: 35 marks
Question 3

Assume the date is 31 December 2022.

You work for a firm of financial analysts that advises Tyrol Ltd (Tyrol), a UK company, and
you are working on two tasks.

3.1 Task 1 – Foreign exchange rate (forex) risk

Tyrol imports goods from Austria and currently uses forward contracts to hedge its forex risk.
The board of Tyrol would like to investigate alternative forex hedging methods, including
money market hedges and over-the-counter (OTC) currency options. Tyrol is due to make a
payment of €2,200,000 in four months’ time on 30 April 2023.

The following information is available at the close of business on 31 December 2022.

Exchange rates
Spot exchange rate (€/£) 1.1900 – 1.1910
Four-month forward contract discount (€/£) 0.0018 – 0.0027

Annual borrowing and depositing interest rates

Euro 3.90% – 3.40%
Sterling 3.30% – 2.90%

Four-month OTC currency options:

• Call options to buy € have an exercise price of €/£1.1930 and a premium of £0.05 per
€ converted.

• Put options to sell € have an exercise price of €/£1.1960 and a premium of £0.04 per
€ converted.

The option premium is payable on 31 December 2022. Interest on the premium should
be ignored.

Requirements

a. Calculate the sterling cost of Tyrol’s €2,200,000 payment using:

• a forward contract
• a money market hedge
• an OTC currency option.

Assume that the spot rate on 30 April 2023 will be €/£ 1.1925 – 1.1950 (9 marks)

b. Explain the advantages and disadvantages of each of the hedging techniques in 3.1 (a).
Advise Tyrol’s board as to which technique to use for hedging its forex risk. (8 marks)

3.2 Task 2 – Interest rate risk

Tyrol needs to borrow £3,150,000 on 31 March 2023 for a period of six months. The loan will
be at an interest rate of SONIA + 3% pa.

The board of Tyrol is concerned about a potential increase in SONIA from its current level of
1% pa over the next three months to 31 March 2023.

The following information is available at the close of business on 31 December 2022:

Forward rate agreements

Term Rate (% pa)

3v6 3.80 – 3.70
3v9 4.00 – 3.90
6v9 4.20 – 4.10

Interest rate futures

March three-month traded sterling interest rate futures are priced at 98.90.

The standard contract size is £500,000.

Requirements

a. Assuming that on 31 March 2023 SONIA is 1.25% pa and the futures price is 98.75,
calculate the six-month interest cost in £ of the £3,150,000 loan using:

• a forward rate agreement; and

• sterling interest rate futures. (8 marks)

b. Explain the relative advantages and disadvantages of each of the hedging techniques in
3.2 (a). Advise Tyrol’s board as to which technique to use for hedging its interest rate
risk. (5 marks)
Total: 30 marks