Paper P4. Advanced Financial Management. Tuesday 3 June Professional Level Options Module. The Association of Chartered Certified Accountants

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1 Profssional Lvl Options Modul Advancd Financial Managmnt Tusday 3 Jun 2014 Tim allowd Rading and planning: Writing: 15 minuts 3 hours This papr is dividd into two sctions: Sction A This ONE qustion is compulsory and MUST b attmptd Sction B TWO qustions ONLY to b attmptd Formula and tabls ar on pags Do NOT opn this papr until instructd by th suprvisor. During rading and planning tim only th qustion papr may b annotatd. You must NOT writ in your answr booklt until instructd by th suprvisor. This qustion papr must not b rmovd from th xamination hall. Papr P4 Th Association of Chartrd Crtifid Accountants

2 Sction A This ONE qustion is compulsory and MUST b attmptd 1 Cocoa-Mocha-Chai (CMC) Co is a larg listd company basd in Switzrland and uss Swiss Francs as its currncy. It imports ta, coff and cocoa from countris around th world, and slls its blndd products to suprmarkts and larg rtailrs worldwid. Th company has production facilitis locatd in two Europan ports whr raw matrials ar brought for procssing, and from whr finishd products ar shippd out. All raw matrial purchass ar paid for in US dollars (US$), whil all sals ar invoicd in Swiss Francs (CHF). Until rcntly CMC Co had no intntion of hdging its forign currncy xposurs, intrst rat xposurs or commodity pric fluctuations, and statd this intnt in its annual rport. Howvr, aftr consultations with snior and middl managrs, th company s nw Board of Dirctors (BoD) has bn rviwing its risk managmnt and oprations stratgis. Th following two proposals hav bn put forward by th BoD for furthr considration: Proposal on Stting up a trasury function to manag th forign currncy and intrst rat xposurs (but not commodity pric fluctuations) using drivativ products. Th trasury function would b hadd by th financ dirctor. Th purchasing dirctor, who initiatd th ida of having a trasury function, was of th opinion that this would nabl hr managmnt tam to mak bttr dcisions. Th financ dirctor also supportd th ida as h flt this would incras his influnc on th BoD and strngthn his cas for an incras in his rmunration. In ordr to assist in th furthr considration of this proposal, th BoD wants you to us th following upcoming forign currncy and intrst rat xposurs to dmonstrat how thy would b managd by th trasury function: (i) (ii) a paymnt of US$5,060,000 which is du in four months tim; and a four-yar CHF60,000,000 loan takn out to part-fund th stting up of four branchs (s proposal two blow). Intrst will b payabl on th loan at a fixd annual rat of 2 2% or a floating annual rat basd on th yild curv rat plus 0 40%. Th loan s principal amount will b rpayabl in full at th nd of th fourth yar. Proposal two This proposal suggstd stting up four nw branchs in four diffrnt countris. Each branch would hav its own production facilitis and sals tams. As a consqunc of this, on of th two Europan-basd production facilitis will b closd. Initial cost-bnfit analysis indicatd that this would rduc costs rlatd to production, distribution and logistics, as ths branchs would b closr to th sourcs of raw matrials and also to th customrs. Th oprations and sals dirctors supportd th proposal, as in addition to abov, this would nabl sals and markting tams in th branchs to rspond to any changs in narby markts mor quickly. Th branchs would b controlld and staffd by th local population in thos countris. Howvr, som mmbrs of th BoD xprssd concrn that such a mov would crat agncy issus btwn CMC Co s cntral managmnt and th managmnt controlling th branchs. Thy suggstd mitigation stratgis would nd to b stablishd to minimis ths issus. Rspons from th non-xcutiv dirctors Whn th proposals wr put to th non-xcutiv dirctors, thy indicatd that thy wr broadly supportiv of th scond proposal if th financial bnfits outwigh th costs of stting up and running th four branchs. Howvr, thy flt that thy could not support th first proposal, as this would rduc sharholdr valu bcaus th costs rlatd to undrtaking th proposal ar likly to outwigh th bnfits. Additional information rlating to proposal on Th currnt spot rat is US$ pr CHF1. Th currnt annual inflation rat in th USA is thr tims highr than Switzrland. Th following drivativ products ar availabl to CMC Co to manag th xposurs of th US$ paymnt and th intrst on th loan: Exchang-tradd currncy futurs Contract siz CHF125,000 pric quotation: US$ pr CHF1 3-month xpiry month xpiry

3 Exchang-tradd currncy options Contract siz CHF125,000, xrcis pric quotation: US$ pr CHF1, prmium: cnts pr CHF1 Call Options Put Options Exrcis pric 3-month xpiry 6-month xpiry 3-month xpiry 6-month xpiry It can b assumd that futurs and option contracts xpir at th nd of th month and transaction costs rlatd to ths can b ignord. Ovr-th-countr products In addition to th xchang-tradd products, Pcunia Bank is willing to offr th following ovr-th-countr drivativ products to CMC Co: (i) (ii) A forward rat btwn th US$ and th CHF of US$ pr CHF1. An intrst rat swap contract with a countrparty, whr th countrparty can borrow at an annual floating rat basd on th yild curv rat plus 0 8% or an annual fixd rat of 3 8%. Pcunia Bank would charg a f of 20 basis points ach to act as th intrmdiary of th swap. Both partis will bnfit qually from th swap contract. Rquird: (a) Advis CMC Co on an appropriat hdging stratgy to manag th forign xchang xposur of th US$ paymnt in four months tim. Show all rlvant calculations, including th numbr of contracts bought or sold in th xchang-tradd drivativ markts. (15 marks) (b) Dmonstrat how CMC Co could bnfit from th swap offrd by Pcunia Bank. (6 marks) (c) As an altrnativ to paying th principal on th loan as on lump sum at th nd of th fourth yar, CMC Co could pay off th loan in qual annual amounts ovr th four yars similar to an annuity. In this cas, an annual intrst rat of 2% would b payabl, which is th sam as th loan s gross rdmption yild (yild to maturity). Rquird: Calculat th modifid duration of th loan if it is rpaid in qual amounts and xplain how duration can b usd to masur th snsitivity of th loan to changs in intrst rats. (7 marks) (d) Prpar a mmorandum for th Board of Dirctors (BoD) of CMC Co which: (i) Discusss proposal on in light of th concrns raisd by th non-xcutiv dirctors; and (9 marks) (ii) Discusss th agncy issus rlatd to proposal two and how ths can b mitigatd. (9 marks) Profssional marks will b awardd in part (d) for th prsntation, structur, logical flow and clarity of th mmorandum. (4 marks) (50 marks) 3 [P.T.O.

4 Sction B TWO qustions ONLY to b attmptd 2 You hav rcntly commncd working for Burung Co and ar rviwing a four-yar projct which th company is considring for invstmnt. Th projct is in a businss activity which is vry diffrnt from Burung Co s currnt lin of businss. Th following nt prsnt valu stimat has bn mad for th projct: All figurs ar in $ million Yar Sals rvnu Dirct projct costs (13 82) (21 96) (29 44) (16 28) Intrst (1 20) (1 20) (1 20) (1 20) Profit Tax (20%) (1 60) (2 69) (3 69) (1 93) Invstmnt/sal (38 00) 4 00 Cash flows (38 00) Discount factors (7%) Prsnt valus (38 00) Nt prsnt valu is ngativ $1 65 million, and thrfor th rcommndation is that th projct should not b accptd. In calculating th nt prsnt valu of th projct, th following nots wr mad: (i) (ii) Sinc th ral cost of capital is usd to discount cash flows, nithr th sals rvnu nor th dirct projct costs hav bn inflatd. It is stimatd that th inflation rat applicabl to sals rvnu is 8% pr yar and to th dirct projct costs is 4% pr yar. Th projct will rquir an initial invstmnt of $38 million. Of this, $16 million rlats to plant and machinry, which is xpctd to b sold for $4 million whn th projct cass, aftr taking any taxation and inflation impact into account. (iii) Tax allowabl dprciation is availabl on th plant and machinry at 50% in th first yar, followd by 25% pr yar thraftr on a rducing balanc basis. A balancing adjustmnt is availabl in th yar th plant and machinry is sold. Burung Co pays 20% tax on its annual taxabl profits. No tax allowabl dprciation is availabl on th rmaining invstmnt assts and thy will hav a nil valu at th nd of th projct. (iv) Burung Co uss ithr a nominal cost of capital of 11% or a ral cost of capital of 7% to discount all projcts, givn that th rat of inflation has bn stabl at 4% for a numbr of yars. (v) Intrst is basd on Burung Co s normal borrowing rat of 150 basis points ovr th 10-yar govrnmnt yild rat. (vi) At th bginning of ach yar, Burung Co will nd to provid working capital of 20% of th anticipatd sals rvnu for th yar. Any rmaining working capital will b rlasd at th nd of th projct. (vii) Working capital and dprciation hav not bn takn into account in th nt prsnt valu calculation abov, sinc dprciation is not a cash flow and all th working capital is rturnd at th nd of th projct. It is anticipatd that th projct will b financd ntirly by dbt, 60% of which will b obtaind from a subsidisd loan schm run by th govrnmnt, which lnds mony at a rat of 100 basis points blow th 10-yar govrnmnt dbt yild rat of 2 5%. Issu costs rlatd to raising th financ ar 2% of th gross financ rquird. Th rmaining 40% will b fundd from Burung Co s normal borrowing sourcs. It can b assumd that th dbt capacity availabl to Burung Co is qual to th actual amount of dbt financ raisd for th projct. Burung Co has idntifid a company, Lintu Co, which oprats in th sam lin of businss as that of th projct it is considring. Lintu Co is financd by 40 million shars trading at $3 20 ach and $34 million dbt trading at $94 pr $100. Lintu Co s quity bta is stimatd at 1 5. Th currnt yild on govrnmnt trasury bills is 2% and it is stimatd that th markt risk prmium is 8%. Lintu Co pays tax at an annual rat of 20%. 4

5 Both Burung Co and Lintu Co pay tax in th sam yar as whn profits ar arnd. Rquird: (a) (b) Calculat th adjustd prsnt valu (APV) for th projct, corrcting any rrors mad in th nt prsnt valu stimat abov, and conclud whthr th projct should b accptd or not. Show all rlvant calculations. (15 marks) Commnt on th corrctions mad to th original nt prsnt valu stimat and xplain th APV approach takn in part (a), including any assumptions mad. (10 marks) (25 marks) 5 [P.T.O.

6 3 Vogl Co, a listd nginring company, manufacturs larg scal plant and machinry for industrial companis. Until tn yars ago, Vogl Co pursud a stratgy of organic growth. Sinc thn, it has followd an aggrssiv policy of acquiring smallr nginring companis, which it fls hav dvlopd nw tchnologis and mthods, which could b usd in its manufacturing procsss. Howvr, it is stimatd that only btwn 30% and 40% of th acquisitions mad in th last tn yars hav succssfully incrasd th company s sharholdr valu. Vogl Co is currntly considring acquiring Tori Co, an unlistd company, which has thr dpartmnts. Dpartmnt A manufacturs machinry for industrial companis, Dpartmnt B producs lctrical goods for th rtail markt, and th smallr Dpartmnt C oprats in th construction industry. Upon acquisition, Dpartmnt A will bcom part of Vogl Co, as it contains th nw tchnologis which Vogl Co is sking, but Dpartmnts B and C will b unbundld, with th assts attachd to Dpartmnt C sold and Dpartmnt B bing spun off into a nw company calld Ndg Co. Givn blow ar xtracts of financial information for th two companis for th yar ndd 30 April Vogl Co Tori Co $ million $ million Sals rvnu Profit bfor dprciation, intrst and tax (PBDIT) Intrst Dprciation Pr-tax profit Vogl Co Tori Co $ million $ million Non-currnt assts Currnt assts % unscurd bond 40 0 Othr non-currnt and currnt liabilitis Shar capital (50c/shar) Rsrvs Shar of currnt and non-currnt assts and profit of Tori Co s thr dpartmnts: Dpartmnt A Dpartmnt B Dpartmnt C Shar of currnt and non-currnt assts 40% 40% 20% Shar of PBDIT and pr-tax profit 50% 40% 10% Othr information (i) (ii) (iii) It is stimatd that for Dpartmnt C, th ralisabl valu of its non-currnt assts is 100% of thir book valu, but its currnt assts ralisabl valu is only 90% of thir book valu. Th costs rlatd to closing Dpartmnt C ar stimatd to b $3 million. Th funds raisd from th disposal of Dpartmnt C will b usd to pay off Tori Co s othr non-currnt and currnt liabilitis. Th 7% unscurd bond will b takn ovr by Ndg Co. It can b assumd that th currnt markt valu of th bond is qual to its book valu. (iv) At prsnt, around 10% of Dpartmnt B s PBDIT com from sals mad to Dpartmnt C. (v) (vi) Ndg Co s cost of capital is stimatd to b 10%. It is stimatd that in th first yar of opration Ndg Co s fr cash flows to firm will grow by 20%, and thn by 5 2% annually thraftr. Th tax rat applicabl to all th companis is 20%, and Ndg Co can claim 10% tax allowabl dprciation on its non-currnt assts. It can b assumd that th amount of tax allowabl dprciation is th sam as th invstmnt ndd to maintain Ndg Co s oprations. 6

7 (vii) Vogl Co s currnt shar pric is $3 pr shar and it is stimatd that Tori Co s pric-to-arnings (PE) ratio is 25% highr than Vogl Co s PE ratio. Aftr th acquisition, whn Dpartmnt A bcoms part of Vogl Co, it is stimatd that Vogl Co s PE ratio will incras by 15%. (viii) It is stimatd that th combind company s annual aftr-tax arnings will incras by $7 million du to th synrgy bnfits rsulting from combining Vogl Co and Dpartmnt A. Rquird: (a) (b) (c) Discuss th possibl rasons why Vogl Co may hav switchd its stratgy of organic growth to on of growing by acquiring companis. (4 marks) Discuss th possibl actions Vogl Co could tak to rduc th risk that th acquisition of Tori Co fails to incras sharholdr valu. (7 marks) Estimat, showing all rlvant calculations, th maximum prmium Vogl Co could pay to acquir Tori Co, xplaining th approach takn and any assumptions mad. (14 marks) (25 marks) 7 [P.T.O.

8 4 Th chif xcutiv officr (CEO) of Faoilan Co has just rturnd from a discussion at a lading univrsity on th application of options to invstmnt dcisions and corporat valu. Sh wants to undrstand how som of th idas which wr discussd can b applid to dcisions mad at Faoilan Co. Sh is still a littl unclar about som of th discussion on options and thir application, and wants furthr clarification on th following: (i) (ii) Faoilan Co is involvd in th xploration and xtraction of oil and gas. Rcntly thr hav bn indications that thr could b significant dposits of oil and gas just off th shors of Irland. Th govrnmnt of Irland has invitd companis to submit bids for th rights to commnc th initial xploration of th ara to assss th liklihood and amount of oil and gas dposits, with furthr xtraction rights to follow. Faoilan Co is considring putting in a bid for th rights. Th spakr lading th discussion suggstd that using options as an invstmnt assssmnt tool would b particularly usful to Faoilan Co in this rspct. Th spakr furthr suggstd that options wr usful in dtrmining th valu of quity and dfault risk, and suggstd that this was why companis facing svr financial distrss could still hav a positiv quity valu. (iii) Towards th nd of th discussion, th spakr suggstd that changs in th valus of options can b masurd in trms of a numbr of risk factors known as th grks, such as th vga. Th CEO is unclar why option valus ar affctd by so many diffrnt risk factors. Rquird: (a) (b) (c) With rgard to (i) abov, discuss how Faoilan Co may us th ida of options to hlp with th invstmnt dcision in bidding for th xploration rights, and xplain th assumptions mad whn using th ida of options in making invstmnt dcisions. (11 marks) With rgard to (ii) abov, discuss how options could b usful in dtrmining th valu of quity and dfault risk, and why companis facing svr financial distrss still hav positiv quity valus. (9 marks) With rgard to (iii) abov, xplain why changs in option valus ar dtrmind by numrous diffrnt risk factors and what vga dtrmins. (5 marks) (25 marks) 8

9 Formula Modigliani and Millr Proposition 2 (with tax) V i i k = k +( 1 T)(k k ) d V d Th Capital Asst Pricing Modl E(r ) = R + β ( E(r ) R ) i f i m f β a Th asst bta formula V V T d = β V + V T)) V V d + ( 1 ) β d ( ( 1 ( + ( 1 T)) d Th Growth Modl P o D ( 1+ g) o = (r g) Gordon s growth approximation g = br Th wightd avrag cost of capital V WACC V V k V d = + V V k ( 1 T) d + d + d Th Fishr formula ( 1+ i) = ( 1+ r)(1+h) Purchasing powr parity and intrst rat parity S S x (1+h ) F S x (1+i ) c c = = 0 0 (1+h ) (1+i b ) 1 0 b 9 [P.T.O.

10 Modifid Intrnal Rat of Rturn PV R MIRR = PV I 1 n ( 1+ r ) 1 Th Black-Schols option pricing modl c = PN(d ) PN(d ) Whr: d 1 a 1 2 rt ln( P / P ) + ( r+ 0.5s ) t a = s t d = d s t 2 1 Th Put Call Parity rlationship p = c P + P a 2 rt 10

11 Prsnt Valu Tabl Prsnt valu of 1 i.. (1 + r) n Whr r = discount rat n = numbr of priods until paymnt Discount rat (r) Priods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% [P.T.O.

12 Annuity Tabl Prsnt valu of an annuity of 1 i.. 1 (1 + r) n r Whr r = discount rat n = numbr of priods Discount rat (r) Priods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

13 Standard normal distribution tabl This tabl can b usd to calculat N(d), th cumulativ normal distribution functions ndd for th Black-Schols modl of option pricing. If d i > 0, add 0 5 to th rlvant numbr abov. If d i < 0, subtract th rlvant numbr abov from 0 5. End of Qustion Papr 13