CIMA F3 - Financial Strategy

Under CIMA F3 (Financial Strategy), sensitivity of operating profit to exchange-rate movements is assessed using transaction exposure: where revenues/costs are denominated in a foreign currency, the home-currency value of those cash flows changes when the exchange rate moves. Because all four companies have the same total revenue and cost levels in K$, the company whose net EUR cash flow is largest (in absolute terms) will have the greatest potential impact on operating profit growth when the EUR/K$ rate changes.

Treat exports as EUR inflows and imports as EUR outflows. Compute each company’s net EUR position:

Company A: EUR exports 20 − EUR imports 10 = +10 (net EUR receivable)

Company B: EUR exports 18 − EUR imports 0 = +18 (net EUR receivable)

Company C: EUR exports 21 − EUR imports 25 = −4 (net EUR payable)

Company D: EUR exports 0 − EUR imports 15 = −15 (net EUR payable)

Now compare absolute exposures: |+10|, |+18|, |−4|, |−15| ⇒ largest is 18 for Company B. Therefore, Company B’s operating profit (and hence its year-on-year growth objective) is most sensitive to movements in the EUR/K$ exchange rate, because the K$ value of its EUR-denominated net inflows will vary the most as rates change.

Workings:

Z$ profit after tax = 10m

Tax rate in Z = 20%

Pre-tax profit in Z:

101−0.20=100.8=12.5m\frac{10}{1 - 0.20} = \frac{10}{0.8} = 12.5\text{m}1−0.2010​=0.810​=12.5m

Home country Y taxes at 50%, with full double tax relief → overall tax rate becomes 50% on pre-tax profits:

Net profit after all tax in Z$:

12.5×(1−0.50)=6.25m12.5 \times (1 - 0.50) = 6.25\text{m}12.5×(1−0.50)=6.25m

Exchange rate: Y$1 = Z$5 → convert:

6.255=1.25m\frac{6.25}{5} = 1.25\text{m}56.25​=1.25m

So expected profit in Y$ = 1.25m → A.

Earnings attributable to ordinary shareholders = profit after preference dividend = $500m.

Current number of shares = 1,250m.

Current EPS = 500 / 1,250 = $0.40 per share.

Share repurchase: 20% of 1,250m = 250m shares bought back and cancelled.

New number of shares = 1,250m − 250m = 1,000m shares.

Assuming profit is unchanged:

New EPS = 500 / 1,000 = $0.50 per share.

Increase in EPS = 0.50 − 0.40 = $0.10 → $0.100.

The division is:

Currently loss-making

Has generated negative free cash flow

Requires significant new investment to return to profitability

Under CIMA F3 valuation principles:

Dividend growth model (A) – not suitable: the division does not pay dividends and may not be a standalone listed entity.

P/E ratio on forecast earnings (D) – inappropriate where current earnings are negative and future earnings highly uncertain.

Discounted forecast free cash flow (C) is theoretically strong, but here forecasts are likely to be very uncertain because profitability depends on substantial new investment by the buyer.

In such cases, the asset-based valuation (B) is often most useful as a negotiation tool: it provides a defensible view of what the business is worth in terms of its underlying net assets and sets a floor for acceptable sale price.

So the most useful approach in negotiations is B. Asset basis.

The pre-acquisition share prices are:

Company S: $5.00

Company T: $4.00

Shareholders in Company T want a 25% premium on the value of their shares, based on T’s current price:

Required value per T share=4.00×1.25=$5.00\text{Required value per T share} = 4.00 \times 1.25 = \$5.00Required value per T share=4.00×1.25=$5.00

Now value each offer using Company S’s pre-acquisition share price of $5:

A. 2 S shares for 1 T share

Value received = 2×5=$102 \times 5 = \$102×5=$10 → 150% premium (too high)

B. 1 S share for 1 T share

Value received = 1×5=$51 \times 5 = \$51×5=$5 →

Premium =5−44=25%= \frac{5 - 4}{4} = 25\%=45−4​=25% ✅

C. 1 S share for 2 T shares

That’s 0.5 S per T → 0.5×5=$2.500.5 \times 5 = \$2.500.5×5=$2.50 → actually a discount

D. 10 S shares for 4 T shares

That’s 2.5 S per T → 2.5×5=$12.502.5 \times 5 = \$12.502.5×5=$12.50 → huge premium (>200%)

Only offer B gives T’s shareholders exactly a 25% premium.

Correct answer: B – 1 share in Company S for 1 share in Company T.

Before announcement:

Equity = 4m shares × $4.0 = $16m

Debt = $7m

Gearing = 7 / 16 = 43.75% → already above 40%.

After additional $2m debt and higher share price:

Debt = 7 + 2 = $9m

Equity = 4m × $4.2 = $16.8m

Gearing = 9 / 16.8 ≈ 53.6% → even further above the 40% ceiling.

So the gearing objective is exceeded both before and after, and gearing rises.

The seller will mainly care about:

Protecting the rest of the group – whether the sale would damage the remaining divisions.

Receiving an acceptable price – whether the MBO team can actually finance the deal.

Evaluate each option:

A: Confidential information about other divisions – If the team leaves and runs an independent business, they could use that confidential information against the remaining divisions. This clearly influences the parent’s decision. ✅

B: Skills/experience important to other divisions – If these managers are key to the success of other divisions, the parent may not want to lose them. This also directly affects the decision. ✅

C: Ability to raise finance at a reasonable price – If the team cannot raise sufficient funds, or can only do so on terms that depress the price, the parent might not proceed. This is crucial to whether the sale can happen. ✅

D: Ability to manage the divested division successfully – this matters more to the venture capitalist than to the selling company once the division is sold.

E: Conditions imposed by the venture capitalist – primarily a concern for the management team and VC, unless they somehow affect the sale price or parent’s risk, which is not indicated here.

Correct answer: A, B and C.

A low dividend payout means the company is retaining more profits instead of distributing them. A classic reason (straight from CIMA F3 theory) is that external finance is expensive or hard to obtain, so the firm relies on retained earnings to fund investments.

High profitability (A) usually supports higher dividends.

Lack of investment opportunities (C) would lead to higher dividends, not lower.