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Question 1

Assume that the current date is 30 September 2021.

Designation plc (Designation) designs and produces prototypes of new products for
manufacturing companies based in the UK and has a 30 September year end.

Designation’s managing director believes that it is vital for the company to adopt the latest
technology and has put forward a proposal for an investment in 3D printing equipment.

You are an ICAEW Chartered Accountant working in Designation’s finance department and
have been asked to undertake an appraisal of the 3D printing equipment investment using
NPV.

Information relating to the 3D printing equipment investment:

• An investment of £1.5 million in plant and equipment will be required on 1 October 2021.
The equipment will have an estimated useful life of four years and an estimated scrap
value of £200,000 on 30 September 2025 (in 30 September 2025 prices).

• The 3D printing equipment will attract 18% (reducing balance) capital allowances in the
year of expenditure and in every subsequent year of ownership by the company, except
the final year. In the final year, the difference between the equipment’s written down value
for tax purposes and its disposal proceeds will be treated by the company as either:

o a balancing allowance, if the disposal proceeds are less than the tax written down
value, or

o a balancing charge, if the disposal proceeds are more than the tax written down
value.

• The new equipment will allow Designation to increase its design and production capacity.
The managing director has predicted that the additional revenue that Designation will earn
each year as a result of the increased capacity will be as follows (in 30 September 2021
prices):

Year to 30 September 2022 £180,000

Year to 30 September 2023 £240,000
Year to 30 September 2024 £340,000
Year to 30 September 2025 £460,000

• The managing director expects Designation to save £250,000 per year (in 30 September
2021 prices) as a result of a reduction in labour costs and other operational efficiencies
that can be achieved by the 3D printing equipment.

• If the new equipment is purchased, the following one-off costs (in 30 September 2021
prices) will be incurred in the year to 30 September 2022:

Staff redundancy costs £120,000

Staff training costs £100,000

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• Unless stated otherwise, assume that the following rates of inflation apply to all revenues,
costs and cost savings:

Year to 30 September 2022 and 2023 3% pa

Year to 30 September 2024 and 2025 2% pa

• Assume that corporation tax will be payable at the rate of 17% for the foreseeable future
and that the corporation tax will be payable in the same year as the cash flows to which it
relates.

• The finance director has calculated the following money discount rates that should be
used to assess this investment:

Year to 30 September 2022 and 2023 14% pa

Year to 30 September 2024 and 2025 13% pa

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

Corporation tax

Designation’s sales director is concerned that there have been recent reports in the media
which suggest that the rate of corporation tax may increase. The government is due to
confirm whether any changes will be made to corporation tax rates in November 2021. Some
reports suggest that the corporation tax rate may be increased from 17% to 25% at some
point in the next few years.

However, Designation’s managing director is very keen to proceed with this investment and
wants Designation’s directors to make the investment decision now, based on the
assumption that the rate of corporation tax will not change in the future.

The managing director is putting pressure on members of the finance department to

complete the NPV calculation before any government announcement is made about potential
corporation tax changes.

Impact on dividends

Designation needs to declare a dividend by the end of October 2021. Dividends paid have
increased at a steady rate for several years.

The managing director has proposed that the shareholders should receive a lower dividend
so that the cash saved from paying a lower dividend can be used to fund the 3D printing
equipment investment. The managing director believes that the shareholders will be willing to
receive a reduced dividend because they will appreciate that this investment will have a long-
term benefit for the company.

Requirements

1. Using money cash flows, calculate the NPV of the 3D printing equipment investment on
30 September 2021 and advise Designation’s directors whether to proceed with the
investment. (14 marks)

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2. Using the tax cash flows from your calculation in requirement 1, calculate the sensitivity of
the investment decision to changes in the rate of corporation tax and discuss this
sensitivity with reference to the recent media reports on possible changes to this tax rate.
(6 marks)

3. Identify the potential ethical issues relating to the managing director’s attempt to ensure
that the 3D printing equipment investment is appraised before any announcement is
made relating to changes in the corporation tax rate. (3 marks)

4. Discuss how Designation’s shareholders may react to the company declaring a lower
dividend than in previous years. (8 marks)

5. Explain what is meant by the term ‘real options’ and identify two real options associated
with the 3D printer investment. (4 marks)

Total: 35 marks

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Question 2

Assume that the current date is 30 September 2021.

Norcom plc (Norcom) manufactures telecommunications equipment. You are Norcom’s

finance manager and have been given two tasks to complete by the board of directors.

2.1 Task one: foreign exchange rate (forex) risk hedging

Norcom sells equipment to a major customer in the US. On 31 March 2022 Norcom is due to
receive $8 million from this customer.

Norcom’s equipment uses technology that is licensed from a software development company
also based in the US. On 31 March 2022 Norcom is due to make a payment of $5 million to
the software provider.

The board of directors would like to use hedging techniques to mitigate the forex risk on
these transactions.

The following information is available on 30 September 2021:

Exchange rates

Spot rate ($/£) 1.2540 – 1.2542

Six-month forward contract discount ($/£) 0.0043 – 0.0044

Annual borrowing and depositing interest rates (%)

US dollar 3.70 – 3.20

Sterling 3.30 – 2.80

Over-the-counter (OTC) currency options

March put options to sell $ are available with an exercise price of $1.2590 per £. The
premium is 3.4 pence per $ and is payable on 30 September 2021.

March call options to buy $ are available with an exercise price of $1.2580 per £. The
premium is 4.8 pence per $ and is payable on 30 September 2021.

Norcom currently has an overdraft.

Requirements

a. Calculate Norcom’s net sterling receipt on 31 March 2022 if it uses the following to
hedge its forex risk:

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

Assume that the spot rate will be $/£ 1.3242 – 1.3244 on 31 March 2022. (9 marks)

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b. Discuss the relative advantages and disadvantages for Norcom of the three hedging
techniques used in (a) above and advise the board of directors which technique would
be most beneficial for Norcom. (8 marks)

c. Identify and explain two risks (other than forex risk) that Norcom is exposed to as a
result of trading overseas. (4 marks)

2.2 Task two: interest rate risk hedging

Norcom will need to borrow £2.1 million for a period of six months from 31 December 2021 to
30 June 2022.

The board of directors is keen to ensure that the interest rate on the loan does not exceed
3.50% pa. You have been asked to show how sterling interest rate options or a forward rate
agreement might be used to manage the company’s interest rate risk.

The following information is available on 30 September 2021:

Sterling Interest Rate Options on 3-month Futures Contracts

Standard contract size: £500,000

Premiums in annual % terms

Calls Puts
Strike price Sep Dec Mar Sep Dec Mar

96.00 0.72 0.76 0.81 0.02 0.03 0.04

96.25 0.46 0.49 0.53 0.05 0.07 0.09
96.50 0.20 0.22 0.25 0.08 0.10 0.13

Forward rate agreements

Term Rate (% pa)

3v6 3.42 – 2.48

3v9 3.50 – 2.40
6v9 3.60 – 2.36

Requirement

Assuming that the spot interest rate for borrowing on 31 December 2021 is 4.10% pa and the
futures price is 95.90, calculate the net interest cost of the £2.1 million loan using the
following hedging techniques:

• sterling interest rate options

• a forward rate agreement

Interest on option premiums should be ignored. (9 marks)

Total: 30 marks

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Question 3

Assume that the current date is 30 September 2021.

Eco-efficient Energy plc (Eco) is a UK listed company providing gas and electricity using
renewable energy sources. Eco’s mission is “to minimise the environmental impact of
providing energy to the local community”.

You work for a firm of ICAEW Chartered Accountants who advise Eco’s board of directors on
investment and finance decisions. You have been asked to provide advice on two issues.

3.1 Issue one: finance decision

Eco’s directors wish to raise £10 million of finance to fund three investments which will
provide additional energy from renewable resources. The combined net present value of the
three investments is expected to be £1.5 million.

The finance director has identified two alternative sources of finance to raise the funds
required.

1-for-4 rights issue

£10 million could be raised by a 1-for-4 rights issue on 1 October 2021, priced at a discount
on the current market value of Eco’s shares.

Eco has in issue 20 million ordinary shares which are trading at £2.40 per share on 30
September 2021.

6% redeemable bonds

Alternatively, £10 million could be raised by an issue of five-year redeemable bonds with a
coupon rate of 6% pa. The bonds would be issued on 1 October 2021 and would be
redeemed on 30 September 2026 at par value. Assets from the three investments would
need to be used as security for these bonds.

Bonds issued by other listed companies in Eco’s market sector have typically offered a gross
redemption yield of 7% pa. However, the finance director has suggested that Eco should
apply to the Climate Bonds Standards Board to request that the bonds are recognised as
‘green bonds’. Investors typically require a lower gross redemption yield on green bonds
because they receive tax incentives. The finance director has estimated that investors would
only require a gross redemption yield of 6.25% pa if the bonds were classed as green bonds.

Requirements

a. Assuming a 1-for-4 rights issue is made on 1 October 2021, calculate the theoretical ex-
rights price of one ordinary share and explain why this may be different to the actual ex-
rights price. (6 marks)

b. Based on the theoretical ex-rights price calculated in (a) above, show the impact that
the rights issue would have on the wealth of an Eco shareholder who currently owns
5,000 shares and who:

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 • takes up all of the rights
• sells all of the rights
• takes no action
(5 marks)

c. Assuming redeemable bonds are issued on 1 October 2021, calculate the issue price
per bond and the total nominal value of the bonds that will have to be issued to give the
gross redemption yield required by investors if:

• the bonds are not recognised as green bonds, and

• the bonds are recognised as green bonds.
(6 marks)

d. Identify the benefits for Eco of issuing green bonds and suggest two reasons why Eco’s
bonds may qualify as green finance. (5 marks)

e. Outline any other factors that Eco’s board of directors should consider when deciding
whether the finance required should be raised by a rights issue or an issue of
redeemable bonds. (5 marks)

3.2 Issue two: investment decision

Eco’s board of directors plans to invest the funds raised in the three renewable energy
projects outlined below:

Investment Net present value

required
£ £
Project 1: Wind farm 4,500,000 540,000
Project 2: Solar farm 3,000,000 510,000
Project 3: Hydro-electricity station 2,500,000 450,000
10,000,000 1,500,000

Due to uncertainties in the financial markets, the directors are concerned that Eco may not be
able to raise the full funds required. The directors would like to know what combination of
projects should be chosen if the total amount of funds raised is only £7 million, assuming that
all three projects are fully divisible.

Whilst all three projects will provide additional energy for the local community from renewable
resources, there have been negative media reports about the impact that hydro-electricity
stations can have on wildlife in the rivers where the stations operate.

Requirements

a. Explain the difference between hard and soft capital rationing and identify which type of
capital rationing applies to Eco if only £7 million is raised. (3 marks)

b. Assuming that £7 million is available to invest, determine the combination of projects

that would maximise Eco’s shareholders’ wealth. (3 marks)

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c. With reference to the concerns raised in media reports, comment on whether the
combination of projects that you have identified in (b) above is consistent with Eco’s
mission. (2 marks)

Total: 35 marks

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