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ACCA

Paper P4

Advanced Financial Management June 2016

Revision Mock – Answers

To gain maximum benefit, do not refer to these answers until you have completed the revision mock questions and submitted them for marking.

Some of these answers are longer than the examiner would have expected from students in the time available. See the marking schemes to assess how many points were needed to achieve a pass.

ACCA P4: ADVAN CED F INAN CIAL MAN AGEME NT

2 KAPLAN PUBLISHIN G

© Kaplan Financial Limited, 2016

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, and consequential or otherwise arising in relation to the use of such materials.

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

REVIS ION MOCK ANSWE RS

KAPLAN PUBLISHIN G 3

1 BUGG CO

REPORT To: The Directors, Bugg Co From: An Advisor Date: Today Subject: The proposed Runan investment

Introduction

I have evaluated the proposed Runan investment by calculating its APV (see Appendix). I have also discussed the impact of austerity measures, the use of WACC and APV in investment appraisal, and the other factors that need to be considered before undertaking the project.

(a) Austerity measures

The austerity measures introduced by European governments have generally focussed on increasing tax rates and reducing government spending, in order to enable the governments to reduce budget deficits and pay off debt.

This has led to citizens having less money to spend, so demand has been reduced for many goods in Europe.

However, we are told that Bugg Co’s sales and profits have grown slightly over the last few years, which initially seems odd given the general downturn in the recessionary markets.

Perhaps the reason for this is the nature of the product being manufactured by Bugg Co. Oven heating elements are not a luxury purchase, where purchase could be delayed in a time of austerity. Instead, a heating element is a necessity, so demand for the heating elements is likely to be extremely inelastic.

Admittedly in these recessionary times, demand for new ovens in newly built homes has probably reduced, which might be why the sales and profits of Bugg Co have not grown dramatically.

However, sales of replacement heating elements for ovens that have broken down is likely to be just the same as ever, so this is probably why Bugg Co’s overall sales and profits have not been adversely affected by the austerity measures.

(b) Use of WACC and APV in investment appraisal

The weighted average cost of capital (WACC) is the effective after-tax cost of the different sources of finance used by a company. The costs of the different sources are normally weighted by their market values.

WACC - merits

WACC is often used to discount the incremental cash flows of an investment in order to estimate the NPV (net present value), the expected change in corporate value resulting from the investment. In order to add value for shareholders it is necessary for the return from an investment to exceed the WACC. WACC is therefore a very useful tool to assist in project evaluation and the measurement of wealth creation.



WACC - problems

However, it has some problems and limitations. It is sometimes not clear about whether or not to include short-term finance such as overdrafts in the estimate of the weighted average cost of capital and in theory WACC should not be used when:

(i) There is a significant change in the capital structure of the company as a result of the investment.

(ii) The operating risk of the company changes as a result of the investment.

(iii) The investment has complex tax payments and tax allowances, and/or periods when tax is not paid.

(iv) There are subsidised loans or other benefits associated explicitly with an individual project.

In such circumstances the adjusted present value (APV) may be a better technique to analyse investments than the WACC with NPV.

APV - merits

APV requires the estimation of the base case NPV of operating cash flows (discounted at the ungeared cost of equity) and, separately, the present value of any financing side effects. It allows more complex financing situations to be dealt with, and the different types of cash flow, with different risks, to be discounted at a rate specific to the individual risk.

APV - problems

However, APV also has theoretical and practical problems.

In order to estimate the APV, it is necessary to correctly identify all of the financing side effects, and the risk of each individual side effect. This is not an easy task, especially for international investments. APV also relies on some of the unrealistic assumptions of the Modigliani and Miller model (with tax), for example the equation for asset betas used in most APV estimates assumes that cash flows are perpetuities, which is normally not the case.

(c) Investment appraisal

The information provided has been used to assess whether the production of the BBB should be moved to Runa from Europe. Initially a base case net present value calculation is conducted to assess the impact of the production in Runa. This is then adjusted to show the impact of cash flows in Europe as a result of the move, the immediate impact of ceasing production and the impact of issue costs, the subsidy and the tax shield benefits from the loan borrowing.

The calculations presented in the appendix show that the move will result in a positive adjusted present value of approximately €3.9 million.

On this basis, the production of BBB should cease in Europe and the production moved to Runa instead.

Assumptions

Several assumptions have been made in preparing the calculations:

It has been assumed that the borrowing rate of 6% is used to calculate the benefits from the tax shield, since this reflects the risk associated with these cashflows. It could be argued that the risk free rate of 3% could be used as the discount rate



instead of 6% to calculate the present value of benefits from the tax shields and the subsidies (in line with Modigliani and Miller’s assumptions). In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not necessarily the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used for the capital investment and the working capital. It has been assumed that the arrangement fee on the loan would be paid out of existing cash resources, so would not need to be covered by increased borrowings. The project NPV has been computed using Bugg Co’s existing all-equity discount rate. This assumes that the business risk associated with the new project is identical to the existing risk of Bugg Co’s operations in Europe. Given that the new project will be based in a different country, this is unlikely to be the case.

It has been assumed that many of the input variables, such as for example the tax and capital allowances rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate over the five-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would be appropriate for Bugg Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions.

(Note: credit will be given for alternative relevant assumptions)

(d) Other factors to consider

The calculations in the Appendix indicate that the new project is very likely to increase shareholder wealth.

However, before a final decision is made, the following factors should also be considered:

Political risk

A change of government could have a significant impact on whether or not the project is beneficial to Bugg Co. The current government of Runa has agreed to provide the finance at a subsidised rate, and (through a public sector company) to buy the business from Bugg Co in five years’ time.

If the government changes in the next five years, either because of democratic elections or even a coup, the new government’s policies may be very different and less favourable to Bugg Co. The directors should seek written assurances from the existing government, and should also assess the likelihood of a new government recognising such assurances in the future.

If Runa is perceived to be a country with an unstable government, perhaps it would be better for Bugg Co to abandon the plans now before the initial investment is made.

Real options

Bugg Co should consider the possibility of becoming established in Runa, and this may lead to follow-on projects. The real options linked to this should be included in the analysis.

Bugg Co needs to consider if the project can be delayed at all. From the calculations, it can be seen that a large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the start of the project may increase the overall value of the project.



Strategy

Bugg Co’s overall corporate strategy should be considered. Does the project fit within this strategy? Even if the decision is made to close the operation in Europe, there may be other alternatives and these need to be assessed.

Culture

The amount of experience Bugg Co has in international ventures needs to be considered. For example, will it be able to match its systems to the Runan culture? It will need to develop strategies to deal with cultural differences. This may include additional costs such as training which may not have been taken into account.

Reputation

Bugg Co needs to consider the impact on its reputation due to possible redundancies. Since the production of the BBB is probably going to be stopped in any case, Bugg Co needs to communicate its strategy to the employees and possibly other stakeholders clearly so as to retain its reputation. This may make the need to consider alternatives even more important.

Financing

Even though Bugg Co intends to borrow the money from the Runan government at a subsidised rate, it is worth noting that the rate at which Bugg Co could borrow euro funds is lower than even this subsidised rate. Of course, the expected movement in the exchange rate over the five year period means that Bugg Co would be exposed to significant exchange rate risk if it borrowed money in euros. However, if Bugg could borrow the euros and set up a hedge (perhaps using a forex swap) it may be possible to find a low risk, cheaper source of finance in euros.

(Note: credit will be given for alternative relevant comments)

Conclusion

In conclusion, the project’s adjusted present value is positive, indicating that the project is financially beneficial.

As long as the analysis of other factors doesn’t reveal any major potential problems, the project should be undertaken.



Appendix

Runan Project Operating Cash Flows

(All amounts in RR/€000’s)

Year Now 1 2 3 4 5 Sales revenue (W2) 41,890 81,206 183,526 247,824 305,844 Local variable costs (W3) (9,600) (19,360) (45,496) (63,888) (81,990) Imported component (W4) (1,745) (3,519) (8,271) (11,615) (14,908) Fixed costs (15,000) (16,500) (18,150) (19,965) (21,962) Profits before tax 15,545 41,827 111,609 152,356 186,984 Taxation (w5) (109) (5,365) (19,322) (27,471) (34,397) Investment (115,000) 140,000 Working capital (20,000) (2,000) (2,200) (2,420) (2,662) 29,282 Cash flows (RR) (135,000) 13,436 34,262 89,867 122,223 321,869 Exchange rate (w1) 27.50 29.09 30.76 32.54 34.42 36.41 Cash flows (€) (4,909) 462 1,114 2,762 3,551 8,840 Discount factor at 12% (W6) 1 0.893 0.797 0.712 0.636 0.567 Present values (€) (4,909) 413 888 1,967 2,258 5,012

Net present value (NPV) of the cash flows from the project is approx. €5,629,000. Adjusted present value (APV) €000 NPV of project cash flows (above) 5,629 PV of European cash flows (extra tax and opportunity cost) (W7) (3,743) Closure revenues and costs (€5m – €4m) 1,000 Financing side effects (Issue costs, tax shield and benefit of subsidy) (W8) 1,011 –––––– Total APV 3,897 ––––––

Workings

(1) Exchange rates

Year 1 2 3 4 5 RR/€1 27.50 × 1.10/

1.04 = 29.09 29.09 × 1.10/ 1.04 = 30.76

30.76 × 1.10/ 1.04 = 32.54

32.54 × 1.10/ 1.04 = 34.42

34.42 × 1.10/ 1.04 = 36.41

(2) Sales revenue (RR 000s)

Year 1 2 3 4 5 Price × units × exchange rate

120 × 12 × 29.09 = 41,890

120 × 22 × 30.76 = 81,206

120 × 47 × 32.54 = 183,526

120 × 60 × 34.42 = 247,824

120 × 70 × 36.41 = 305,844

(3) Local variable costs (RR 000s)

Year 1 2 3 4 5 Cost × units × inflation after yr 1

800 × 12,000 = 9,600

800 × 22,000 × 1.10 =19,360

800 × 47,000 × 1.102 =45,496

800 × 60,000 × 1.103 =63,888

800 × 70,000 × 1.104 =81,990



(4) Imported component (RR 000s)

Year 1 2 3 4 5 Price × units × inflation after year 1 × exchange rate

5 × 12,000 × 29.09 = 1,745

5 × 22,000 × 1.04 × 30.76 =

3,519

5 × 47,000 × 1.042 × 32.54 =

8,271

5 × 60,000 × 1.043 × 34.42 =

11,615

5 × 70,000 × 1.044 × 36.41 =

14,908

(5) Taxation (RR 000s)

Year 1 2 3 4 5 Profits before tax 15,545 41,827 111,609 152,356 186,984 Tax allowable depreciation (15,000) (15,000) (15,000) (15,000) (15,000) Profit/(loss) after depreciation 545 26,827 96,609 137,356 171,984

Taxation (20%) (109) (5,365) (19,322) (27,471) (34,397)

(6) Runa project all-equity financed discount rate

• Bugg Co equity beta = 1.40 and debt beta = 0.20 • MVe = €1.32 × 40m shares = €52.8m • MVd = €20m × €122/€100 = €24.4m • Bugg Co asset beta: • [1.40 × 52.8m/(52.8m + 24.4m × 0.7)] + [0.20 × 24.4m × 0.7/(52.8m + 24.4m ×

0.7)] = 1.11 • Project all-equity financed discount rate = 3% + 8% × 1.11 = 11.88%, say 12%

for discounting (7) Additional tax and opportunity cost (€000s)

Year 1 2 3 4 5 Additional tax 10% × Taxable profits/exchange rate

0.10 × 545/29.09

= (2)

0.10 × 26,827/30.76

= (87)

0.10 × 96,609/32.54

= (297)

0.10 × 137,356/34.42

= (399)

0.10 × 171,984/36.41

= (472) Opportunity cost Units × contribution × (1 – tax)

50 × €30 × 0.7 = (1,050)

40 × €30 × 0.7 = (840)

32 × €30 × 0.7 = (672)

25.6 × €30 × 0.7 = (538)

20.48 × €30 × 0.7 = (430)

Total cash flows (1,052) (927) (969) (937) (902) DF at 9% 0.917 0.842 0.772 0.708 0.650 PV of cash flows (965) (781) (748) (663) (586) NPV €(3,743,000)



(8) Financing side effects (€/RR 000s)

Tax shield (RR) Year 1 2 3 4 5Interest × loan × tax rate

7% × 135,000 × 20% = 1,890

1,890 1,890 1,890 1,890

Annual subsidy benefit (RR) Interest gain × loan × (1 – tax rate)

8% × 135,000 × 0.8 = 8,640

8,640 8,640 8,640 8,640

Total tax shield + subsidy benefits (RR)

10,530 10,530 10,530 10,530 10,530

Exchange rate (RR/€1) 29.09 30.76 32.54 34.42 36.41Cash flows (€) 362 342 324 306 289DF at 6% 0.943 0.890 0.840 0.792 0.747PV of cash flows 341 304 272 242 216

NPV of tax shield and subsidy benefit is €1,375k and the initial issue cost (arrangement fee) is RR 10 million/27.50 = €364k.

Therefore, the net financing side effect benefit is 1,375 – 364 = €1,011,000



Marking scheme Marks

(a) 1 mark per sensible comment throughout Max 4 ––– Maximum 4 (b) 1 mark per sensible comment throughout –––– Discussion of WACC Max 4 Discussion of APV Max 4 ––– Maximum 8 ––– (c) Estimated future rates based on purchasing power parity 1 Sales rev, var costs, component cost and fixed costs (in RR) – 1 each 4 Taxable profits and taxation – 1 each 2 Investment and terminal value (1 mark) and working capital (1 mark) 2 Cash flows in RR 1 Cash flows in € 1 Discount rate of all-equity financed project 2 Base case PVs and NPV 2 PV of additional tax and opportunity cost (1 each) 2 PV of issue costs (1 mark), tax shield (2 marks) and subsidy (1 mark) 4 Closure costs and benefits 1 Initial comments and conclusion Max 2 Assumptions – 1 mark per sensible point Max 4 ––– Maximum 25 ––– (d) Other factors (1 to 2 marks per well explained factor) Max 9 ––– Maximum 9 ––– Professional Marks Report format 1 Layout, presentation and structure 3 ––– Maximum 4 ––– Total 50 –––



2 MAC CO

(a) The yield on a bond is the IRR of the market value, the annual interest payments and the redemption amount. Therefore, in the case of Echo Co: Year Cash

flow Discount

rate Present value

Discount rate

Present value

$ 5% $ 3% $ 0 Market Value (105.10) 1 (105.10) 1 (105.10) 1–4 Interest 5.00 3.546 17.73 3.717 18.59 4 Capital repayment 100.00 0.823 82.30 0.888 88.80 ––––– ––––– (5.07) 2.29 ––––– –––––

The approximate yield is therefore:

3% + [2.29/(2.29+5.07)]2% = 3.62%

It seems fair to assume that the Bunnymen Co bonds will have the same yield as the Echo Co bonds, since the bonds have the same term to maturity and the two companies have the same credit rating.

Therefore the theoretical value of the Bunnymen Co bonds will be equal to the investor’s expected returns (interest and redemption amount) discounted at the yield (3.62% calculated above) i.e.

[$110 × 4-year discount factor @ 3.62%] + [$2 × 4-year annuity factor @ 3.62%]

= ( )

−×+

×

−

0362.00362.112$

0362.11110$

4

4

= ($110 × 0.867) + ($2 × 3.663)

= $102.70

(b) Duration is found by taking the the sum of (time to maturity × PV of receipts) for the bond, and then dividing by the theoretical bond price.

Echo Co bond (PV of receipts)

5 × 1.0362–1 + 5 × 1.0362–2 + 5 × 1.0362–3 + 105 × 1.0362–4

So PV of cash flows (years 1 to 4) = 4.83 + 4.68 + 4.49 + 91.10 = $105.10

(i.e. market price)

Duration = [4.83 × 1 + 4.68 × 2 + 4.49 × 3 + 91.10 × 4]/105.10 = 3.73 years

Bunnymen Co bond (PV of receipts)

2 × 1.0362–1 + 2 × 1.0362–2 + 2 × 1.0362–3 + 112 × 1.0362–4

So PV of cash flows (years 1 to 4) = 1.93 + 1.83 + 1.79 + 97.15 = $102.70

(i.e. theoretical market price)

Duration = [1.93 × 1 + 1.83 × 2 + 1.79 × 3 + 97.15 × 4]/102.70 = 3.89 years



(c) Risk v return

The main consideration for any investment is the trade-off between risk and return.

The risk associated with a corporate bond is reflected by the issuing company’s credit rating. In this case both Echo Co and Bunnymen Co have an A credit rating, so the expected return (yield) from the two bonds is the same (3.62% – see workings in part (a) above).

Note that another contributing factor to this identical yield is that the term to maturity of the two bonds is the same. If the two bonds had had different terms to maturity, the longer dated bond would most probably have had a higher yield. This is because the yield curve for bonds is generally upward sloping.

If Mac Co wants a higher yield from its bonds, it has to be prepared to take on an increased level of risk, either by investing in a lower rated company, or by investing in longer dated bonds (which are inherently more risky because of the longer time to redemption).

Pattern of receipts and Macauley duration

Another consideration is the split of the return on the bond between its coupon return and its redemption payment. In this case, even though the two bonds have identical yields, the higher coupon on the Echo Co bonds means that Mac Co would receive its return from the Echo Co bonds sooner than the return from the Bunnymen Co bonds (where the bulk of the return comes at the end, in the large redemption payment). This issue is what the Macauley duration attempts to measure.

Duration measures the average time it takes for a bond to pay its coupons and principal and therefore measures the redemption period of a bond. It recognises that bonds which pay higher coupons effectively mature ‘sooner’ compared to bonds which pay lower coupons, even if the redemption dates of the bonds are the same. This is because a higher proportion of the higher coupon bonds’ income is received sooner. Therefore these bonds are less sensitive to interest rate changes and will have a lower duration.

As calculated in part (b) above, the Echo Co bonds (with the higher coupon rate) have a lower duration. This is indicative of lower risk, so note that even though we were told to assume that the yields on the two companies’ bonds were identical, in reality the yield on the Echo Co bonds may be slightly lower to reflect this lower risk.

(d) Industry risk measures the resilience of the company’s industrial sector to changes in the economy. In order to measure or assess this, the following factors could be used:

• Impact of economic changes on the industry in terms of how successfully the firms in the industry operate under differing economic outcomes

• How cyclical the industry is and how large the peaks and troughs are • How the demand shifts in the industry as the economy changes. Earnings protection measures how well the company will be able to maintain or protect its earnings in changing circumstances. In order to assess this, the following factors could be used:

• Differing range of sources of earnings growth • Diversity of customer base • Profit margins and return on capital.



Financial flexibility measures how easily the company is able to raise the finance it needs to pursue its investment goals. In order to assess this, the following factors could be used:

• Evaluation of plans for financing needs and range of alternatives available • Relationships with finance providers, e.g. banks • Operating restrictions that currently exist as debt covenants. Evaluation of the company’s management considers how well the managers are managing and planning for the future of the company. In order to assess this, the following factors could be used:

• The company’s planning and control policies, and its financial strategies • Management succession planning • The qualifications and experience of the managers • Performance in achieving financial and non-financial targets.

Marking scheme Marks (a) IRR method – correct use of MV, Int and Redemption amount 1 IRR calculation 1 Bond value – correct method (discounted value of interest stream and

redemption amount at YTM) 1

Correct value calculation 1 Total part (a) Maximum 4 (b) Correct formula/method used 1 Echo Co calculation 2 Bunnymen Co calculation 2 Total part (b) Maximum 5 (c) 1-2 marks per sensible point throughout Max 8 Total part (c) Maximum 8 (d) For each of the four criteria – 2 marks for explanation and suggestion of any

sensible factors Max 8

Total part (d) Maximum 8 –––

Total 25 –––



3 PERIGUEUX CO

Tutorial note

This answer contains lots of detailed workings, in order to show different ways of presenting the answer. The answer is therefore longer than a good student’s answer in the real exam would have been.

(a) Perigueux Co can borrow at LIBOR + 0.75 (currently 7.25%).

Using a futures hedge the company will attempt to make a futures gain in order to offset a possible cash market loss if interest rates rise. As the primary concern is an interest rate rise (because the company is borrowing money), the company will sell futures contracts.

Cash market

Current cost of borrowing for 4 months is:

£18,000,000 × 7.25% × 4/12 = £435,000

If interest rates increase by 150 basis points, or 1.5%, the new cost of borrowing will be:

£18,000,000 × 8.75% × 4/12 = £525,000

This represents a cash market 'loss' of £90,000.

Futures market

Sell March futures contracts (as March is the nearest expiry after the borrowing commences).

In order to hedge a 4-month risk:

000,500£000,000,18£

× 34 = 48 contracts are required

Basis is (100 – Spot rate of interest (e.g. the current LIBOR rate)) – futures price.

i.e. (100-6.50%) - 93.10 = 0.40%

At maturity of the futures contract at the end of March, the basis will be zero. Assuming basis falls at a constant rate, the expected basis when the loan is taken at the start of February will be 0.20% or 20 basis points. (The contract matures in four months’ time, and the loan is taken out in two months’ time, so basis will be 2/4 × 40 = 20 basis points.)

Interest rates rise by 1.5%

The expected futures price in 2 months will be 93.10 – 1.50 + 0.20 = 91.80.

The futures position will be closed by buying 48 contracts at 91.80. The gain on closing out will be (93.10 – 91.80) = 1.30 or 130 points.

The total expected futures gain if the 48 contracts are closed out in 2 months’ time is:

48 × 130 × £12.50 per point = £78,000.



The overall cost of the loan is expected to be: £ Cost of borrowing at 8.75% 525,000 Gain on futures hedge 78,000 ––––––– 447,000 ––––––– £447,000 represents an effective interest rate on borrowing £18 million for four months of:

(£447,000/£18 million) × (12/4) × 100% = 7.45%.

Tutorial note

This 'lock in rate' of 7.45% could alternatively been calculated as:

100 – (current futures price + unexpired basis on the transaction date)

i.e. 100 –( 93.10 + 0.20) = 6.70%

adjusted for Perigueux Co’s own credit spread of 0.75% (above the LIBOR rate)

i.e. 6.70% + 0.75% = 7.45%

Interest rates fall by 0.5%

If interest rates fall by 50 basis points, the new cost of borrowing will be:

£18,000,000 × 6.75% × 4/12 £405,000.

This is a cash market 'gain' of £30,000 on the cost of borrowing at the current interest rate (which is £435,000, see above).

The same futures contract will have been used to hedge the risk, and the expected basis at the start of February will still be –0.20%.

The expected futures price in 2 months is therefore 93.1 + 0.50 + 0.20 = 93.80.

The futures position will be closed by buying 48 contracts at 93.80. The expected futures loss if the 48 contracts are closed out in 2 months’ time is (93.10 – 93.80) = 0.70 or 70 points. The total loss on the futures position will be:

48 contracts × 70 × £12.50 = £42,000.

The overall cost of the loan is expected to be: £ Cost of borrowing at 6.75% 405,000 Loss on futures hedge 42,000 ––––––– 447,000 –––––––



This is the same as if interest rates went up by 1.5%, and represents an effective interest rate of 7.45% per annum.

No matter how interest rates move the futures hedge should keep the cost of borrowing below the desired 7.50% maximum.

However, note that in reality any futures gains or losses would occur on a daily basis, not at the end of the period, and basis may not fall at a constant rate. Options March put options are required. (The company would want to exercise the right to sell futures contracts, so it should buy put options.) Perigueux Co will buy 48 put options on March futures.

The worst case scenario for Perigueux Co is if interest rates rise and the options have to be exercised.

Cash market

If interest rates increase by 150 basis points, or 1.5%, the new cost of borrowing will be £525,000 (calculation shown earlier).

Options market

Using the 93.00 exercise price

Buy 48 March put options contracts, at a cost of £18m × 0.20% p.a. × 4/12 = £12,000.

If interest rates increase by 1.5%, the options will be exercised and 48 futures contracts will be sold at the exercise price of 93.00. (Note: It might be possible to sell the options themselves at a better rate as they still have some time value.)

Expected profit = 93.00 – 91.80 (the expected futures price in 2 months) = 120 points per contract.

The total expected gain is 48 contracts × 120 × £12.50 = £72,000.

The overall cost of the loan is expected to be:

£ Cost of borrowing at 8.75% 525,000 Cost of option premiums 12,000 Gain on options hedge (72,000) ––––––– 465,000 –––––––

This represents an effective interest rate on a four-month loan of £18 million of:

(£465,000/£18 million) × (12/4) × 100% = 7.75% p.a.



The expected profit is 93.50 – 91.80 (the expected futures price in 2 months) = 170 points.

The expected total gain is 48 × 170 × £12.50 = £102,000.





A net cost of £459,000 represents an effective interest rate on a four-month loan of £18 million of:

(£459,000/£18 million) × (12/4) × 100% = 7.65% p.a.



The expected profit is 94.00 – 91.80 (the expected futures price in 2 months) = 220 points.

The expected gain is 48 × £12.50 × (94.00 – 91.80) × 100 = £132,000.



A net cost of £474,000 represents an effective interest rate on a four-month loan of £18 million of:

(£474,000/£18 million) × (12/4) × 100% = 7.90% p.a.

Tutorial note

The cheapest of these three options could have been calculated as:

Exercise Interest Plus put price rate premium Total cost 93.00 7.00% 0.20% 7.20% 93.50 6.50% 0.60% 7.10% 94.00 6.00% 1.35% 7.35%

Which shows that the 93.50 option is the cheapest of the three.

If interest rates fall by 50 basis points, the new cost of borrowing will be:

£18m × 6.75% × 4/12 = £405,000.

The expected futures price will be 93.80 (see earlier).



The 93.00 and 93.50 options will not be exercised and the overall cost will be:

(1) 93.00 exercise price: £405,000 + £12,000 = £417,000 or 6.95%

(2) 93.50 exercise price: £405,000 + £36,000 = £441,000 or 7.35%

The 94.00 contract will be exercised giving an expected profit of 94.00 – 93.80 (the expected futures price in 2 months) = 20 points.

The expected total gain is 48 × 20 × £12.50 = £12,000.

The overall cost of the loan is expected to be: £ Cost of borrowing at 6.75% 405,000 Cost of option premiums 81,000 Gain on options hedge (12,000) ––––––– 474,000 –––––––

A net cost of £474,000 represents an effective interest rate on a four-month loan of £18 million of 7.90% p.a.

Conclusion

If basis is expected to fall to -0.20%, none of the option contracts has a maximum expected interest rate (including option premium) of 7.50%, although the 93.50 exercise price is close to it. If the finance director does not wish to pay more than 7.5%, hedging with futures should be selected.

An option collar might also be possible in this situation, if Perigueux Co is prepared to limit the benefit from any fall in interest rates.

(b) Market traded interest rate options have several advantages over OTC options:

(i) There is greater price transparency, with current prices on the market immediately available and widely disseminated, which facilitates the management of option positions.

(ii) Exchange traded options offer greater liquidity, with easy sale or purchase of options of a known standard quality.

(iii) There is a central marketplace, with quick access to large numbers of buyers and sellers.

(iv) Lower counterparty risk. Contracts are marked to market on a daily basis, and a central clearing house monitors the ability of all counterparties to meet their obligations.

(v) Better regulation. Most options exchanges are subject to stringent regulation by government authorities.

(vi) Market traded options are normally American style and may be exercised at any time. OTC options are often European style, and can only be exercised at their maturity date.



Advantages of OTC options include:

(i) OTC options offer a much larger choice of contract size, maturity, and type of interest option which allows the purchaser of the option to tailor the option much more specifically to individual needs.

(ii) Option sizes are typically much larger on the OTC market.

(iii) Options may be arranged for longer periods than is possible on traded options markets.

(c) Option prices are influenced by the following factors: (i) The price of the underlying security, in this case a specific interest bearing

instrument.

(ii) The exercise price of the option.

(iii) The time until expiry of the option.

(iv) The risk of the option, as normally measured by the historic volatility of a similar option.

(v) The level of interest rates within the economy.

(vi) Whether the option is European style or American style, the American style being more flexible and slightly more expensive.

Whether or not the option is expensive will depend upon whether it has been correctly priced, which will itself largely depend upon what assumptions have been made by the seller of the OTC option about the volatility of the option.

OTC options are not very price transparent, but there is a competitive market in such options, and reputable banks and other sellers of options have little to gain in the long run by overpricing options. There is, however, evidence that some forms of options have been substantially more expensive than would be expected from option pricing models.



Marking scheme Marks (a) Futures Set up hedge: – sell futures and March futures (1 mark for both) 1 – 48 contracts 1 Current basis 1 Expected basis on 1 February 1 Interest rates rise by 1.5% Expected futures price on 1 February, and gain on futures 1 Overall cost of borrowing (borrowing cost net of futures gain), and effective

interest rate 1

Interest rates fall by 0.5% Expected futures price on 1 February, and loss on futures 1 Overall cost of borrowing (inc. futures loss), and effective interest rate

Futures lock in rate 1 3

Options Use 48 March put options 1 Identification of the 93.50 option as the cheapest 1 Premium payable for options 1 Interest rates rise by 1.5% Cost of options if exercised – 1 mark for each exercise price Max 3 Interest rates fall by 0.5% Identification of the fact that 93.00 and 93.50 would not be exercised 1 Cost of 94.00 options if exercised 1 Comments/assumptions throughout – 1 mark per sensible point Max 5 Total part (a) Maximum 16 (b) 1 mark per sensible, well-explained point throughout Max 4 Total part (b) Maximum 4

(c) List of factors impacting option price (max 3 marks for all 5 key BSOP

variables – Pa, Pe, r, s, t – with 0.5 marks deducted for each omission)Max 3

Comments on OTC options being expensive – 1 mark per sensible point Max 3 Total part (c) Maximum 5

––– Total 25

–––



4 RUBIDIUM

(a) Corporate risk diversification

One of the primary reasons put forward for all mergers but especially conglomerate mergers is that the income of the combined entity will be less volatile (less risky) as its cash flows come from a wide variety of products and markets. This is a reduction in total risk, but has little or no affect on the systematic risk.

Will this benefit the shareholders?

The basic answer is no. Shareholders should diversify for themselves, because a shareholder can more easily and cheaply eliminate unsystematic risk by purchasing international unit trusts. Indeed the majority of investors are well diversified. Therefore the more expensive company diversification option is generally not recommended.

However diversification may have some advantages for shareholders:

(i) The company’s credit rating may improve and it may become cheaper to borrow, reducing the WACC and increasing the share price.

(ii) The reduction of total risk may lead to a reduction in bankruptcy risk.

(iii) If the diversification is into foreign markets where the individuals cannot directly invest themselves this may lead to a reduction in their systematic risk. However as it gets easier for individuals to gain access to foreign markets this argument diminishes.

(b) Valuation of Rubidium In order to discuss whether the bids made by Caesium and Francium are 'financially prudent', it is necessary to first present calculations of the valuation of Rubidium.

In order to decide which valuation method(s) to use, first consider the question 'why is Rubidium being purchased?'

From the Caesium perspective:

Caesium is likely purchasing Rubidium as a going concern. Therefore what we should value is what is being purchased i.e. the future earnings/cash flows.

The future earning/cash flows methods:

(1) `The Present Value of the Free Cash Flows

(2) Dividend Valuation Model

(3) P/E ratio method

(4) Market Capitalisation (stock market value)

Ideally the valuation of Rubidium should be based upon the expected net present value of the future free cash flows, but accurate estimates of these cash flows are not be available in this question.

Rubidium Co is a private company so it does not have a quoted share price.

Therefore we only have available to us the Dividend Valuation Model and the P/E ratio method.



From the Francium perspective:

Francium has a strategy of acquiring what are perceived to be undervalued companies. If the intention is to asset strip Rubidium then we should value what is being purchased i.e. the assets. Therefore the realisable value of the net assets would an appropriate approach. However, if asset stripping is not going to occur then the valuation of the future earnings is recommended.

Net Asset Valuation – NAV

€000Book value of net assets 6,500Less Inventory devaluation (€5,500 × 10%) (550) ––––––Net realisable value 5,950 or €1.49 per share ––––––

However a precise estimate of the realisable value of assets is not possible because:

• Information is not provided regarding current realisable values of assets except for inventories.

• The potentially valuable patents are not valued in the statement of financial position.

• Land and buildings have not been revalued for 5 years. Earnings Valuations:

Dividend Valuation Model

The intrinsic value of Rubidium may be estimated using Po = gK

)g1(D

e

o

−+

g is the growth rate in dividends of 9%

Po: 09.016.0

)09.1(1500−

= €23,357k, or €5.84 per share

Weakness of the DVM:

• Its major problem is estimating a future growth rate. • It assumes that growth will be constant in the future this is not true of most

companies. • The model is highly sensitive to changes in its assumptions. • It assumes that dividends are paid annually. Price Earnings Ratio Model

As Rubidium is not listed, a P/E valuation must be based upon the P/E of a similar company. The only available information for a company in the same industry is for Caesium, a much larger company.

Value per share = EPS × Same Industry Adjusted P/E Ratio

P/E ratio of Caesium = 320 ÷ 58 = 5.52 times

Same Industry Adjusted P/E Ratio:

Obviously, no two companies are the same, therefore we cannot simply apply the P/E ratio of one company to another company’s earnings without adjusting for the differences between the two companies.



Since Rubidium is a private company, its shares are less liquid and it may have a less detailed compliance environment and therefore may be more risky than Caesium Co. Therefore we could adjust the P/E ratio downwards. However Rubidium has a much higher historical growth rate earnings of 12% compared with Caesium growth rate of 6% and assuming that the past growth rare will continue in the future, this is a reason to adjust the P/E ratio upwards.

Overall, for simplicity, we shall leave the P/E ratio unchanged to value Rubidium.

Therefore, value of Rubidium shares = 80.5 cents × 5.52 = €4.44

Where are the synergies?

The earnings may change after a merger because of existence of synergies. These are unlikely to be major in the case of Francium as its operations are dissimilar to those of Rubidium. However Rubidium and Caesium are in the same industry so considerable synergies could result from cost savings, sharing of know-how and reduced competition. However, these synergies have not been valued, since no specific information is provided.

Value of the given bids

7 September – Francium bid:

Value of bid per share = €7.10 × 2/3 = €4.73 per share

2 October – Caesium bid:

Cash €1.70

Bond issue

25 shares = €100 of Debt so 1 share = €4 of Debt €4.00 ––––– Total value €5.70 per share

19 October – Francium bid:

Cash €6.00 per share

Commentary

Although all offers are significantly above the estimated asset valuation, the final successful bid is only 16 cents above the dividend valuation model figure. If this is accurate, the bid would seem to be financially prudent. However, Francium’s strategy is to acquire undervalued companies. Unless Francium has knowledge of how to significantly increase the value of Rubidium e.g. by disposing of parts of the operations, or land, the acquisition of Rubidium does not appear to be in line with this strategy.

Additionally financing the €6.00 cash offer with a €24m term loan increases the book value of Francium’s gearing (measured by Total Loans to Equity) from its already high level of 94% ((30+35)/69).

If the stock market is efficient the significant falls in Francium’s share price on the occasions of both of the company’s bids illustrate that the acquisition is not regarded as financially beneficial by the company’s shareholders.



Marking scheme Marks (a) 1 mark per sensible point throughout Max 6 Total part (a) Maximum 6 (b) Net asset valuation – calculation 2 Net asset valuation – comments/criticisms 2 Dividend valuation – calculation 2 Dividend valuation – comments/criticisms 2 P/E valuation – calculation 2 P/E valuation – comments/criticisms 2 Bid value – 7 September 1 Bid value – 2 October 2 Comment on Francium’s strategy of acquiring undervalued companies 1 Comment on the implications of the change in stock market prices 1 Other comments 2 Total part (b) Maximum 19 –––

Total 25 –––

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