Paper P4. Advanced Financial Management. Tuesday 12 June Professional Level Options Module. The Association of Chartered Certified Accountants

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1 Profssional Lvl Options Modul Advancd Financial Managmnt Tusday 12 Jun 2012 Tim allowd Rading and planning: Writing: 15 minuts 3 hours This papr is dividd into two sctions: Sction A BOTH qustions ar 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 BOTH qustions ar compulsory and MUST b attmptd 1 Nnt Co, an unlistd company, dsigns and dvlops tools and parts for spcialist machinry. Th company was formd four yars ago by thr frinds, who own 20% of th quity capital in total, and a consortium of fiv businss angl organisations, who own th rmaining 80%, in roughly qual proportions. Nnt Co also has a larg amount of dbt financ in th form of variabl rat loans. Initially th amount of annual intrst payabl on ths loans was low and allowd Nnt Co to invst intrnally gnratd funds to xpand its businss. Rcntly though, du to a rapid incras in intrst rats, thr has bn limitd scop for futur xpansion and no nw product dvlopmnt. Th Board of Dirctors, consisting of th thr frinds and a rprsntativ from ach businss angl organisation, mt rcntly to discuss how to scur th company s futur prospcts. Two proposals wr put forward, as follows: Proposal 1 To accpt a takovr offr from Mij Co, a listd company, which dvlops and manufacturs spcialist machinry tools and parts. Th takovr offr is for $2 95 cash pr shar or a shar-for-shar xchang whr two Mij Co shars would b offrd for thr Nnt Co shars. Mij Co would nd to gt th final approval from its sharholdrs if ithr offr is accptd; Proposal 2 To pursu an opportunity to dvlop a small prototyp product that just braks vn financially, but givs th company xclusiv rights to produc a follow-on product within two yars. Th mting concludd without agrmnt on which proposal to pursu. Aftr th mting, Mij Co was consultd about th xclusiv rights. Mij Co s dirctors indicatd that thy had not considrd th rights in thir computations and wr willing to continu with th takovr offr on th sam trms without thm. Currntly, Mij Co has 10 million shars in issu and ths ar trading for $4 80 ach. Mij Co s pric to arnings (P/E) ratio is 15. It has sufficint cash to pay for Nnt Co s quity and a substantial proportion of its dbt, and blivs that this will nabl Nnt Co to oprat on a P/E lvl of 15 as wll. In addition to this, Mij Co blivs that it can find cost-basd synrgis of $150,000 aftr tax pr yar for th forsabl futur. Mij Co s currnt profit aftr tax is $3,200,000. Th following financial information rlats to Nnt Co and to th dvlopmnt of th nw product. Nnt Co financial information Extract from th most rcnt incom statmnt $ 000 Sals rvnu 8,780 Profit bfor intrst and tax 1,230 Intrst (455) Tax (155) Profit aftr tax 620 Dividnds Nil Extract from th most rcnt statmnt of financial position $ 000 Nt non-currnt assts 10,060 Currnt assts 690 Total Assts 10,750 Shar capital (40c pr shar par valu) 960 Rsrvs 1,400 Non-currnt liabilitis: Variabl rat loans 6,500 Currnt liabilitis 1,890 Total liabilitis and capital 10,750 2

3 In arriving at th profit aftr tax amount, Nnt Co dductd tax allowabl dprciation and othr non-cash xpnss totalling $1,206,000. It rquirs an annual cash invstmnt of $1,010,000 in non-currnt assts and working capital to continu its oprations. Nnt Co s profits bfor intrst and tax in its first yar of opration wr $970,000 and hav bn growing stadily in ach of th following thr yars, to thir currnt lvl. Nnt Co s cash flows grw at th sam rat as wll, but it is likly that this growth rat will rduc to 25% of th original rat for th forsabl futur. Nnt Co currntly pays intrst of 7% pr yar on its loans, which is 380 basis points ovr th govrnmnt bas rat, and corporation tax of 20% on profits aftr intrst. It is stimatd that an ovrall cost of capital of 11% is rasonabl compnsation for th risk undrtakn on an invstmnt of this natur. Nw product dvlopmnt (Proposal 2) Dvloping th nw follow-on product will rquir an invstmnt of $2,500,000 initially. Th total xpctd cash flows and prsnt valus of th product ovr its fiv-yar lif, with a volatility of 42% standard dviation, ar as follows: Yar(s) Now to 7 (in total) Cash flows ($ 000) (2,500) 3,950 Prsnt valus ($ 000) (2,029) 2,434 Prpar a rport for th Board of Dirctors of Nnt Co that: (i) Estimats th currnt valu of a Nnt Co shar, using th fr cash flow to firm mthodology; (7 marks) (ii) Estimats th prcntag gain in valu to a Nnt Co shar and a Mij Co shar undr ach paymnt offr; (8 marks) (iii) Estimats th prcntag gain in th valu of th follow-on product to a Nnt Co shar, basd on its cash flows and on th assumption that th production can b dlayd following acquisition of th xclusiv rights of production; (8 marks) (iv) Discusss th likly raction of Nnt Co and Mij Co sharholdrs to th takovr offr, including th assumptions mad in th stimats abov and how th follow-on product s valu can b utilisd by Nnt Co. (8 marks) Profssional marks will b awardd in qustion 1 for th prsntation, structur and clarity of th answr. (4 marks) (35 marks) 3 [P.T.O.

4 2 Thr proposals wr put forward for furthr considration aftr a mting of th xcutiv dirctors of Enna Co to discuss th futur invstmnt and financing stratgy of th businss. Enna Co is a listd company oprating in th haulag and shipping industry. Proposal 1 To incras th company s lvl of dbt by borrowing a furthr $20 million and us th funds raisd to buy back shar capital. Proposal 2 To incras th company s lvl of dbt by borrowing a furthr $20 million and us ths funds to invst in additional non-currnt assts in th haulag stratgic businss unit. Proposal 3 To sll xcss non-currnt haulag assts with a nt book valu of $25 million for $27 million and focus on offring mor srvics to th shipping stratgic businss unit. This businss unit will rquir no additional invstmnt in non-currnt assts. All th funds raisd from th sal of th non-currnt assts will b usd to rduc th company s dbt. Enna Co financial information Extracts from th forcast financial position for th coming yar $m Non-currnt assts 282 Currnt assts 66 Total assts 348 Equity and liabilitis Shar capital (40c pr shar par valu) 48 Rtaind arnings 123 Total quity 171 Non-currnt liabilitis 140 Currnt liabilitis 37 Total liabilitis 177 Total liabilitis and capital 348 Enna Co s forcast aftr tax profit for th coming yar is xpctd to b $26 million and its currnt shar pric is $3 20 pr shar. Th non-currnt liabilitis consist solly of a 6% mdium trm loan rdmabl within svn yars. Th trms of th loan contract stipulats that an incras in borrowing will rsult in an incras in th coupon payabl of 25 basis points on th total amount borrowd, whil a rduction in borrowing will lowr th coupon payabl by 15 basis points on th total amount borrowd. Enna Co s ffctiv tax rat is 20%. Th company s stimatd aftr tax rat of rturn on invstmnt is xpctd to b 15% on any nw invstmnt. It is xpctd that any rduction in invstmnt would suffr th sam rat of rturn. (a) (b) Estimat and discuss th impact of ach of th thr proposals on th forcast statmnt of financial position, th arnings and arnings pr shar, and garing of Enna Co. (20 marks) An altrnativ suggstion to proposal thr was mad whr th non-currnt assts could b lasd to othr companis instad of bing sold. Th las rcipts would thn b convrtd into an asst through scuritisation. Th procds from th sal of th scuritisd las rcipts asst would b usd to rduc th outstanding loan borrowings. Explain what th scuritisation procss would involv and what would b th ky barrirs to Enna Co undrtaking th procss. (5 marks) 4 (25 marks)

5 Sction B TWO qustions ONLY to b attmptd 3 Smbilan Co, a listd company, rcntly issud dbt financ to acquir assts in ordr to incras its activity lvls. This dbt financ is in th form of a floating rat bond, with a fac valu of $320 million, rdmabl in four yars. Th bond intrst, payabl annually, is basd on th spot yild curv plus 60 basis points. Th nxt annual paymnt is du at th nd of yar on. Smbilan Co is concrnd that th xpctd ris in intrst rats ovr th coming fw yars would mak it incrasingly difficult to pay th intrst du. It is thrfor proposing to ithr swap th floating rat intrst paymnt to a fixd rat paymnt, or to rais nw quity capital and us that to pay off th floating rat bond. Th nw quity capital would ithr b issud as rights to th xisting sharholdrs or as shars to nw sharholdrs. Ratus Bank has offrd Smbilan Co an intrst rat swap, whrby Smbilan Co would pay Ratus Bank intrst basd on an quivalnt fixd annual rat of 3 76¼% in xchang for rciving a variabl amount basd on th currnt yild curv rat. Paymnts and rcipts will b mad at th nd of ach yar, for th nxt four yars. Ratus Bank will charg an annual f of 20 basis points if th swap is agrd. Th currnt annual spot yild curv rats ar as follows: Yar On Two Thr Four Rat 2 5% 3 1% 3 5% 3 8% Th currnt annual forward rats for yars two, thr and four ar as follows: Yar Two Thr Four Rat 3 7% 4 3% 4 7% (a) (b) (c) Basd on th abov information, calculat th amounts Smbilan Co xpcts to pay or rciv vry yar on th swap (xcluding th f of 20 basis points). Explain why th fixd annual rat of intrst of 3 76¼% is lss than th four-yar yild curv rat of 3 8%. (6 marks) Dmonstrat that Smbilan Co s intrst paymnt liability dos not chang, aftr it has undrtakn th swap, whthr th intrst rats incras or dcras. (5 marks) Discuss th factors that Smbilan Co should considr whn dciding whthr it should rais quity capital to pay off th floating rat dbt. (9 marks) (20 marks) 5 [P.T.O.

6 4 Tisa Co is considring an opportunity to produc an innovativ componnt which, whn fittd into motor vhicl ngins, will nabl thm to utilis ful mor fficintly. Th componnt can b manufacturd using ithr procss Omga or procss Zta. Although this is an ntirly nw lin of businss for Tisa Co, it is of th opinion that dvloping ithr procss ovr a priod of four yars and thn slling th productions rights at th nd of four yars to anothr company may prov lucrativ. Th annual aftr-tax cash flows for ach procss ar as follows: Procss Omga Yar Aftr-tax cash flows ($000) (3,800) 1,220 1,153 1,386 3,829 Procss Zta Yar Aftr-tax cash flows ($000) (3,800) ,055 5,990 Tisa Co has 10 million 50c shars trading at 180c ach. Its loans hav a currnt valu of $3 6 million and an avrag aftr-tax cost of dbt of 4 50%. Tisa Co s capital structur is unlikly to chang significantly following th invstmnt in ithr procss. Elfu Co manufacturs lctronic parts for cars including th production of a componnt similar to th on bing considrd by Tisa Co. Elfu Co s quity bta is 1 40, and it is stimatd that th quivalnt quity bta for its othr activitis, xcluding th componnt production, is Elfu Co has 400 million 25c shars in issu trading at 120c ach. Its dbt financ consists of variabl rat loans rdmabl in svn yars. Th loans paying intrst at bas rat plus 120 basis points hav a currnt valu of $96 million. It can b assumd that 80% of Elfu Co s dbt financ and 75% of Elfu Co s quity financ can b attributd to othr activitis xcluding th componnt production. Both companis pay annual corporation tax at a rat of 25%. Th currnt bas rat is 3 5% and th markt risk prmium is stimatd at 5 8%. (a) (b) (c) Provid a rasond stimat of th cost of capital that Tisa Co should us to calculat th nt prsnt valu of th two procsss. Includ all rlvant calculations. (8 marks) Calculat th intrnal rat of rturn (IRR) and th modifid intrnal rat of rturn (MIRR) for Procss Omga. Givn that th IRR and MIRR of Procss Zta ar 26 6% and 23 3% rspctivly, rcommnd which procss, if any, Tisa Co should procd with and xplain your rcommndation. (8 marks) Elfu Co has stimatd an annual standard dviation of $800,000 on on of its othr projcts, basd on a normal distribution of rturns. Th avrag annual rturn on this projct is $2,200,000. Estimat th projct s Valu at Risk (VAR) at a 99% confidnc lvl for on yar and ovr th projct s lif of fiv yars. Explain what is mant by th answrs obtaind. (4 marks) (20 marks) 6

7 5 Kilnc Co, a larg listd company basd in th UK, producs pharmacutical products which ar xportd around th world. It is rviwing a proposal to st up a subsidiary company to manufactur a rang of body and facial crams in Lanosia. Ths products will b sold to local rtailrs and to rtailrs in narby countris. Lanosia has a small but growing manufacturing industry in pharmacutical products, although it rmains largly rliant on imports. Th Lanosian govrnmnt has bn kn to promot th pharmacutical manufacturing industry through purchasing local pharmacutical products, providing govrnmnt grants and rducing th industry s corporat tax rat. It also imposs larg dutis on importd pharmacutical products which compt with th ons producd locally. Although politically stabl, th rcnt worldwid financial crisis has had a significant ngativ impact on Lanosia. Th country s national dbt has grown substantially following a bailout of its banks and it has had to introduc conomic masurs which ar hampring th country s ability to rcovr from a dp rcssion. Growth in ral wags has bn ngativ ovr th past thr yars, th conomy has shrunk in th past yar and inflation has rmaind highr than normal during this tim. On th othr hand, corporat invstmnt in capital assts, rsarch and dvlopmnt, and ducation and training, has grown rcntly and intrst rats rmain low. This has ld som conomists to suggst that th conomy should start to rcovr soon. Employmnt lvls rmain high in spit of low nominal wag growth. Lanosian corporat govrnanc rgulations stipulat that at last 40% of quity shar capital must b hld by th local population. In addition at last 50% of mmbrs on th Board of Dirctors, including th Chairman, must b from Lanosia. Kilnc Co wants to financ th subsidiary company using a mixtur of dbt and quity. It wants to rais additional quity and dbt financ in Lanosia in ordr to minimis xchang rat xposur. Th small siz of th subsidiary will hav minimal impact on Kilnc Co s capital structur. Kilnc Co intnds to rais th 40% quity through an initial public offring (IPO) in Lanosia and provid th rmaining 60% of th quity funds from its own cash funds. (a) (b) Discuss th ky risks and issus that Kilnc Co should considr whn stting up a subsidiary company in Lanosia, and suggst how ths may b mitigatd. (15 marks) Th dirctors of Kilnc Co hav larnt that a sizabl numbr of quity trads in Lanosia ar conductd using dark pool trading systms. Explain what dark pool trading systms ar and how Kilnc Co s proposd Initial Public Offring (IPO) may b affctd by ths. (5 marks) (20 marks) 7 [P.T.O.

8 Formula Modigliani and Millr Proposition 2 (with tax) V i i k = k +( 1 T)(k k ) d V d Two asst portfolio s = w s + w s +2w w r s s p 2 2 a a 2 2 b b a b ab a b 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 8

9 Modifid Intrnal Rat of Rturn PV R MIRR = PV I 1 n ( 1+ r ) 1 Th Black-Schols option pricing modl c = P N(d ) P N(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 9 [P.T.O.

10 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%

11 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% [P.T.O.

12 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 12