CIMA F3 - Financial Strategy

This question examines loan covenant compliance, a topic covered in CIMA F3 under Debt Finance, Financial Risk, and Dividend Policy. Loan covenants are contractual restrictions imposed by lenders to protect their interests. Breaching a covenant can trigger penalties or loan repayment demands, so directors must assess compliance carefully using projected financial information.

The company has two covenants:

Interest cover must not fall below 4 times

Retained earnings for the year must not fall below $5.00 million

Step 1: Interest Cover Covenant

CIMA F3 defines interest cover as:

From the projections:

EBIT = $25.00 million

Interest = $3.20 million

Since 7.8 > 4, the company meets the interest cover covenant.

Step 2: Retained Earnings Covenant

Earnings after tax are projected at $15.26 million.

The most recent dividend per share is $0.10, and dividends are planned to increase by 8%:

With 100 million shares in issue:

Retained earnings for the year:

Since $4.46 million < $5.00 million, the company breaches the retained earnings covenant.

Conclusion (CIMA F3 Interpretation)

Interest cover covenant: Complied with

Retained earnings covenant: Breached

Under CIMA F3 guidance, directors must recognise that even when profitability appears strong, dividend policy can cause covenant breaches if distributions are excessive.

(A) describes a collar, not a pure cap. With a collar you sell a floor and buy a cap; that reduces the premium cost. (B) is wrong because with a collar you don’t benefit from rates falling below the floor. (D) is not necessarily true – options can be traded via markets or other counterparties, not just the company’s bank.

The IIRC’s Integrated Reporting Framework is about showing how an organisation creates value over short, medium and long term, not just financial but using all capitals.

From the projections, the company’s interest cover remains above the required 3 times, so that covenant is satisfied. However, after paying the increased dividend (10% rise in DPS), the retained earnings for the year fall below the required $3.5 million, so the company would breach only the retained earnings covenant.

Dividend Growth Model (DGM):

P0=D1ke−gP_0 = \frac{D_1}{k_e - g}P0​=ke​−gD1​​

Dividend just paid: D0=0.08D_0 = 0.08D0​=0.08

Dividend growth: g=2%=0.02g = 2\% = 0.02g=2%=0.02

Cost of equity: ke=15%=0.15k_e = 15\% = 0.15ke​=15%=0.15

Future dividend:

D1=D0(1+g)=0.08×1.02=0.0816D_1 = D_0 (1+g) = 0.08 \times 1.02 = 0.0816D1​=D0​(1+g)=0.08×1.02=0.0816

Theoretical price:

P0=0.08160.15−0.02=0.08160.13≈0.63P_0 = \frac{0.0816}{0.15 - 0.02} = \frac{0.0816}{0.13} \approx 0.63P0​=0.15−0.020.0816​=0.130.0816​≈0.63

Current market price = 0.60

Expected change: 0.63−0.60=0.030.63 - 0.60 = 0.030.63−0.60=0.03 increase → Option A.

A scrip issue (bonus issue) is just slicing the same “pie” into more pieces – no new value is created.

Issue: 1 new share for every 4 existing → after the issue, each holder who had 4 shares will now have 5.

Total value before = 4 shares × $20 = $80.

After the issue, that $80 is spread over 5 shares:

Price after=805=$16\text{Price after} = \frac{80}{5} = \$16Price after=580​=$16

So the best estimate of the ex-scrip share price is $16.00.

IFRS 7 requires sensitivity analysis for market risks: currency risk, interest rate risk and other price risk (which includes commodities), not credit or liquidity.

Answer: A, C, D

Interest rate parity (IRP) says the forward exchange rate adjusts so that investors earn the same return in different currencies once hedged, otherwise arbitrage profits would exist. If parity doesn’t hold, traders can lock in risk-free gains, and their trades push rates back to parity.

So the model works well because:

Answer: C – Any divergence from parity can be observed by the market and corrected by arbitrage.

Consider each statement:

A. Foreign tax rate 40% – higher than home 20% → disadvantage.

B. Double tax treaty – avoids double taxation on profits remitted → advantage.

C. 100% Year-1 tax depreciation in foreign country – big early tax shield → advantage.

D. High customs duties on imports into foreign country – makes exporting costly; local production via subsidiary avoids duties → advantage.

E. Restrictions on remitting profits – makes getting cash out difficult → disadvantage.

Answer: B, C, and D