Paper P4. Advanced Financial Management. Tuesday 2 June Professional Level Options Module. The Association of Chartered Certified Accountants

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1 Profssional Lvl Options Modul Advancd Financial Managmnt Tusday 2 Jun 2015 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 Yilandw Yilandw, whos currncy is th Yilandw Rand (YR), has facd xtrmly difficult conomic challngs in th past 25 yars bcaus of som qustionabl conomic policis and political dcisions mad by its prvious govrnmnts. Although Yilandw s population is gnrally poor, its popl ar nvrthlss wll-ducatd and ambitious. Just ovr thr yars ago, a nw govrnmnt took offic and sinc thn it has imposd a numbr of strict montary and fiscal controls, including an annual corporation tax rat of 40%, in an attmpt to bring Yilandw out of its difficultis. As a rsult, th annual rat of inflation has falln rapidly from a high of 65% to its currnt lvl of 33%. Ths strict montary and fiscal controls hav mad Yilandw s govrnmnt popular in th largr citis and towns, but lss popular in th rural aras which sm to hav suffrd disproportionatly from th strict montary and fiscal controls. It is xpctd that Yilandw s annual inflation rat will continu to fall in th coming fw yars as follows: Yar Inflation rat % % 3 onwards 19 8% Yilandw s govrnmnt has dcidd to continu th progrss mad so far, by ncouraging forign dirct invstmnt into th country. Rcntly, govrnmnt rprsntativs hld trad shows intrnationally and offrd businsss a numbr of concssions, including: (i) (ii) zro corporation tax payabl in th first two yars of opration; and an opportunity to carry forward tax losss and writ thm off against futur profits mad aftr th first two yars. Th govrnmnt rprsntativs also promisd intrnational companis invsting in Yilandw prim locations in towns and citis with good transport links. Imoni Co Imoni Co, a larg listd company basd in th USA with th US dollar ($) as its currncy, manufacturs high tch diagnostic componnts for machinry, which it xports worldwid. Aftr attnding on of th trad shows, Imoni Co is considring stting up an assmbly plant in Yilandw whr parts would b snt and assmbld into a spcific typ of componnt, which is currntly bing assmbld in th USA. Onc assmbld, th componnt will b xportd dirctly to companis basd in th Europan Union (EU). Ths xports will b invoicd in Euro ( ). Assmbly plant in Yilandw: financial and othr data projctions It is initially assumd that th projct will last for four yars. Th four-yar projct will rquir invstmnts of YR21,000 million for land and buildings, YR18,000 million for machinry and YR9,600 million for working capital to b mad immdiatly. Th working capital will nd to b incrasd annually at th start of ach of th nxt thr yars by Yilandw s inflation rat and it is assumd that this will b rlasd at th nd of th projct s lif. It can b assumd that th assmbly plant can b built vry quickly and production startd almost immdiatly. This is bcaus th basic facilitis and infrastructur ar alrady in plac as th plant will b built on th prmiss and grounds of a school. Th school is idally locatd, nar th main highway and railway lins. As a rsult, th school will clos and th childrn currntly studying thr will b rlocatd to othr schools in th city. Th govrnmnt has kindly agrd to provid fr buss to tak th childrn to ths schools for a priod of six months to giv parnts tim to arrang appropriat transport in th futur for thir childrn. Th currnt slling pric of ach componnt is 700 and this pric is likly to incras by th avrag EU rat of inflation from yar 1 onwards. Th numbr of componnts xpctd to b sold vry yar ar as follows: Yar Sals componnt units (000s) Th parts ndd to assmbl into th componnts in Yilandw will b snt from th USA by Imoni Co at a cost of $200 pr componnt unit, from which Imoni Co would currntly arn a pr-tax contribution of $40 for ach componnt unit. Howvr, Imoni Co fls that it can ngotiat with Yilandw s govrnmnt and incras th transfr pric to $280 pr componnt unit. Th variabl costs rlatd to assmbling th componnts in Yilandw ar currntly 2

3 YR15,960 pr componnt unit. Th currnt annual fixd costs of th assmbly plant ar YR4,600 million. All ths costs, whrvr incurrd, ar xpctd to incras by that country s annual inflation vry yar from yar 1 onwards. Imoni Co pays corporation tax on profits at an annual rat of 20% in th USA. Th tax in both th USA and Yilandw is payabl in th yar that th tax liability ariss. A bilatral tax traty xists btwn Yilandw and th USA. Tax allowabl dprciation is availabl at 25% pr yar on th machinry on a straight-lin basis. Imoni Co will xpct annual royaltis from th assmbly plant to b mad vry yar. Th normal annual royalty f is currntly $20 million, but Imoni Co fls that it can ngotiat this with Yilandw s govrnmnt and incras th royalty f by 80%. Onc agrd, this f will not b subjct to any inflationary incras in th projct s four-yar priod. If Imoni Co dos dcid to invst in an assmbly plant in Yilandw, its xports from th USA to th EU will fall and it will incur rdundancy costs. As a rsult, Imoni Co s aftr-tax cash flows will rduc by th following amounts: Yar Rdundancy and lost contribution 20,000 55,697 57,368 59,089 Imoni Co normally uss its cost of capital of 9% to assss nw projcts. Howvr, th financ dirctor suggsts that Imoni Co should us a projct spcific discount rat of 12% instad. Othr financial information Currnt spot rats Euro pr Dollar 0 714/$1 YR pr Euro YR142/ 1 YR pr Dollar YR101 4/$1 Forcast futur rats basd on xpctd inflation rat diffrntials Yar YR/$ Yar YR/ Expctd inflation rats EU xpctd inflation rat: Nxt two yars 5% EU xpctd inflation rat: Yar 3 onwards 4% USA xpctd inflation rat: Yar 1 onwards 3% Rquird: (a) (b) Discuss th possibl bnfits and drawbacks to Imoni Co of stting up its own assmbly plant in Yilandw, compard to licnsing a company basd in Yilandw to undrtak th assmbly on its bhalf. (5 marks) Prpar a rport which: (i) Evaluats th financial accptability of th invstmnt in th assmbly plant in Yilandw; (21 marks) (ii) Discusss th assumptions mad in producing th stimats, and th othr risks and issus which Imoni Co should considr bfor making th final dcision; (17 marks) (iii) Provids a rasond rcommndation on whthr or not Imoni Co should invst in th assmbly plant in Yilandw. (3 marks) Profssional marks will b awardd in part (b) for th format, structur and prsntation of th rport. (4 marks) (50 marks) 3 [P.T.O.

4 Sction B TWO qustions ONLY to b attmptd 2 Th trasury dpartmnt of Chawan Co, a listd company, aims to maintain a portfolio of around $360 million consisting of quity shars, corporat bonds and govrnmnt bonds, which it can turn into cash quickly for invstmnt projcts. Chawan Co is considring disposing 27 million shars, valud at $2 15 ach, which it has invstd in Odn Co. Th had of Chawan Co s trasury dpartmnt is of th opinion that, should th dcision b mad to dispos of its quity stak in Odn Co, this should b sold through a dark pool ntwork and not sold on th stock xchang whr Odn Co s shars ar listd. In th last fw wks, thr hav also bn rumours that Odn Co may bcom subjct to a takovr bid. Odn Co oprats in th travl and lisur (T&L) sctor, and th poor wathr conditions in rcnt yars, coupld with a continuing rcssion, has mant that th T&L sctor is undr-prforming. Ovr th past thr yars, sals rvnu fll by an avrag of 8% pr yar in th T&L sctor. Howvr, thr ar signs that th conomy is starting to rcovr, but this is by no mans crtain. Givn blow ar xtracts from th rcnt financial statmnts and othr financial information for Odn Co and th T&L sctor. Odn Co Yar nding 31 May (all amounts in $m) Total non-currnt assts Total currnt assts Total assts 1,100 1,132 1,106 Equity Ordinary shars ($0 50) Rsrvs Total quity Non-currnt liabilitis Bank loans Bonds Total non-currnt liabilitis Currnt liabilitis Trad and othr payabls Bank ovrdraft Total currnt liabilitis Total quity and liabilitis 1,100 1,132 1,106 Odn Co Yar nding 31 May (all amounts in $m) Sals rvnu 1,342 1,335 1,185 Oprating profit Financ costs (23) (27) (35) Profit bfor tax Taxation (35) (32) (16) Profit for th yar

5 Othr financial information (Basd on annual figurs till 31 May of ach yar) Odn Co avrag shar pric ($) Odn Co dividnd pr shar ($) T&L sctor avrag shar pric ($) T&L sctor avrag arnings pr shar ($) T&L sctor avrag dividnd pr shar ($) Odn Co s quity bta T&L sctor avrag quity bta Th risk-fr rat and th markt rturn hav rmaind fairly constant ovr th last tn yars at 4% and 10% rspctivly. Rquird: (a) (b) Explain what a dark pool ntwork is and why Chawan Co may want to dispos of its quity stak in Odn Co through on, instad of through th stock xchang whr Odn Co s shars ar listd. (5 marks) Discuss whthr or not Chawan Co should dispos of its quity stak in Odn Co. Provid rlvant calculations to support th discussion. Not: Up to 10 marks ar availabl for th calculations. (20 marks) (25 marks) 5 [P.T.O.

6 3 In ordr to rais funds for futur projcts, th managmnt of Bnto Co, a larg manufacturing company, is considring disposing of on of its subsidiary companis, Okazu Co, which is involvd in manufacturing rubbr tubing. Thy ar considring undrtaking th disposal through a managmnt buy-out (MBO) or a managmnt buy-in (MBI). Bnto Co wants $60 million from th sal of Okazu Co. Givn blow ar xtracts from th most rcnt financial statmnts for Okazu Co: Yar nding 30 April (all amounts in $000) 2015 Total non-currnt assts 40,800 Total currnt assts 12,300 Total assts 53,100 Equity 24,600 Non-currnt liabilitis 16,600 Currnt liabilitis Trad and othr payabls 7,900 Bank ovrdraft 4,000 Total currnt liabilitis 11,900 Total quity and liabilitis 53,100 Yar nding 30 April (all amounts in $000) 2015 Sals rvnu 54,900 Oprating profit 12,200 Financ costs 1,600 Profit bfor tax 10,600 Taxation 2,120 Profit for th yar 8,480 Nots rlating to th financial statmnts abov: (i) (ii) Currnt assts, non-currnt assts and th trad and othr payabls will b transfrrd to th nw company whn Okazu Co is sold. Th bank ovrdraft will b rpaid by Bnto Co prior to th sal of Okazu Co. With th xcption of th bank ovrdraft, Bnto Co has providd all th financing to Okazu Co. No liabilitis, xcpt th trad and othr payabls spcifid abov, will b transfrrd to th nw company whn Okazu Co is sold. (iii) It is stimatd that th markt valu of th non-currnt assts is 30% highr than th book valu and th markt valu of th currnt assts is quivalnt to th book valu. (iv) Th group financ costs and taxation ar allocatd by Bnto Co to all its subsidiaris in pr-agrd proportions. Okazu Co s snior managmnt tam has approachd Dofu Co, a vntur capital company, about th proposd MBO. Dofu Co has agrd to provid lvragd financ for a 50% quity stak in th nw company on th following basis: (i) (ii) $30 million loan in th form of an 8% bond on which intrst is payabl annually, basd on th loan amount outstanding at th start of ach yar. Th bond will b rpaid on th basis of fixd qual annual paymnts (constituting of intrst and principal) ovr th nxt four yars; $20 million loan in th form of a 6% convrtibl bond on which intrst is payabl annually. Convrsion may b undrtakn on th basis of 50 quity shars for vry $100 from th bginning of yar fiv onwards; 6

7 (iii) 5,000,000 $1 quity shars for $5,000,000. Okazu Co s snior managmnt will contribut $5,000,000 for 5,000,000 $1 quity shars and own th rmaining 50% of th quity stak. As a condition for providing th financ, Dofu Co will impos a rstrictiv covnant that th nw company s garing ratio will b no highr than 75% at th nd of its first yar of oprations, and thn fall to no highr than 60%, 50% and 40% at th nd of yar two to yar four rspctivly. Th garing ratio is dtrmind by th book valu of dbt dividd by th combind book valus of dbt and quity. Aftr th MBO, it is xpctd that arnings bfor intrst and tax will incras by 11% pr yar and annual dividnds of 25% on th availabl arnings will b paid for th nxt four yars. It is xpctd that th annual growth rat of dividnds will rduc by 60% from yar fiv onwards following th MBO. Th nw company will pay tax at a rat of 20% pr yar. Th nw company s cost of quity has bn stimatd at 12%. Rquird: (a) (b) (c) Distinguish btwn a managmnt buy-out (MBO) and a managmnt buy-in (MBI). Discuss th rlativ bnfits and drawbacks to Okazu Co if it is disposd through a MBO instad of a MBI. (5 marks) Estimat, showing all rlvant calculations, whthr th rstrictiv covnant imposd by Dofu Co is likly to b mt. (12 marks) Discuss, with supporting calculations, whthr or not an MBO would b bnficial for Dofu Co and Okazu Co s snior managmnt tam. (8 marks) (25 marks) 7 [P.T.O.

8 4 For a numbr of yars Daikon Co has bn using forward rat agrmnts to manag its xposur to intrst rat fluctuations. Rcntly its chif xcutiv officr (CEO) attndd a talk on using xchang-tradd drivativ products to manag risks. Sh wants to find out by how much th xtra cost of th borrowing dtaild blow can b rducd, whn using intrst rat futurs, options on intrst rat futurs, and a collar on th options, to manag th intrst rat risk. Sh asks that dtaild calculations for ach of th thr drivativ products b providd and a rasond rcommndation to b mad. Daikon Co is xpcting to borrow $34,000,000 in fiv months tim. It xpcts to mak a full rpaymnt of th borrowd amount in 11 months tim. Assum it is 1 Jun 2015 today. Daikon Co can borrow funds at LIBOR plus 70 basis points. LIBOR is currntly 3 6%, but Daikon Co xpcts that intrst rats may incras by as much as 80 basis points in fiv months tim. Th following information and quots from an appropriat xchang ar providd on LIBOR-basd $ futurs and options. Thr-month $ Dcmbr futurs ar currntly quotd at Th contract siz is $1,000,000, th tick siz is 0 01% and th tick valu is $25. Options on thr-month $ futurs, $1,000,000 contract, tick siz 0 01% and tick valu $25. Option prmiums ar in annual %. Dcmbr calls Strik pric Dcmbr puts Initial assumptions It can b assumd that sttlmnt for both th futurs and options contracts is at th nd of th month; that basis diminishs to zro at a constant rat until th contract maturs and tim intrvals can b countd in months; that margin rquirmnts may b ignord; and that if th options ar in-th-mony, thy will xrcisd at th nd of th hdg instad of bing sold. Furthr issus In th talk, th CEO was informd of th following issus: (i) Futurs contracts will b markd-to-markt daily. Th CEO wondrd what th impact of this would b if 50 futurs contracts wr bought at on 1 Jun and 30 futurs contracts wr sold at on 3 Jun, basd on th $ Dcmbr futurs contract givn abov. Th closing sttlmnt prics ar givn blow for four days: (ii) Dat Sttlmnt pric 1 Jun Jun Jun Jun Daikon Co will nd to dposit funds into a margin account with a brokr for ach contract thy hav opnd, and this margin will nd to b adjustd whn th contracts ar markd-to-markt daily. (iii) It is unlikly that option contracts will b xrcisd at th nd of th hdg priod unlss thy hav rachd xpiry. Instad, thy mor likly to b sold and th positions closd. Rquird: (a) (b) Basd on th thr hdging choics availabl to Daikon Co and th initial assumptions givn abov, draft a rspons to th chif xcutiv officr s (CEO) rqust mad in th first paragraph of th qustion. (15 marks) Discuss th impact on Daikon Co of ach of th thr furthr issus givn abov. As part of th discussion, includ th calculations of th daily impact of th mark-to-markt closing prics on th transactions spcifid by th CEO. (10 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