Advanced Financial Management

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1 Progress Test 2 Advanced Financial Management P4AFM-PT2-Z14-A Answers & Marking Scheme 2014 DeVry/Becker Educational Development Corp.

2 Tutorial note: the answers below are more comprehensive than would be expected in exam conditions. They are provided for leaning purposes. 1 MULTINATIONAL FINANCE Multinational companies will normally seek to minimise the after tax cost of funds whilst keeping risk at an acceptable level. This can be facilitated by: Using international sources of finance, both from international markets such as the Euromarkets, and from individual foreign domestic money and capital markets. Hedging techniques exist to protect against short term and longer term foreign exchange, interest rate and political risk, but the cost of these must be considered as part of the overall cost of any foreign currency financing. Diversifying the type and source of funds, and not relying on funds from one financial market. This protects against adverse economic conditions in individual markets. Taking advantage of market imperfections that make borrowing relatively cheap in some countries, for example through covered interest arbitrage opportunities. Taking advantage of subsidised finance that is offered by individual governments to attract direct investment. Making use of financing innovations, and the flexibility that is offered through swaps, swaptions etc., to modify financing obligations as circumstances change. Using tax haven holding companies as vehicles to move funds between overseas subsidiaries in a tax efficient manner, and to raise new finance without the restrictions that exist in some national markets. 2 SERVING OVERSEAS MARKETS (i) Exporting Exporting allows the use of spare capacity (if any) at existing plants, and is considered a safe way to enter new markets, as costs are likely to be relatively small if the strategy fails. The cost of producing in the home market and exporting is likely to be low relative to establishing a new foreign subsidiary. However exporting has possible disadvantages including: High transportation costs to foreign markets. Tariffs, quotas and trade taxes that are imposed by foreign governments may make exporting difficult and/or expensive. Consumers may prefer locally produced goods. Service, spare parts, repairs and refunds are normally less reliable with exports. Companies often regard exporting as a first step to be followed by direct investment, licensing, franchising or joint-ventures DeVry/Becker Educational Development Corp. All rights reserved. 2

3 (ii) Licensing Licensing involves allowing a local company to manufacture the multinational company s product(s) in return for royalty or other payments. Its main advantage is that it allows the penetration of foreign markets without the necessity for large capital outlays. Additionally, as the product is manufactured by a local company political risk is substantially reduced. Licensing is often used where countries have high import barriers. Transportation costs are also avoided, relative to the alternative of exporting. However, licensing has several possible disadvantages: It is difficult to ensure quality control of the product. The local company might export the product to markets where it directly competes with the multinational s exports from the home market. There may be problems of technology transfer via leaks to competitors, or the licensee company may itself use (or develop) the technology to become a significant competitor of the multinational when the licence period expires. (iii) Foreign direct investment Foreign direct investment normally involves the commitment of substantial amounts of capital and significant risk. It may occur either by establishing a new subsidiary or by acquiring an existing local company, although some countries restrict foreign acquisitions. There are many possible motives for foreign direct investment including: To establish new markets and attract new demand. To benefit from economies of scale. To take advantage of relatively cheap foreign labour, land or buildings. To avoid tariffs and trade restrictions. International diversification (although the benefits to shareholders of this motive are debatable). To use foreign raw materials, avoiding high transportation costs. Reaction to overseas investment by competitors. To take advantage of what is perceived to be an undervalued foreign currency. Exploit monopolistic or competitive advantage. The process of internalisation whereby multinationals maintain competitive advantage through the internal possession and control of information, technology, marketing or other commercial expertise is often cited as an important reason for FDI DeVry/Becker Educational Development Corp. All rights reserved. 3

4 3 PRICE OF CURRENCY OPTION The exercise price i.e., the price at which the underling currency can be bought (in the case of call options) or sold (in the case of put options). Today s price of the underlying currency i.e. the spot exchange rate. The time to go to expiry - the longer the period to expiry the greater the probability that exercising the option will be worthwhile. The volatility of the underlying currency - the option gives protection against downside risk, as well as allowing participation in the upside risk. Accordingly, the greater the volatility of the currency the greater the possibility of a high gain from the option. Domestic interest rates the holder of calls can delay payment for the foreign currency and, in the meantime, deposit their home currency to earn interest. This boosts the value of calls (but damages the value of puts). 4 MAXIMISING EPS Whilst it is important to ensure that the share price is maximised, share price maximisation is dependent upon maximising the present value of future cash flows, not on maximising earnings per share or profits. There is of course a correlation between earnings per share, profit and share price, but, as long as the stock market is efficient, short-term accounting measures are not the most important influence on share price. If the stock market is not efficient then short-term accounting measures might influence the company s share price. In an efficient market, in order to maximise share price the company should concentrate on undertaking capital investments with a positive net present value. Some of the suggestions might anger stakeholders and result in a reduction in share price. For example: (i) Minimising capital investment Minimising capital investment to produce a short-term increase in accounting profit takes a short-term perspective, and could mean ignoring excellent investment projects which would increase the value of the organisation. Shareholder wealth could be reduced as a result of such actions, and employee remuneration could be lower than would be achievable with further investment. (ii) Wages increases less than inflation and sale of sports field Increasing wages and salaries by less than inflation could increase profits, but the detrimental effect on workforce morale might produce the opposite effect, because of reduced efficiency. Conflict with labour unions could occur, and some employees might seek employment elsewhere. Disposal of the sports field could produce a very hostile response from staff. (iii) Delay payment to suppliers There might be some scope for delaying payments, but if this delay is significant, relations with suppliers might be harmed, and the company might face more stringent credit terms from suppliers when new orders are placed. Additionally such a move could result in a lower credit rating with rating agencies, and possibly higher costs of finance. (iv) Delay expenditure on pollution control The company might have some flexibility to delay expenditure on pollution control equipment, but we must ensure that we can still meet all government standards for pollution DeVry/Becker Educational Development Corp. All rights reserved. 4

5 There might be significant local social costs. Delay might harm our reputation in the local community, and with environmental pressure groups. The effect of adverse publicity could outweigh any savings from delaying expenditure. 5 CENTRALISED TREASURY Memo: To: From: All directors of foreign subsidiaries Group Finance Director It is proposed that the group will shortly centralise its treasury functions. Centralisation of group treasury management functions means that decisions regarding currency management, short-term investment and borrowing and financial risk management will be taken centrally rather than at subsidiary level. This will permit significant efficiency improvements and cost savings. The major effects will be that: Decisions will be taken in line with the tactical and strategic objectives of the group as a whole, rather than by individual subsidiaries which might from time to time have different objectives. A central treasury can better appreciate the total foreign exchange exposure position of the group. Netting and matching of receivables and payables in different currencies will be possible, allowing transactions cost savings as only the net amounts need be hedged or transmitted. Better knowledge will exist of total debts and cleared bank balances. This will facilitate interest rate hedging. Surplus cash from one subsidiary will be lent to other subsidiaries at relatively favourable rates, at the very least eliminating a bank lending-borrowing spread. Cash may be aggregated together and invested at better rates, and borrowing may be possible at favourable rates, including from international markets to which individual subsidiaries would not have direct access. It is expensive to establish a high quality specialist treasury management team and supporting technical infrastructure. It is not financially prudent to set up high cost expert teams for each subsidiary. A centralised treasury will collect and analyse relevant economic and financial information, and supply such information to subsidiaries to aid in their decision-making. Transfer prices will be centrally set to try to minimise the group global tax bill. A centralised treasury function, with effective internal controls, will be able to prevent the possibility of major financial losses such as occurred with the collapse of Barings. The main effect of any form of centralisation is of course that some decision-making will be removed from senior managers of the subsidiaries. The centralisation is intended to increase the efficiency of subsidiaries. I would be pleased to receive any comments and suggestions that you have on the implementation process, and can assure you that at all times you will be fully consulted. From time to time centralised treasury decisions, taken in the interests of the group, might distort reported cash flows and/or profitability of subsidiaries. Any such distortions will be removed from data used for the performance evaluation of the subsidiaries, and managers of subsidiaries will only be evaluated on the results of actions over which they have full control DeVry/Becker Educational Development Corp. All rights reserved. 5

6 It is important that information flows to the central treasury from subsidiaries are quick and accurate. Full computer support and links will be provided. If you have specialist knowledge of any local conditions that you feel that the central team needs to be aware of, or if you have any specific questions regarding this new policy please contact me at your earliest convenience. DIVESTMENT There are several advantages that are common to both a sell-off and a demerger. Both offer a way to restructure a company. Restructuring may be to dismantle a conglomerate enterprise in order to focus upon a core competence, to react to a change in the strategic focus of the company, or to sell off unwanted assets. Both forms of restructuring may result in reverse synergy, where the separated elements of the business are worth more than the value of the old combined business. The main difference between a sell-off and a demerger is that the sell-off involves the sale of part of the company to a third party, for cash or some other consideration. Thus control of these assets is lost. However, funds are raised which can be used to develop other parts of the business, or to make acquisitions. A demerger need not involve a change in ownership. One or more new companies are created and the assets of the old company are transferred to these new companies. 7 FREE CASH FLOW (i) Meaning if free cash flow to equity Free cash flow to equity is the cash flow available to a company from operations after interest expenses, tax, debt repayments and lease obligations, any changes in working capital and capital spending on assets needed to continue existing operations i.e. replacement capital expenditure. (ii) Conflicts over use of free cash flow A company that generates a significant free cash flow has to decide how to use such cash flow. In theory, if the company has positive NPV investments (in addition to replacement investments), the cash should be invested in such investments to increase shareholder wealth. Any surplus cash after all positive NPV investments have been undertaken should be returned to shareholders, either in the form of dividends, or possibly by share repurchase. However, it has been suggested by Jensen and others that managers might be reluctant to lose control of the surplus cash. Managerial compensation, power and status are to some extent related to company size, rather than just share price performance. Managers might therefore be motivated to grow the company to a size greater than that which maximises shareholder wealth, for example by investing in negative NPV projects. More commonly managers might make investment decisions that aim to ensure the survival of the company for a longer period, and the survival of their jobs, perhaps by diversifying into new areas. Such decisions might not maximise shareholder wealth. Shareholders might seek to remove free cash flow from managerial control by insisting on large cash dividends, share repurchase schemes, or a higher level of gearing. High gearing increases interest payments and reduces the discretionary cash flow available to managers DeVry/Becker Educational Development Corp. All rights reserved.

7 8 REAL OPTIONS Capital investment decisions are often based upon the present value of expected future cash flows, discounted at a rate that reflects the risk of the project. However, this ignores any actions that can be taken after the project has commenced to alter the cash flows, or any future opportunities that might arise as a direct result of having undertaken the project. Opportunities to respond to changing future circumstances are known as options. When such options relate to capital investments they are commonly known as real options. The existence of real options can significantly add to the value of an investment. If investments are judged only on their expected NPV, and the value embedded in the options is ignored, then an incorrect investment decision might result. Unfortunately the valuation of real options is extremely difficult. In the context of the power station investment a number of options might exist including: The option to abandon the project. This is likely to be easier and more valuable with the gas project than the nuclear project because of the lower cost, and much fewer decommissioning problems of the gas project. The option to expand production. This is also likely to be more valuable with the gas project as much lower investment is required in new plant to expand. The option to adjust the nature of production, for example the fuel used. This is far easier for the gas project which could probably switch to oil or other fuels at a much lower cost than the nuclear project. The option to take advantage of new technology. Once again there is likely to be more flexibility in the gas project. In conclusion there are likely to be more valuable real options associated with the gas fuelled power station project DeVry/Becker Educational Development Corp. All rights reserved. 7

8 Marking Scheme 1 MULTINATIONAL FINANCE One mark per explained strategy 5 max 2 SERVING OVERSEAS MARKETS Exporting one mark per explained advantage/disadvantage 2 Licencing one mark per explained advantage/disadvantage 2 FDI one mark per explained advantage/disadvantage 2 3 PRICE IF CURRENCY OPTION One mark per explained factor 5 4 MAXIMISING EPS Critique of link between EPS and share price 2 Each suggestion one mark for impact on relevant stakeholders 4 Each suggestion one mark for impact on share price CENTRALISED TREASURY Benefits one mark per explained point 4 Mitigation of conflicts one mark per suggestion 2 DIVESTMENT Reasons for divestment one mark per explained point 3 Distinguishing between sell off and demerger 3 7 FREE CASH FLOW Definition of free cash flow to equity 2 Discussion of conflicts between management and shareholders 3 Possible actions by shareholders 1 8 REAL OPTIONS Explanation of relevance to project appraisal 3 Potential real options in scenario one per suggestion DeVry/Becker Educational Development Corp. All rights reserved. 8

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