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Module B, Paper DB1 (examination)
Incorporating subject areas:

• Financial Strategy
• Risk Management.

The examination paper followed the same format as in previous sittings. Section A contained 20 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. Although the general standard of scripts was satisfactory, some candidates were clearly unprepared for the examination and, as a result, did not do themselves justice.

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

The general standard of presentation was satisfactory, although in a few cases candidates would have gained more marks if they had written more legibly or had provided clearer workings. As in previous sittings, candidates often achieved higher marks in the narrative elements than the computational elements of the paper. This is probably due to a lack of familiarity with computational problems. It is, therefore, essential that candidates get plenty of practice in computational areas when preparing for the examination.

Question 1

Question 1 concerned an investment appraisal problem. Part (a) required a calculation of the net present value of a proposed project. Most candidates who attempted this question made a reasonable attempt at this part and some of the marks achieved were very high. However, a number of candidates failed to select the correct cost of capital for use as the appropriate discount rate. The question stated that the proposed project had the same level of risk as that of other projects undertaken by the company and so the weighted average cost of capital was the appropriate discount rate to use.

Part (b) of the question was less well answered. This part required candidates to calculate the required reduction in annual net cash flows from operations before the project becomes unprofitable. Although the calculations required were relatively straightforward, it was clear that a significant number of candidates did not really know how to approach the problem. This was disappointing because similar problems have been included in previous examination sittings and so candidates should have been better prepared. The final part of the question required comments on the calculations undertaken in the preceding parts of the question. This part was generally well-answered with candidates managing to make comments that were consistent with their earlier findings.

Question 2

Question 2 concerned a rights issue of shares. This was a popular question with some candidates who were well-prepared for a question on this topic. As a result, some of the marks achieved were very high. Parts (a) and (b) required candidates to calculate the theoretical ex-rights price of an ordinary share in a company and the price at which the rights were likely to be traded. These two parts were generally well-answered with a large number of candidates scoring maximum marks.

Part (c) required an evaluation of the options available to a shareholder holding 10,000 shares in the company. This part was generally less well done. Too many candidates failed to make the point that the wealth of the shareholder would be unaffected whether the rights were taken up or sold. However, the wealth of the shareholder would be reduced if the rights were allowed to lapse. The final part of the question required a discussion of how critical the pricing of a rights issue is likely to be.

Few managed to make the point that, providing the issue price is below the market value, the price is not critical as it will have no effect on the total value of the underlying assets of the business or, where the rights issue is taken up, the proportion of those assets owned by a particular shareholder.

Question 3

Question 3 concerned the use of debt factoring as a means of raising finance. On the whole, this question provided disappointing answers. The first part required candidates to calculate the net annual cost, or savings, to a business of employing a debt factor. Many who attempted this question struggled with this part and the marks awarded were generally low. Probably the best way to approach the problem was to calculate the costs incurred in financing credit sales using a debt factor and to calculate separately the costs of financing credit sales without the use of a debt factor.

However, many were unable to separate the various costs in this way and the answers provided were often both confused and confusing. The second part of the question required a comparison of debt factoring with invoice discounting. Generally speaking, the answers to this part were satisfactory, although a disturbing number of candidates managed to confuse invoice discounting with offering cash discounts for prompt settlement of trade debts.

Question 4

Question 4 concerned foreign exchange risk. In previous examinations, questions of this type have not proved popular with candidates and such was the case in this examination. The first part of the question required a calculation of the cost of a futures contract and the hedge efficiency of the contract under two different scenarios. A few candidates were well-prepared for such a problem and managed to score very high marks. However, they were in the minority and, on the whole, the answers provided were disappointing.

The second part required a calculation of the outcome under each of two scenarios using over-the-counter options. This part was answered somewhat better than the first part, but answers were still rather disappointing. Parts (c) and (d) required comments on the calculations and on the appropriateness of each hedging instrument. Although the narrative parts of questions are usually better answered, the general standard achieved in this case was not high. Overall, the marks awarded for this question were low.

Question 5

Question 5 was concerned with capital structure and company valuation. The first part of the question required calculations to find the value of a company using the dividend valuation model. Before doing so, however, it was necessary to calculate an asset beta, using information from a similar company, and to use this figure in the CAPM model to derive the cost of equity for the company to be valued. The first part of the question also required calculations to find the value of a company using the Modigliani and Miller (MM) proposition concerning the value of a geared company. These calculations proved rather too challenging for most candidates and, as a result, marks were generally low.

The second part of the question required an examination of the arguments for and against the view that the capital structure of a company has no effect on the value of a company. Candidates seemed better prepared for this topic and many were able to discuss the traditional and MM views without difficulty.

Question 6

Question 6 was concerned with the role of audit in contributing towards an effective system of corporate governance. This was a popular question and many of the answers provided were either of a good or satisfactory standard. Most candidates managed to differentiate the roles of the external auditor and the internal auditor and were able to discuss the role of each in the context required by the question. However, candidates often found it more difficult to explain the relationship between the internal auditor and the external auditor. Nevertheless, the marks awarded overall were often high.

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