Paper F3 financial strategy: the ASAP method of tackling scenario-based questions is designed to help you maximise your marks while making the best use of your time, so it's well worth practising repeatedly.In the previous issue, Ian Blackmore showed how the ASAP approach (analyse the requirements, source syllabus knowledge, analyse the scenario, plan your answer) could be applied in answering a scenario-based exam question from the May 2011 P2 paper. Let's now attempt question 3 from November 2011's F3 exam to see how ASAP works in this case. The full paper can be downloaded from CIMA's website at bit.ly/F3Nov2011.
A: Analyse the question's requirements The requirements are as follows:
(i) The terms of the rights issue (to the nearest whole number of shares) at discounts of both 25 per cent and 40 per cent (three marks).
(ii) The yield-adjusted theoretical ex-rights price per share at rights discounts of both 25 per cent and 40 per cent (four marks).
B. Demonstrate the likely impact of the proposed project together with the related rights issue on the wealth of a shareholder with 100 ordinary shares. Your answer should consider rights discounts of both 25 per cent and 40 per cent (four marks).
C. Recommend an appropriate discount - if any - for the rights issue. Your answer should address the concerns raised by each of the three directors: A, B and C. No further calculations are required in this part (eight marks).
D. Advise the directors of DCD on factors that are likely to affect the company's share price, both before and after next month's planned press statement (six marks).
First, note the key verbs used: "calculate" in part A, "demonstrate" in part B, "recommend" in part C and "advise" in part D. The first verb is straight-forward to understand, but the others may not be so clear. "Demonstrate" is defined in CIMA's list of verbs as "prove with certainty or exhibit by practical means". "Recommend" is defined as "propose a course of action", while "advise" is defined as "counsel, inform or notify".
Part A requires you to calculate the terms of the rights issue - ie, in terms of X for Y - and work out the yield-adjusted theoretical ex-rights price for both discount levels.
The key phrase in B is "likely impact". You need to exhibit by practical means the probable effect of the rights issue and the proposed project on the wealth of a shareholder under both potential discount levels. This should be compared against existing shareholder wealth.
Part C requires you to recommend the more beneficial level of discount for the price of the rights issue. Your discussion must consider the comments made by each of the directors.
Part D requires you to advise the directors on information from the scenario that could change the company's share price both before and after the press statement is made. This requirement should lead you to include a discussion of the efficiency of the market.
The post-exam guides written by the F3 examiner give clear advice on how marks were allocated. These guides are available on CIMA's website at bit.ly/F3Pegs and you should review them as part of your exam preparation. They stress the importance of providing fully developed points in your answers, rather than simply giving a list, and of ensuring that your points apply to the scenario. I have included these factors in the following rules of thumb to remember in the exam:
* Assume that each relevant point you make will earn up to two marks.
* To gain maximum marks for each point, you need to do three things: make your point clearly, relate it to the scenario and draw out its implications in terms of how it solves problems facing the company. (This approach is described in more detail in a June 2011 Velocity article by Adrian Sims, which is available at bit.ly/VelocityASAP.)
So for part A the marks available are purely for the calculations. The same applies to part B. For part C, providing one well-explained point for each director's comments will give you six marks. The remaining two marks can be gained by providing another well-explained relevant point and recom-mending a discount level. In part D three well-explained points should secure the full six marks. Alternatively, making six briefly explained points should also give you full marks, but there doesn't seem to be enough information in this particular scenario for you to pull out six different points, so it would seem a better option to explain fewer points in greater depth instead.
This guidance oversimplifies the marking process somewhat, but the general theme - ensure that your answer for each part reflects the number of marks on offer - is important.
S: Source the syllabus knowledge
Scenario-based questions require you to apply your knowledge. When analysing the DCD scenario, you should be thinking about the knowledge you will need to apply in order to satisfy the requirements. Possible topics include:
* Terms of rights issues.
* The formula for the yield-adjusted theoretical ex-rights price (Terp).
* Shareholder wealth.
* Discounted share issues.
* The link between performance and reward.
* Stock market efficiency.
A: Analyse the scenario
Don't simply read the question. You need to be proactive - for example, by underlining or high-lighting key points in the scenario and making annotations in the margin. You are permitted to do this during the 20 minutes of reading time you have at the start of the exam.
Seek out information in the scenario that you can use to help satisfy the requirements. For example, in the DCD scenario you are told:
* The company has ordinary share capital of $70m (paragraph two).
* The shares have a nominal value of $0.50 (para two).
* The current market price per share is $6 (para two).
* The share price has increased from $5.40 three months ago (para two).
* The manufacturing facilities are operating at close to capacity (para three).
* New manufacturing facilities are expected to generate a return of 20 per cent and the current level of return is 15 per cent (para four).
* The rights issue needs to raise $250m (para five).
* The rights issue will be underwritten, but this will be paid out of existing funds (para five).
* The rights issue will be at a discount of either 25 per cent or 40 per cent on the current market price (para. six).
* Directors A, B and C have each given their views on the rights issue, which will need to be addressed (indented points).
* A press statement will be released next month detailing the rights issue and the investment project (final para).
In order to answer part A we need to calculate the number of existing shares, the share price at each discount level and the number of shares to be issued in order to raise $250m. This figure should be rounded up to give whole-number terms for the rights issue. You should have picked out the following points from the scenario:
* Since the shares have a nominal value of $0.50 there are 140 million shares currently in issue.
* The discount should be applied to the current market price of $6.
To answer part B you need to remember to adjust the value of the new shares for the different rate of return that will be generated by the project. The relative increase to be applied to the share price is the new rate of 20 per cent divided by the existing rate of 15 per cent. You will need to compare the shareholder wealth before and after the rights issue at both levels of discount. A base level of, say, 100 shares can be used to illustrate each situation.
Part C requires you to address each director's concerns. You should realise that the point made by director A on share prices seems valid, as the Terp will be lower with a bigger discount. Director A's point about shareholder wealth will be proved correct or incorrect by your answer to part B. You should realise immediately that the point raised by director B is not valid, since the same amount of funds needs to be raised whichever discount is offered, although shareholders may feel they are getting more of a bargain at a bigger discount. You should also recognise that director C has a valid point if a "stable dividend" is taken to mean from a dividend-per-share point of view. In this case there would be more shares in issue, which would require more funds to be able to pay the same dividend per share. But if a stable dividend is considered to be a fixed percentage of earnings, the discount level will have no effect. In addition, if shareholders take up their full entitlement of rights, they will receive the same total dividend irrespective of the level of discount.
For part D you should recognise that the share price has risen in recent months, which suggests that the market's confidence in DCD is growing.
P: Plan your answer
Writing out an answer plan will help to give structure to your answer and should ensure that it covers all the points you want it to. Few examiners look at detailed answer plans, so your plan can be a rough outline showing key headings and key words. Use it as a reminder of these points once you start writing your answer.
To aid your understanding, the points included in the following example are more detailed than those that you would include in your plan:
Part A (seven marks).
* Calculate the issue prices by discounting $6 by 25 per cent and 40 per cent.
* Divide the $250m funds required by the issue price to get the number of shares to be issued. Round up the number of shares to be issued to ensure that the answer can be given in whole-number terms.
* Use the Terp calculation, inflating the price of the new shares by the relative rise in rates of return (20 per cent /15 per cent).
Part B (four marks).
* Use the yield-adjusted Terp results to calculate shareholder wealth under both discount levels.
* Shareholder wealth is total number of shares at relevant Terp less the purchase cost of new shares.
* Use the same base number in each situation to compare wealth.
Part C (eight marks).
* Director A: a larger discount may mean the share price will fall after rights issue. Comment on the shareholder wealth calculations from part B.
* Director B: discounting may make the price look more attractive as a bargain. Shareholders will still need to contribute same level of funds in order to raise $250m.
* Director C: the greater the discount, the more shares will be issued. With more shares, greater funds are required to keep the dividend per share stable. The dividend as a percentage of earnings is unaffected by the discount level. The total dividend to each shareholder will also be unaffected if all rights are taken up.
* Underwriting costs may be relevant.
* Make recommendation.
Part D (six marks).
* Factors that are likely to affect the share price: market efficiency (most likely to be semi-strong and react as the news of the rights issue is made public); whether the market agrees with the company or not about the benefits from the proposed project; how strongly the market supports the rights issue and whether the company can raise sufficient funds.
Once you have planned your answer, you're ready to start writing it. Again, remember the four-point mnemonic acronym - Pert (point, explain, relate, time) -highlighted in the earlier Velocity article:
* Point. Make your points in concise sentences.
* Explain. Make the meaning of your point obvious by using phrases such as "this is a result of". Markers can mark only what you explicitly say, not what you might have meant. For example, using a simple phrase such as "higher risk" will earn fewer marks than a statement such as "risk increases because of potential foreign currency movements affecting the contract".
* Relate. Try to mention the company in the scenario by name in each paragraph and state why the point you are making applies to the problems facing the company.
* Time. You cannot say everything there is to say, so keep within your time allocation.
Above all, remember that the points you make will earn you marks only if they are relevant to the question that has been set.
By Andrew Finch, BPP Learning Media