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Diploma in Financial Management - December 2007  - Examiner’s report

Paper DB1 incorporating subject areas
- Financial strategy
- Risk management

The examination paper followed the same format as in previous sittings. Section A contained twenty multiple-choice questions, which covered both the Financial Strategy and Risk Management syllabuses. Section B, which contained three questions, was devoted to the Financial Strategy syllabus and Section C, which also contained three questions, was devoted to the Risk Management syllabus.

The question report set out below considers the candidates’ performance in the six questions contained within Sections B and C of the examination paper.

General comments

Overall, the standard of scripts was satisfactory.

The examination questions in Sections B and C consisted of three computational questions and three narrative questions. Although candidates have too often shown a preference for narrative questions in the past, the computational questions were answered reasonably well with some candidates scoring very high marks.

There was, however, some evidence of poor examination technique. A minority of candidates seemed to manage their time poorly as some answers were either provided in note form or were incomplete. In addition, a few candidates did not appear to read the instructions carefully and answered four questions rather than a total of three from Sections B and C. As a result, valuable time was wasted.
 

Question 1 concerned an investment appraisal problem. Part (a) required candidates to calculate the net present value of a project, which involved the production of a new product and to comment on the viability of the project. Candidates were provided with projected income statements for the project as well as additional information relating to the project. Various adjustments had to be made to the figures provided in the income statements in order to derive the relevant cash flows. On the whole, this part was answered satisfactorily, although some candidates struggled to identify some of the relevant cash flows. The failure to adjust correctly for the materials and components costs and the inclusion of interest charges in the net present value calculations were common sources of error.

Part (b) required candidates to explain the reasons for adjustments that were made to the figures provided in order to determine the relevant cash flows. Although some candidates scored well on this part, a surprising number had difficulty in justifying the reasons for making particular adjustments. In some cases, a description of the adjustment made rather than a rationale for the adjustment was provided.

Part (c) required an explanation as to why the net present value method was an appropriate method to use when assessing the financial viability of the project. This part was usually answered well with many candidates gaining a clear pass on this element. Some candidates, however, missed the central feature of the net present value approach. Although they often recognised that it takes account of the time value of money and only takes into consideration relevant cash flows, they failed to point out that it is consistent with shareholder wealth maximisation, which was the stated objective of the company concerned.

Question 2 required an evaluation of a proposal for a company to introduce a discount policy for trade receivables. Part (a) required candidates to calculate the forecast net income under the company’s existing policy and under a policy where discounts for prompt payment were given. This part was usually well answered with many candidates scoring high marks. However, the expense figure for discount allowed was often incorrectly calculated. Part (b) required a calculation of the forecast investment in working capital under the same two scenarios as in Part (a). This part was usually less well done with few candidates scoring high marks. Inventories held were often calculated on the basis the selling price of goods rather than their cost price and many candidates struggled when trying to calculate the appropriate trade receivables and trade payables figures. The final part required a discussion of the calculations in (a) and (b) and a decision concerning whether the discount policy should be adopted. This part was usually well done although some candidates failed to provide a decision, as required, and so failed to gain full credit.

Question 3 concerned mergers and acquisitions. This question proved to be popular with candidates although it was often not attempted well and many candidates failed to achieve high marks. This was disappointing as it was a fairly straightforward topic, which is covered in some detail in the manual. Part (a) required candidates to outline the operating and financial synergies that may accrue as a result of a merger or acquisition. Often candidates were only able to identify two or three types of synergy and were sometimes confused as to whether these were operating or financial synergies.

Part (b) required candidates to discuss whether diversification through mergers and acquisitions was an effective means of reducing risk and securing future growth. Although the idea of risk reduction through diversification is appealing, the question that must be asked is whether the shareholders or the company should undertake this themselves. Often, shareholders can diversify their portfolio of investments more cheaply than companies by purchasing the relevant shares on the stock market. This point, however, was rarely mentioned in the answers provided. Nevertheless, some candidates managed to identify problems that may undermine future growth prospects such as rivalry between the two management teams and a lack of cultural fit.

Part (c) required candidates to outline the advantages and disadvantages of both share-for-share exchange and cash payments as forms of bid consideration. This part was often answered reasonably well. Most candidates managed to identify two or three points that were relevant to each form of bid consideration and marks for this part were generally higher than for the other parts of the question.

Question 4 concerned the weighted average cost of capital. Relatively few candidates attempted this question and the general standard of answers from those who did was disappointing. Part (a) required candidates to calculate the weighted average cost of capital (WACC) for a particular company. This involved calculating the cost of the individual elements of capital and then determining the weighted average cost of these elements. A common problem was that candidates tried to calculate the cost of debt capital using the formula for irredeemable debt rather than for redeemable debt. The question clearly stated, however, that the debt was redeemable and so a discounting approach was required. Calculating the cost of equity often produced better answers, although in some cases the dividend growth model was either not used or applied incorrectly.

Part (b) required a brief discussion of the implications of calculating the WACC incorrectly. Most candidates made a reasonable attempt at this part and displayed an awareness of its possible effect on net present value calculations. Part (c) required a discussion of the assumptions underpinning the use of the WACC as a discount rate in investment appraisal. This part often produced reasonable answers, although some candidates merely described how the WACC is calculated rather than seeking to identify the assumptions associated with its use.

Question 5 was concerned with risk management. The question described a small company that had recently been taken over and whose senior managers were required to implement an Enterprise Risk Management (ERM) approach in order to comply with the policies laid down by its new owners. Part (a) required candidates to identify the problems associated with the company’s current approach to risk management and to explain how an ERM approach differed from this approach. Most candidates recognised that the current approach did not take a holistic or integrated view of managing risks whereas an ERM approach does. For this, credit was given. However, a detailed discussion of the differences between the two approaches was rarely provided. Part (b) required a discussion of the benefits of employing an ERM approach. Most candidates made a reasonable attempt at this part, although surprisingly few mentioned the potential benefits of ERM in improving shareholder value.
The final part of the question required a discussion of the problems of implementing an ERM approach within the company and how these problems may be overcome. This part was done reasonably well with many candidates recognising the possibility of cultural problems and resistance among senior managers.

Question 6 concerned audit committees. This proved to be a very popular question although the standard of answers provided was rarely high. This was disappointing as the area was covered in an article appearing in Finance Matters, which candidates should have read. Part (a) required candidates to outline the role of the audit committee and to explain how this role might be carried out. Most candidates made a reasonable attempt at outlining the role but often failed to explain how this role may be carried out. As fulfillment of the committee’s role was an important element, which carried almost half the marks for Part (a), it was a costly omission. Part (b) required a discussion of the problems that might be confronted by a listed company having an audit committee. This part was rarely well attempted and often candidates struggled to identify possible problem areas.