top stories

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 covering both the Financial Strategy and Risk Management syllabuses. Section B was devoted to the Financial Strategy syllabus and contained three questions. Section C was devoted to the Risk Management syllabus and also contained three questions. 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

Standards of presentation were generally satisfactory and candidates appeared to have heeded advice given in previous examination reports concerning the need for workings to be clearly shown. There was still evidence, however, of candidates gravitating towards narrative questions and shying away from computational questions. It has been mentioned in previous reports that this seems to be due to a lack of familiarity in dealing with computational questions. It is worth therefore repeating the advice given in the past, that candidates should get plenty of practice in computational areas when preparing for the examination.

Question reports

Question 1 concerned an investment appraisal problem. Overall, answers to this question were satisfactory with some candidates scoring very high marks. Part (a) required a calculation of the incremental cash flows for a proposed project. To answer this part correctly, candidates needed to identify relevant cash flows. The written down value of the machine, market survey costs and re-allocation of existing overheads were all irrelevant and so should have been excluded from any calculations. The majority of candidates were able to identify some but not all of these irrelevant items. Part (b) required a calculation of the internal rate of return. Although most candidates made a reasonable stab at this part of the question, a number struggled. Many of those who struggled appeared to have understood the general approach that was needed but were unfamiliar with its application. Part (c) required a discussion of the viability of the proposal and part (d) required a discussion of the internal rate of return method. The general standard of answer for both parts was satisfactory.

Question 2 concerned the operating cash cycle. Overall, answers to this question were satisfactory. Part (a) required an explanation of the operating cash cycle and why it is important. Most candidates managed to explain the term reasonably well but an explanation of its importance was less well done. Candidates would have scored high marks for pointing out that the length of the operating cash cycle can have a significant effect on both financing needs and financing risks. Part (b) required an understanding of how the operating cash cycle can be reduced and what problems might ensue as a result of doing this. This part was reasonably well answered. Most candidates were able to identify ways in which the cycle could be reduced and managed to discuss at least some of the problems to be faced. Part (c) required a calculation of the operating cash cycle. Most candidates knew the relevant ratios that are required to make this calculation but a significant number struggled with the necessary calculations. This usually arose because of confusion over what figures the key ratios, such as the creditor settlement period, should contain. Many also failed to use average, rather than year end figures in the calculations. Part (d) required a discussion of an external, short-term source of finance that may be used by a business. A surprising number of candidates either failed to understand the question or failed to read the question carefully. Hence, many answers contained irrelevant discussions concerning long-term sources of finance, such as the issue of share capital and debentures, or discussions of internal sources of finance, such as adjustments to credit periods for debtors and creditors.

Question 3 concerned venture capital as a source of finance. This question was a popular choice among candidates and generally the standard of answers was satisfactory. Part (a) required candidates to explain the term ‘venture capital’ and to identify the types of businesses that might appeal to a venture capitalist. Most candidates were able to explain the term, although a few confused venture capital with joint ventures. Identifying the types of businesses that might appeal to venture capitalists proved a slightly more difficult task, however, most recognised that venture capitalists sought high returns and were prepared to accept the level of risk that is commensurate with such returns. Part (b) required a discussion of the main issues that the board of directors should consider when considering the use of venture capital. This part produced the weakest answers with many candidates managing only one valid point. Part (c) required a discussion of the factors that a venture capitalist would consider when assessing an investment opportunity. This part was generally done well with many candidates scoring high marks.

Question 4 was concerned with establishing a dividend policy. Although popular, this question was not very well answered. Many candidates displayed a lack of knowledge of key theoretical issues. Part (a) required a discussion of comments made by the chairman and chief operating officer of a business concerning dividend policy. A good answer would have discussed the Modigliani and Miller propositions as well as the clientele effect and signaling effect. However, few candidates discussed these factors, with too many answers devoid of any theoretical underpinning. Part (b) required an examination of the dividend policy pursued by the company. Answers to this part were generally better with many candidates undertaking relevant calculations to highlight the erratic pattern of dividends. Part (c) required a discussion of key points to be taken into account when establishing a dividend policy. This part provided a few reasonable answers but, on the whole, the points made were fairly weak. Candidates could have used the work of Lintner and others to gain high marks.

Question 5 was concerned with interest rate hedging. This was not a popular question and few good answers could be found. Part (a) required a description of a cap, a floor and a collar. This provided the best answers with some candidates scoring high marks. Most candidates had a reasonable idea of the underlying principles of these hedging devices. Part (b) required a calculation of effective interest rates using a cap and a collar. Once again, the application of principles provided candidates with their biggest challenge. Many struggled with the calculations and few managed to score high marks. Part (c) required a discussion of an alternative hedging device. Most candidates chose interest rate swaps as an alternative and the general standard of answers was satisfactory.

Question 6 concerned securitisation This question was not very popular, despite having no computational element. It seemed that few candidates were expecting to be tested on this area of the syllabus. Although a few excellent answers were provided, the majority candidates had only a tenuous grasp of the topic and so could only manage to make a few valid points. In some cases, candidates were clearly confused and discussed security for a loan rather than the process of securitisation.

Back to top