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Introduction

The pass rate for this sitting was satisfactory, with the majority of candidates producing projects of a good standard. In this sitting, marks were more widely dispersed than in previous sittings. Candidates tended to score either high marks or low marks with relatively few marginal candidates. The main weakness displayed by candidates was the failure to adopt a more thoughtful approach to the issues raised. In previous reports it has been mentioned that any principles or points raised should take account of the particular circumstances that are set out in the case study. Failure to do this results in answers that are too broad and superficial. 

Specific comments

The case study upon which the question was based concerned a biotechnology company, Burrator plc, which is a wholly-owned subsidiary of a large pharmaceutical company. Burrator plc is about to be demerged and the questions posed were based around the proposed demerger.

Part (a) was divided into four sub-parts. Part (a)(i) carried 10 marks out of 100 marks for the whole project and required candidates to calculate the average cost of capital for Burrator plc.

To answer Part (a), the ungeared beta of a similar company had to be calculated. This could then be used in the CAPM formula to calculate the cost of equity capital for Burrator plc. This part was often answered well with many candidates gaining full marks. In some cases, however, candidates had no clear idea as to how the problem should be approached and so scored low marks. In other cases, candidates were able to identify the approach required but were unable to apply the formula in the correct manner. In particular, the correct weighting of debt and equity when calculating the ungeared beta proved problematic.

Part (a)(ii) carried 27 marks and required candidates to suggest a value for the shares in Burrator plc based on both the lower end and the higher end of expectations concerning future market demand for its products.

This sub-part required candidates to calculate future sales from each of the company’s products and then to forecast the future discounted net cash flows arising from the company’s operations. Once again, this part was often answered well with the majority of candidates adopting an appropriate approach to the problem. However, a number of candidates came unstuck on specific technical points. In particular, candidates experienced problems in taking account of the probability of success of those products still in the pipeline and the treatment of development costs of the new products, which were fully reimbursed. In some cases, candidates were unable to grasp the approach needed and resorted to simple valuation models, such as the dividend growth model, to calculate a share value. Given the wealth of information available concerning future market demand, market share, costs etc, any approach used should have taken this information into account.

Part (a)(iii) carried eight marks and required candidates to value the shares of Burrator plc using an alternative approach in order to test the reliability of the share value figure derived in Part (a)(ii).

Most candidates employed the
price-earnings approach to share valuation and used the P/E ratio of a similar listed company to undertake the valuation. This is a
forward-looking valuation method and was an appropriate choice. Some candidates, however, chose to use the net assets approach to share valuation, rather than the P/E ratio method. While this approach could be used, it has serious limitations and is much less likely to provide a suitable means of testing the reliability and validity of the DCF-based measure used in Part (a)(ii). Overall, marks awarded for this sub-part were high.

Part (a)(iv) carried 11 marks and required candidates to recommend an allocation of shares in Burrator plc for shareholders in the parent company and to assess the effect of the demerger on the wealth of a large shareholder in the parent company.

To answer this sub-part, the EPS of the parent company had to be calculated and the market value of a share, before and after the proposed demerger, could then be calculated using the P/E ratio method. The value of the total shareholdings before and after the demerger, and taking into account the shareholdings in the newly-demerged company, could then be compared. This part was answered well by most candidates and marks were generally high.

Part (b) carried 16 marks and required a briefing paper setting out the criteria that may be used in the annual appraisal of a
non-executive director of Burrator plc.

This part was rarely answered well. Too often a rather mechanical approach was adopted, whereby candidates simply listed the attributes required of a non-executive director, based either on the Combined Code or some other authoritative source. There was no real attempt to clearly specify the criteria for assessment or to take account of the particular needs of the company. To gain higher marks, most candidates had to address the question posed in a more thoughtful manner.

Part (c) carried 28 marks and concerned the identification, assessment and management of risks of Burrator plc.

Most candidates made a reasonable attempt to this part, although the identification of risks posed fewer problems than the ways in which they may be assessed and managed. Once again, the main weakness in the answers provided was the failure to adopt a more thoughtful approach to the issues and to tailor the answer to the company’s situation. Too often, answers to this part were rather superficial and failed to take account of information provided in the case study.