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

GENERAL COMMENTS

Overall, the general standard of scripts was satisfactory and this was reflected in the pass rate. Candidates often displayed a preference for the narrative questions rather than the computational questions in the paper. This follows the pattern of previous sittings and may display a lack of confidence in the ability to undertake quantitative analysis. It has been mentioned in previous reports that practice is an essential element in developing the necessary skills and confidence to answer computational questions.

QUESTION 1

Question 1 concerned an investment appraisal problem. Part (a) required candidates to calculate the incremental cash flows from a proposed project. On the whole, this was well answered with a significant number of candidates scoring full marks. A common mistake, however, was to take account of the design and developments costs. These costs, which were to be written off over the life of the project, were sunk costs and therefore irrelevant for decision-making purposes. Part (b) required candidates to calculate the net present value (NPV) and discounted payback period for the project. Most candidates seemed prepared for the NPV calculations, and marks awarded for the answers provided tended to be high. A number of candidates, however, came unstuck when attempting to calculate the discounted payback period. This was usually caused by problems in undertaking the calculations required to derive the precise point between years two and three at which the project achieves ‘break-even’. Although credit was given for correctly undertaking these calculations, they were not strictly necessary and an answer of between two and three years would have been sufficient. To derive a more precise ‘break-even’ point, candidates had to assume that cash flows accrued evenly over time, although there was nothing in the question to suggest that this was the case. Part (c) required candidates to evaluate the investment criteria used in the answer to Part (b) and to recommend whether the project should go ahead. A key point to make was that the NPV method was consistent with the stated aim of the company, which is to maximise shareholder wealth. It is this method, therefore, that is most appropriate for decision-making purposes. Although many candidates were able to discuss the strengths and weaknesses of each investment appraisal method, this key point was often missed.

QUESTION 2

Question 2 concerned a proposed takeover and contained a computational and a narrative element with each awarded significant marks. This was one of the less popular questions and answers tended to be either very good or very weak. Part (a) required the calculation of the offer price for shares in the takeover target, the rate of share-for-share exchange required between the two companies, and the market value of the shares in the bidding company following a successful takeover. To answer this part, the earnings per share (EPS) of each company had to be calculated as these were not provided. These EPS figures could then be multiplied by the relevant price earnings ratio to derive the market value per share for each company. A number of candidates, however, fell at this first hurdle and so were unable to gain high marks. Part (b) required candidates to identify four defensive tactics the target company’s directors might employ to defend against an unwelcome bid. This was a fairly straightforward topic for which well-prepared candidates gained high marks.

QUESTION 3

Question 3 concerned the management of credit. This narrative question was a popular choice for many candidates, although the standard of answers was not very high. Part (a) required a discussion of the main elements of credit policy. Many candidates struggled with this part and were unable to identify the key elements. As a result, marks were often low. Part (b) required a discussion of the particular problems that small businesses might have in managing customer credit. Although most candidates managed to make some general references to resource and staff problems affecting small businesses, fewer managed to identify the particular areas where these problems would impinge on credit management. Part (c) required a discussion of the main sources of information that can be used to assess credit policy. On the whole, this part was better answered than the previous parts, with most candidates managing to gain reasonable marks.

QUESTION 4

Question 4 concerned a company that wished to review its cost of capital. This question had a significant computational element and was not a popular choice. Once again, answers tended to be either very good or very weak. Most candidates managed to gain marks for Part (a) by recognising that the company’s change of direction was likely to change its risk profile. However, Part (b), which required a calculation of the new weighted average cost of capital proved too difficult for many. Although there was evidence that candidates understood the broad approach to be taken, they often struggled with the formulae that had to be applied in the various steps in the process. Part (c) required candidates to discuss the strengths and weaknesses of the approach used in Part (b) and provided many candidates with their main source of marks from this question.

QUESTION 5

Question 5 concerned the role of the chairman of the board of directors. This question was answered reasonably well by many candidates and the general quality of answers was satisfactory. Part (a) required an explanation of the role and responsibilities of the chairman and carried the majority of marks. A key role is to create the right conditions for effective decision-making and the way in which board meetings are organised and managed is at the heart of this role. Although the chairman’s role in the effective functioning of board meetings was referred to in most of the answers provided, a discussion of this role could often have been developed further in order to gain more marks. A common weakness in the answers provided was to ascribe to the chairman responsibilities that were not directly associated with the role. Part (b) required a discussion of the benefits and problems of separating the roles of chairman and chief executive. Most candidates managed to identify the benefits and were able to articulate why this separation of roles is part of the Combined Code. However, fewer were able to identify possible drawbacks with such a separation of roles.

Question 6 concerned the management of risk. Part (a) required a discussion of the main elements of an effective risk management system and carried the majority of marks allocated to this question. This was a fairly straightforward topic and, on the whole, created few problems for candidates. Part (b) required a discussion of the steps that could be taken to ensure that risk management becomes embedded within a company. This part was answered less well, with a number of candidates failing to answer the question posed. Part (c) concerned the role of the audit committee in reviewing the risk management system. This part provided a rather patchy response. Although there were some good answers, the majority of candidates could only muster a few valid points.

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