P4

Answers

Financial Strategy Formulation, Stakeholders, Ethics, Economic Environment, Emerging Issues

1. Corporate governance
(a) This suggested answer focuses upon the UK Corporate Governance Code. Answers which include comments on how
points (i) – (vi) might comply with other corporate governance systems are equally acceptable.
Many aspects of the extracts would not comply with corporate governance systems such as the UK Corporate
Governance Code guidelines. Specifically:
– It is correct to say that all audit fees, and fees for other services provided by auditors should be fully disclosed.
However, it is recommended that the partner(s) responsible for the audit should be regularly changed so that the
audit is perceived to be more objective, and there is less chance of missing important anomalies in the audit
process.
– No executive directors should be members of the remuneration committee. The remuneration committee should be
comprised entirely of non-executive directors, who should objectively determine executive remuneration and
individual packages for each executive director.
– A balance of power and authority should exist within companies; the same person should not normally hold the
Chairman and Chief Executive positions. If the same person does hold both positions there should be a strong
independent element in the Board of Directors limiting the power of such a person.
– The disclosure of whether principles of good corporate governance have been applied is not normally enough;
companies should also fully explain how such principles have been applied.
– There is a requirement for directors to meet regularly and to retain full and effective control over the company. It is
doubtful if anyone holding so many directorships, whether executive or non-executive, could devote sufficient time to
each company to effectively fulfil their responsibilities.
– This is likely to comply with the Corporate Governance Code. Regular reporting on the effectiveness of the
company’s system of internal control would normally be a requirement of any system of corporate governance.
(b) Report on Corporate Governance in the USA, Germany and Japan.
The broad principles of corporate governance are similar in the UK, the USA and Germany, but there are significant
differences in how they are applied. The UK and Germany have voluntary corporate governance codes, the US system
is based upon legislation within the Sarbanes-Oxley Act.
USA
Whereas the UK has historically relied upon a system of self-regulation and voluntary codes of best practice, the USA
corporate governance structure is more formalised, with legally enforceable controls.
In the US, statutory requirements for publicly-traded companies are set out in the Sarbanes-Oxley Act. These
requirements include the certification of published financial statements by the CEO and the Chief Financial Officer
(CFO), faster public disclosures by companies, legal protection for whistleblowers, a requirement for an annual report
on internal controls, and requirements relating to the audit committee, auditor conduct and avoiding ‘improper’
influence of auditors.
The Act also requires the Securities and Exchange Commission (SEC) and the main stock exchanges to introduce
further rules, relating to matters such as the disclosure of critical accounting policies, the composition of the Board and
the number of independent directors. The Act has also established an independent body to oversee the accounting
 profession, which is known as the Public Company Accounting Oversight Board. Managers must be careful to comply
with regulations to avoid possible legal action against the company or themselves individually.
Germany
As both the UK and Germany are members of the EU, they must both follow EU directives on company law. A major
difference that exists in the board structure for companies is that the UK has a unitary board (consisting of both
executive and non-executive directors), whereas German companies have a two-tier board of directors. The
Supervisory Board of non-executives has responsibility for corporate policy and strategy and the Management Board
of executive directors has responsibility primarily for the day-to-day operations of the company.
The Supervisory Board typically includes representatives from major banks that have historically been large providers
of long-term finance to German companies (and are often major shareholders). The Supervisory Board does not have
full access to financial information, is meant to take an unbiased overview of the company, and is the main body
responsible for safeguarding the external stakeholders’ interests. The presence on the Supervisory Board of
representatives from banks and employees (trade unions) may introduce perspectives that are not present in some UK
boards. In particular, many members of the Supervisory Board would not meet the criteria under the UK Corporate
Governance Code for their independence.
Japan
Although there are signs of change in Japanese corporate governance, much of the system is based upon negotiation
or consensual management rather than upon a legal or even a self-regulatory framework. Banks as well as
representatives of other companies (in their capacity as shareholders) also sit on the Boards of Directors of Japanese
companies.
It is not uncommon for Japanese companies to have cross-holdings of shares with their suppliers, customers and
banks etc., all being represented on each other’s Board of Directors. There are often three boards of directors: Policy
Boards, responsible for strategy and comprised of directors with no functional responsibility; Functional Boards,
responsible for day-to-day operations; and largely symbolic Monocratic Boards. The interests of the company as a
whole should dictate the actions of these boards. This is in contrast to the UK or USA systems where, at least in
theory, the board should act primarily in the best interests of the shareholders, being the owners of the company.
2. World Trade Organisation
(a) Historically, the most important protectionist measures were tariffs, a levy or effectively a tax on imports, and quotas,
which restricted either the volume or value of imports. In most recent years import barriers have tended to become
more subtle, largely in response to the actions of GATT (General Agreement on Tariffs and Trade) and the WTO, which
sought to promote free trade. Such barriers include explicit or ‘hidden’ subsidies favouring local companies, and
regulations/red tape that made access to markets by importers difficult. These might include onerous environmental or
health regulations, very lengthy bureaucratic process before permission to import is given, and very slow customs
procedures which delay the entry of goods into a market. All of these measures are intended to deter overseas
companies from exporting to the country.
(b) The World Trade Organisation (WTO) in 1995 succeeded GATT (General Agreement on Tariffs and Trade) as the
major world forum for international negotiations and agreement in trade. It now encompasses about 150 countries,
which represent the vast majority of world trade. In contrast to GATT, which focussed on the trade in goods, the WTO
also covers trade in services including banks, insurance companies, telecommunications and hotels, intellectual
property and agriculture.
The WTO’s overriding objectives are to promote freer trade and thereby to help trade flow smoothly, and to reduce or
eliminate protectionist barriers. It administers trade agreements, acts as a forum for negotiations and settles trade
disputes. Its activities involve:
– Extending trade concessions equally to all members of the WTO.
– Encouraging lower tariffs and fairer trade around the world, including anti-dumping measures and subsidies.
– Introducing rules that make trade more predictable.
– Stimulating competition through cutting subsidies.
(c) A developing country that had recently joined the WTO would be expected to gradually reduce any barriers to trade of
its goods and services. However, because it is a developing country it would be permitted a much longer time to
undertake such measures. The effect on multinational companies could vary. If the multinational currently takes
advantage of protectionist barriers that exist in the country, such barriers would be gradually removed, exposing the
multinational to more competition.
However, freer trade might facilitate the expansion of the multinational’s exports into more markets and stimulate
demand for its products. In either case the multinational company would normally have a considerable period of time in
which to modify its operations in response to the reduction in barriers to trade.
3. Mr Moon
(a) Note: Regimes which regulate the conduct of takeovers and mergers vary between different jurisdictions. In
answering this question the examiners will wish to see evidence that candidates are either (a) aware of the regulations
or codes within their own countries or (b) are familiar with the UK’s City Code on Takeovers and Mergers.
Memorandum
To: John Moon
From: Candy Date
Potential Bid for Pluto plc
The remarks made at the dinner last night (whilst general in nature and non-specific about this company’s plans) could
be construed as an intention to bid for Pluto plc. Set out below are the principal regulatory, financial and ethical issues
we currently face:
Regulatory issues
Most regulatory regimes around the world impose strict rules concerning the release of price sensitive information,
such as an intention to bid. Furthermore, directors of a publicly quoted company are obliged to take all reasonable care
to ensure that any information they place in the public domain does not mislead investors. Within the UK, for example,
the City Code on Takeovers and Mergers stresses the vital importance of absolute secrecy before any announcement
is made. The Code places the burden of secrecy upon anybody in possession of confidential information, particularly
where that information is price sensitive, and it stresses that they should conduct themselves so as to minimise the risk
of any accidental disclosure.
When a target company is a particular subject of rumour or speculation, or it experiences an untoward movement in its
share price (and where it is reasonable to assume that the source was the offeror), the Code stipulates that an
announcement of intention should then be made.
An announcement that we do not intend to bid (or are withdrawing a bid) normally means that we are restricted from
making another bid within a specified time period (normally six months hence) unless:
– an offer to be made by us is recommended by the board of Pluto to its shareholders;
– another offer is made by a third party;
– a whitewash proposal is made by the board of Pluto; or
– there is a significant change of circumstances, whereby the regulator is disposed to waive the requirement.
The underpinning requirement is that in our public announcements we have a clear duty not to be seen to create a
false market in the shares of Pluto plc and we must provide all shareholders (both our own and those of Pluto) with
equal access to information about our intentions.
Financial issues
Under different circumstances, the comments made by you might not have been interpreted by the market as
significant. However, the 15% price movement strongly suggests that the market now views Pluto as a target and
Saturn as one of a number of potential predators. Evidence accumulated on the reaction of stock markets to new
information entering the public domain – the so-called reaction studies of the semi-strong form of the Efficient Market
Hypothesis – confirms that the market has a powerful ability to anticipate announcements. It is no surprise that the
market recognises the potential of the situation with respect to Pluto. The sudden price increase strongly suggests that
we are now seen as potential bidders. The problems that we now face are threefold! Firstly, we are not yet in a position
to announce a formal bid in that we have performed neither a due diligence study of Pluto nor have we undertaken a
valuation of the company. Secondly, the price range over which we can negotiate has now been raised. Finally, if we
now withdraw we cannot make a further bid within a six month period.
The valuation of Pluto will not be straightforward. Our preliminary view is that although the company is part of our
supply chain it may not carry our exposure to business risk. We have entered into preliminary discussions with our
investment bankers about raising the necessary debt finance. The size of the acquisition means that it is most likely to
alter our exposure to both business risk and financial risk. Thus our perception of the value of Pluto cannot be
determined without a full revaluation of our existing business - on the presumption that this acquisition actually occurs.
The increase in the valuation of Saturn would determine the maximum that we should be willing to pay without
impacting adversely upon our own shareholder value.
Ethical issues
One possibility is to deny that we are considering a bid for Pluto. The distinction we need to draw is whether our
current investigations could be classed as ‘strategic scanning’, or whether we are actively considering this company as
a bid target. The major difficulty we have is that Pluto is one of four companies discussed at the May board meeting as
a potential target and although that discussion was very speculative, investors will be aware that we have consistently
sought growth by acquisition rather than by organic growth. Given these circumstances and the commitment of this
company to adopt the highest standards of ethical conduct with respect to transparency and the treatment of investors,
I recommend that we clarify our position.
 (b) Recommendation
I therefore recommend that the following consultation with the regulator we make an announcement as follows:
Following recent speculation, the Board of Saturn plc confirms that it is considering a possible combination with Pluto plc.
However, the Board has decided not to make an offer at this time. The Board reserves its right to make an offer or take any other
action which might otherwise be restricted under the six month rule in the event of (a) an agreement from the Board of Pluto, (b)
an announcement by any other party of a possible or actual offer, (c) a whitewash proposal from the Board of Pluto plc, or (d) a
significant change in circumstances.
Given this announcement, we will still have the opportunity to develop a bid proposal and to enter into substantive
negotiations with the board of Pluto. However, we will not during the next six months be able to make a hostile
approach, unless during that period another company makes a bid for Pluto.
4. Agenda for change
(a) Agenda for change
Over recent years, the competitiveness of our business has been reduced by a number of factors – not least the
significant reductions in defence spending in our constituent markets. Over this time we have introduced new
technologies through acquisition and have not engaged in significant research and development on our own account.
Our current position is one of significant strength: we have substantial cash resources and cash flow generation is still
strong. Our gearing (at 12% of market capitalisation) is very low and this, combined with our earnings history and
liquidity, gives us a high credit rating and hence a relatively low cost of capital. Our weakness is our lack of investment
in new projects and our lack of research and development (R & D) to support such investment. In this position we are
exposed to the risk of a hostile bid by one of the many companies which do have substantial R & D, but are chronically
short of liquidity for future developments. I propose the following alternatives for discussion. These alternatives are not
mutually exclusive:
Alternative 1:
Given that building a viable R & D facility would take many years of investment and development that would not
appear to be a route to follow. However, we do have the financial resources to acquire a competitor who does have
strong R & D in relevant technologies. This would achieve two ends, it would reduce the risk of predatory attack –
there is substantial evidence that companies who acquire are less likely to be acquired themselves – and it would
eliminate one part of the competition; furthermore, it would give us the capability for development that we do not
currently possess. The downside is if the perceived benefits do not materialise, shareholder value is lost. We may also
lose shareholder value if we do not pitch the level of our bid correctly; and in that regard much will depend on our
investigation of potential targets.
Alternative 2:
We increase our efforts at our current strategy of seeking key technology targets at the best price and redouble our
efforts to manage our own cost base. In our industry cost has become a strategic tool and we have not invested in
advanced manufacturing technology to the extent of some of our competitors. In a contracting environment, it is
important to achieve high levels of efficiency within our matrix structure and to minimise the dysfunctional aspects of
this type of operational management. To this end, we should consider making project leaders responsible for the
labour they utilise at current market rates and establish a coherent project-based budgeting and cost control system.
Alternative 3:
We recognise that our future cash generation is based upon a set of current projects of finite life and that we are
moving into a phase of the company’s life where new positive net present value projects are unlikely to be found. Our
recent history suggests that we do have agency problems, in that there are lower level managers who have
championed projects which have not generated the promised returns. This is indicative of a situation where the market
opportunities are very limited and net present values have been competed down to zero. In this situation, one option is
to return cash to shareholders through enhanced dividends or by share repurchase schemes. The latter approach has
the advantage that it does not signal similar payout commitments in the future.
Alternative 4:
It is recognised that we have a shortage of managerial talent at different levels and that this has been brought about by
relatively low levels of remuneration in comparison to the rest of the sector. Executive remuneration is not just about
salary levels, but we may wish to consider a stock option scheme whereby managers are rewarded for the delivery of
positive net present value investments which hopefully lead to a resulting increase in share price. This may well have
the desirable effect of reducing the agency loss, caused by over-emphasising the merits of projects and overstating
potential returns.
(b) Ethical issues
The key element of this case is that the company is no longer able to find positive net present value projects. As a
result, its rate of growth is slowing and may, very soon, start to decline. The source of growth would appear to be new
 technology and superior management practice in the planning and control of projects and related costs. However, the
company has no effective R & D expertise and its scope for technology- led acquisitions appears to be very limited.
The ethical issue which emerges is that if a company is no longer able to use its owner’s cash, then it should return
money to its investors and not use it to enhance managerial rewards and perks. There is only one justification for
increasing levels of executive remuneration, and that is that those managers are better motivated to create the high
levels of growth that lead to increased shareholder value. There are some who would argue that maximising
shareholder value is a constrained objective and that the company owes a duty to other stakeholders, such as
employees, managers, suppliers and customers.
However, overriding this is the efficiency argument. By returning cash to shareholders, the effective operation of the
capitalist system ensures that they have at their disposal those cash resources, thus making their own judgements
about the most efficient use of those resources – to the greater benefit of the stakeholders of other businesses in
which they choose to invest. The ethical arguments are therefore based upon both social policy and property rights.
Social policy is concerned with the efficient operation of market economies and the maximisation of social welfare and
property rights. That is, the surplus value within a company belongs to its investors, both legally and morally.
Dependent upon the situation, options that increase shareholder return (either through the maximisation of company
value, or by return of cash to them for new investment elsewhere) are to be preferred.
The scenario also raises a question mark concerning the company’s accounting practices and the use of excessively
prudent accounting policies. If the ratio of EBITDA to operating cash flow is consistently less than one for an
expanding company, this would suggest that management is deliberately concealing earnings.
There are a number of reasons for this. Perhaps the company is attempting to smooth its earnings figures in order to
present more consistent performance measures over time, or it is concealing earnings in order to suppress pressure
from various other stakeholder groups for e.g. higher wages or other forms of compensation. It may be that the
company is also trying to present a relatively low earnings history as part of its pricing negotiations. However, this type
of earnings management strategy is self-correcting in the long run and it is doubtful to what extent the market is
misled. The ethical dimension arises if this represents an intention to deceive, rather than a function of the company’s
market sector and the constraints of the GAAP.
Finally (given the ethical requirement to act responsibly) it is also important to consider the environmental issues
presented by the scenario. There is an argument that operational economy and the efficient use of resources has an
environmental dimension, in as far as a given level of growth can be achieved with a given level of inputs. However,
we are informed that the company has been fined for allowing untreated discharge into a local river. As social concern
about the environmental impact of industry increases, the regulation of waste and the penalties for breaches of
environmental security are likely to become more and more severe. In order to protect the interests of all stakeholders,
the company should urgently make the necessary investment to control its effluent discharge. It should also seek to
minimise energy consumption across all of its operations.
5. Large Multinational Pharmaceutical Company
To: Chief Financial Officer
From: Deputy Financial Officer
Four issues of concern
The four issues you have raised with me touch upon our ethical and commercial responsibilities.
(a) The payment of a commission to an official in any country can be justified if it was in recognition of a service
performed that:
– She or he was legitimately entitled to perform for payment;
– That the payment was duly authorised within this company; and
– A service was received, for which the payment was fair and reasonable.
Clearly, such a payment should not have been made if it contravened the ruling law in either this or the official’s
country. Given this, a payment for consultancy, legal or lobbying services to an independent consultant would be
legitimate.
However, given that the individual concerned was an official of the agency concerned then the payment should not
have been authorised. As the payment was for a substantial amount, the matter should be taken up with the
company’s chief executive officer with a view to an internal investigation being mounted.
Disciplinary action should be considered when a more detailed understanding of the circumstances is known. It may
also be appropriate to raise this with the health department in the government of the country concerned with a view to
full public disclosure of the facts, once the situation has been clarified.
 (b) The actions of the agent in using price sensitive information for personal gain would be classed as insider dealing
irrespective of whether the transactions took place on the shares, or on options on the shares of our company.
Much depends on what could be established in the circumstances. Did the agent know that the licensing agreement
would be forthcoming, or was it a speculative trade on the anticipation that it would be granted? If it were the former,
then it would be classed as insider trading.
The more difficult issue relates to speculative trading in that if the attempt to gain the licence was in the public domain,
then the dealing would not be an issue. If however, the agent was only aware of the possibility through his or her
relationship with this company, then it would be insider dealing.
Probably, the most sensible and ethical course of action from the viewpoint of both parties is (that if insider dealing is
involved) the company should encourage the agent to abandon the call options (i.e. to allow these options to expire
unexercised).
(c) This problem raises a number of issues:
– First, hedging is not an efficient means of reducing translation risk. Translation risk arises because of the conversion
of assets and liabilities held in dollars into the domestic currency for accounting purposes. Translation risk will
impact upon the residual earnings of the business, but does not impact upon the company’s cash flow as no
transaction has occurred. There would appear to be an absence of risk management policy in this area and even
though a senior member of the treasury team has been making the trades, policy of this type should be set at board
level through a risk management committee.
– Second, substantial trades of this type should be authorised and again, it would appear, that there is an absence of
policy in this area. Disciplinary action against the treasury manager concerned would only be appropriate if trading of
this type lay outside his or her role description, or if there was an explicit policy in place requiring authorisation for
trades of greater than a given size. In deciding what action to take, making a gain or a loss is irrelevant.
– Third, the current position suggests a $1.25 million loss (i.e. 10% × $12,500,000) is likely against a dollar position of
$12.5 million (i.e. 50 contracts × $250,000). This may not be material from the point of view of the company’s overall
financial position, but the potential for further loss on an uncovered position such as this should be immediately
reversed by shorting (i.e. selling) the contract concerned. If the loss is deemed material, then a brief statement to
shareholders should be made specifying the magnitude of the loss and the action taken.
(d) This problem appears to be an abuse of copyright and as such is against the WTO’s Trade Related Aspects of
Intellectual Property Rights ‘TRIPS’ agreement. However, to gain protection under TRIPS, we have to make sure that
we have made a supply available of the drugs concerned.
If a member country takes the view that we have abused our patent position, then they can issue a ‘compulsory
licence’ which would allow a competitor to produce the product under licence. At a Doha ministerial conference, it was
agreed that TRIPS should not prevent a country adopting measures for the protection of its population’s health. In this
case, it would appear that the dispute is one of piracy and gaining protection through the local courts.
Whilst this could in principle be resolved through the WTO and the dispute resolution procedure, this may be an issue
which would be most satisfactorily resolved through inter-governmental mediation. Any bilateral concession would
need to be made multilateral through the WTO in the light of the member’s most favoured-nation obligations.
It would be worthwhile attempting to discover exactly why the government concerned has blocked access to the courts
– presumably to ensure that there are no public health policy issues involved. Thereafter, there should be an attempt to
secure the involvement of our own government in helping to resolve this issue.
6. Kengai Co (December 2011)
(a) The Triple Bottom Line (TBL) is an accounting framework that incorporates three dimensions of performance: social,
environmental and financial (economic). This differs from traditional reporting frameworks as it includes environmental
(ecological) and social measures that can be difficult to assign appropriate means of measurement. The TBL
dimensions are also commonly called the three Ps: people, planet and profits. The principle of TBL reporting is that a
corporation’s true performance must be measured in terms of a balance between economic (profits), environmental
(planet) and social (people) factors; with no one factor growing at the expense of the others.
Clearly, making money is essential to business success. A TBL company, however, recognises that its own
sustainability rests on its ability to work harmoniously in its social and environmental settings. For this reason, the
costs of pollution, worker displacement, and other factors are included in the profit calculations. That is, companies
that accommodate the pressures of all the three factors will enhance shareholder value by addressing the needs of its
stakeholders and also by building the company’s reputation.
Firms usually issue TBL reports mainly for two purposes: to meet the demands of the investors and also to be
recognized for the actions that the firms performs. Firms are usually being scrutinized by the media coverage and
public watchdog groups. It is an undeniable fact that company directors who are capable of ensuring that their
companies have good reputations in environmental conservation and social policies improve their chances of success.
 The economic/financial impact can be measured using proxies such as operating profits margin and return on capital
employed. Companies that follow the TBL think about the impact their actions have on all the people involved with
them. The proxies to measure this include health care, good working hours, safe working conditions and opportunity
for advancement and education. On the other side measures include whether the company does not exploit its labour
force (say by using child labour or paying very low wages/salaries). TBL companies take pain to reduce or eliminate
their ecological footprint. They strive for sustainability, recognising the fact that going green may be more profitable in
the long-run. They look at the entire life cycle of their actions and try to determine the true cost of what they are doing
in regards to the environment. Proxies such as percentage reduction in energy usage, safe disposal of toxic waste and
usage of renewable energy sources could be used to assess the environmental impact.
(b) The social feature of triple bottom line reporting is focusing on reasonable treatment of a firm’s human resources. In
addition to the provision of a safe place of work and also reasonable salary for workers, being responsible socially
involve performing responsible and helpful business practices in the community that surrounds the business. Triple
bottom line reporting requiries a corporation to be involved in sustainable ecological activities. Corporations and firms
ought to put great efforts to conserve the surroundings, or to significantly minimise the harm that they are inflicting on
the surroundings. A corporation using triple bottom line reporting is capable of managing the utilisation of energy,
minimises waste, recycles resources and also shuns the production of very dangerous substances like toxic
chemicals.
When a business appears to be both socially and environmentally responsible to its clients, it will be capable of
maximising the profits that it is making. It is very common situation to see many companies making headlines due to
being involved in accounting scandals, giving their workers very unjust salaries, unsafe work conditions and prejudice.
All these reports affect the reputation of the firms that are involved through their goodwill, thereby resulting into the loss
of revenues and profits. Also, focusing on wider issues than just profits can help a company open market potential that
was unattainable before. Conversely companies may also lose market share to other competing businesses that are
utilising triple bottom line reporting, because they appear more socially responsible to consumers.
TBL is capable of making a firm to reach untapped markets. Indeed TBL firms are capable of finding niches that are
financially profitable, and which were previously missed by the firms when their driving force was money only.
For example in social entrepreneurship, the businesses that are having hopes of reaching this growing market have to
prepare themselves of being profitable financially, socially helpful and economically sustainable or else they will not be
able to compete with the firms which are not designing themselves that way. For instance, ethically trading firms need
moral and sustainable practices from every supplier providing them with goods and services. Any businesses that
have plans of working with the firms that are dealing in moral and sustainable trade have to design their business
models to become TBL.
Through the integration of sustainability into the business models and thinking, a company is capable of realising the
following bottom line benefits:
Enhancement of reputation and brand
Efficient communication with the shareholders and also the stakeholders on one or more dimensions of TBL plays a
significant role in the management of the perceptions of the stakeholders. This will not only protect but also enhance
the reputation of the company.
Securing a social licence to operate
Having a good reputation, the members of the community and the stakeholders will strongly support the operations of
the organisation. The surrounding communities will probably provide more support to the company because they are
communicating openly and the company is honest about their performance in relation to environmental factors, social
factors and economic factors.
Attraction and retention of high calibre employees
Through the publication of the information regarding TBL, the information is capable of playing a significant role in
positioning the company as an employer to work for. This helps enhance worker loyalty, reduces staff turnover and
attracts skilled workers.
Reduced risk profile
During TBL’s reporting, the company will usually indicate its obligation to minimise risk, within reason. This takes place
during the times of growing legal action so the more that the company recognises the risks it faces, the better those
risks can be managed. Consequently this advances relations with stakeholders, makes it simpler to attract investment
capital and consequently positively influence the price of the shares.
Identification of potential cost savings
TBL reporting involves the scrutiny of information on resources, the usage of materials and the evaluation of business
processes. This helps the company to identify the opportunities that are present for savings of costs through effective
and efficient allocation of both resources and materials.
 Reduced risk, easier financing
If the company shows both environmental and social responsibility it is likely to be seen as less dangerous. That is
capable of translating into cost reduction, reduced insurance premiums and lower regulatory costs.
One of the main problems of TBL reporting is that it lacks a universal method of gauging/measuring its success as
there is no social, economic, environmental or ethical equivalents of assets, liabilities, equity, expenses and revenue
and no numerical method of accurately describing consumer, environmental or community benefits. Other problems
associated with TBL are lack of understanding by top management, lack of human resource capacity, lack of support
from the government and other development agencies, resistance by privately listed firms to reveal their financial
information and resource constraints that affect SMEs.
Conclusion
In all the above examples, the result of the assessment required in producing the TBL report and comparing the
corporation’s progress to its aim of becoming a sustainable organisation will create opportunities which senior
managers can develop into financial benefits. The company should assess the costs versus benefits of adopting the
TBL and ensure that the benefit outweighs the costs in the long-run.
7. Ennea Co (June 2012)

Tutor's Tips

Ennea Co relates to basic ratios analysing the effect of different financing options on some key accounting ratios. This
type of question is not regularly tested as the subject matter relates more to F9.
(a)
• Calculate the effect of each proposal on the income statement and statement of financial position. You need to apply
the basic principles of double entry.
• Calculate the ratios, EPS and gearing for each option.
• Discuss the outcome of your calculations by comparing to the current ratios (position) and selecting the best
outcome.
(b)
• The question relates to securitisation and your answer should be related to the question. Do not discuss
securitisation in general. In addition, discuss the challenges the company may face when using this type of
securitisation.
• Session (b) should be answered first as it is a straightforward discussion question on securitisation. There are also
some easy marks to be collected from the effects on the financial statements relating to requirement (a).

(a) Forecast financial statement after adjustment of each proposal

Adjusted earnings after tax Proposal 1 Proposal 2 Proposal 3

$000 $000 $000

Forecast earnings before adjustment 26,000 26,000 26,000

Net interest on amount borrowed (W1) (1,000) (1,000) 0

Adjustment for original interest (W2) (280) (280) 0

Return on investment (W3) 0 3000 0

Net profit on sale of asset (W4) 0 0 1,600

Loss of earning due to asset sale (W5) 0 0 (3,750)

Interest saved due to decrease in interest rate (W6) 0 0 136

Interest saved on the debt paid (W7) 0 0 1,296

Adjusted earnings 24,720 27,720 25282

Adjusted statement of financial position $000 $000 $000

Non-current asset (W8) 282,000 302,000 257,000

Current assets (W9) 64,720 67,720 63,282

Total assets 346,720 369,720 320282

Share capital (40c per share par value) (W10) 45,500 48,000 48,000

Retained earnings (W11) 104,220 124,720 122,282

Total equity 149,720 172,720 170,282

Non-current liabilities (W12) 160,000 160,000 113,000

Current liabilities (no effect) 37,000 37,000 37,000

Total liabilities 197,000 197,000 150,000

Total equity and liabilities 346,720 369,720 320,282

Effect/impact on earnings per share and gearing

Current Proposal 1 Proposal 2 Proposal 3

Gearing:

Non–current liability = debt 140,000 160,000 160,000 113,000

Equity 171,000 149,720 172,720 170,282

Gearing Ratio 81.9% 106.9% 92.6% 66.4%

Earnings per share

Adjusted Earnings 26,000 24,720 27,720 25,282

Number of shares (W13) 120,000 113,750 120,000 120,000

Earnings per share in cents 21.67 21.73 23.10 21.07

Discussion
Proposal 1
Under this proposal earnings per share increase from the current level of 21.67 cents to 21.73 cents, representing an
2.8% increase, due to the reduction in the number of shares and earnings decreasing by only 5%. The decrease in
earnings is mainly attributable to the increase in interest payments as a result of the additional debt of $20 million. The
gearing of the company would also increase from 81.9% to 106.9%, signifying a substantial increase in financial risk of
about 30%. Both earnings per share and gearing under this proposal are worse than that of proposal 2 and 3 and
therefore would not be attractive to the company.
Proposal 2
Under this proposal earnings per share increase from the current level of 21.67 cents to 23.10 cents, representing only
a 6.6% increase due to the increase in earnings, as a result of the return on assets being more than the additional
interest payments on the new and existing debt. The number of shares remained constant. The gearing ratio increased
by about 13% due to the increase in debt from the $20,000 new debt capital. This will increase financial risk but not as
much as proposal 1.
Proposal 3
Under this proposal earnings per share decrease from the current level of 21.67 cents to 21.07 cents, representing a
decrease of 2.8%. Even though the number of shares remained constant, the earnings fell due to the loss in earnings
as a result of selling the asset being more than the net profit on the asset sale and the savings on interest. However,
the gearing of the company decreased substantially, thereby reducing the financial risk.
Conclusion
From the above analysis it can be concluded that proposal 1 would not be attractive to the company. Proposal 2 offers
better earnings per share than proposal 3 but has a higher gearing and financial risk than proposal 3. The choice
between proposal 2 and 3 would depend on the company’s attitude towards risk, reaction of its shareholders and the
effect on its overall cost of capital.
Workings:
Net interest on amount borrowed (W1)
Proposal 1 and Proposal 2
Increase in borrowing will result in an increase in interest rates by 0.25% (25 basis points). Given current interest rate
of 6%, the current interest net of tax = 6.25% x $20,000 x (1 - 0.2) = $1000
Adjustment for original interest (W2)
Proposal 1 and Proposal 2
The additional interest of 0.25% (25 basis points) also affects the existing debt. The net additional interest is = 140,000
x 0.25% x (1 – 0.2) = $280
Return on investment (W3)
This affects proposal 2 only because by buying the new asset the return post-tax on that asset would be 15%. Return
post-tax = 15% x $20,000 = $3,000.
Net profit on sale of asset (W4)
This affects proposal 3 only. The asset to be sold has a book value of $25,000 and would be sold for $27,000 therefore
making a profit of $2,000. However, this profit is before tax and should be subject to tax of 20%, hence the after-tax
profit is $2000 – $400 (20% x 2,000) = $1,600.
Loss of earnings due to asset sale (W5)
This affects proposal 3 only. When the asset is sold there would be a decrease in post-tax return by 15%.
Loss post-tax = $25,000 x 15% = $3,750
Interest saved due to the decrease in interest rate (W6)
This affects proposal 3 only. Reduction in borrowing would save interest on the remaining borrowing by 15%.
Remaining borrowing = $140,000 – $27,000 paid from the asset sale proceeds = $113,000
Interest saved net of tax = $113,000 x 0.15% x (1 – 0.2) = $136
Interest saved on the debt paid (W7)
The debt paid would save net interest of $27,000 x 6% x (1 – 0.2) = $1,296
Non-current asset (W8)
Proposal 1: No effect
Proposal 2
The non-current asset should increase by the additional asset purchase of $20,000.
Total non-current assets = $282,000 + $20,000 = $302,000
Proposal 3
The non-current asset should reduce by the book value of the asset sold of $25,000.
Total non-current assets = $282,000 - $25,000 = $257,000
Current assets (W9)
Proposal 1
The current asset should decrease by the additional net interest paid of $1,000 and $280 deducted from the earnings.
Total current assets = $66,000 – $1,000 - $280 = $64,720
Proposal 2
The current asset should decrease by the additional net interest paid of $1,000 and $280 deducted from the earnings
and increase by extra cash obtained from the extra return on the asset of $3,000, which is added to earnings.
 Total current assets = $66,000 – $1,000 - $280 + = $67,720
Proposal 3
Current assets should decrease by the cash lost due to loss of earnings of $3,750 and tax paid on the profit on sale of
the asset ($400) and increase by interest saved on debt paid of $1,296 and saving on other debt interest of $136.
Total current assets = $66,000 – $3,750 - $400 + $1,296 + $136 = $63,282
Share capital (40c per share par value) (W10)
Proposal 1
$20,000 of the equity was paid. Given a market price of $3.20, 6250 shares (20,000/3.20) were purchased. However,
only the nominal value is recorded in ordinary share capital, so given a nominal value per share of 40 cents, 6250 x
$0.4 = $2,500 should be deducted from share capital.
Total share capital = $48,000 – $2,500 = $45,500
The remaining payment of $17,500 ($20,000 – $2,500) is deductible from retained earnings. This represents premium
on purchase of share.
Proposal 2: No effect
Proposal 3: No effect
Retained earnings (W11)
Proposal 1
The retained earnings should be adjusted by deducting the extra interest expenses paid of $1,000 and $280, and the
premium paid on the purchase of the shares of $17,500.
Total retained earnings = $123,000 - $1,000 - $280 - $17,500 = $104,220
Proposal 2
The retained earnings should be adjusted by deducting the extra interest expenses paid of $1,000 and $280, and
adding the return on the asset of $3000.
Total retained earnings = $123,000 - $1,000 - $280 + $3,000 = $124,720
Proposal 3
The retained earnings should be adjusted by deducting the loss on earnings due to the sale of asset ($3,750) and
adding interest saved of $1,296 and $136, and also the net profit from the sale of asset of $1600.
Total retained earnings = $123,000 - $3,750 + $1,296 + $136 + $1,600 = $122,282
Non-current liabilities (W12)
Proposal 1 and proposal 2
The current non-current liabilities are to be increased by the amount of the new borrowing of $20,000.
Total non-current liabilities = $140,000 + $20,000 =$160,000
Proposal 3
The current non-current liabilities are to be decreased by the amount of the debt paid from the proceeds of the sale of
asset of $27,000.
Total non-current liabilities = $140,000 - $27,000 =$113,000
Number of shares (W13)
Number of shares is the total nominal value divided by the nominal value per share.
Proposal 1
Number of shares = $45,500/$0.4 = 113,750 shares
Proposal 2 and proposal 3
Number of shares = $48,000/$0.4 = 120,000 shares
(b) The securitisation would involve converting the lease rentals/receipts into assets and that the assets are sold as
bonds. The bonds will be serviced by the income received from the underlying assets and, on the maturity of the
bonds, the amounts owing may be repaid in various ways including from the income generated from the underlying
assets, the issue of new bonds or by the repayment of the underlying claims (e.g. where mortgage obligations provide
the asset backing).
Individual securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche
has a different level of credit protection or risk exposure: there is generally a senior (“A”) class of securities and one or
more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A” class. The senior
 securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a
lower credit rating, signifying a higher risk.
In order to improve the marketability of the securitisation issue, investors may be offered protection against the risk that
the underlying assets are of poor quality. This may be done in various ways such as providing credit insurance from a
third party or offering underlying assets of greater value than the value of the security issue. In the securitisation
process a rating agency would normally advise on the structure of the liabilities created, such that the AAA tranche will
attract investors such as banks and other financial institutions who demand a low level of risk exposure. This reduction
in risk for the senior and intermediate level notes is balanced by a significant transfer of risk to the subordinated
certificate holders. Dividing up the issue rather than creating a single issue of an asset backed security is the most
important mechanism for credit enhancement.
Securitisation may be of benefit to a business in reducing credit risk. Where, for example, a bank has been engaged in
heavy borrowing to a particular sector of industry, it may reduce its risk by selling some of the loans through a
securitisation issue. The effect of such a move will also result in releasing tied-up capital and may enable the bank to
use the capital for more profitable purposes. Securitisation can also be helpful to a business in overcoming short-term
cash flow problems as the sale of the assets results in an immediate injection of funds. Investors may find a
securitisation issue attractive because the securities are marketable and, for reasons already mentioned, the
underlying assets provide good security.
However, the main barrier of securitisation is that it is an expensive process as it involves higher management and
administrative costs as well as legal fees. Given that the asset the company want to sell is small, these costs may
represent a significant proportion of the income.
8. Kilenc Co (June 2012)

Tutor's Tips
This is a discussion question relates to international investment appraisal. Investment appraisal is regularly tested in P4
exams.
(a)
• This is a regular discussion question on factors to consider before establishing a foreign subsidiary/foreign direct
investment.
• Remember to relate the factors to the scenario rather than giving general answers.
(b) A discussion question on Dark pool trading.
Both requirements (a) and (b) are fairly straightforward and candidate should be able to obtain reasonable marks.

(a) Kilenc Co has to consider many factors before establishing the subsidiary in Lanosia, some of which are as follows:
Exchange rate
Changes in exchange rates can cause considerable variation in the amount of funds received by the parent (Kilenc
Co) company. The company will face both economic and translation exposure as a result of exporting to the
neighbouring countries. The changes in exchange rates may result in the company receiving more or less and the long
term effect is that the value of the company will fluctuate with the changes in exchange rate.
Political and fiscal risk
The company may face political and fiscal risk as Kilenc Co will find it difficult to establish the subsidiary in that country
because that is likely to be seen as against the government intention to develop local industry. The company may be
restricted by way of increased taxes, including imposition of excise duties on imported goods or services and
imposition of indirect taxes. However, it may also be that the government may want to encourage foreign direct
investments and Kilenc Co may receive tax incentives.
Composition of ownership
The composition of the Board of Directors and the large proportion of the subsidiary’s equity held by minority
shareholders may create agency issues and risks.
Regulatory risk
The company may also face regulatory risk. Regulatory risk is a risk that arises from changes in the legal and
regulatory environment which determines the operation of a company. Examples are anti-monopoly laws, health and
safety laws, copyright laws and employment legislation.
Agency issues and risks
The composition of the Board of Directors and the large proportion of the subsidiary’s equity held by minority
shareholders may create agency issues and risks. The company may find that the subsidiary’s Board make decisions
which are not in the interests of the parent company, or that the shareholders attempt to move the subsidiary in a
direction which is not in the interests of the parent company. On the other hand, the subsidiary’s Board may feel that
the parent company is imposing too many restrictions on its ability to operate independently and the minority
shareholders may feel that their interests are not being considered by the parent company.
Cultural risk
The company needs to consider the cultural issues when setting up a subsidiary in another country. These may range
from cultural issues of different nationalities and doing business in the country to cultural issues within the organisation.
Communication of how the company is organised and understanding of cultural issues are very important in this case.
The balance between independent autonomy and central control needs to be established and agreed.
Financing of the project
The company intend to finance the project by means of equity and debt. Even though raising the capital in Lanosia will
result in a natural hedge as the income generated from the project would be used to service its finance, the company
should consider how easily it can raise such capital in Lanosia as a foreign company and the higher cost associated
with such financing. Given that the government has had to finance the banks may mean that the availability of funds to
borrow may be limited. Also interest rates are low at the moment but inflation is high, this may result in pressure on the
government to raise interest rates in the future. The consequences of this may be that the borrowing costs increase for
Kilenc Co.
Costs and benefits of the subsidiary
The company needs to compare the costs and benefits of establishing the subsidiary. A full investment appraisal need
to be done to assess if the project will result into a positive net present value. Given the fact that the country is
experiencing recession, the demand for the product may be affected. In evaluating this venture the company should
also consider the value of the real option effect as this project may open other opportunities for the company to do a
follow-up venture.
Opportunity cost
The company should also consider the opportunity cost of establishing the subsidiary in Lanosia. If the company
currently exports to Lanosia there would be lost contribution if the Lanosia subsidiary is established, as the company
cannot export to that country and the neighbouring countries. In addition to lost contribution, the company may have to
downsize its operations in the parent country causing redundancies. This may have a negative effect on the company’s
reputation.
The company may adopt the following techniques to reduce the risk:
Structuring the investment in such a way that it becomes an unattractive target for government action. For example,
the company might ensure that manufacturing plants in risk-prone countries are reliant on imports of components from
other parts of the group, or that the majority of the technical “know-how” is retained by the parent company. These
actions would make expropriation of the plant far less attractive.
Clear corporate governance mechanisms need to be negotiated and agreed on, to strike a balance between central
control and subsidiary autonomy. The negotiations should involve the major parties and legal advice may be sought
where necessary. These mechanisms should be clearly communicated to the major parties.
Borrowing locally so that in the event of expropriation without compensation, the enterprise can offset its losses by
defaulting on local loans.
Prior negotiations with host governments over details of profit repatriation, taxation, etc, to ensure no problems will
arise. Changes in government, however, can invalidate these agreements.
Effective marketing communication such as media advertising should be conducted for the products produced by the
subsidiary, to ensure that the customers’ perceptions of the new products do not change. This could be supported by
retaining the packaging of the products. Internal and external communication should explain the consequences of any
negative impact of the move to Lanosia to minimise any reputational damage. Where possible, employees should be
redeployed to other divisions in order to minimise any negative disruption.
Attempting to be “good citizens” of the host country to reduce the benefits of expropriation for the host government.
These actions might include employing large numbers of local workers, using local suppliers, and reinvesting profits
earned in the host country.
The subsidiary organisation should be set up to take account of cultural differences where possible. Induction sessions
for employees and staff handbooks can be used to communicate the culture of the organisation and how to work within
the organisation.
Sensitivity and probability analysis should be undertaken to assess the impact and possibility of falling revenues and
rising costs. Analysis of real options should be undertaken to establish the value of possible follow-on projects.
The company could use currency hedging techniques, such as swaps, to protect itself against adverse movement in
exchange rates.
 (b) The term “Dark pool” trading relates to trades which are concealed from the public – as if they had been undertaken
in “pools of murky water”. Many traders believe that such activities should be publicised in order to make trading more
fair for all parties involved, so that all such transactions are performed on “a level playing field”.
Dark pool trading refers to the volume of trade created by institutional investors in financial trading venues or “crossing
networks” that are unavailable to the general public. The bulk of ‘Dark pool’ liquidity is represented by block trades
undertaken away from the central exchanges. Such transactions are never displayed and are useful for institutions
who wish to deal in large numbers of shares, whilst not revealing such trades to the open market.
Dark liquidity pools avoid the risk of revealing the actions of such institutions, since neither the identity of the trader nor
the price at which the transactions took place are displayed. Dark pools are recorded as over-the-counter transactions,
but detailed information is only reported to clients if they so desire and are under a contractual obligation to do so.
The ‘Upstairs market’ allows Fund managers to move large blocks of equity shares without revealing details as to what
has actually occurred. The lack of human intervention within the electronic platforms employed has reduced the
timescale for such trades. The increased responsiveness of equity price movements has made it extremely difficult to
trade large blocks of shares without affecting the price. It is unlikely that the dark pool trading systems would have an
impact on Kilenc Co’s subsidiary company because the subsidiary’s share price would be based on Kilenc Co’s share
price and would not be affected by the stock market in Lanosia.
9. Limni Co (June 2013)
(a) Limni Co is a high growth company and requires cash flows to finance rapid growth. It is not paying any dividend in
order to retain profit to finance further investments. Shareholders of such high growth companies are happy to receive
their returns in the form of capital appreciation than in the form of dividend return.
According to the Pecking order theory the main preference is to obtain finance from retained earnings before raising
funds externally. If a firm has to raise funds externally, its preference of financing method in descending order (Pecking
order) is straight debt, followed by convertible securities, preference shares and equity shares. The reason for the
Pecking order is that there are no issue costs if retained earnings are used, and the issue costs of debts are cheaper
than those of equity. It is easier to use retained earnings than go to the trouble of obtaining external finance and have
to live up to the demands of external finance providers.
However, capital structure theory suggests that because of the benefit of the tax shield on interest payments,
companies should have a mix of equity and debt in their capital structure. Since Limni Co operates in a rapidly
changing industry, it likely faces significant business risk. A capital structure with significant debt levels would involve
high financial risk, something Limni Co cannot afford. This, along with agency costs related to restrictive covenants,
may have determined Limni Co’s financing policy.
Risk management theory suggests that managing the volatility of cash flows helps a company plan its investment
strategy better. Limni Co needs to manage its cash flows to ensure that cash is available for future projects. Moreover,
because Limni Co faces high business risk, managing the risk that the company’s managers cannot control through
their actions may be even more necessary. The change to making dividend payments or undertaking share buybacks
will affect all three policies. The company’s clientele may change, leading to fluctuations in share price. However, since
the push for change is coming from the shareholders themselves, there may not be large share price fluctuations.
Limni Co may have to look at accessing the debt markets, due to the reduction in available internal funds. Its financing
policy will therefore change, causing it to look again at its business risk–financial risk balance. A change in financial
structure may lead to a change in risk management policy, because Limni may now have to manage interest rate risk
as well.
(b) Theta
From the information provided and comparing the profit after tax and the dividend payment, it can be deduced that
Theta is paying 40% of its profit after tax as dividend and having a fixed dividend cover of 2.5 every year. Paying a
constant pay-out ratio means that decrease in profit will result in decrease in dividend payment and this may not be
good for shareholders who invested for the purpose of dividend return. The uncertainty about the amount of dividend
may lead to fluctuation (fall) in share price.
Omega
Omega is not paying a constant pay-out ratio of its profit after tax as dividend, but annual dividends are growing at a
stable rate of approximately 5% per year, while the company’s profits after tax are growing steadily at around 3% per
year. Also a high proportion of earnings are paid out as dividends, increasing from 60% in 2009 to almost 65% in 2013.
Such an investment would be attractive to investors requiring high levels of dividend returns from their investments.
Kappa
Kappa appears to be a growing company with its profit after tax growing between 3% to 35% and dividend growing by
29% to 30% from 2009 to 2013. Dividend payment represent on 20% in 2009 to 27% in 2013 indicating that most of
 the profits are retained to finance future growth. Such an investment would be attractive to investors requiring lower
levels of dividend returns, but higher capital returns from their investments.
The company Limni Co should invest in would depend on the objective it wants to achieve on the investment, ie
whether to achieve capital gain or to receive more dividend. From the above analysis it can be concluded that if Limni
Co’s objective is to receive higher dividend it should choose omega as it pays more of its profit as dividend, but if the
objective is to achieve capital gain then it should invest in Kappa. Limni Co may not want to invest in Theta due to the
uncertainty about the amount of dividend receivable and the potential fall in share price.
(c) Current dividend capacity of Limni Co
The dividend capacity of the company should be assessed based on the free cash flows to equity.

$000

Profit before tax ($600,000,000 × 23%) 138,000

Tax ($138,000,000 × 26%) (35,880)

Add back depreciation ($220,000,000 × 25%) 55,000

Less investment in assets (67,000)

Remittances from overseas subsidiaries 15,000

Additional tax on remittances ($15,000,000 × 6%) (900)

Dividend capacity (free cash flow to equity) 104,220

10% increase in dividend capacity after tax = 10% × $104,220 = $10,422

10% increase in dividend capacity before tax = $10,422/(100% − 6%) = $11,087
Percentage increase = $11,087/15,000 = 74%
Dividend from subsidiaries should increase by 74% before Limni Co can increase dividend capacity by 10%. This may
have a negative effect on the subsidiaries’ cash flows and working capital and may discourage the managers of those
subsidiaries.
(d) A buyback is beneficial to shareholders as it increases the percentage of ownership of each investor by reducing the
total number of outstanding shares.
Increased shareholder value – There are many ways to value a profitable company but the most common measurement
is Earnings Per Share (EPS). If earnings are constant and the number of outstanding shares decreases, there will be
an increase in period-to-period EPS.
Higher stock prices – An EPS increase often alerts investors that a stock is undervalued or has the potential to increase
in value. This will usually result in an increase in demand and an upward movement in the stock price.
Increased float – When the number of outstanding shares decreases, the remaining shares represent a larger
percentage of the float. If demand increases and supply does not meet demand, then there is a greater possibility of
upward movement in the stock price.
Excess cash – Companies usually buy back their stock with excess cash. If a company has excess cash, we can
conclude that it does not have a cash flow problem. However, this also indicates that the company’s executives prefer
reinvesting in the corporation rather than investing in alternative investments, as they believe that the former will
provide better returns.
Income taxes – When a company uses excess cash for a buyback instead of increasing or paying dividends,
shareholders often have the opportunity to defer capital gains and lower their tax bill if there is an increase in stock
price. While dividends are taxed as ordinary income in the year they are received, the sale of appreciated stock is
taxed when sold. Additionally, if the stock is held for more than one year the gain will be subject to lower capital gain
rates.
Price support – Companies often announce a buyback when their share prices have dropped, this is to take
advantages of the low price. This also indicates to investors that the company has confidence that its prices will go up;
this will in turn lend support to the stock price and security to long-term investors.
Discounted cash flow techniques and application of option pricing theory

10. Jonas Chemical Systems Ltd (Pilot paper 2012)

(a) Board Paper Presenting Proposed Procedures for Large Capital Expenditure Projects
This paper proposes revised guidelines for the Board approval of large capital investment projects. The current two-
stage process of preliminary and final approval serves an important role in ensuring that any initial concerns of the
Board in terms of strategic fit and risk are brought to the attention of the Financial Appraisal Team. The two stage
process would consider:
Stage 1:
Business proposal including assessment of strategic requirement, business fit and identified risks.
Outline financial appraisal to include capital requirement, mode of financing, expected net present value, modified
internal rate of return and project duration.
It is recommended that the conventional payback method is dropped, because it ignores the cost of finance and the
magnitude of post-payback cash flows. Duration is recommended as this measures the time required to recover half of
the project’s weighted average present value.
Duration is defined as “the average time taken to recover the cash flows on an investment. The average is taken as the
weighted average of the number of the year (1 to n) in which the cash flows arise. In capital investment the duration
can be calculated either using the firm’s original outlay or the present value of its future cash flows as the basis for the
annual weighting”.
Stage 2:
– A proposed business plan must be presented giving the business case with an assessment of strategic benefits, risks,
finalised capital spend and capital sources.
– A value impact assessment giving a NPV calculation supported by a calculation of the project value at risk. The NPV of the
project represents our best estimate of the likely impact of the investment on the value of the entity. This is the key
statistic from the capital market perspective in that unless we are assured that the project NPV is positive, then
investment will reduce and not enhance the value of the firm. This NPV calculation should be supported by a
modified internal rate of return, which measures the additional economic return of the project over the company’s
cost of capital where intermediate cash flows are reinvested at that cost of capital. In a highly competitive business,
the reinvestment assumption implicit in the MIRR is more realistic than that assumed with IRR, where intermediate
cash flows are assumed to be reinvested at the IRR. This may be satisfactory for near-the-money projects, but is far
less satisfactory for projects which offer high levels of value addition to the enterprise.
– An accounting impact assessment, including the differential rate of return on capital employed and a short-term liquidity
assessment. Although positive NPV projects are value enhancing they may not do so in ways that are readily apparent
in the financial reports. To manage investor expectations effectively, the company needs to be aware of the impact of
the project on the company’s reported profitability and this is most accurately reflected by the differential rate of
return measure. Accounting rate of return, as normally calculated, does not examine the impact of the project on the
financial position of the company, but is restricted to the rate of return the investment offers on the average capital
employed.
– An assessment of the project duration. This project, for example, reveals a duration of 4.46 years which is the mean time
over which half of the project value is recovered. This is more useful than the other liquidity based measures
especially when used as a relative (as opposed to an absolute) measure of the cash recovery. Cash recovery
assumes that the future project cash flows are achieved at a constant rate over the life of the project.
(b) The proposed business case concludes that this is a key strategic investment for the company to maintain operating
capacity at the Pembroke Plant. The financial assessment is as detailed above (excluding an assessment of the
impact of the project on the financial reports of the company).
(i) Probability of a positive NPV and Project Value at Risk
Probability of a positive NPV
The NPV of this project is calculated using a discount rate of 8% and gives a value of $1.964 million. The volatility
attaching to this NPV of $1.02 million indicates that there are a number of standard deviations between the expected
NPV and a zero NPV. Therefore is set to zero i.e.

From the normal distribution tables, 1.9255 gives 0.473 (approx).

 (0.5 + 0.473) = 0.973 i.e. a 97.3% probability of a POSITIVE NPV, in other words, there will be a 2.7% probability of
a NEGATIVE NPV.
Project Value at Risk (VaR)
Value at risk is defined as “the value which can be attached to the downside of a value or price distribution of known
standard deviation and within a given confidence level. Value at risk and related measures give an indication of the
potential loss in monetary value which is likely to occur with a given level of confidence. The setting of the
confidence level is necessary because in principle, if a price distribution is normally distributed for example, the
downside loss is potentially infinite”.

σZ = X – µ
σZ + = X
X = σZ + µ
However, project VaR relies upon an assessment of the number of years during which the project cash flows are at
risk. In this case there is a 10 year period. Therefore the formula is amended as follows:
X = σZ

+µ
in this case

= 3.162
At a 95% confidence level, for a one-tailed probability, 0.45 is approximately 1.645
VaR (X) = (1.02 × 1.645 × 3.162) + 0 = $5.31m
At a 99% confidence level, for a one-tailed probability, 0.49 is approximately 2.327
VaR (X) = (1.02 × 2.327 × 3.162) + 0 = $7.51m
These values reflect the fact that the capital invested is at risk for 10 years and assumes that the volatility of the
project is fairly represented by the volatility of its NPV.
(ii) Project Return
The internal rate of return is shown as 11.0%. The Modified Internal Rate of Return (MIRR) is calculated by (i)
projecting forward the cash flows in the recovery stage of the project at 8% to a future terminal value of $41.798
million, and (ii) discounting back the investment phase cash flows to give a present value of the investment of
$17.396 million. The nth root (in this case 10, i.e. the project life) of the future terminal value of the recovery stage
cash flows, divided by the present value of the investment phase cash flows, is then calculated. Finally, 1 is
subtracted from this result to reveal the MIRR i.e.
Recovery phase

Year $m Compound factor 8% $m

3 4.50 1.087 7.712

4 6.40 1.086 10.156

5 7.25 1.085 10.653

6 6.50 1.084 8.843

7 5.50 1.083 6.928

8 4.00 1.082 4.666

9 (2.00) 1.08 (2.16)

10 (5.00) 1 (5.00)
 Terminal value of recovery phase cash flows 41.798

Investment phase

Year $m Discount factor 8% $m

0 (9.50) 1 (9.50)

1 (5.75) 0.926 (5.325)

2 (3.00) 0.857 (2.571)

Present value of investment phase cash flows (17.396)

The MIRR of 9.16% suggests that the margin on the cost of capital (i.e. 8%) is rather small, with a premium of only
1.16% for the strategic and competitive advantage implied by this project.
(iii) Project liquidity
Project recovery period
Having calculated the terminal value of the recovery phase cash flows, there is a quick way in which an approximate
present value of those cash flows can be calculated over the 10 year life of the project i.e. ($41.798 ÷ 1.0810) =
$19.361m. It is now possible to establish the recovery period of this project, which has a 2 year investment phase
with a PV of $17.396 and an 8 year recovery phase i.e.

The above calculation effectively assumes that the recovery cash flows arise evenly throughout the recovery period.
However, in this instance, the actual recovery period is shorter than this, because significant cash inflows occur
earlier (rather than later) during the recovery phase of the project.
Project duration
In the solution which follows, duration is based upon the average time taken to recover the present value of the
project. Therefore the present value of recovery cash flows must be established for each year of the project i.e.

Year $m Discount factor (8%) $m

3 4.50 0.794 3.573

4 6.40 0.735 4.704

5 7.25 0.681 4.9372

6 6.50 0.630 4.095

7 5.50 0.583 3.2065

8 4.00 0.540 2.16

9 (2.00) 0.500 (1.0)

10 (5.00) 0.463 (2.315)

PV of Recovery Phase 19.3607

Project duration (taken to recover the present value of the project) can now be calculated i.e.

Year As above PV Year Weighted

$m $m number years

3 3.573 ÷ 19.3607 = 0.1845 × 3 = 0.5536

 4 4.704 ÷ 19.3607 = 0.2430 × 4 = 0.9719

5 4.9372 ÷ 19.3607 = 0.2550 × 5 = 1.275

6 4.095 ÷ 19.3607 = 0.2115 × 6 = 1.269

7 3.2065 ÷ 19.3607 = 0.1656 × 7 = 1.1593

8 2.16 ÷ 19.3607 = 0.1116 × 8 = 0.8925

9 (1.0) ÷ 19.3607 = (0.0517) × 9 = (0.4649)

10 (2.315) ÷ 19.3607 = (0.1196) × 10 = (1.196)

Weighted average number of years 4.4604

Project duration is therefore 4.46 years

Therefore, in this case, the project duration is calculated by multiplying the proportion of cash recovered in each year
(i.e. discounted recovery cash flow and then present value of the recovery phase) by the relevant year number from
project commencement. The sum of the weighted years gives the project duration.
The project duration reveals that this project is more highly cash generative in the early years - notwithstanding the
two year investment phase.
In summary, the analysis confirms that this project is financially viable as it will add value to the company, although
there is substantial value at risk given the volatility of the net present value stated. In terms of return, the premium
over the company’s hurdle rate is small at 1.16% and any significant deterioration in the company’s cost of capital
would be very damaging to the value of this project. The liquidity statistics reveal that the bulk of the project’s cash
returns are promised in the early part of the recovery phase and that half of the present value of the project should
be recovered before the end of the fifth year. Taking this into account, acceptance of the project is recommended to
the Board.
11. Fuelit
(a) Financial evaluation of the alternative power station:
Gas fuelled power station

Cash flows at current prices

(£ million)

Year 4 -13 (annual) 14-28 (annual)

Revenue 800 800

Labour 75 75

Fuel purchases 500 500

Sales and marketing 40 40

Customer relations 5 5

Other 5 5

Tax allowable depreciation 60 0

685 625

Taxable profit 115 175

Taxation (30%) 34.5 52.5

80.5 122.5
Add back tax depreciation 60 0

140.5 122.5

Present values year 4 – 13 at 6%: 140.5 × 7.360 × 0.84 (end of year 3) = £868.6
Present values year 14 – 28 at 6%: 122.5 × 9.712 × 0.469 (end of year 13) = £558.0
Other cash flows (£ million)

Year 1 2 3 4 28

Redundancy 4

Capital outlay 300 300

Decommissioning costs 0 0 10 0 25

300 300 10 4 25

DF 6% 0.943 0.89 0.84 0.792 0.196*

PV 282.9 267 8.4 3.168 4.9

Total PV £566.37

= 0.196
Expected net present value = £868.6 + £558.0 - £566.37 = £860.23 million.
Notes:
– The interest cost is included in the discount rate.
– Decommissioning is assumed to have the same risk as the rest of the project.
– Discount rate is calculated as:
Gas cost of equity using CAPM is = 4.5% + 0.7(14% - 4.5%) = 11.15%
WACC = 11.15% × 0.65 + 8.5% (1 - 0.3) × 0.35 = 9.33%
However, this is the nominal cost of capital which includes inflation. The cash flow projections exclude inflation and
must be discounted at a real cost of capital.

Nuclear cost of equity using CAPM is 4.5% + 1.4(14% - 4.5%) = 17.8%

WACC = 17.8% × 0.40 + 10%(1 - 0.3) × 0.60 = 11.32%
Real cost of capital is

These estimates of the discount rates assumes that the value of the pound will not change relative to the Euro, or
alternatively that the UK will join the Euro UK bloc in the near future. If this does not occur, and inflation differential
between the UK and Euro bloc remain similar, the cost of debt should be slightly less as the Euro is expected to fall in
value relative to the pound.
Nuclear fuelled power station:

Cash flows at current prices (£ million)

Year 4 -13 (annual) 14-28 (annual)

Revenue 800 800

Labour 20 20

Fuel purchases 10 10

Sales and marketing 40 40

Customer relations 20 20

Other 25 25

Tax allowable depreciation 330 0

445 115

Taxable profit 355 685

Taxation (30%) 106.5 205.5

248.5 479.5

Add back tax depreciation 330 0

578.5 479.5

Present values year 4 – 13 at 8%: 578.5 × 6.71 × 0.794 (end of year 3) = £3,082
Present values year 14 – 28 at 8%: 479.5 × 8.559 × 0.368 (end of year 13) = £1,510.3
Other cash flows (£ million)

Year 1 2 3 4 28

Redundancy 36

Capital outlay 1,650 1,650

Decommissioning costs 0 0 10 0 1,000

1,650 1,650 10 36 1,000

DF 8% 0.926 0.857 0.794 0.735 0.116

PV 1,527.9 1,414.05 7.94 26.46 116

Total PV 3,092.35

Expected net present value = £3,082 + £1,510.3 - £3,092.35 = £1,500 million.

Notes:
– If the decommissioning costs £500 million the expected NPV is £1,558 million
– For the purpose of selecting between alternatives the demolition costs in three years’ time could be ignored.
Conclusion: On financial grounds the nuclear alternative is expected to produce the highest NPV.
(b) Information that might assist the decision process includes;
– How accurate are the projected cash flows? Are the various revenues and costs likely to be subject to the same
price level changes?
– Is the risk of the project correctly measured by the beta estimates?
 – What is the chance of significant changes in tax rates or tax allowable depreciation?
– Are there likely to be delays in construction?
– How accurate is the estimate of the working life of the power stations? What happens if the technology changes?
– Is the technology well tested, especially for the nuclear alternative? Sensitivity and/or simulation analysis to
investigate outcomes under different assumptions is strongly recommended.
– What will be the impact of alternative levels of gearing on other activities of the company and on the company’s
share price?
– What real options might exist with the alternative projects?
– How significant are non-financial factors? How safe is the nuclear alternative? How environmentally or politically
acceptable would this alternative be? Even if the nuclear alternative is the better choice financially, this might be
outweighed by non-financial considerations.
(c) The external advisor has suggested adjusting the discount rate as the decommissioning costs are not known with
certainty. As these cash flows are relatively risky, an adjustment to the discount rate might be justified. The
decommissioning costs are cash outflows. In order to reflect the higher risk the discount rate of these cash flows
should be reduced to result in a higher negative present value.
(d) 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 investment 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 option 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 far 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.
12. RST
(a) (i) The net present values of the projects can be calculated as follows:

Project NPV

$m

A (4/0.15) – (16 × 0.87) – 9 3.75

B (4/0.15 × 0.87) – (10 × 0.87) -10 4.50

C (5 × 5.019) – (12 × 0.87) – 10 4.66

D (6 × (4.16 – 1.626)) – (5 × 0.87) – 8 2.85

E (2 × 3.352) + (5 × (5.847 – 3.352) – (8 × 0.87) – 9 3.22

Based on the NPV the projects can be ranked as C, B, A, E, and D. With only $30 million available, projects C, B
and A should be accepted.
(ii) The profitability index can be calculated as follows. Remember that the capital rationing occur in year one and not
year zero.
 Project Net Present Value Amount required in year 1 Profitability
index

A 3.75 16 – 4 = 12 0.313

B 4.5 10 – 0 = 10 0.450

C 4.66 12 – 5 = 7 0.666

D 2.85 5 -0 = 5 0.570

E 3.22 8–2=6 0.537

The ranking on the basis of Profitability index is C, D, E, B and A. With only $30 million available, projects C, D, E
and B should be accepted.
Conclusion:
In capital rationing situation the limited money should be allocated on the basis of which combination of projects
gives the highest combined net present value and the combined outlay is at or below the amount available. In this
case projects B, C, D and E should be selected, as that combination provides the highest combination of net present
value.
(b) As mentioned above, capital rationing is based on the application of NPV which is more appropriate for private
companies whose main objective is to maximise the wealth of its shareholders. However, public sector entities such as
RST will have other priorities and objectives and therefore capital rationing based on net present value may not be
appropriate.
However, public entities may also be subject to spending constraints as they cannot normally borrow to finance their
project but rather would have to work within their budget. As a result they should have effective way of allocating the
limited amount available to them.
Other factors that need to be considered include:
Sensitivity analysis which will indicate the impact of changes in the key variable to the outcome calculated above;
Non-financial factors such as government or self-imposed targets and priorities, for example patient care,
environmental and staffing issues.
13. Detailed Review of an Investment Project
(a) The project cash flow contains a number of errors of principle which should be corrected. As the project cash flows
are shown after tax, the corrections should be made net of tax by either adding back or deducting the change required.
– Interest has been deducted and should be added back as this finance charge is properly charged through the
application of the discount rate.
– Depreciation should be added back as this is not a cash flow.
– The indirect cost charge should be added back as this does not appear to be a decision relevant cost.
– The site clearance and reinstatement costs of $5 million have been included net of tax.
– The unclaimed capital allowance is calculated as follows:
The adjusted project cash flow and net present value calculation (in $ million) for this project are as follows:

Year 0 1 2 3 4 5 6

Profit after tax cash flow (127.50) (36.88) 44.00 68.00 60.00 35.00 20.00

Add back interest 2.80 2.80 2.80 2.80 2.80

(8% × $50m × 0.7)

Add back depreciation 2.80 2.80 2.80 2.80 2.80

(net of tax)
($4m × 0.7)

Add back ABC charge (net of tax) 5.60 5.60 5.60 5.60 5.60
($8m × 0.7)
Less corporate infrastructure costs (2.80) (2.80) (2.80) (2.80) (2.80)
($4m × 0.7)

Estimate for site clearance (3.50)

($5m × 0.7)

Tax benefit of unrecovered capital allowances 3.69

(W2)

Adjusted project (127.50) (36.88) 52.40 76.40 68.40 43.40 28.59

cash flow

Discount factor 1.0000 0.909 0.826 0.751 0.683 0.621 0.564

Discounted cash flow at 10% (127.50) (33.52) 43.28 57.38 46.72 26.95 16.12

Net present value $29.43 million

Workings
(i) First and second phase post-tax cash flows

Year 0 1
$m $m

Capital investment (150) (50)

Tax saved on WDA (W2) 22.50 13.12

Cash flows per question 127.50 36.88

(ii) Tax saved on WDA

Year $m $m

0 ($150m × 50% = $75m × 30%) 22.50

1 ($150m – $75m) × 25% × 30% 5.62

($50m × 50% = $25m × 30%) 7.5

13.12

2 5.62 × (1 – 0.25) = 4.22

($50m – $25m) × 25% × 30% = 1.87

6.09

3 6.09 × (1 – 0.25) 4.57

4 4.57 × (1 – 0.25) 3.43

5 3.43 × (1 – 0.25) 2.57

6 2.57 × (1 – 0.25) 1.93

6 Balance of unrecovered capital allowances 3.69

($200m – $7m) × 30% 57.90

 The sensitivity of the project to a $1 million increase in capital expenditure (expressed in $ millions) is as follows:

Year 0 1 2 3 4 5 6

Impact upon CAPEX (1)

Tax saving due to WDA 0.15 0.037 0.028 0.021 0.015 0.012 0.009
& FYA

Tax benefit of unrecovered 0.027

capital allowances (see W)

Net impact (0.85) 0.037 0.028 0.021 0.015 0.012 0.036

Discount factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564

Discounted cash flow (0.85) 0.0336 0.0231 0.0158 0.0102 0.0075 0.0203

Working
Tax saved on WDA for $ million increase in initial capital expenditure

Year $m

0 ($1m × 50% = $0.5m × 30%) 0.150

1 ($1m – $0.5m) × 25% × 30% 0.037

2 0.037 × (1 – 0.25) 0.028

3 0.028 × (1 – 0.25) 0.021

4 0.021 × (1 – 0.25) 0.016

5 0.016 × (1 – 0.25) 0.012

6 0.012 × (1 – 0.25) 0.009

6 Balance of unrecovered capital allowances 0.027

($1m × 30%) 0.300

Thus an increase in CAPEX by $1 million results in a loss of NPV of $0.74 million due to the benefit of the capital
allowances available discounted over the life of the project.
(b) The discounted payback is estimated as follows:

Year 0 1 2 3 4 5 6
$m $m $m $m $m $m $m

Discounted cash flows (at 10%) from (127.50) (33.52) 43.28 57.38 46.72 26.95 16.12
project

Cumulative discounted (127.50) (161.02) (117.74) (60.36) (13.64) 13.31 29.43

cash flow

Payback 4.50
(discounted)

The duration of a project is the average number of years required to recover the present value of the project.
Duration is estimated as follows:
Year 0 1 2 3 4 5 6
$m $m $m $m $m $m $m

Discounted cash flow at 10% 43.28 57.38 46.72 26.95 16.12

Present value of return phase 190.45

Proportion of present value in each year 0.2273 0.3013 0.2453 0.1415 0.0846

Multiply by year no. 2 3 4 5 6

PV weighted by year no. 0.4546 0.9039 0.9812 0.7075 0.5076

Duration (=sum of the weighted years) 3.55

Payback, discounted payback and duration are three techniques that measure the return to liquidity offered by a capital
project. In theory, a firm that has ready access to the capital markets should not be concerned about the time taken to
recapture the investment in a project. However, in practice, managers prefer projects to appear to be successful as
quickly as possible.
Payback as a technique fails to take into account the time value of money and any cash flows beyond the project date.
It is used by many firms as a coarse filter of projects and it has been suggested to be a proxy for the redeployment real
option.
Discounted payback does surmount the first difficulty but not the second in that it is still possible for projects with highly
negative terminal cash flows to appear attractive because of their initial favourable cash flows. Conversely, discounted
payback may lead a project to be discarded that has highly favourable cash flows after the payback date.
Duration measures are either the average time to recover the initial investment (if discounted at the project’s internal
rate of return) of a project or to recover the present value of the project if discounted at the cost of capital as is the
case in this question. Duration captures both the time value of money and the whole of the cash flows of a project. It is
also a measure which can be used across projects to indicate when the bulk of the project value will be captured. Its
disadvantage is that it is more difficult to conceptualise than payback and may not be employed for that reason.
(c) Report to Management
Prepared by: D Obbin, ACCA
Project acceptance and criteria for acceptability
I have reviewed the proposed capital investment and after making a number of adjustments have estimated that the
project will increase the value of the firm by approximately $29.43 million. The project is highly sensitive to changes in
the level of capital investment. Increases in immediate capital spending on this project will lead to a loss in the overall
project value less the tax saving resulting from the increased capital allowances. However, given the size of the net
present value of the project, it is unlikely that an adverse movement in this variable would lead to a significant
reduction in the value of the firm.
The analysis of the payback on this project using discounted cash flows suggests that the value of the capital invested
will be wholly recovered within five years of commencement. The bulk of the cash flow recovery occurs early within the
life cycle of the project with an average recovery of the total present value occurring 3.55 years from commencement.
On the basis of the figures presented and the sensitivity analysis conducted, I recommend the Board approves this
project for investment.
For many years the Board has used payback as one technique for evaluating investment projects. The Board has
noted concerns that (i) the method chosen does not reflect the cost of finance either in the cash flows or in the
discount rate applied and (ii) it fails to reflect cash flows beyond the payback date. Discounted payback surmounts the
first but not the second difficulty. I would recommend that the Board considers the use of ‘duration’ which measures the
time to recover either half the value invested in a project or, by alternative measurement, half the project net present
value. Because this measure captures both the full value and the time value of a project it is recommended as a
superior measure to either payback or discounted payback when comparing the time taken by different projects to
recover the investment involved.
As part of its review process the Board has asked for sensitivities of the project to key variables. Sensitivity analysis
demonstrates the likely gain or loss of project value as a result of small changes in the value of the variables chosen.
Unfortunately, sole variables such as, for example, price changes and the cost of finance, are highly correlated with
one another and focusing upon the movement in a single variable may well ignore significant changes in another
variable. To deal with this and given our background information about the volatility of input variables and their
 correlation, I would recommend that a simulation is conducted taking these component risks into account. Simulation
works by randomly drawing a possible value for each variable on a repeated basis until a distribution of net present
value outcomes can be established and the priority of each variable in determining the overall net present value
obtained. Furthermore, the Board will be in a position to review the potential ‘value at risk’ in a given project.
I recommend that the Board reviews a simulation of project net present values in future and that this forms part of its
continuing review process.
14. Slow Fashions Ltd
(a) Capital investment plan
Net present value is not a sufficient criterion for choosing between projects when capital is in short supply. On the
assumption that the priority of the company is to maximise overall net present value, then the optimal ranking of
projects is achieved through the profitability index as measured below by the ($ net present value ÷ $ of invested
capital at year zero). The ranking of the projects using the profitability index (PI) is as follows:

Project NPV Investment P1 Ranking

$000 at t0 (NPV ÷
to investment)

PO801 55 620 0.0887 3

PO802 69 640 0.1078 2

PO803 20 240 0.0833 4

PO804 72 1,000 0.0720 6

PO805 19 120 0.1583 1

PO806 29 400 0.0725 5

264

In order of preference, the best projects are as follows:

Project NPV Investment Cumulative P1

$000 at to investment (NPV ÷
$000 $000 to investment)

PO805 19 120 120 0.1583

PO802 69 640 760 0.1078

PO801 55 620 1,380 0.0887

Project PO801 is now the marginal project given the available capital of $1,200,000. However, this ordering of projects
is not viable as P0801 cannot be varied and is either promoted in the ranking or is not produced, as the plan as it
stands requires an investment of £1,380,000 to satisfy the supermarket contract. The investment structure can be
specified in one of two ways therefore:
Acceptance of PO801 ahead of PO802 (which can be scaled down):

Project NPV Investment Cumulative investment P1 Proportion Total

$000 at to $000 (see NPV
$000 above) $000

PO805 19 120 120 0.1583 100% 19

PO801 55 620 740 0.0887 100% 55

PO802 69 460 (not 640) 1,200 0.1078 (460 ÷ 640) 50

 Maximum total NPV 124

Removal of PO801 from the plan

Project NPV $000 Investment Cumulative investment P1 Proportion Total

at to $000 $000 (see above) NPV $000

PO805 19 120 120 0.1583 100% 19

PO802 69 640 760 0.0887 100% 69

PO803 20 240 1,000 0.1078 100% 20

PO806 29 200 (not 400) 1,200 0.0725 (200 ÷ 400) 15

Maximum total NPV 123

(i) The revised plan should be to produce all of PO805, PO801 and a reduced scale of production of PO802 as shown
in the revised schedule.
(ii) The net present value of the plan is $124 million.
The internal rate of return (IRR) cannot be calculated using the proportions of projects invested, because of scale
effects - but it must be calculated for the overall plan. Using the interpolation method (and calculating the net present
value of the optimum plan at 14% and 18%) the IRR can be estimated by interpolation:

Year PO805 PO801 PO802 Total Try 14% Try 18%

100% 100%(460 ÷ 640) PV PV

$000 $000 $000 $000 DF $000 DF $000

Now (120) (620) (460) (1,200) 1 (1,200) 1 (1,200)

2010 25 280 57 362 0.877 317 0.847 307

2011 55 400 86 541 0.769 416 0.718 388

2012 75 120 144 339 0.675 229 0.609 206

2013 21 – 151 172 0.592 102 0.516 89

2014 – – 302 302 0.519 157 0.437 132

2015 – – (22) (22) 0.456 (10) 0.370 (8)

11 (86)

(iii) The profitability index for the plan is ($124 million ÷ $1,200 million) = $0.1033 per dollar invested.
(b) Estimate and advice upon the maximum interest rate
When calculating the rate for short-term financing, the maximum rate which should be offered is that which generates a
zero net present value on those projects which do not qualify for the current plan. The internal rate of return is not
appropriate as that is the rate that would be the maximum rate for investment over the life of the projects concerned.
This is, however, a short-term capital rationing problem. The profitability index gives the net present value of each
pound invested.
The NPV of rejected projects can easily be established as follows:

$000
 NPV of all available projects (see above) 264

NPV of revised plan (PO805 + PO801 + reduced scale of PO802) as above 124

NPV of rejected projects 140

Alternatively, the NPV of rejected projects can be established as follows:

Project Now 2009 2010 2011 2012 2013 2014

$000 $000 $000 $000 $000 $000 $000

PO802 Marginal project:

Cash flows (C/f) (640) 80 120 200 210 420 (30)

Already spent 460 (57) (86) (144) (151) (302) 22

Balance to spend (180) 23 34 56 59 118 (8)

PO803 (240) 120 120 60 10

PO806 (400) 245 250

PO804 (1,000) 300 500 250 290

C/f of rejected projects (1,820) 688 904 366 359 118 (8)

DF @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564

PV (1,820) 625 747 275 245 73 (5)

NPV of rejected projects 140

If you prefer, the NPV of rejected projects can be calculated thus:

Project NPV

$000

PO802: $69,000 × (180 ÷ 640) 19

PO803 20

PO806 29

PO804 72

NPV of rejected projects 140

Profitability Index = ($140m ÷ $1,820m) = 0.07692

Therefore these projects could support a maximum additional finance charge of the following:
Cost of additional finance = $1,820,000 × 0.7692 = $140,000
Given that 10% is the rate assuming no short-term market failure for finance for this company, the maximum rate for
the one year over which capital rationing is expected to hold is (10% + 7.692%) = 17.692%.
At the end of year 1, the borrowing of $1,820 million will have to be refinanced at the market interest rates then
prevailing.
15. Seal Island Nuclear Power Company (June 2010)
 Tutor's Tips
The answer should be presented as a briefing note to include the evaluation of the project using the net present value
technique, discussion of the principal uncertainties associated with the project and using sensitivity and simulation to
assess the volatility of the net present value of the project.

(i) Net present value of the project

2012 2013 2014 2015 - 2044 2044

Years 1 2 3 4-33 33

$m $m $m $m $m

Construction cost (nominal value) (300) (600) (100)

Annual operating surplus (real) 100

Decommissioning cost (nominal value) (2,189)

Discount factor 10% 0.909 0.826 0.751 14.11 x 0.751 0.043

Present values (273) (496) (75) 1,060 (94)

Net present value = $122m

Since the net present value of the project is positive the project is financially acceptable.
Workings
(i) Decommissioning cost
Nominal cost = (600 x 1.0433) = $2,189 million at the end of the 33 years of the project life.
(ii) Annual operating surplus
Using the formula provided, the 30 year annuity factor using a growth rate of 4% and cost of capital of 10% is as
follows:

Multiplying the 14.11 by the real annual cash flows of $100 determines the nominal present value in terms of year 3
and therefore should be discounted to present value in year zero by multiplying the result by the 10% discount factor
in year 3 (0.751).

Alternative approach

Tutor's Tips

This could be used if the above formula is not given in the exam.

The alternative approach is to convert the 10% nominal cost of capital to a real cost of capital using the Fisher formula (1 +
n) = (1 + r)(1 + i), and discounting the $100 using the annuity factor as follows:

Stages
• Real rate = (1.1/1.04) – 1 = 5.769%
• Determine the annuity factor of 5.769%, 30 years. Unfortunately, the annuity table is only up to 15 years, so use the
annuity formula which can be seen on the annuity table:

• Multiplying the 14.11 by the real annual cash flows of $100 determines the nominal present value in terms of year 3 and
therefore should be discounted to present value in year zero by multiplying the result by the 10% discount factor in
year 3 (0.751).
(i) Uncertainties associated with the project
The main uncertainties associated with the project are:
Decommissioning costs
It might be difficult to determine reliably the amount of the decommissioning costs. There is usually high closure
costs associated with this type of project and an inaccurate estimate may have an impact on the outcome of the
project. However, discounting the cost over 33 years, the decommissioning cost may have an insignificant effect on
the net present value of the project, thus the longer the period the lower the present value.
Annual operating surplus
This value has been well validated by preliminary studies and includes the cost of fuel reprocessing, ongoing
maintenance and systems replacement as well as the continuing operating costs of running the plant. However, the
estimate may be based on certain assumptions which may not be accurate. In addition the supply of electricity is
subject to national demand and also unit prices may depend upon alternative capacity and alternative energy
supplies (fossil and renewable).
Construction costs
Estimating the construction costs for large scale projects like this is normally subject to inaccuracies. This is because
there may be increase in cost of labour, materials and other supplies due to unexpected increases in inflation or
even shortages of supply. There could also be delay in construction due to engineering difficulties, causing the cost
to overrun.
Cost of capital
The cost of capital used to discount the cash flows should always be consistent with the systematic risk of the
project. This can be difficult to estimate for a project of this scale. In practice such rates are taken from a mixture of
models and sources, all of which have assumptions and uncertainties attached.
The duration of the project
It is estimated that the project will have investment phase and return phase of three and thirty years respectively.
However, engineering and other construction difficulties may delay the construction and future competition and
changes in technology may render this project obsolete before the end of 2044.
Real option
There are many real option associated with this project. There is the option to delay, option to expand or contract,
option to abandon or even extend the number of operating life of the project. Each of these options has its value and
this will change the overall net present value of the project.
(ii) Sensitivity of the project’s net present value
Sensitivity analysis measures how much a variable used to calculate the NPV needs to change for the NPV to
become zero. For cash flow items the margin of error is calculated as the NPV of the project divided by the present
value of the variable under consideration, all multiplied by 100%.
Construction cost

Net present value of the project 122

Present value of construction cost over the three years 844

(273 +496 + 75)

Margin of error (sensitivity) (122/844) x 100% 14.5%

This means if construction cost increase by 14.5% the NPV will become zero.
Therefore:
Year 1 construction should increase to: 300 x 1.145 = $344 million
Year 2 construction should increase to: 600 x 1.145 = $687 million
Year 3 construction should increase to: 100 x 1.145 = $115 million
 Annual operating surplus

Net present value of the project 122

Present value of annual operating surplus 1,060

Margin of error (sensitivity) (122/1,060) x 100% 11.5%

This means if annual operating surplus decreases by 11.5% the NPV will become zero.
Therefore the annual operating surplus should reduce to: (100 – 11.5)% x 100 =$88.5 million per annum in real
terms.
Decommissioning costs

Net present value of the project 122

Present value of decommissioning costs 94

Margin of error (sensitivity) (122/94) x 100% 129.8%

This means if decommissioning costs increase by 129.8% the NPV will become zero.
Therefore the decommissioning costs should increase to: 2.298 x 600 =$1,378.8 million in real terms.
(iii) Simulation
Sensitivity analysis assesses the effect on an overall decision if a single constituent variable were to change. Monte
Carlo simulation is a mathematical model which will include all combinations of the potential variables associated
with the project. The assessment of the volatility (or standard deviation) of the net present value of a project entails
the simulation of the financial model using estimates of the distributions of the key input parameters and an
assessment of the correlations between variables. It results in the creation of a distribution curve of all possible cash
flows which could arise from the investment and allows for the probability of the different outcomes to be calculated.
The steps involved are as follows:
○ Specify all major variables
○ Specify the relationship between those variables
○ Using a probability distribution, simulate each environment.
Some of these variables are normally distributed but some (such as the decommissioning cost) are assumed to
have limit values and a ‘most likely’ value. Given the shape of the input distributions, simulation employs random
numbers to select specimen values for each variable in order to estimate a ‘trial value’ for the project NPV. This is
repeated a large number of times until a distribution of net present values emerge. By the central limit theorem, the
resulting distribution will approximate normality and project volatility can be estimated.
The advantage of this technique is that it includes all foreseeable outcomes. The disadvantages are that the model
may be very complex and there is difficulty in formulating the probability distribution.
16. Lamri Co (December 2010)
(a) The dividend capacity of a company is measured by its free cash flow to equity. Free cash flow to equity is calculated
as:
Operating profit – interest – tax + depreciation – investment in working capital and fixed capital.
Workings
Depreciation is ignored as it is equal to the amount required to retain assets at their current productive capability.

W1: Before implementation of TE proposal

Strymon Magnolia

$000 $000 $000 $000

Sales revenue 5,700 15,000

 Cost

Variable (3,600) (2,400)

Fixed (2,100) (1,500)

Transfer 5,700 (5,700) 9,600

Profit before tax 0 5,400

Tax 1,188

Profit after tax 4,212

Remitted 3,159

Retained 1,053

W2: After implementation of TE proposal

Strymon Magnolia

$000 $000 $000 $000

Sales revenue 7,980 15,000

Cost

Variable (3,600) (2,400)

Fixed (2,100) (1,500)

Transfer 5,700 (7,980) 11,880

Profit before tax 2,280 3,120

Tax (42%, 22%) 958 686

Profit after tax 1,322 2,434

Remitted 892
(75% x 1,322 x 90%)

Remitted 1,826

Retained 331 608

Total remitted
(892 + 1826) = 2,718

Dividend capacity before TE proposal implementation

$000

Operating profit (30% x $80,000,000) 24,000

Less interest (8% x $35,000,000) (2,800)

21,200

Less: taxation (28% x 21,200) (5,936)

 Less: investment in working capital (15% x (20/120 x 80,000)) (2,000)

Less: investment in additional non-current assets

(25% x (20/120 x 80,000)) (3,333)

Less: investment in project (4,500)

Domestic operations cash flows 5,431

Overseas subsidiary dividend remittances (W1) 3,159

Additional tax payable on Magnolia profits (6% x 5,400) (324)

Free cash flows to equity = Dividend capacity 8,266

Dividend capacity after TE proposal implementation

Domestic operations cash flows (from above) 5,431

Overseas subsidiaries dividend remittances (W2) 2,718

Additional tax payable on Magnolia profits (6% x 3,120) (187)

Dividend capacity 7,962

(b) The implementation of the TE recommendation will lead to a reduction in Lamri’s dividend capacity. Before the TE
proposal, the dividend capacity of the company is $8,266,000 which is greater than the actual dividend requirement for
next year (estimate of actual dividend for next year = (7,500 x 1·08) = 8,100m), showing the ability of the company to
pay next year’s dividend. However, if the TE recommendation is implemented, the dividend capacity will fall to
$7,962,000, which is below the actual dividend requirement for next year. The company will therefore not be in position
to meet its dividend commitment next year. From the calculation above it can been seen that even though lower
additional tax is paid on Magnolia’s profits, the tax savings is not enough to cover the additional tax that will be paid in
the country in which Strymon operates, resulting in the reduction in the dividend capacity.
If the TE recommendation is implemented there will be a small shortfall of $138,000 (8,100,000 – 7,962,000). The
company can adopt many different approaches to make up this shortfall, some of these are:
Revising the dividend growth rate
The company can reduce the dividend growth rate from the current level of 8% to say 6.16% ((7,963 -7,500)/7500).
This growth rate will equate the dividend requirement to the dividend next year if the TE recommendation is
implemented. However, reducing the growth rate may have a signalling effect and if the company fails to explain this to
its shareholders properly its share price may fall.
Increase dividend from subsidiary
In order to increase cash flow, the company can ask the subsidiaries to remit a higher proportion of their profits in the
form of dividends. This will however reduce the retained earnings in the subsidiaries.
Borrowing
The company can borrow through overdraft to make up the $138,000 shortfall. This policy will depend on whether the
company has exhausted its overdraft facility or whether it is willing to increase its debt.
17. Arbore Co (December 2012)
(a) NPV of project PDur05
Annual costs = $3,230
Annual sales revenue = $14 × 300 = $4,200
Annual cash flows = $4,200 – $3,230 = $970
Annuity factor 4 – 18 years = 7·191 × 1/1·113

Year 0 1 2 4 to 18 years

Cash flows (2,500) (1,200) (1,400) 970

DF (11%) 1 0.901 0.811 5.258

PV (2,500) (1,081) (1,136) 5,100

NPV = $383
Sensitivity of selling price = (NPV/PV of sales) × 100% = (383/22084) × 100% = 1.7%
PV of sales = $4,200 × 5.258 = $22,084
If the selling price decrease by 1.7%, the NPV will be zero, hence the NPV is very sensitive to changes in selling price.
(b) Linear programming:
Define the unknowns:
Let:
a = investment in project PDur01; b = investment in project PDur02; c = investment in project PDur03; d = investment
in project PDur04; and e = investment in project PDur05
Define the objective function
Objective is to maximise NPV
464a + 244b + 352c + 320d + 383e
Define the constraints
Start of:
Year 1: 4,000a + 800b + 3,200c + 3,900d + 2,500e ≤ 9,000
Year 2: 1,100a + 2,800b + 3,562c + 0d + 1,200e ≤ 6,000
Year 3: 2,400a + 3,200b + 0c + 200d + 1,400e ≤ 5,000
Define the non-negatives
0 ≤ a, b, c, d, e, ≤ 1
(c) Category 1: Total final value
The final value represents the maximum net present value that can be achieved within the restricted capital
expenditure over the three-year period. This amount is less than the total NPV if all the projects were fully undertaken.
Category 2: Adjustable final values
The adjustable final values represent the proportions of projects undertaken within the restricted capital available to
maximise the net present value. All of project PDur05, 95·8% of project PDur01, 73·2% of project PDur03 and 40·7%
of project PDur02 will be undertaken.
Category 3: Constraints utilised, slack.
Slack represents the amount of the limited capital not utilised to achieve the objective function. The constraint utilise
indicate the amount of the limited capital used in achieving the objective of maximising the NPV. The slack was zero
indicating that all the limited capital was fully utilised in achieving the maximum NPV.
(d) (i) Capital rationing occurs whenever there is a budget ceiling or a market constraint on the amount of funds which
can be invested during a specific period of time. It is a situation where there are insufficient funds to finance all
profitable projects.
Soft capital rationing is often used to refer to the situation where, for various reasons, the firm internally imposes a
budget ceiling on the amount of capital expenditure. Management may be reluctant to issue additional share capital
because of the concern that this may lead to a dilution in control and earnings per share. Management may not want
to raise additional debt capital because they do not want to be committed to large fixed interest payments or due to
concerns about gearing.
Hard capital rationing occurs whenever there is a market constraint on the amount of funds which can be invested
during a specific period of time. Hard capital rationing may lead to soft capital rationing.
(ii) A capital investment monitoring system is a system of monitoring how a capital project is progressing according to
plan by comparing the actuals to the plan. It involves setting up targets (plan) by establishing what needs to be done
and by what time it should be achieved. The plan will factor in both internal and external risk factors, which may
impact on the success of the project, and contingency plans, deciding how problems will be resolved when they
occur during the implementation of the project. The actual result from the project is compared to the plan and any
variances analysed so that corrective action can be undertaken to ensure the success of the project.
Capital investment monitoring system is beneficial because it ensures that the project is progressing according to
the plan and budgets and target are achieved at the stipulated time. It also ensures that risk factors are properly
 analysed and resolved before they even occur, hence it is proactive. The monitoring system also helps in the
adjustment of the plan if it is too difficult to achieve, due to changes in the business environment.
18. AVT
(a) Option pricing is the method of determining the value of an option or deciding what premium the writer of an option
needs to charge the buyer of that option.
The Black-Scholes model includes the following five factors in determining the value of a call option:
– The price of the underlying security. The lower the price of the underlying instrument, the lower the value of the call
option.
– The exercise price. The lower the exercise price of the option, the higher the value of the call option.
– A measure of price volatility. The lower the volatility of the price of the underlying item the lower the probability of the
option yielding profits, so a call option will decrease in value.
– The risk-free rate of interest. The lower the interest rate, the lower the value of the call option because the present
value of the exercise price will be higher.
– The length of time to expiry of the option period. The shorter the remaining period to expiry, the lower the probability
of the underlying item changing in value. Call options are worth less the shorter the time to expiry because there is
less time for the price of the underlying item to rise. There is less time value.
(b) (i) The advantages and disadvantages of using options include the following:
Advantages
o It will help to align the interests of directors with those of shareholders. Share options provide directors with an
incentive to increase the value of the company’s shares (and hence their options) and thereby to increase the
wealth of shareholders. This should help to avoid the risk of directors pursuing their own interests at the
expense of the shareholders.
o By exercising an option and acquiring shares, the directors may identify more closely with other shareholders.
This argument does depend, however, on the directors keeping the shares acquired rather than selling them.
o It may act as a useful retention tool. As directors’ share options are usually forfeited when a director leaves
office, the value of outstanding options may provide a strong incentive to stay.
Disadvantages
o Share option schemes do not normally differentiate between the performances achieved by individual
managers.
o If the share price falls significantly below the exercise price, the prospects of receiving any benefits may
become remote and their value as a form of incentive will be lost.
o It is also debatable how much middle managers can directly influence the company’s share price and whether
they are aware of which of their decisions will have influence on the share price.
o Share price movements may be beyond the control of the managers. Changes in the economy or changes in
demand may result in the directors being either under-rewarded or over-rewarded for their efforts.
The main advantage of using earnings as the basis of paying bonuses is that earnings are easily measured.
Earnings basis may encourage the managers to increase profits and can be used to assess the performance of
each individual manager. However, maximising earnings is not the same as maximising share price and hence
shareholders wealth. Managers may use different accounting concepts to manipulate the earnings in order to earn
bonuses.
(ii) The dividend is to be paid before the option expires and therefore the price of the underlying item should be
reduced by the present value of the dividend.
Present value of dividend at risk free rate = 25/1.06 = 23.58 cents
The price of the share ex-div = 610 – 23.58 = 586.42 cents
The value of the call option can be calculated using the Black-Scholes model as follows;

From the normal distribution table, the N(d1) = 0.5 + 0.2794 = 0.7794
 From the normal distribution table, the N(d2) = 0.5 + 0.1517 = 0.6517
Value of the call option
c = (586.42 × 0.7794) – (500 × 0.6517 × e-0.06 × 1)
c = 457.06 - 306.87 = 150.19 cents
Total value of the call option = 150.19 cents × 5,000 = $7,510
The total value of the option is more than the earnings-based payment between $5,000 and $7,000. This may
encourage the managers to accept share options. However, the value of the option is based on using Black-Scholes
model which is subject to many limitations.
(iii) A put option will be in the money when the price of the underlying item falls below the exercise price. By giving a
put option, managers will be encouraged to take decisions that may reduce the share price so that they can exercise
their option at a gain. This will not be consistent with the objective of maximising shareholders’ wealth and as such
AVT Inc should not agree to offer a put option to its managers.
The value of a put option can be calculated using the put-call parity theory.
P = c - Pa + Pe e -rt
P = 150.19 – 586.42 + 500 × e-0.06 × 1
P = 34.65 cents
From this value we can conclude that the manager is incorrect, as the value of the call option (150.19c) is more than
the value of the put option (34.65c).
19. Daylon plc
(a) The investment bank is prepared to sell an appropriate six month option to Daylon and this will represent a put option
to Daylon plc. To determine whether or not the price at which the investment bank is willing to sell the option is fair will
depend on the value of the put option compared to the asking price. If the asking price is more than the value of the
put option then is not fair. The value of the put option can be calculated using the put-call parity theory and the Black-
Scholes model can be used to determining the value of the call option.
Estimating the value of call option:
As the investment bank would not want to sell at a price worse than 5% of the current market price, the minimum
exercise price they will accept is 95% × 360 = 342 pence.

From the normal distribution table, the N(d1) = 0.5 + 0.2939 = 0.7939
d2 = d1 – S√t = 0.8218 – 0.13 √0.5 = 0.7299 = 0.73
From the normal distribution table, the N(d2) = 0.5 + 0.2673 = 0.7673
Value of call option
c = (360 × 0.7939) - (342 × 0.7673 × e-0.04 × 0.5)
c = 285.80 – 257.22 = 28.58 pence
The value of a put option can be calculated using the put-call parity theory.
P = c – Pa + Pee-rt
P = 28.58 – 360 + 342 × e-0.04 × 0.5
P = 3.81 pence
The total value of the put option = 5,550,000 shares × 3.81 pence = £211,455
Holding all other things constant, the asking price of £250,000 is above the book value of the put option £211,455,
hence the asking price is unfair. The investment bank is charging £38,545 above the theoretical fair value.
(b) Other relevant factors that might influence the decision may include:
 – The theoretical value is based on Black-Scholes model which has a number of limitations, including the assumptions
that:
o no dividends are paid in the period of the option,
o the model applies to European call options only, and not to American options,
o the risk free rate is known and constant throughout the option life,
o we can estimate the standard deviation of the returns of the underlying item to which the model is sensitive, and use
this historical measure to estimate future movements.
– There may be transaction costs and tax effects involved in buying or selling the option or its underlying item
– Daylon should consider protecting all of its portfolio rather than just the investment in Mondeglobe.
– The option is available for a six month period only. Daylon should consider whether to protect the investment after
this period, in which case there might be further cost.
– Daylon should also consider whether there are other alternative offers other than the one offered by the investment
bank.
20. Uniglow plc
(a) Delta measures the change in the option price (premium) as the value of the underlying share moves by 1%.

It is measured by N(d1) in the Black-Scholes option pricing model

As the share price falls delta falls towards zero, Delta may be used to construct a risk-free hedge position, whereby
overall wealth will not change with small changes in share price.
Theta measures the change in the option price as the time to expiry changes. The longer the time to expiry of an
option, the greater its value. Theta may be used to estimate by how much the value of an option will fall as time to
maturity reduces.
Vega measures the change in option price as a result of a 1% change in the share price volatility or variance. As
volatility increases, the value of both call and put options increase.
All three are of use to treasury managers when hedging their investments. As their values approach zero the hedged
position will become unaffected by changes in these variables.
(b) (i) N(d1) is required in order to determine the delta hedge.

Using the standard normal distribution tables:

d1 = – 0.20 provides – 0.0793
N.B.A more accurate, but time consuming method (used by the ACCA model answer), would be to use linear interpolation.
Therefore N(d1) = 0.5 – 0.0793 = 0.4207
In order to protect against a fall in Uniglow’s share price, the easiest hedge would be to write call options on
Uniglow’s shares. To ensure that your company holds sufficient shares in Uniglow to satisfy the buyer of the call
options (who may decide to exercise his options), the following number of call option contracts may be written:
 (ii) A hedge such as this is only valid for a small change in the underlying share price. As the share price changes the
option delta will alter and the hedge will need to be periodically rebalanced.
21. Digunder
(a) Application of the Black Scholes option pricing model
Each of the input components is stated in the question:

Current price (Pa) i.e. Present Value of the project ($24m + $4m) $28m

Exercise price (Pe) i.e. capital expenditure $24m

Time to expiry (t) (may be expressed as 500 trading days) 2 years

Risk free rate (r) 0.05

Volatility (s or σ) 0.25

Using the formulae provided:

Using normal distribution tables:

d1 = 0.8956 (say 0.90) gives 0.3159

d2 = 0.5420 (say 0.54) gives 0.2054

N(d1) = 0.5 + 0.3159= 0.8159

N(d2) = 0.5 + 0.2054= 0.7054

c = (28 × 0.8159) – (24 × e–0.05 × 2 × 0.7054)

= 22.8452 – (24 × 0.9048 × 0.7054)

= 22.8452 – (21.7161 × 0.7054)

= 22.8452 – 15.3186

= 7.5266 ($7.53m)

This implies that at the current time, the project has a value equal to its net present value plus the value of the call
option to delay ($4m + $7.53m) i.e. $11.53 million. The additional value arises because the delay option allows the
company to avoid the downside element of risk.

Tutor's Tips

The calculation of the call option has slightly rearranged the order of the items shown in the ACCA formula. This has
been done to allow for the eventuality of the examiner requesting the subsequent calculation of the value of the related
put option premium, using put-call parity i.e.
P = 7.5266 – 28 + 21.7161 = 1.2427 ($1.24m)
Notice how all of the above numbers are readily available from the calculations already performed to establish the call
option premium. In other words, it would avoid duplication of effort.
 (b) Option to delay
This project has a net present value of $4 million on a capital expenditure of $24 million, which whilst significant has a
volatility estimate of 25% p.a. of the present value. This volatility is brought about by uncertainties about the
Government’s intentions with respect to the Bigcity-Newtown transport link and the consequential impact upon property
values. Currently, the project presents substantial value at risk and there is a high likelihood that the project will not be
value generating. To surmount this, an estimate is provided of the value of the option to delay construction for two
years until the Government’s transport plans will be made known.
The option to delay construction is particularly valuable in this case. It eliminates much of the downside risk that the
project does not generate the cash flows expected and it gives us the ability to proceed at a point in time most
favourable to us. The nature of the delay option is that it becomes more valuable the greater the volatility of the
underlying cash flows and the greater the time period before we are required to exercise.
The valuation of the option to delay has been undertaken using the Black and Scholes model which members have
been briefed about with respect to fair value accounting practices under the International Financial Reporting
Standards. The model has some limiting assumptions relating to the underlying nature of the cash flows and our ability
to adjust our exposure to risk as time passes. In reality, the use of this type of modelling is more appropriate for
financial securities that are actively traded. Our use of the model is an approximation of the value of the flexibility
inherent in this project; and although the model will not have the precision found in its security market application, it
does indicate the order of magnitude of the real option available. A positive value of $11.53 million is suggested by the
model emphasising the considerable benefit in delay.
In interpreting this valuation, it is important to note that the actual project present value at commencement could be
significantly larger than currently estimated and will certainly not be less than zero (otherwise we will not exercise the
option to build). The additional value reflects the fact that downside risk is eliminated by our ability to delay the decision
to proceed.
On the basis, of our valuation, the option to delay commencement of the project should be taken and investment
delayed until the Government’s intention with respect to transport links becomes clearer. On this basis, we would place
a value of $11.53 million on the project, inclusive of the delay option.
(c) Limitations of valuation and changes in exercise terms
The Black and Scholes model makes a number of assumptions about the underlying nature of the pricing and return
distributions which may not be valid with this type of project. More problematically, it assumes that continuous
adjustment of the hedged position is possible and that the option is European style. Where the option to delay can be
exercised over any set period of time up to the exercise date the Black and Scholes model will cease to be accurate.
For a call option, such as the option to delay, then the level of inaccuracy is likely to be quite low, especially for options
that are close to the money. Given that an option always has time value, it will invariably be in the option holder’s
interest to wait until expiry date before exercising his or her option. However, in those situations where the level of
accuracy is particularly important, or where it is suspected that the Black and Scholes assumptions do not hold, then
the binomial option pricing approach is necessary.
22. Alaska Salvage
(a) Warrants or subscription rights are usually issued with a bond or preference shares and gives the owner the right to
buy a specified number of ordinary shares at a stated price during a specified number of years. Warrants are used by
firms as an added sweetener when raising capital through a bond or preference shares.
The value of a warrant can be calculated in the same way as valuing a call option using Black-Scholes model:
Option price = Pa(Nd1) – Pe(Nd2) e-rt

From the normal distribution table:

Nd1 = 0.5 + 0.2422 = 0.7422
Nd2 = 0.5 + 0.0832 = 0.5832
Value of warranty = 85(0.7422) – 90(0.5832) e-0.05 × 5
 = 63.087 – 40.878
= 22.21
Since each warrant represents 100 shares, the value of each warrant is:
$22.21 × 100 =$2,221
The Black-Scholes model used is based on many assumptions including the following:
– It assumes that no dividends are paid in the period of the warrant
– It applies to European call options only, and not to American options
– It assumes that the risk free rate is known and constant throughout the option life
– It assumes that there is no transaction costs and tax effects involved in buying or selling the option or its underlying
item
– The difficulty of estimating the standard deviation of the returns of the underlying item to which the model is
sensitive, and the use of this historical measure to estimate future movements.
(b) The coupon rate can be calculated as follows:

Year Cash flows DF (13%) PV

0 MV – value of warrant = (7,779) 1.000 (7,779)

(10,000 – 2221)

l – 5 Interest = 100 × A% 3.517 100 × A% × 3.517

5 Redemption value = 10,000 0.543 5,430

NPV 0

Solving the equation:

100 × A% × 3.517 + 5,430 = 7,779

Therefore, at the cost of capital of 13% the investor will require a coupon rate of 6.68%.
(c) Mezzanine finance is a form of finance that combines features of both debt and equity. It is usually used when the
company has used all bank borrowings capacity and cannot also raise equity capital.
It is a form of borrowing which enables a company to move above what is considered as acceptable levels of gearing if
there are low level of assets to cover a loan. It is therefore of higher risk than normal forms of borrowing. It offers equity
participation in the company either through warrants or share options. If the venture being financed is successful the
lender can obtain an equity stake in the company.
For Alaska Salvage, raising $1.6 million to acquire salvage equipment would increase the gearing of the firm. Given
the increase in gearing coupled with the cost of operation, conventional lenders such as commercial banks would not
be attracted to provide the amount required. The disadvantage to current equity holders is that their value will reduce
by the value of the warrants issued.
23. MesmerMagic Co (June 2011)
(a) The overall value of the project is the net present value of the project plus the value of the option to delay.
Net present value of the project without the option to delay

Year 0 1 2 3 4 5 6

Cash flows (m) (7) (7) (35) 25 18 10 5

Discount factor (11%) 1.000 0.901 0.812 0.731 0.659 0.593 0.535

Present value (7) (6.31) (28.42) 18.28 11.86 5.93 2.68

 Net present value = - $2.98m
Option to delay
An option to delay gives the company the right to undertake the project in a later period without losing the opportunity
creating a call option on the future investment.
Pa =the present value of future cash inflows from the project. This is the present value from years 3 to 6 = (18.28 +
11.86 +5.93 +2.68) = 38.75
Pe = Exercise price = 35, t = Exercise date = 2 years, r = Risk free rate = 3·5%, s = Volatility = 30%

N(d1) = 0.5 + 0.2324 = 0.7324

d2 = 0·6170 – (0·30 x√ 2) = 0·1927
N(d2) = 0·5 + 0·0753 = 0.5753
Value of option to delay = (38·75 x 0·7324) – (35 x 0·5753 x e–0·035 x 2) = 28·38 – 18·77 = $9·61
Overall value of the project = $9·61 – $2·98 = $6·55 million.
The overall net present value of the project with the option to delay is positive and therefore the project is financially
acceptable.
(b) An option to delay gives the company the right to undertake the project in a later period without losing the opportunity.
This option will give the company’s managers the time to monitor and take appropriate actions to respond to changing
situations, such as increases in competition and how popular the film will be within the next two years, before it will
commit capital and other resources into the project.
The project without the option produces a negative net present value of $2·98 which would be financially unacceptable.
With the flexibility provided by real options to delay the project managers could take action to help boost the project’s
NPV if it falls behind forecast. They can create and take advantage of options in managing the project. The value of
the flexibility to delay has a value of $9·61 million which would turn the negative NPV to positive, making the overall
value of the project $6·55 million. However, it should be emphasised that the value of the option is based on the Black-
Scholes model which has many assumptions such as the risk free rate and the difficulties of calculating the standard
deviation, which measures the volatility of the present value of the cash inflows.
The management of the company may also consider other options available as a result of undertaking this project.
There could be the option to expand which gives the company the possibility to undertake follow-on projects as a result
of undertaking this first project.
24. Faoilean Co (June 2014)
(a)
Real options are concerned with options related to operational and strategic decisions, in particular those concerned
with investment in projects.
Conventional DCF analysis looks at whether a project is going to add value for shareholders. In practice, managers of
a business are unlikely to consider net present values of projects alone. Investing in a particular project might lead to
other opportunities that may have been ignored in a DCF analysis. Managers could take action to help boost a
project’s NPV if it falls behind forecast. They can create and take advantage of options in managing projects. For
example, situations may exist where a company does not have to make a decision on a now-or-never basis, or where
it can abandon a decision, which has been made, at some future point, or where it has an opportunity for further
expansion as a result of the original decision. In such situations, using option pricing formulae, which incorporate the
uncertainty surrounding a project and the time before a decision has to be made, can determine a value attached to
this flexibility. This value can be added to the conventional net present value computation to give a more accurate
assessment of the project’s value.
The flexibility provided by real options in investments appears in many guises, such as option to delay, expand,
abandon or redeploy.
Option to abandon
In the case of Faoilean Co, the company can negotiate a get-out clause with the government of Ireland which gives it
the right to sell the project back to the government at a later date at a pre-agreed price, when the project is not yielding
the expected return.
Option to delay
 The company can use the initial exploration rights to delay the decision of whether to undertake the extraction of oil
and gas to a later date. This will give the company the opportunity to assess whether the quantity of oil and gas
deposit are more accurate. The option to abandon gives the company the opportunity to dispose of a project on a
future date, if uncertainties today become negative outcomes in the future.
Option to expand
The company can also assess whether or not by applying for this current right may have the priority over other
companies in terms of future projects, thus have the right to expand into other oil and gas project that may arise in the
future. These opportunities would allow it to gain competitive advantage over rivals, which, in turn, could provide it with
greater opportunities in the future, but which are uncertain at present
Option to redeploy
The option to redeploy or switch exist when the company can use it productive assets for activities other than the
original one. The company could build the facilities for this project in such a way that if this first project is yielding the
expected result it can use the facilities to undertake new projects.
Limitations of Black-Scholes option pricing model
○ It applies to European call options only, and not to American options. That is, the model is applicable when the
option will be exercised on a particular future date.
○ It assumes that the risk free rate is known and constant throughout the option life.
○ It assumes that there is no transaction costs and tax effects involved in buying or selling the option or its
underlying item.
○ It assumes a perfect market, information is free and equally assessable, no tax and prices can be determined
fairly.
○ The difficulty of estimating the standard deviation of the returns of the underlying item to which the model is
sensitive, and the use of this historical measure to estimate future movements.
(b)
A major aspect of the P4 syllabus is the emphasis on corporate valuation. There may, of course, be some companies
that cannot realistically be valued by conventional techniques.
The Black Scholes Option Pricing (BSOP) model provides a basis for corporate valuation in cases where traditional
methods are either inappropriate, or where they fail to fully reflect the risks involved. Some authors refer to the Black
Scholes Merton model to reflect the work performed by Robert Merton (a key member of the research team which
developed the model).
The usual determinants in the valuation of options need to be redefined, when the valuation of equity is treated as a
call option:

Determinants Possible appropriate measures

Valuation of the underlying The fair value of the assets of the company

Exercise price Settlement values of outstanding liabilities

Volatility of the underlying Standard deviation of underlying assets

Risk-free rate of interest Current yield on company debt

Time to expiry Average period to settlement of company liabilities

Where the assets of the company are actively traded and easily liquidated, their current market value would be
appropriate. In the case of most companies, fair value will normally be based upon the present value of the future cash
flows that the company’s assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to estimate accurately. One approach is
to estimate the probabilities of the likely future cash flows of the company and generate a distribution of their present
values from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the company’s liabilities consist
entirely of debt in the form of a zero coupon bond. If the company’s debt includes other types of bond, adjustments are
necessary as shown in the following illustration.
 The work of Black, Scholes and Merton provides a framework to value those companies that are financed, in part, by
borrowing. Where shareholders are protected by limited liability, they have a call option on the underlying business
assets. Employing the BSOP model, an estimate can be made of the value of a company’s equity and default risk on
the basis of the value of its assets and their volatility.
For companies that are deep “in-the-money”, time value is small and the intrinsic value of the business (i.e. the present
value of the net assets) will dominate the value of the equity. In this case, normal risk aversion can be expected to
apply as that intrinsic value will be exposed to equal positive and negative movements in the value of the company’s
assets.
This situation dramatically changes when companies are “near-the-money”. This occurs with high growth start-ups
financed by debt, leveraged buyouts and companies that are in risk of default.
One class of company (banks) always operate “near-the-money”, and in valuing such businesses, time value would be
more significant than intrinsic value in equity valuation.
When time value dominates, shareholders become risk-seekers and they will grant management incentives to take
greater risk, which will cause the company to be pushed closer and closer “to-the-money”, by expanding assets and
liabilities without increasing the equity capital.
(c)
The Black-Scholes option pricing model calculate the value of call option and then using the put-call parity to calculate
the value of a put option by using five variables; Pa = price of the underlying item; Pe = exercise price; r = risk free rate
of return; t= time to exercise the option and s=standard deviation measuring the volatility of the price of the underlying
item. This means that the value of an option depends on these five variables and a change in any of these variables
will lead to a change in the value of the option. Such assessments of sensitivity are measured by the “Greeks”, which
can be used by options traders in evaluating their hedge positions
Vega measures the sensitivity of the option value to a change in volatility. The higher the volatility the higher will be the
value of a call option. Therefore, any change in volatility can affect the option value.
Thus:

Impact of financing on investment decisions and adjusted present values

25. Tisa Co (June 2012)

Tutor's Tips
The question relates to cost of capital and investment appraisal. These two topics are tested every sitting in P4 exams.
(a)
• The question requires the calculation of project specific cost of capital for the two processes.
• Use Elfu as the proxy company and calculate the beta of its component division.
• Use the debt-equity proportion of Tisa to re-gear the asset beta from Elfu’s component division.
• Using CAPM, calculate the cost of equity and the using WACC formula, calculate the project specific cost of capital.
(b)
• This is a straightforward calculation of IRR and modified IRR for process Omega.
• Remember to discuss the outcome of the calculations by comparing IRR and MIRR for each process.
• Finally select the process with the highest MIRR as MIRR is consistent with NPV.
(c)
• This is a straightforward calculation question on Value at Risk (VaR).
• Remember to discuss the outcome of the calculations
The calculations in requirements (b) and (c) are fairly usual and candidate should be able to obtain good marks.
(a) To determine the business risk associated with the project, information on Elfu Co will be used to estimate the
project’s asset beta. Then based on Tisa plc’s capital structure, the project’s equity beta, cost of equity and weighted
average cost of capital will be estimated.
Market value of Elfu Co debt = $96m
Market value of Elfu Co equity = $1·20 x 400m shares = $480m
Elfu Co combined asset beta =1·40 x $480m/($480m + $96m x (0.75)) = 1·217
Asset beta of Elfu Co’s other activities:
1·25 x $360m/($360m + $76·8m x (0.75)) = 1·078
Elfu Co combined asset beta is calculated as:
1·217 = (component asset beta x 0·25) + (1·078 x 0·75)
Therefore the asset beta of the company division is:
Component asset beta = [1·217 – (1·078 x 0·75)]/0·25 = 1·634
Now regear to reflect the debt/equity of Tisa Co to include its financial risk:
1·634 x [($18m + $3·6m x 0·75)/$18m] = 1·879
Using CAPM, component Ke = 3·5% + 1·879 (5·8%) = 14·4%
Component WACC = [(14·4% x $18m) + (4·5% x $3·6m)]/($18m + $3·6m) = 12·8%,
= Say 13%
(b) Calculation of IRR and MIRR for process Omega

Year 0 1 2 3 4

($000) ($000) ($000) ($000) ($000)

Net cash flows (3,800) 1,220 1,153 1,386 3,829

DF 13% 1 0.885 0.783 0.693 0.613

PV (3,800) 1,080 903 960 2,347

NPV = +1,490,000

Year 0 1 2 3 4

($000) ($000) ($000) ($000) ($000)

Net cash flows (3,800) 1,220 1,153 1,386 3,829

DF 13% 1 0.781 0.610 0.477 0.372

PV (3,800) 953 703 661 1,424

NPV = - 59,000

Internal rate of return = 13% + (1490 /1490 + 59) x (28% - 13%) = 27·4%
Modified internal rate of return (MIRR) using the formula:
PVR at cost of capital of 13% = $5,290
PVI at cost of capital of 13% = $3,800
MIRR =

MIRR = [(5,290/3,800)1/4 x (1.13)] – 1 = 22.7%

 On the basis of the internal rate of return process Omega should be selected as it gives the highest internal rate of
return.
However, on the basis of modified internal rate of return process Zeta should be selected as it gives the highest
modified internal rate of return.
The reason for these conflicting conclusions is that internal rate of return assumes that the cash flows from the process
are reinvested at the internal rate of return whilst the modified internal rate of return assumes that the cash flows are
reinvested at the cost of capital consistent with the assumption made by the net present value technique.
Since the net present value approach leads to maximisation of shareholders’ wealth and modified internal rate of
return is consistent with NPV, process Zeta should be selected.
(c) The tail measure of 99% confidence level is 2.33 and given a standard deviation of $800,000 the annual value at risk
is:
Annual value at risk = $800,000 x 2·33 = $1,864,000
Five year VAR = $1,864,000 x 51/2 = $4,168,000
There is a 1% chance of the expected value falling to $336,000 ($2,200,000 – 1,864,000) annually. There is a 1%
chance of the expected value falling to [($2,200,000 x 5) – $4,168,000] =$6,832,000.
26. Strayer
(a) APV = Base case NPV ± Present value of financing effects
Base case NPV
This may be estimated by discounting net cash flows by the discount rate applicable to the risk associated with an
ungeared investment.
– As Strayer is moving to the printing industry we can use the geared beta of the printing industry as a proxy beta.
– Ungear the proxy beta to an ungeared beta using the formula on the assumption that companies in the industry have
the same business risk and debt is risk free.

– Using CAPM, calculate the ungeared cost of equity as

Keu = 5.5% + 0.71(12% – 5.5%) = 10.115%
Say 10%
– Calculate the base case NPV by discounting the relevant cash flows by 10% as follows:

Cash flow Df10% PV

$m $m

Year 0 (25) 1 (25)

Y1 – 10 5 × 0.7 3.5 6.145 21.508

Y10 5 0.386 1.93

Base case NPV $(1.562)m

Present value of financing effects

Issue cost

$m

Rights issue = 10m × 4% = 0.40

Debts = 5m × 1% = 0.05
PV of issue cost $0.45m

Tax savings on debt interest

8% loan of $5m

Annual interest = $5m × 8% = 0.4m

Tax saved per annum = $0.4 × 30% = 0.12m

$4m subsidised loan

Annual interest = $4m × 6% = 024m

Tax saved per annum = $0.24 × 30% = 0.072m

PV of tax savings on interest using risk-free rate of 5.5% as discount factor

Annuity factor of 5.5% over 10 years is simply calculated as the sum of annuity factor of 5% and 6% over 10 years
divided by 2:
= (7.722 + 7.360)/2 = 7.541

Total tax saving on interest: 0.12m + 0.072m = $0.192m

PV of tax savings = $0.192 × 7.541 = $1.448m

Present value of Subsidy

After-tax interest saved as a result of subsidy:

2% × $4m = $0.08 × (1 – 0.3)

= $0.056m

Present value of subsidy at risk-free rate:

$0.056 × 7.541 = $0.422m

APV
The expected APV of the investment is:

$m

Base case NPV (1.562)

Tax relief on interest 1.448

Benefit from subsidised loan 0.422

Issue costs (0.45)

APV ($0.142)

(b) Since the APV is negative, the project is financially not viable.
The APV method may be better than NPV in situations where:
 – The operating risk of the company changes as a result of the new investment.
– There is a significant change in the capital structure and hence financial risk of the company as a result of the
investment.
– The investment has complex tax payments and tax allowances, and/or periods when tax is not paid.
– There are subsidised loans or other benefits associated explicitly with an individual project.
27. Sleepon Hotels plc
Sleepon Hotels plc should consider both financial and non-financial factors in deciding whether or not to undertake the
theme park project. It is important to make a sound investment decision because; the decisions often involve large
amounts of money; the commitment may be for a long period of time; it may not be easy to reverse a decision once
implemented and once a project is undertaken it may preclude other strategic choices being made. The net present value
of a project provides a valuable indication as to whether the project will increase the wealth of shareholders.
NPV calculation

(£ million)

Year 0 1 2 3 4 5 6

Cash receipts:

Adult admission 41.25 42.49 43.76 45.07

Child admission 34.37 35.40 36.47 37.56

Food (incremental cash flow) 13.75 14.16 14.59 15.02

Gifts (incremental cash flow) 11.46 11.80 12.16 12.52

Total receipts 100.83 103.85 106.98 110.17

Expenses:

Labour 42.44 43.70 45.02 46.37

Maintenance 15.00 19.00 23.00 27.00

Insurance 2.12 2.19 2.25 2.3

Total expenses 59.56 64.89 70.27 75.67

Net Receipts 41.27 38.96 36.71 34.50

Tax @30% (12.38) (11.69) (11.01) (10.35)

Tax savings on capital allowances 18.75 14.06 10.55 7.91

47.64 41.33 36.25 32.06

Initial cost/residual value (200) (200) 250

Working capital (51.5) (1.55) (1.59) (1.64) (1.69) 57.97

Net cash flows (200) (251.5) 46.09 39.74 34.61 280.37 57.97

DF (11%) 1.000 0.901 0.812 0.731 0.659 0.593 0.535

Present value (200) (226.60) 37.43 29.05 22.81 166.26 31.01

Net present value = (£140.04 million)

 Notes and workings
• Interest is an irrelevant cash flow. It is included as part of the cost of capital (discount factor).
• The market research cost is a sunk cost.
• Apportioned overhead is an irrelevant cash flow.
• Advertising cost savings is not an additional cash flow and therefore is an irrelevant cash flow.
• Receipts

Adult admission = 15,000 × 40% × 360 days × £18 × 1.032 = 41.25 million

Child admission = 15,000 × 60% × 360 days × £10 × 1.032 = 34.37 million

Food = 15,000 × 360days × £8 × 30% × 1.032 = 13.75 million

Gifts = 15,000 × 360 × 5 × 40% × 1.032 = 11.46 million

Construction is assumed to be completed in year one and therefore revenues and costs will commence in year two. The
year two receipts are then subject to an increase of 3% per annum.
• Capital allowances:

Year Capital allowance Tax savings

1 250 × 25% = 62.50 62.5 × 30% 18.75

2 18.75 × 75% 14.06

3 14.06 × 75% 10.55

4 10.55 × 75% 7.91

The realisable value of the asset is calculated after tax and therefore no balancing allowance or charge has been
calculated.
• Discount factor. The project’s cash flows are to be discounted at a rate that reflects their systematic risk. The risk
associated with Hotel business may be different from that of the Theme park and therefore specific discount rate
should be calculated using information from Thrillall plc, as it operates in the theme park sector.
The geared equity beta of Thrillall plc is 1.45.
Thrillall’s ungeared equity beta can then be calculated as:

Regearing 1.214 to reflect the gearing of Sleepon:

Beta equity (geared beta) = 1.748

Using capital asset pricing model, calculate cost of equity;
Ke = 3.5% + (10% – 3.5%) 1.748 = 14.86%
Then calculating the project specific WACC:
14.86% (0.614) + 7.5% (1 – 0.3) (0.386) = 11.15%, say 11%
Other factors
• Sleepon Hotel Inc should consider the accuracy of the cash flow projections, sales, costs, tax rate and the realisable
value of the asset. Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key
cash flows.
 • The discount rate used was calculated on the assumption that Thrillall’s business risk will be the same as the business
risk that Sleepon will face in the Theme park sector. This might not necessary be true.
• No consideration is taken of the cash flows beyond the company’s four year planning horizon.
• Sleepon should also consider whether or not the investment might lead to other opportunities. In that case, they should
determine the value of that real option.
• Sleepon should carefully consider whether the theme park investment will fit into its corporate strategy. The theme park
investment is a diversification away from their main stream activity (Hotel) and would they have the experience and
other resources to ensure effective and efficient integration of these two different activities.
28. Trosoft pte ltd
(a) The weighted average cost of capital (WACC) is the average cost of the different sources of finance within the capital
structure of a company, using the market value of each of the different elements as the basis of the weightings. It is
used as the discount factor when calculating the net present value. Where the return from the investment is more than
the WACC the project net present value will be positive and indicate expected increase in the wealth of shareholders.
This means WACC is important in project evaluation. However, WACC may not be appropriate where the following
situation apply:
– The operating risk of the company changes as a result of the new investment.
– There is a significant change in the capital structure and hence financial risk of the company as a result of the
investment.
– The investment has complex tax payments and tax allowances, and/or periods when tax is not paid.
– There are subsidised loans or other benefits associated explicitly with an individual project.
The adjusted present value (APV) is more appropriate to use in evaluation investment if the above situation are
applicable. APV suggest that the net present value (NPV) of a project can be increased or decreased by the side-
effects of financing. The APV method involves two stages: evaluate the project first of all as if it were all equity
financed, and so as if the company were an all equity company to find the ‘based case NPV’ and making adjustment to
the based case NPV to allow for the side effects of the method of financing that has been used. However, APV also
have limitations such as:
– Determining a suitable cost of equity for the initial base-case NPV computation as if the project was all equity
financed, and also establishing the all equity beta are still based on M&M assumptions.
– Difficulties in identifying all the cost associated with the method of financing
– Difficulties in choosing the correct discount rate used to discount the side effects such as issue cost and the
corporation tax savings on debt capital interest. Although the risk-free rate of return is assumed.
– In complex investment decisions the calculations can be extremely long and hence more difficult.
(b) APV = Base case value of NPV ± Present financing effects
Base- case NPV
This may be estimated by discounting net cash flows by the discount rate applicable to the risk associated with an
ungeared investment.
– Ungear the proxy beta to an ungeared beta using the formula on the assumption that companies in the industry have
the same business risk and debt is risk free.

– Using CAPM, calculate the ungeared cost of equity as

Keu = 4% + 1.035(9.5% – 4%) = 9.69%
Say 10%
– Calculate the base case NPV by discounting the relevant cash flows by 10% as follows:

Year 0 1 2 3 4 5 6

Receipts
Auction fees 4,300 6,620 8,100 8,200 8,364 8,531

Costs:

IT maintenance costs 1,210 1,850 1,920 2,125 2,168 2,211

Telephone costs 1,215 1,910 2,230 2,420 2,468 2,518

Wages 1,460 1,520 1,680 1,730 1,765 1,800

Salaries 400 550 600 650 663 676

Incremental head office overhead 50 55 60 65 66 68

Marketing 500 420 200 200 – – –

Royalty payments for use of technology 680 500 300 200 200 200 200

Lost contribution 80 80 80 – – –

Rental of premises 280 290 300 310 316 323

Total cost 1,180 5,615 6,755 7,270 7,500 7,646 7,796

Net receipts (1,180) (1,315) (135) 830 700 718 735

Tax @ 24.5% 289 322 33 (203) (172) (176) (180)

Tax saved on tax Depreciation – 132 106 106 106 106 106

IT infrastructure cost (2,700)

Working capital (400) (24) (24) (25) (26) (10) 509

Net cash flows (3,991) (885) (20) 708 608 638 1,170

DF(10%) 1.000 0.909 0.826 0.751 0.683 0.621 0.564

Present value (3,991) (804) (17) 532 415 396 660

Base-case NPV = ($2809)

Notes:
– Market research cost is an irrelevant cash flow as it is a sunk cost.
– Working capital in year five is assumed to increase by 2%. (2% × 499) = 10 and all the working capital is recouped in
year 6 (499 + 10) = 509.
– Tax allowable depreciation

Year 1 2 3 4 5 6

Tax depreciation 540 432 432 432 432 432

Tax saved (24.5%) 132 106 106 106 106 106

Financing effects
– Issue costs
Issue cost = 1.5% × 3,100,000 = $46,500
The present value of issue costs = $46,500 as it occurs in year zero.
– Tax savings on interest
 Applicable interest rate after subsidy = 5.5% - 1% = 4.5%
Interest on debt = 3,100,000 × 4.5% = 139,500
Tax saved = 139,500 × 24.5% = $34,178
Present value at risk free rate = 34,178 × 5.242 = 179,161
– Singapore government subsidy
Subsidy/interest saved = 1% × 3,100,000 = $31,000
Net interest saved = 31,000 × (1- 0.245) = $23,405
Present value of net interest saved at risk free rate = 23,405 × 5.242 = $122,689

APV

Base case NPV (2,809,000)

Issue costs (46,500)

Tax savings on interest 179,161

Subsidy 122,689

APV (2,553,650)

On financial grounds the project is not viable as the APV is negative.

Other factors
– Trosoft should consider the accuracy of the cash flow projections, sales, costs, tax rate the realisable value of the
asset. Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key cash
flows.
– Trosoft should also consider whether or not the investment might lead to other opportunities. In that case, they
should determine the value of that real option. These options may include option to delay, expand, redeploy and
withdraw.
– The discount rate used is based on CAPM, which is subject to theoretical and practical limitations
– Competitors’ actions. Will there be an introduction of new technology that will render this obsolete?
– Trosoft should carefully consider whether the investment will fit into its corporate strategy.
29. Tampem plc
(a) Net present value is calculated as the present value of future cash flows using the company’s WACC as the discount
factor.
Calculation of WACC
Ke = 4% + (10% – 4%) 1.5 = 13%

WACC = 13% (0.6) + 8% (1-0.3) (0.4) = 10.04% say 10%

Tax savings on capital allowance

Year Capital allowance Tax savings

1 [(5,400 -600-400) = 4,400 × 25% = 1,100] 1,100 × 30% 330

2 330 × 75% 248

3 248 × 75% 186

 4 186 × 75% 139

Realisable value is after tax.

Net present value calculation

£000

Year 0 1 2 3 4

Operating cash flows 1,250 1,400 1,600 1,800

Taxation (30%) (375) (420) (480) (540)

Tax saving on capital allowance 330 248 186 139

Investment cost/realisable value (5,400) 1,500

Net cash flows (5,400) 1,205 1,228 1,306 2,899

Discount factors (10%) 1.000 0.909 0.826 0.751 0.683

Present values (5,400) 1,095 1,014 981 1,980

Net present value (£330,000)

The investment is not financially viable as the net present value is negative.
Adjusted present value calculation
APV = Base case NPV ± Present value of financing effects
Base case NPV
This may be estimated by discounting net cash flows by the discount rate applicable to the risk associated with an
ungeared investment.
– Ungear the proxy beta to an ungeared beta using the formula, on the assumption that companies in the industry
have the same business risk and debt is risk free.

– Using CAPM, calculate the ungeared cost of equity as

Keu = 4% + 0.882 (10% – 4%) = 9.292%
Say 9%
– Calculate the base case NPV by discounting the relevant cash flows by 9% as follows:
The net cash flows will be same as that of NPV calculation, except in year zero where the issue cost should be
excluded as it is part of financing effect

£000

Year 0 1 2 3 4

Net cash flows (5,000) 1,205 1,228 1,306 2,899

Discount factors (9%) 1.000 0.917 0.842 0.772 0.708

Present values (5,000) 1,105 1,034 1,008 2,052

Base case NPV = £199,000

 Financing effects
– Issue costs
Issue cost =£ 400,000
The present value of issue costs = £400,000 as it occurs in year zero.
– Tax savings on interest
Interest on debt = 2,700,000 × 8% = £216,000
Tax saved = 216,000 × 30% = £64,800
Present value at cost of debt of 8% = 64,800 × 3.312 = £214,618

APV

Base case NPV 199,000

Issue costs (400,000)

Tax savings on interest 214,618

APV + 13,618

Since the APV is positive the project is financially acceptable.

(b) Manager A suggests the use of NPV. A positive net present value indicates that the project will increase shareholders’
wealth and vice versa. This will occur where the return from the investment is more than the WACC. However, NPV
may not be appropriate where the following apply:
– The operating risk of the company changes as a result of the new investment.
– There is a significant change in the capital structure, and hence financial risk of the company, as a result of the
investment.
– The investment has complex tax payments and tax allowances, and/or periods when tax is not paid.
– There are subsidised loans or other benefits associated explicitly with an individual project.
Manager B suggests using the adjusted present value method. The adjusted present value (APV) method is more
appropriate to use in evaluating investments if the above assumptions are applicable. APV suggest that the net
present value (NPV) of a project can be increased or decreased by the side-effects of financing. The APV method
involves two stages: evaluate the project first of all as if it were all-equity financed, as if the company were an all-equity
company, to find the ‘base case NPV’. Then make adjustment to the base case NPV to allow for the side effects of the
method of financing that has been used. However, APV also has limitations:
– It may be difficult to determine a suitable cost of equity for the initial base-case NPV computation as if the project
was all equity financed.
– establishing the all-equity beta is based on M&M assumptions.
– Difficulties in identifying all the costs associated with the method of financing.
– Difficulties in choosing the correct discount rate used to discount the side effects, such as issue costs and the
corporation tax savings on the interest on debt capital (though the risk-free rate of return is sometimes assumed).
– In complex investment decisions the calculations can be extremely long and hence more difficult.
APV and NPV fails to consider real options such as an option to expand, delay or abandon or the option to redeploy or
switch.
30. Do-it-Yourself (Pilot paper 2012)
(a) Calculation of the expected WACC
The major problem in the official ACCA solution to this question was “Where does the current (risk free) yield on the 3
year debt of 3.45% come from?” Presumably, the yield curve in the question was inaccurately drawn. Inspection of the
curve would indicate a risk-free yield on 3 year debt of about 3.8%. Therefore the answer which follows will be based
on this 3.8% and not the 3.45% used by the ACCA.
 The current Gross kd on the 3 year debt is 4.2%, consisting of the risk free rate of 3.8% (referred to above) plus the retail
sector spread for an AA- rating on 3 year debt of 40 basis points (i.e. 0.4%) as shown in the table in the question.
The revised gross kd on the 3 year debt will be based upon that same risk free rate of 3.8%, but the risk premium will
depend upon the change in the credit rating which occurs as a result of issuing the new 10 year debt. There is a 60%
chance of an A+ rating (at 44 basis points) and a 40% chance of an A rating (at 75 basis points). Thus the revised yield
on the 3 year debt is estimated as follows:

Risk free rate 3.8

Risk premium: (0.6 × 0.44%) + (0.4 × 0.75%) 0.564

4.364

The new 10 year debt must now be considered. From inspection of the bond yield curve, the risk free yield on 10 year
debt appears to be 4.2% (which, incidentally, was correctly used in the official ACCA solution). The risk premium will
depend upon the revised credit rating. There is a 60% chance of an A+ rating (at 70 basis points) and a 40% chance of
an A rating (at 107 basis points). Thus the yield on the new 10 year debt is estimated as follows:

Risk free rate 4.2

Risk premium: (0.6 × 0.7%) + (0.4 × 1.07%) 0.848

5.048%

Accordingly the revised combined gross kd becomes:

Value Kd
$bn $bn

3 year debt 0.5 x 4.364% 0.02182

10 year debt ($0.38bn-– $0.08bn) 0.3 x 5.048% 0.015144

0.8 0.036964

Existing keg

WACC = keg + kd (1 – t)

6.8 = keg + 4.2 (1 – 0.3)

6.8 = keg + 0.42

6.38 = keg

= keg

7.443% = keg
 Existing keu (formula is given on the formula sheet)

Keg = keu + (keu – kd)

7.443 = keu + (keu – 4.2)

7.443 = keu + (keu – 4.2)

7.443 = keu + (0.11667 keu – 0.49)

7.443 = 1.1167 keu – 0.49

7.933 = 1.1167 keu

7.104% = keu

The following approach is a far quicker method, however the formula is NOT given on the formula sheet:

WACC =

6.8 =

6.8 = 0.9571428 keu

7.104% = Keu

New ke (using the revised combined Gross kd)

keg =

= 7.5676%

New WACC (using the revised combined Gross kd)

This demonstrates a fall in the WACC of 14.5 basis points (i.e. from 6.8% to 6.655%).
(b) Report on the alternative sources of finance
For a company in this position, the following sources of finance are suggested:
– Sale and leaseback of existing assets;
– US debt, financed through a further bond issue;
– Debt raised on the Chinese market; and
 – Equity finance by rights or new issue of shares.
The choice of financing is partly down to the cost and availability of the various sources and partly down to the method
the company chooses to hedge its foreign exchange exposure.
If we ignore foreign exchange considerations for a moment, the pecking order theory suggests that debt should be
preferred to equity and the weighted average cost of capital calculation suggests that the company should increase its
gearing to capture further tax shield effects, which are not currently being offset by increased default risk (the static
trade-off theory). However, issue costs may be expensive and the company may seek to raise finance by sale and
leaseback of existing assets. There are implications for reporting under FASB 13, depending upon whether the leases
are financing or operating leases. Raising $300 million of debt by a bond issue is at the low end of the scale for new
debt issues of this type, although it may be possible that a syndicated issue (i.e. where a number of companies of
similar credit rating are joined by a lead bank) could be arranged. It is to be expected that the costs of the issue will be
high in terms of commissions and underwriting fees.
Raising finance directly in China has been eased considerably with recent changes in the rules of the Chinese
Securities Regulatory Commission opening better access for foreign entities to the Chinese bond and equity markets.
However, the entry of China into the WTO is still feeding through the economy as tariff barriers and other constraints
are removed. This process of liberalisation is likely to continue accelerating although, as with any emerging market,
there are risks associated with inward investment and capital entry. These risks may be sufficient to raise the risk
assessment against this company and as a result the benign implications of increased gearing outlined above may not
be realised in practice.
The problem of hedging the foreign exchange exposure can be partly solved by borrowing directly in China and using
the income flows from the new venture to finance the interest charges and capital repayments. Because the borrowing
and the income flows are in the same currency, transactions exposure is largely eliminated -although any appreciation
in the Chinese currency would increase the dollar value of the translated debt in the company’s balance sheet. If the
borrowing is used to purchase matching assets in China then the translation risk is mitigated along with the transaction
risk. However, if the assets are not owned (but leased or rented) then translation effects will impact upon the balance
sheet and may be misread by the market. A second alternative would be to raise finance in the US and then engage in
a currency swap for a 10 year term. The effect of this would be to lock into the current exchange rate for the duration of
the borrowing. However, finding a swap of this type would entail the services of a financial institution, which specialises
in bringing appropriate counterparties together. Such derivative arrangements have been mis-sold in the past with
disastrous leveraging effects built into the contract.
31. Your Company

Guidance manual
• The discount rate used should normally reflect the weighted average cost of equity and debt, taking into account the
systematic risk of the investment. The company’s weighted average cost of capital should only be used if the
investment has a similar systematic business risk to the company as a whole, and if the gearing of the company is
unchanged. When the gearing of the company changes as a result of the investment, an alternative technique, the
adjusted present value, is recommended.
• The cost of equity and cost of debt should always be estimated using market values.
• If the estimated cash flows of an investment include estimates of price/cost changes caused by inflation, the discount
rate must also include expected inflation. Estimates of the discount rate which use market based estimates of the cost
of equity and the cost of debt will include expected inflation and there is no need for any further adjustment. If
estimated cash flows are in real terms, excluding inflation, the discount rate should also be in real terms.
• The cost of equity may be estimated using either the dividend valuation model or the capital asset pricing model
(CAPM). In theory the two models should provide the same estimate of the cost of equity. In many instances because
of market imperfections, and problems in the estimation of an appropriate growth rate in the dividend valuation model,
the two models often give different results. CAPM is normally considered to be the better alternative. However, this
model also has theoretical weaknesses and there may be problems in obtaining data to put into the model.
• The cost of debt should be based upon the current market cost of debt. Where different types of debt are used,
estimates of more than one debt cost may be necessary, and these costs weighted according to the proportion of each
type of debt that is used. The redemption yield of existing debt may be used to estimate the cost of debt if no obvious
market price is available. If the company is in a tax paying position the cost of debt should be estimated net of any tax
relief on interest paid on the debt.
• There is no need to round the solution up to the nearest whole percentage. NPV estimates may be made using the
estimated cost of capital without rounding. The estimated cost is likely to be subject to some margin of error, and
sensitivity analysis using alternative discount rates is suggested to investigate the significance of an incorrect discount
rate to the estimated NPV of the investment.
 Revised illustrative examples:

When the company is expanding existing activities:

Cost of equity

An incorrect formula for the dividend valuation model was used in the draft. An estimate of the next dividend, not the
current dividend should be used. The growth rate should be based upon dividend growth and not earnings growth.
Capital asset pricing model:
The equity beta and not the asset beta is required when estimating the cost of equity.
Assuming debt to be risk free:

Asset beta = Equity beta ×

1.1 = Equity beta ×

The equity beta is 1.41

Ke = rf + (Erm – rf) beta = 6% + (14% - 6%) 1.41 = 17.28%
The CAPM estimate of the cost of equity will be used in the estimate of the weighted average cost of capital.
Cost of debt
The debenture will be used to estimate the current cost of debt as it is the only marketable debt. The current market value
of the debenture is £45m (£85m less the £40m amount of the bank loan). Tax relief has been omitted from the estimate of
the cost of debt. The annual after-tax cost of interest payments on the debenture is £40m × 10% (1 – 0.3) or £2.8m,
assuming no lag in time before tax relief on interest is available.
To find the redemption yield, with four years to maturity the following equation must be solved

By trial and error

At 5% interest

2.8 × 3.546 = 9.93

40 × 0.823 = 32.92

42.85

5% discount rate is too high

At 3% interest

2.8 × 3.717 = 10.41

40 × 0.888 = 35.52

45.93

Interpolating:
 The after tax cost of debt is 3.60%
Weighted average cost of capital
Market value of equity £214m
Market value of debt £85m

The discount rate to be used in the investment appraisal is 13.39%

No further adjustment for inflation is necessary as the estimates of the cost of equity and cost of debt already include
inflation.

When the company is diversifying its activities:

Cost of equity
The beta of the comparator company will be used to estimate the systematic risk of the new investment.
No ungearing is necessary, as the asset beta of the comparator company is given. This will need to be regeared to take
into account the capital structure of our company.
Regearing:

Beta equity = beta asset ×

Beta equity = 0.90 × = 1.15

Using the capital asset pricing model:

Ke = rf + (Erm – rf) beta = 6% + (14% – 6%) 1.15 = 15.20%
Cost of debt
This remains at 3.60%
Weighted average cost of capital
Market value of equity: £214m
Market value of debt: £85m
15.20% ×

+ 3.60% ×

= 11.90%
The discount rate to be used in the investment appraisal when diversifying into the new industry is 11.90%, and again a
further adjustment for inflation is unnecessary.
32. Cost of capital
(a) If interest rates do not change the lowest value that the convertible is likely to have during the next two months is its
value as straight debt. Any value above this will be the value attributed to the conversion option that exists, and will
give a higher conversion price per share.

The expected value as straight debt is £8 × 3.240* 25.92

£100 × 0.708 70.80

96.72
 * 3.240 is the present value of an annuity of £1 for four years at 9%, the cost of straight debt.
This would give a price per share of

= 484 pence
If the market price falls to 470 pence, no conversion will be expected, and the market value of the debentures will be
£20m×

=£19.344 million
Assuming the cost of equity remains unchanged, as the equity has the same systematic risk as the market the cost is
estimated to be same as market return of 15%. The market value of equity will fall to

= £162.69 million.
The existing market value of debt is £45 million, 20% of the total capital, of which

or £22 million is currently represented by the convertible debenture, and £23 million by other debt.
If conversion does not occur the new value of debt is expected to be:
£23m + £19.344 = £42.344m
The after-tax weighted average cost of capital is estimated to be:

If the market price in two months is 570 pence then conversion is likely. At the current price of debt of £110, the
conversion price would be:

This will lead to the issue of 200,000 × 20 or 4million shares, with an assumed market value of 4m × 570 pence or
£22.8 million. (In reality the conversion may lead to dilution in the earnings per share and the price of the shares could
fall to lower than 570 pence.)
The total value of equity to be

The value of debt will be the remaining debt £23 million.

With conversion the weighted average cost of capital is estimated to be:

The weighted average cost of capital is expected to increase because of the higher proportion of relatively expensive
equity in the capital structure. The cost of equity and cost of debt have been assumed to remain unchanged. Even if
the share price changes the cost of equity might remain unchanged, the price changes being caused directly by
general market movements and the beta remaining at one. However, the change in gearing upon conversion could
influence both the cost of debt and cost of equity as the risk to both shareholders and bondholders is likely to be
reduced with a lower level of gearing.
(b) If the companies merge:

£ million
 Recession Slow growth Rapid growth Expected value

Total Values 105 135 195 142.5

of which:

Equity 50 80 140 87.5

Debt 55 55 55 55

105 135 195 142.5

The calculation of the expected value of the debt is fairly obvious. The expected value of the equity can be calculated
in a similar manner to the total values, or treated as a balancing figure.
Without a merger:

£ million

Recession Slow growth Rapid growth Expected value

Peden

Total of which: 42 55 75 57.05

Equity 0 10 30 12.5

Debt 42 45 45 44.55

42 55 75 57.05

Tulen

Total of which: 63 80 120 85.45

Equity 53 70 110 75.45

Debt 10 10 10 10

63 80 120 85.45

The expected value of the totals and of the debt of Peden is calculated as follows:

Probability £ million £ million

Recession 0.15 × 42 = 6.3

Slow growth 0.65 × 55 = 35.75

Rapid growth 0.2 × 75 = 15

57.05

Probability £ million £ million

Recession 0.15 × 42 = 6.3

Slow growth 0.65 × 45 = 29.25

Rapid growth 0.2 × 45 = 9

44.55
 The expected value of the equity can be calculated in a similar manner, or treated as a balancing figure.
The expected value of the totals of Tulen is calculated as follows:

Probability £ million £ million

Recession 0.15 × 63 = 9.45

Slow growth 0.65 × 80 = 52

Rapid growth 0.2 × 120 = 24

85.45

The calculation of the expected value of the debt is fairly straightforward. The expected value of the equity can be
calculated in a similar manner to the total values, or treated as a balancing figure.
In the case of recession the shares of Peden are expected to be worthless, and the value of the company insufficient
to repay all of the debt. The merger will eliminate the risk that full repayment of the debtholders will not be made,
through what is known as the coinsurance effect.
In the absence of any operational synergy the total value of the companies remains unchanged, but the wealth of the
debtholders of Peden will increase by £0.45 million at the expense of the shareholders of the two companies.
The merger might also result in a gain for shareholders if the merged company’s cash flows are perceived to be less
risky. This might lead to small reductions in both the cost of debt and cost of equity, and make it easier for the company
to raise new external finance.
33. Semer
(a) Revised estimates of the current cost of capital and value.
The cost of equity has been correctly estimated using the capital asset pricing model to be 11.8%.
The cost of debt should be the current cost of debt, not the historic cost of debt of 8% when the debenture was issued.
It should also be estimated on an after-tax basis as interest on debt is a tax allowable expense.
The current cost of debt may be estimated from the redemption yield of the existing debenture. The debenture matures
in five years’ time. The redemption yield may be estimated by solving the following equation for kd.

By trial and error:

At 5% interest:

PV annuity 5.6 × 4.329 24.24

PV 100 × 0.784 78.40

102.64

At 3% interest:

PV annuity 5.6 × 4.580 25.65

PV 100 × 0.863 86.30

111.95

The after tax cost of debt is approximately 3%.

The weighted average cost of capital (WACC) should be estimated using the market values of equity and debt, not
book values.
The market value of equity is 160 million × 410 pence = £656m
The market value of debt is £119m + (£50m × 1.12) = £175m
 WACC = 11.8% ×

+ 3% ×

= 9.95%
As free cash flow is expected to grow by 3% per year, the present value of the company’s free cash flows may be
estimated by using the equation for a growth perpetuity:

(b) Estimated new cost of capital:

If equity is repurchased such that the gearing becomes 50% equity, 50% debt, the new estimated weighted average
cost of capital is:

Impact on the value of the company:

The free cash flow to the company will not change when equity is replaced by debt.
Expected new value

This is a very large potential increase in value.

(c) Report on the proposed adjustment of gearing through the repurchase of ordinary shares
The effect of capital structure on the value of a company is not fully understood.
Increasing the proportion of debt in the capital structure may reduce the overall cost of capital due to the interest on
debt being a tax-allowable expense. Even if a company is in a non-tax paying position, mixing additional low cost debt
with relatively expensive equity might reduce the weighted average cost of capital. In such circumstances the
proposed strategy to increase gearing would have some validity. However, increasing gearing can also bring problems.
Risk to investors, and therefore the required returns on equity and debt, will increase as gearing increases. Very high
levels of gearing might lead to direct and indirect bankruptcy costs, with a detrimental effect on cash flow and
corporate value. Any benefits from increasing the proportion of debt in the capital structure will be to some extent offset
as a result of increased risk with high gearing.
The revised estimates of the effect on the cost of capital and value of Semer are not likely to be accurate. Reasons for
this include:
– The company will not be able to repurchase the necessary shares at their current market value. Approximately £240
(656 – 415.5) million value of equity would need to be repurchased, or more than one third of the existing market
value of equity. As repurchases take place it is likely that the share price will significantly increase.
– The cost of debt is unlikely to remain constant. As more debt is issued lenders will demand a higher interest rate to
compensate for the extra risk resulting from higher gearing levels. The cost of equity will also increase with higher
gearing. These effects will increase the weighted average cost of capital to a higher level than that estimated.
– The precise market values of debt and equity after the repurchase are unknown, and again will reflect the market
attitude to the new risk of the higher gearing.
The value of the company is likely to be much lower than that estimated, as the weighted average cost of capital is
likely to be underestimated.
34. Kulpar
(a) The company’s existing gearing is £458 million equity to £305 million debt, or 60% equity, 40% debt and the existing
WACC is 12.96%.
A change in gearing will result in a change in the equity beta. Assuming the beta of debt is zero, the equity beta with
no gearing may be estimated by:
 or

If gearing was 80% equity, 20% debt by market values, the ungeared beta may be regeared to find the new equity
beta:

or

Using CAPM, Ke = Rf + beta(Rm – Rf) or 5.5% + 1.122(14% -5.5%) = 15.04%

If gearing was 40% equity, 60% debt by market values, the ungeared beta may be regeared to find the new equity
beta:

or

Using CAPM, Ke = Rf +beta(Rm – Rf) or 5.5% + 1.1.957(14% -5.5%) = 22.13%

The cost of debt depends on the interest cover and the credit rating.

80% E, 20%D 40%E,60%D

Net operating income 110 110

Depreciation 20 20

Earnings before interest and tax 90 90

Interest 12.21 50.36

(approximate £152.6m debt) (approximate £457.8m debt)

Interest cover 7.37 1.79

Cost of debt 8.00% 11.00%

The interest payable is found by examining different interest rate and interest cover possibilities.
80% equity 20% debt must fall into the AA rating (if the interest rate was 9%, interest would be £13.73 million and
cover 6.55, still AA cover)
40% equity, 60% debt must fall into the BB rating (interest of 9% would be £41.20 million, and cover 2.18 still in the BB
rating).
Weighted average cost of capital at 80% equity and 20% debt
WACC = 15.04% × 0.8 + 8.0% (1-0.3) 0.2 = 13.15%
Weighted average cost of capital at 40% equity and 60% debt
WACC = 22.13% × 0.4 + 11.0% (1-0.3) 0.6 = 13.47%
Existing weighted average cost of capital
The existing cost of equity is 5.5% + 1.4(14% -5.5%) = 17.4%
The existing WACC = 17.4% × 0.6 + 9.0% (1 -0.3) 0.4 = 12.96%
The two alternative capital structures are expected to increase the cost of capital from its current level.
 Corporate value:
Using the suggested equation, the company cash flow = 90 (1-0.3) + 20 -20 = 63.
The growth rate is unknown. However, existing corporate value, company cash flow and weighted average cost of
capital are known, allowing the growth rate to be estimated.

Assuming this growth rate remains unchanged corporate value with different gearing levels is estimated to be:

Altering the capital structure to either of the two suggested levels is expected to reduce corporate value from its current
level of £763 million. It is recommended that the capital structure is kept at its current level of 60% equity and 40% debt.
(b) The estimates of corporate value are only approximations and may be incorrect for many reasons including:
– The assumption of constant growth may be incorrect.
– Corporate value in this model is sensitive to the level of capital spending which might alter considerably from period
to period.
– The model ignores the cash flow impact of any changes in working capital.
– Corporate cash flow would be better estimated by (EBIT –deprecation)(1-t) + depreciation – capital spending + or –
changes in working capital.
– Any changes in gearing would involve transaction costs as shares were repurchased or issued, and debt was issued
or redeemed.
– Repurchases of share might not be possible at the current market price.
– The corporation tax rate might change.
– Crediting rating agencies use other factors in addition to interest cover when deciding a company’s rating, such as
the quality of the company’s management or the volatility of a company’s cash flows.
– Operating cash flow might itself be affected by a change in debt rating.
– The valuation does not take account of any additional costs that might exist at high levels of gearing such as direct
and indirect bankruptcy costs.
– Tax exhaustion might exist at high gearing levels whereby the company can no longer benefit from tax relief on
interest paid on incremental debt issue.
– Corporate debt is not risk free and does not have a beta of zero. A positive beta will alter the cost of capital
estimates.
35. Neptune
(a) Adjusted present value
The adjusted present value (APV) technique separates the value created by the Galileo project into two components:
– The value of the project cash flows at the company’s pure rate of equity (i.e. the ungeared cost of equity capital), and
– The gain or loss of value associated with the costs and benefits of the new financing arrangement.
The APV method is only appropriate where the project does not affect the company’s exposure to business risk.
However, it is the appropriate technique to use where the project creates changes to the financial risk of the company.
Under the APV method, we estimate the changes to the company’s cash flows as a whole if the Galileo project were to
proceed. This adjustment not only entails a substantial tax benefit because of writing down allowances, but also a
further tax charge attributable to the increase in the company’s taxable earnings generated by the project.
The project cash flows exclude all non-relevant costs, but must include the opportunity costs associated with the
redeployment of labour. The projected relevant cash flows and the sale proceeds on the eventual disposal of the
capital equipment are as follows:

Calculation of net cash flows (in $ million)

 Year 1 2 3 4 5 6

Sales revenue 680.00 900.00 900.00 750.00 320.00

Direct costs (60% × sales) (408.00) (540.00) (540.00) (450.00) (192.00)

Redeployment of labour (150.00) (150.00)

Operating cash flow 122.00 210.00 360.00 300.00 128.00

Tax on operating cash flows (36.60) (63.00) (108.00) (90.00) (38.40)

Residual value 40.00

Tax saved on WDA 120.00 48.00 28.80 17.28 10.37 3.55

Money net cash flow 242.00 221.40 325.80 209.28 88.37 (34.85)

Base case NPV (in $ million)

Year 1 2 3 4 5 6

Money net cash flow 242.00 221.40 325.80 209.28 88.37 (34.85)

Discounted at 8.97% 0.918 0.842 0.773 0.709 0.651 0.597

Present value 222.08 186.45 251.79 148.42 57.51 (20.81)

$m

Present value of cash flows for years 1 – 6 845.44

Less: Capital expenditure at year 0 (800.00)

Base case NPV $45.44m

Transaction costs (in $ million)

The new bond issue must be sufficient to cover the immediate capital expenditure of $800 million together with the
transaction costs themselves (2% × 800m) i.e. $16.32 million. Therefore the amounts raised would have to be $816.32
million. It is assumed that tax relief is not available on these issue costs.
Tax shield (in $ million)
The new bond is issued at Year 0. The first interest payment will therefore arise at Year 1, accordingly the initial tax
saving thereon will occur at Year 2. Since these tax savings can be assumed to be virtually certain, they are
discounted at the $LIBOR rate of 5.4%.

Year 2 3 4 5 6

Annual tax saved on interest payments ($816.32m × 7.2% × 0.3) 17.63 17.63 17.63 17.63 17.63

Discounted at 5.4% (almost risk free) 0.900 0.854 0.810 0.769 0.729

Present value 15.87 15.06 14.28 13.56 12.85

Present value of tax savings (tax shield) = $71.62m

Adjusted present value comprises the following:

$m
 Base case NPV 45.44

Financing side effects:

Transaction costs (16.32)

Tax shield 71.62

Adjusted present value $100.74m

Workings
(i) Cost of equity of ungeared company
1 – 6 in part (a) of this solution as $845.44m; another way of calculating
(ii) Tax saved on writing down allowances (WDA)

Year $m

1 (800 × 50%) = 400 (400 × 30%) = 120.00

2 (400 × 40% × 30%) = 48.00

3 48 × (1 – 0.4) = 28.80

4 28.8 × (1 – 0.4) = 17.28

5 17.28 × (1 – 0.4) = 10.37

6 BALANCING FIGURE = 3.55

30% × (800 – 40) 228.00

(iii) Cost of debt

kd = ($LIBOR + 1.8%) = (5.4% + 1.8%) = 7.2%
This new project will clearly add substantial value to the business, although $71.62m of this benefit relates to the tax
advantages associated with the new debt finance. The clear conclusion on the basis of the above financial analysis
is to proceed; although it is worth bearing in mind that other more marginal projects may be solely justified through
the financing effect.
(b) Modified internal rate of return (MIRR)
In this case, since we are only concerned with the project’s money (i.e. nominal) cash flows (excluding financing
costs), use can be made of the ungeared cost of equity (keu) as the appropriate discount rate and reinvestment rate.
Terminal value of recovery phase cash flows (in $ million)

Year 1 2 3 4 5 6

Money net cash flow 242.00 221.40 325.80 209.28 88.37 (34.85)

Compounded at 8.97% 1.08975 1.08974 1.08973 1.08972 1.08971 1

Terminal value 371.83 312.18 421.57 248.51 96.30 (34.85)

Terminal value of cash flows for years 1 – 6 = $1,415.54m

= 9.98%

Alternatively, having already calculated the present value of cash flows for years 1 – 6 in part (a) of this solution as
$845.44m; another way of calculating the MIRR (which would have removed the necessity to calculate the terminal
 value of $ 1,415.54m above) is as follows:

It is to be expected that in a highly competitive business, new opportunities with significant positive net present values
are difficult to find. This project, if successful, will add value to the business, since it offers a rate of return of 9.98%,
which is approximately 1% higher than the current reinvestment rate of 8.97%.
36. Your airline company
(a) The coupon rate on the new debt
The coupon rate should be the same as the yield for four year debt at 6% i.e.:

Four year government treasury bond yield 5.1

Add 90 basis points spread needed to guarantee take up 0.9

6.0

If the company’s bankers have overestimated the credit risk and set the spread too high, then a coupon of 6% will
result in the debt being issued at a premium in the market. If they have set it too low, then the debt will not be fully
taken up and the underwriters will have to reissue it at a discount. The investment banks suggest that a yield (and
hence a coupon) of 6% would guarantee that the issue would be taken up by their institutional clients. On this basis,
the company may wish to ask for an underwriting agreement to that effect, although there would inevitably be a charge
for this.
(b) Impact of the new debt on the company’s market valuation and cost of debt
The issue of the new debt can only be achieved at the cost of a reduction in the company’s credit rating and/or a
consequent increase in its cost of debt capital.
Using our current market gearing ratio, the current amount of debt in issue is calculated as follows:

Since Ve = $1,200m

Vd = × $1,200m

Vd = × $1,200m = $400m

$m

That is Ve = (75%) 1,200

Vd = (25%) 400

Total market value of company (100%) 1,600

Thus, the market value of existing company debt is $400 million. Given that the average coupon rate on current debt is
4% and the current market yield is also 4%:

Three year government treasury yield 3.5

Add: Current credit risk spread estimated at 50 basis points 0.5

4.0
 The par value of existing debt will be the same as its current market value of $400m.
As shown in the solution to part (a) above, the yield on new debt will be 6%. If the new debt is issued at par at this
yield of 6%, then the market value of the existing debt will fall in line with the decrease in the company’s credit rating
with a consequent increase in the yield to 4.4%:

Three year government treasury bond yield 3.5

Add: Revised credit risk spread estimated at 90 basis points 0.9

4.4

On the assumption that the new debt is taken up at par then the new market value of debt in issue will rise to:

$m

Market value of new debt 400

Revised market value of existing debt 395.60

795.60

The company’s effective cost of debt capital is calculated by weighting the yields of the two components of debt and
also adjusting for tax:

$m $m

New debt 400 × 6% × (1 – 0.3) = 16.8

Existing debt 395.60 × 4.4% × (1 – 0.3) = 12.185

795.60 28.985

Revised kd = = 3.64%

The company’s current after-tax kd is [4% × (1 – 0.3)] = 2.80%

Therefore, the increase in gearing will raise the company’s after-tax kd by 0.84%, ie. 84 basis points.
However, this increase is in part due to the longer term to maturity on the new borrowing rather than the increase in the
credit spread and the company might wish to consider extending the term depending upon the yield curve and the
rates beyond four years.
(c) The advantages and disadvantages of this mode of capital financing
Debt finance is a relatively low cost method of raising long term finance. Under the static trade-off theory, we would
expect higher gearing to generate improvements in the company’s cost of capital given the benefit of the tax shield.
However, the cost of debt capital consists of three components: the pure risk free rate, the term premium and the credit
spread. In this case we are proposing to alter our capital structure by taking on longer term debt and thus the
advantages of higher gearing are to a certain extent obscured. Pecking order theory suggests that debt finance should
be preferred to new equity finance and is normally taken by the market as a signal that management believe that the
company is undervalued. In the context of an efficient market, this is doubtful, but it is certainly the case that there are
strong agency effects through debt. Debt will exert a greater discipline over our action then equity finance and tends to
suppress opportunistic investment and over-consumption of perks.
From a transactions costs’ perspective, debt tends to be preferred for the acquisition of general assets with high
marketability and equity for intangibles and highly specific assets. In the airline business, finance of this level is
normally for aeroplane acquisitions which do have a reasonably active second hand market.
37. Jupiter Co
The impact of the proposed financing package requires an estimation of the firm’s cost of capital before and after the event
and a calculation of the likely impact of the refinancing scheme upon the value of the company:
(a) The current cost of debt, cost of equity and weighted average cost of capital
The current debt has a cost of finance of 4.65% for a yield to maturity of four years in the Euro market, calculated as
follows:

Yield to maturity on 4 year European government bonds 4.20

Credit risk premium for Jupiter (45 basis points) i.e. 0.45

4.65

The current cost of equity is as follows:

ke = rf + ßj (Erm – rf) = 4% + 1.5 × 3% = 8.5%

The weighted average cost of capital relies upon a valuation of the current debt. This is achieved by discounting the
current average coupon rate applied to a nominal $100 of borrowing at the current cost of debt finance.
The market value of a $100 bond with four years to maturity is:

Year $ $

1 (5.6% × $100) = (5.6 ÷ 1.0465) = 5.351

2 = (5.6 ÷ 1.04652) = 5.113

3 = (5.6 ÷ 1.04653) = 4.886

4 $100 + $5.6 = (105.6 ÷ 1.04654) = 88.046

103.396

The market value weightings are:

$m

MVd = × $800m = 827.17

MVe = 500m × $13.80 = 6,900.00

7,727.17

From this the weighted average cost of capital is as follows:

(b) The revised cost of debt, cost of equity and weighted average cost of capital
The revised cost of debt is calculated as an average of the 10 year risk free rate plus the credit premium in both the
euro and the Yen markets.
kd for the 10 year borrowing is as follows:

%
Yield on Japanese market 1.80% (risk free) + 0.50% (risk premium) 2.30

Yield on European market 4.60% (risk free) + 0.85% (risk premium) 5.45

Raised in equal proportions on these two markets 7.75% ÷2 3.875%

The market value of the debt (on the assumption that the fixed rate on the bond is set at the current weighted average
cost of debt) will be $2,400 million.
The increased gearing will impact upon the cost of equity for the company. The procedure for calculating the revised
cost of equity is to degear the current equity beta and regear it to the new gearing level, using the tax-adjusted market
gearing ratio. In practice this would entail an iterative calculation as the revised market gearing ratio will be dependent
upon the value of the equity after the issue of the new debt.

The revised cost of equity capital is:

ke = rf + βj (Erm − rf) = 4% + 1.735 × 3% = 0.09205 say 9.21%
Assuming no alteration in the market value of the company’s equity, the revised gearing and WACC after the issue of
the new debt will be:

(c) Estimation of the minimum rate of return on the additional debt financing required to maintain shareholder values
The free cash flow to equity model appears to satisfactorily predict the value of the company. The model gives a share
price as follows:

i.e. ($6,894m ÷ 500m) = $13.79 per share

Given the refinancing of the business and the revised cost of equity capital we can rearrange the valuation formula to
find the free cash flow required to maintain shareholder value as follows:

Since V0 =

Therefore, = FCFE0

Thus, the revised FCFE0 = $6,894m ×

= = $432.3m

The original FCFE0 $400.0m

was

Therefore, the increase in the FCFE0 is $32.3m

 The addition to the operating cash flow that this implies is calculated by taking the free cash flow before tax and adding
back the excess of the interest charge on the new debt over the old debt i.e.:

$m $m

FCFE0 before tax = 43.1

Add back: the increase in interest charges

New debt ($2,400m × 0.03875) 93

Old debt ($800m × 0.056) (44.8)

48.2

$91.3m

Therefore the company will need to generate $91.3 million, which as a percentage of the new debt investment is
($91.3m ÷ $2,400m) i.e. 3.8%
(d) Comparison of the proposed method of raising capital for investment compared with the alternative means of raising
debt finance
The proposed method of financing through a bond issue is an attractive means of raising large scale debt. There are
significant issue costs and a risk that the issue will not be fully subscribed – although much of that risk can be
mitigated through an underwriting agreement. A more popular means of financing an issue of this size is through a
syndicated loan.
Global lending through this means is now believed to exceed US$3 trillion with an average loan size in excess of
US$400 million. Syndication entails the creation of a banking syndicate led by an ‘arranging’ bank whose function is to
bring together other banks that are willing to participate in the loan. The arranging bank may also act in an on-going
agency relationship with the client company once the deal has been established. The advantages of syndication are:
– Loans can be arranged that are considerably greater than could be offered by any single bank without unbalancing
its lending portfolio or without breaching its capital requirements under the Basel agreements.
– Banks in different currency jurisdictions combine to create mixed lending packages to suit the needs of companies
requiring finance for investment in different countries.
– Speed of creation and relatively low transaction costs.
Excluding the FOREX risk arising with any overseas borrowing, the disadvantages of syndication from the borrower’s
point of view are relatively small. There is a risk of bank default and the rates offered may be somewhat above the
spreads available in the bond market.
38. BBS Stores
BBS Stores
Report to Management
From: N. Erd, Financial Consultant
(a) Impact of Property Unbundling on the Statement of Financial Position and Reported Earnings per Share
The unbundling of the buildings component entails a sale value of 50% of the land and buildings and 50% of the
assets under construction, to yield sales proceeds of [50% × ($2,297m + $ 165m)] i.e. $1,231 million. Under Option 1,
$360 million would be used to repay the outstanding medium-term loan notes with the balance of $871 million
reinvested within the business. Option 2 would entail repayment of that loan and a share buyback. The value released
would buy back ($871 million ÷ $4) i.e. 217.75 million shares with a nominal value of 25 cents each (i.e. $54.44 million,
or $54 million approx) and a charge to reserves of $817 million (approx).
The comparative Statements of Financial Position under each option are as follows:

Assets As at 2008 Sale Option 1 Option 2

year end proceeds Reinvestment Share buyback

Non-current assets $m $m $m $m $m $m
Intangible assets 190 190 190

Property, plant and equipment 4,050 (1,231) 871 3,690 (1,231) 2,819

Other assets 500 500 500

4,740 4,380 3,509

Current assets 840 1,231 (1,231) 840 840

Total assets 5,580 5,220 4,349

LIABILITIES

Current liabilities 1,600 1,600 1,600

Non-current liabilities

Borrowings and other financial liabilities 1,130 (360) 770 (360) 770

Other liabilities 890 890 890

Total liabilities 3,620 3,260 3,260

Net assets 1,960 1,960 1,089

EQUITY

Called-up share capital – equity 425 425 (54) 371

Retained earnings 1,535 1,535 (817) 718

Total equity 1,960 1,960 1,089

The first option has the effect of reducing the company’s book gearing, whilst the second option increases the
company’s book gearing. Book gearing is (in this solution) based upon Borrowing and other financial liabilities to Total
capital employed, i.e.:

Current [1,130 ÷ (1,130 + 1,960)] = 36.6

Option 1 [770 ÷ (770 + 1,960)] = 28.2

Option 2 [770 ÷ (770 + 1,089)] = 41.4

The net impact upon the earnings of the business is less straightforward. Under both Option 1 and Option 2, the
company would benefit from a reduction in interest payable, but would be required to pay an open market rent at 8%
per annum on the property released. In addition, under Option 1 the reduction in gearing would lead to a 30 basis
points saving in interest on the variable component of the swap. Under Option 1, the company would be able to earn a
rate of return of 13% on the funds reinvested. The adjustment to the current earnings to incorporate these effects is as
follows:

Current Option 1 Option 2

$m $m $m

Earnings for the year 670.00 670.00 670.00

add back interest saved (net of tax) 14.51 14.51

($360 million × 6.2% × 0.65)

add reduction in credit spread on six-year debt 1.50

($770 million × 0.003 × 0.65)

deduct additional property rent (net of tax) (64.01) (64.01)

($1,231 million × 8% × 0.65) 73.60
add additional return on equity
($871 million × 13% × 0.65)

Revised earnings 670.00 695.60 620.50

Number of shares in issue (425 × 4) and (371 × 4) 1,700m 1,700m 1,484m

Revised EPS (in cents per share) 39.41 40.92 41.81

As the company has swapped out of its variable rate liability, there will be no change in the interest charge against
earnings for the six-year debt from the current 5.5% per annum, unless the lender has the ability to change the
variable rate on current borrowing for changes in credit rating. Since the fixed rate and the floating rate are the same at
6.2% (as the current credit spread is 70 basis points over LIBOR, or in addition to the swap rate of 5.5%) the nominal
value of the company’s debt is equal to its current market value.
(b) Impact of unbundling on the company’s overall cost of finance
Because the company is currently a combination of both Stores and Property, it is necessary to estimate the asset beta
(ßa) for the Stores business alone.
The current equity cost of capital is given as follows:
E(re) = Rf + ßi × ERP = 5% + 1.824 × 3% = 10.47%
The current weighted average cost of capital, based upon:
Ve = 1,700 million shares × $4.00 per share = $6,800m
Vd = $1,130m

To calculate the unbundled cost of equity capital, the current βe of the company must be degeared as follows,
remembering that the debt betas are assumed to be zero:

The Stores ßa can then be calculated from the weighted average of the component betas.
The Property ßa can be derived from the representative ße given (i.e. 1.25). After allowing for an average market
gearing (adjusted for tax) of 50%, the ßa of the representative portfolio of commercial property companies will be 0.625.
The total market value of the two components of BBS Stores plc (and their representative proportions of the overall
company) can be determined as follows:

$m Proportion
of company

Property, as provided in question ($2,297m + $165m) 2,462 0.36206

Stores – the balancing figure 4,338 0.63794

Ve as calculated above (1,700 million shares × $4.00 per share) 6,800 1.00000

Accordingly, if the overall ßa of BBS Stores is 1.646, and the ßa of the Property portfolio is 0.625, with that Property
portfolio representing 36.206% of the value of the company, the ßa of the Stores activities is estimated by:

(0.36206 × 0.625 + 0.63794) × ßa Stores = 1.646

 (0.22629 + 0.63794) × ßa Stores = 1.646

(0.63794) × ßa Stores = 1.41971

ßa Stores = 2.225

However, the beta of the continuing company will be a combination of this Stores beta and the Property beta of the
remaining company. On the assumption that the share price does not change under either option, the Ke and the
WACC are estimated as follows:

Option 1 Option 2

$m $m

Ve $425m × $4/25c = 6,800 $371m × $4/25c = 5,936

of which, Property element = 1,231 Property element = 1,231

therefore, Stores element = 5,569 Stores element = 4,705

ßa of restructured company

ße of restructured company

Ke of restructured company
Ke = 5% + 2.0774 × 3%= 11.23%
5% + 2.0526 × 3%= 11.16%
WACC of restructured company
WACC: Option1:

WACC: Option 2:

Note that under Option 1, the variable component of the swap would be reduced by 30 basis points. However, the
market value of the debt would remain unchanged because given LIBOR and the fixed component of the swap are the
same at 5.5%, the reduction in basis points will reduce the effective coupon and the yield to 5.9%.
Both options will significantly increase the cost of capital for the company from 9.55% to 10.48% in the case of Option
1 and 10.34% in the case of Option 2.
(c) The potential impact upon the value of the company
The value of the company for a low geared business such as this is represented by the present value of the company’s
future earnings discounted at the company’s cost of capital. The ownership of property does not add value to the
business providing that the company can enjoy a continuing and unencumbered use of the assets concerned.
 On the assumption that an independent property company can be established and an arm’s length rental agreement
concluded, then it is possible that the ownership of the property assets could be taken off balance sheet. However, the
ease with which this can be done depends upon the local accounting regulations and financial reporting standards.
As it stands, Option 1 appears to increase the potential earnings more than either the current situation or than Option
2. However, Option 2 offers the highest EPS. With an unbundling exercise such as this, it is difficult to predict with
precision the likely impact upon the value of the company. The removal of part of the company’s property portfolio will
increase the equity beta, but this will be offset by the reduction in the company’s gearing. Much also depends upon the
ability of the business to generate a return of 13% on the reinvested proceeds of the property disposal. If this is not
achieved, then a significant loss in shareholder value would result. For this reason, the shareholders might prefer the
lower risk option of a repurchase of their equity at 400c, leaving the company’s EPS largely unchanged.
The analysis of the impact upon the company’s equity cost of capital assumes that the value of the company’s equity
will remain unchanged at 400c per share. In practice, that is unrealistic and a model of the company’s value would
have to be constructed to test the full impact of either option on shareholder value. Given the problem is recursive (in
that the output value determines the estimation of the equity beta, which is also an input variable in the calculation),
computer modelling would be required.
39. Moose Co
(a) The bank will consider the following factors before granting a loan:
– The purpose of the loan
– The amount of the loan
– Duration of the loan
– How the borrower is proposing to repay the loan
– Security against non-payment – assets strength
– The borrower’s profit margin
– The borrower’s credit rating
– The borrower’s outstanding debt level
(b) Syndication is where a group of banks is brought together by a lead bank to provide medium-to long-term loans to
large companies. These loans may run to the equivalent of hundreds of millions of pounds. By arranging a syndicate of
banks to provide the loan, the lead bank reduces its risk exposure.
The advantages of syndication are:
– Loans can be arranged that are considerably greater than could be managed by any single bank without unbalancing
its lending portfolio or indeed breaching its capital requirements under the Basle agreements.
– Banks in different currency jurisdictions combine to create mixed lending packages to suit the needs of companies
requiring finance for investment in different countries.
– Speed of creation and relatively low transaction costs.
A bond issue is where debt is floated onto a capital market, normally with a fixed interest coupon with a set redemption
date. A bond issue is an attractive means of raising large scale debt. There are significant issue costs and there is the
risk that the issue will not be fully subscribed, although much of that risk can be mitigated through an underwriting
agreement.
(c) In order to undertake a major capital investment project in the current global economic cycle, there is the need to
consider whether there is the option to delay the project to a future date or to undertake the project now.
Given the level of uncertainties in the current economic cycle the decision to undertaken the project now should only
be made provided the company is relatively sure that it has estimated the potential risks and included them in the
evaluation, which then provides a positive net present value. The main advantage of undertaking the project now will
be to reduce/eliminate the risk of potential competition. However, there is much risk associated with this option. Where
there is a positive delay option then from a financial perspective the best advice may be to delay investment,
dependent on the likely actions by competitors and how markets for the product develop.
40. Fubuki Co (December 2010)
(a) Workings
(i) Sales

Year 1 2 3 4
 Units 1,300 1,300 1,820 2,548

Growth 1 1.4 1.4 1.05

Units produced and sold 1,300 1,820 2,548 2,675.4

Selling price (3% growth) $ 2.5 2.575 2.652 2.732

Sales $000 3,250 4,687 6,757 7,309

(ii) Variable costs

Year 1 2 3 4

Units produced and sold 1,300 1,820 2,548 2,675.4

Variable cost per unit (8%)$ 1.2 1.296 1.4 1.512

Total variable cost $000 1,560 2,359 3,567 4,045

(iii) Working capital

Year 0 1 2 3 4

Sales 3,250 4,686.5 6,757 7,309

Total WC (15%) 488 703 1014 1096

Cash flows (488) (215) (311) (82) 1,096

(iv) Discount rate (Haizum Co ungeared Ke)

Ke (g) = ke(u) + (1– t)(ke(u) – kd)Vd/Ve
Ve = 2·53 x 15 = 37·95
Vd = 40 x 0·9488 = 37·952
Assume Vd/Ve = 1
14 = Ke(u) + 0·72 x (Ke(u) – 4·5) x 1
14 = 1·72Ke(u) – 3·24
Ke(u) = 10·02 assume 10%
Alternative approach – ungearing the beta of Haizum Co through CAPM
14% = 4.5% + Beta geared (4%)
Beta geared = 14 – 4.5/4 = 2.375
Un-gear 2.375 to determine the asset beta;
Asset beta = 2.375 x 1/(1 + 1 x 0.72) =1.381
Using CAPM, calculate the un-geared cost of equity;
Ke(u) = 4.5% + 1.381 x (4) = 10.02%

Base Case

Year 0 1 2 3 4

$000 $000 $000 $000 $000

Sales 3,250 4,687 6,757 7,309

Variable costs 1,560 2,359 3,567 4,045

Attributable fixed cost (5%) 1,000 1,050 1,103 1,158

690 1,278 2,087 2,106

Tax 25% (173) (319) (522) (526)

Tax saved on CA:

(3000-400/4) * 25% 163 163 163 163

Working capital (488) (215) (311) (82) (1,096)

Initial capital (14,000)

Residual value 16,000

Net cash flows (14,488) 465 810.78 1,646 18,839

Df 10% 1 0.909 0.826 0.751 0.683

Present values (14,488) 422.7 669.7 1,236.2 12,867

Base case NPV 708

Present value of financing effect

$’000

(1) Issue costs 4/96 x $14,488 (604)

(2) Tax Shield

Annual tax relief = (14,488 x 80% x 0·055 x 25%)

(14,488 x 20% x 0·075 x 25%)

= 159·4 + 54·3 = 213·7

Present value 213·7 x 3·588 766

(3) Subsidy benefit

14,488 x 80% x 0·02 x 75% x 3·588 624

Total benefit of financing side effects 786

Adjusted present value (708 + 786) 1,494

Note: In calculating the present values of the tax shield and subsidy, the annuity factor used is based on 4·5%
government debt yield rate (risk free rate) for four years. It could be argued that 7·5% may also be used as this reflects
the normal borrowing/default risk of the company. Credit would be given where this assumption is made to estimate the
annuity factor.
Conclusion: Since the APV is positive the project should be acceptable on financial grounds.
(b) The APV method may be a better method of appraising investment where:
– There is a significant change in capital structure of the company as a result of the investment.
– There are subsidised loans or other benefits (grant) associated explicitly with an individual project which require
discounting at a different rate than that applied to the mainstream cash flows.
 – The investment involves complex tax payments and tax allowances, and or has periods when taxation is not paid.
– The operating risk of the company changes as a result of the investment.
The project involves significant changes in business risk and there is a subsidised loan, therefore the APV appraisal
method will be better than the net present value technique.
Assumptions (credit given for alternative valid assumptions):
– It is assumed that the annual reinvestment needed on plant and machinery is equivalent to the tax allowable
depreciation.
– It is assumed that all cash flows occur at the end of the year, unless specified otherwise.
– The feasibility study is ignored as a past cost.
– Haizum Co’s ungeared cost of equity is used because it is assumed that this represents the business risk attributable
to the new line of business.
– It is assumed that the five-year debt yield is equivalent to the risk-free rate.
– The ungeared cost of equity is calculated on the assumption that Modigliani and Miller’s (MM) proposition 2 applies.
– It is assumed that initial working capital requirement will form part of the funds borrowed but the subsequent
requirements will be available from the funds generated from the project.
41. GNT Co (June 2011)
(a) The Macaulay duration method measures the number of years required to recover the cost of the bond (taking
account of the present value of all interest and capital cash flows within the future time period) using the bond’s gross
redemption yield (gross internal rate of return or yield to maturity) as the discount factor.
Calculation of the gross redemption yield

Year Cash flow Try 4% Try 5%

£000 DF £000 DF £000

0 MP (1,079.68) 1 (1079.68) 1 (1,079.68)

1-5 Interest 60 4.452 267.12 4.329 259.74

5 Red value 1,000 0.822 822.00 0.784 784.00

NPV +9.44 -35.94

Bond 1

Years Cash flows Discount factor 4.2% Present value Present value x years

$ $ $ $

1 60 1.042-1 57.58 57.58

2 60 1.042-2 55.26 110.52

3 60 1.042-3 53.03 159.09

4 60 1.042-4 50.90 203.60

5 1060 1.042-5 862.91 4,314.55

1,079.68 4,845.34

Duration of Bond 1 = 4,845.34/1,079.68 = 4.49 years.

Bond 2
Both bonds are expected to have the same gross redemption yields (yields to maturity or internal rate of return) of
4.2%.
 Years Cash flows Discount factor 4.2% Present value Present value x years

$ $ $ $

1 40 1.042-1 38.39 38.39

2 40 1.042-2 36.84 73.68

3 40 1.042-3 35.36 106.08

4 40 1.042-4 33.93 135.72

5 1040 1.042-5 846.63 4,233.15

991.15 4,587.02

Duration of Bond 1 = 4,587.02/991.15= 4.63 years

(b) Duration is an important measure for fixed-income investors and their advisers, since bonds with higher durations
may have greater price volatility than similar bonds with lower durations. In general:
– Changes in the value of a bond are inversely related to changes in the rate of return ie the lower the yield to maturity,
the higher the value of the bond;
– Long-term bonds have higher interest rate risk than shorter term bonds, due to the greater probability (over the
longer time period) of market interest rate increases; and
– High coupon bonds have less interest rate sensitivity than low coupon bonds, since the greater the amounts of the
cash flows received in the short-term, the earlier the purchase price of the bond will be recouped.
The Macaulay duration method measures the number of years required to recover the cost of the bond (taking account
of the present value of all interest and capital cash flows within the future time period). The result is expressed in
years.
The basic lessons of “duration” are:
– As maturity increases, the measure of duration will also increase and the market value of the bond will become more
sensitive to changes in the level of interest rates;
– As the coupon rate of a bond increases, duration will decrease and the value of the bond will be less sensitive to
changes in the level of interest rates; and
– As interest rates rise, duration will decrease and the value of the bond will be less sensitive to subsequent rate
changes.
However, because duration is an average measure based on the gross redemption yield, it can only be used to
measure the change in a bond price due to changes in interest rates where the change in interest rates do not lead to
a change in the shape of the yield curve. That is, duration cannot be used to measure the change in bond price due to
changes in interest rate.
42. Levante Co (December 2011)
(a) The market price of the bond should be the present value of the cash flows from the bond (interest and redemption
value) using the relevant year’s yield curve spot rate plus the relevant credit spread (cost of debt) as the discount
factor.
Cost of debt based on an ‘A’ credit rating

Years 1 2 3 4 5

Spot yield rate (%) 3.2 3.7 4.2 4.8 5.0

Credit spread (A rated) (%) 0.65 0.76 0.87 1.00 1.12

Cost of debt (%) 3.85 4.46 5.07 5.80 6.12

Market value of debt based on A credit rating

 Years 1 2 3

Cash flows 4 4 104

Discount factor 1.03851 1.04462 1.05073

Present value 3.85 3.67 89.66

Market value based on A credit rating = $97.18 per $100 nominal.

The current market value based on AA credit rating = $98.71 per $100 nominal.
The fall in value = $98.71 - $97.18 = $1.53
Percentage fall (1.53/98.71) x 100% = 1.55%
(b) (i) The issue price should be calculated as the present value of the cash flows from the bond (interest and
redemption value) using the relevant year’s yield curve spot rate plus the relevant credit spread (cost of debt) as the
discount factor. At an A credit rating the issue price is calculated as:

Years 1 2 3 4 5

Cash flows 5 5 5 5 105

Discount factor (as above) 1.03851 1.04462 1.05073 1.0584 1.06125

Present value 4.81 4.58 4.31 3.99 78.01

Issue price = $95.70 per $100

(ii) The coupon rate (R%) at which the issue price of the new bond will be $100 per unit and equal to its par value is
calculated as:

Years 1 2 3 4 5

Cash flows R R R R 100 + R

Discount factor(as above) 1.03851 1.04462 1.05073 1.0584 1.06125

Present value R x 1.03851 R x 1.04462 R x 1.05073 R x 1.0584 (100 + R) x 1.06125

Calculate the R as follows:

(R x 1.03851) + (R x 1.04462) + (R x 1.05073) + (R x 1.0584) + (R x 1.06125) + (100 x 1.06125) = 100
4·2826R + 74·30 = $100
R = (100 - 74.30)/4·2826
R = $6
R% = (6/100) x 100% = 6%
The 5% coupon bond can be issued at a price of $95.70 per $100, a discount of 4.3% on the nominal value of $100. At
this discounted price the company would have to issue 1,567,398 ($150,000,000/95.70) units of the bond in order to
raise the required amount of $150,000,000, instead of issuing 150,000,000 units at nominal price of $100. There would
be 67,398 extra units of the bond to be issued and the company would have to pay $6,739,800 on the redemption date
as the debt is redeemable at par.
Alternatively, if the company issue the new bonds at par then it should be paying a higher coupon rate of 6%, an extra
1% compared to being issued at a discount. The total extra cost per year would be $1,500,000 (1% x $150,000,000).
From the above it appears that issuing the new bonds at a discount and paying a lower coupon rate of 5% is cheaper
than issuing at par and paying a higher coupon rate of 6% so the company should opt to issue the new debt at a
discount. This is even more appropriate if the company estimates that the cash flows from the project are not enough
 each year to pay the extra interest of $1,500,000. However, if management want to spread the cash payment over the
period it can opt to issue the new bonds at par.
(c) The credit rating of the debtor measures the debtor's ability to pay back the debt by making timely interest payments
and of the likelihood of default.
– Industry Risk
The industry risk is measured by assessing the performance of the industry in which the debtor operates in relation
to changes in economic circumstances. This can be assessed by comparing the performance of the industry to other
industries in different economic situations in order to measure how successful or otherwise firms in that industry
performed. Indicators such as changes in demand and prices, the number of firms liquidating and actual and
potential competition in different economic circumstances could be used to assess the industry risk.
– Earnings protection
The earnings protection criteria measures how the company can protect and maintain its earnings in different
economic circumstances. Key accounting ratios such as return on capital employed, operating profit margin and
earnings per share could be used. It can also be assessed based on the company’s customer base and the different
income streams of the company.
– Financial flexibility
Financial flexibility is measured by assessing the ability of the company to raise capital to finance its investment
projects. This can be measured by looking at the financial needs of the company, alternative sources of finance
available to it and relationship with its bankers and other capital providers to assess how easily the company can
raise capital from them. Gearing ratios, interest cover and any debt covenant or restrictions attached to existing debt
could also be used.
– Evaluation of company’s management
This is measured by assessing the ability of the company’s management to successfully run the operations of the
company. This can be measured by looking at the qualification and experience of the managers, the financial and
non-financial strategies, including planning and control policies, to see whether they are being achieved.
43. Coeden Co (December 2012)
(a) Before implementing the proposal
Current cost of equity
Cost of equity = 4% + 1·1(6%) = 10·6%
Market value of equity
The current market value of equity can be calculated as the present value of free cash flows to equity using the cost of
equity as the discount factor.
The free cash flow to equity is subject to growth which can be calculated using Gordon’s growth model:
g = rb
where r = cost of equity (return on investment) and b = proportion of the free cash flows retained.
g = 10·6% × 0·4 = 4·24%
Market value of equity = 2,600 × 1·0424/(0·106 − 0·0424) = $42,614
Current cost of debt
Cost of debt = 4% + 0·9% = 4·9%
Market value of equity
The market value of the debt is calculated as the present value of interest and redemption value using the cost of debt
as the discount rate:
Interest = 5.2% × $42,000 = $2,184

Year 1 2 3

Cash flows 2,184 2,184 2,184 + 42,000

DF (4.9%) 0.953 0.909 0.856

PV 2,081 1,985 38,263

MV of debt = $42,329
 Current weighted average cost of capital
= 10·6% × $42,614/($42,614 + $42,329) + 4·9% × 0.8 × $42,329/($42,614 + $42,329) = 7·3%
After implementing the proposal
Current equity beta of Coeden Co =1.1
The asset beta (Ba) = Be × (E/(E+ D(1 − t))) = 1.1 × (42,614/(42,614 + 42,329(0.8)) = 0.61
This asset beta of Coeden was calculated as the weighted average of the asset beta of property and hotel using their
respective values as the weighting. Given this combined asset beta of 0.61 and property asset beta of 0.4, the asset
beta of the hotel services can be calculated as:
0·61 = Asset beta (hotel services) × 60% + 0·4 × 40%
Asset beta (hotel services only) = 0·75
However, after repayment of 70% debt, Coeden Co, providing only hotel services, will still have 30% debt, hence it is a
geared company.
The market value of equity is assumed to remain constant at $42,614.
The market value of debt is the present value of interest and redemption value based on the remaining 30% at the new
cost of debt.
Interest = $42,000 × 30% = $12,600 × 5.2% = $655
New cost of debt = 4% + 0.6% = 4.6%

Year 1 2 3

Cash flows 655 655 655 + 12,600

DF (4.6%) 0.956 0.914 0.874

PV 626 599 11,585

MV of debt = $12,810
The geared equity beta:
0·75 = Equity beta × 42,614/(42,614 + 12,810 × 0·8)
0·75 = Equity beta × 0·806
Equity beta = 0·93
Revised cost of equity
Cost of equity = 4% + 0·93 × 6% = 9·6%
Revised cost of weighted average cost of capital
9·6% × $42,614/($42,614 + $12,810) + 4·6% × 0.8 × $12,810/($42,614 + $12,810)
= 8.2%
Summary

Before proposal After proposal

Cost of equity 10·6% 9·6%

WACC 7·3% 8·2%

Comments
The payment of debt has reduced the level of gearing and financial risk, hence there has been a decrease in the equity
beta and cost of equity. This is even though the business risk, as measured by the asset beta, increased, as providing
hotel services without the company’s own property increases business risk. The weighted average cost of capital
increased upon the reduction of debt because the expensive equity will now represent a higher proportion of the
capital structure. The director is therefore wrong to suggest that decreasing debt will decrease the weighted average
cost of capital.
 (b) The market value of equity is calculated as the present value of the free cash flows to equity using the cost of equity
as the discount factor. Hence the market value depends on the cost of equity, growth rate and the free cash flows.
The market value of equity will not remain the same, as the repayment of debt from the proceeds from disposal of the
properties led to changes in both business and financial risk. The cost of equity decreased, and the growth rate and
the free cash flows to equity will also decrease due to changes in sales and expenses (revenue will come from only
hotels and there will be payment of rents).
It should be noted that the cost of equity depends on the equity beta, which in turn depends on the market value of
equity. The market value of equity also depends on cost of equity, so neither the cost of equity nor the market value of
equity is independent of each other. Therefore a change in business strategy will change both the market value and
the cost of equity.
(c) Demerger involves splitting a company into two or more separate parts of roughly comparable size, which are large
enough to carry on independently after the split. Each company would probably have separate management but the
shareholders of the original company would hold shares in both companies.
Demergers have many benefits. A demerger can increase the value of the shareholders, as management of each
separate company can concentrate on creating value for each company separately. Demerger may be better than a
sale because it will still maintain the shareholders’ portfolio of investment and lead to reduction in unsystematic risk.
Some shareholders of Coeden might have invested in the company because of the risk profile of property and hotel
activities. Selling the properties will reduce their portfolio and hence increase their risk. With the demerger, since the
equity holders will retain an equity stake in both companies, the benefit of diversification is retained.
Demerger may be better than sale because demerger can still maintain a good relationship between the separated
companies. Coeden Co is proposing to rent the properties if they are sold and the new owners of the properties may
not co-operate with the company and Coeden may end up losing customers and its brand. Communication between
the two management teams would be relatively stronger than with a third party.
The demerger can help Coeden Co to at least maintain the market value of the properties, as selling many properties
in the market at a time may force property prices down. The cost of disposing of the properties would also be saved.
The demerger may have some problems. The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced. The debt holders may not accept the 70% of their debt to be transferred
to the property company or they may change the terms of the debt.
The demerger may be an expensive process and may reduce the value of the company.
44. Burung Co (June 2014)
(a) Calculation of APV

Year 0 1 2 3 4

$million $million $million $million $million

Sales W1 24.87 42.69 61.81 36.92

Direct project costs W2 (14.37) (23.75) (33.12) (19.05)

10.5 18.94 28.69 17.87

Tax 20% (2.1) (3.79) (5.74) (3.57)

Tax saved on capital allowances W3 1.6 0.4 0.3 0.1

Initial investment (38)

Residual value 4

Working capital W4 (4.97) (3.57) (3.82) 4.98 7.38

(42.97) 6.43 11.73 28.23 25.78

DF 12% W5 1 0.893 0.797 0.712 0.636

(42.97) 5.74 9.345 20.10 16.40

 $million

Base case net present value 8.62

Present value of issue cost W6 (0.88)

Present value of tax saved on debt interest W7 0.78

Present value of net subsidy W8 1.89

APV 10.41

The project is financially acceptable as the APV is positive.

Workings
W1 Sales

Year 1 2 3 4

Sales 23.03 36.6 49.07 27.14

Inflation 1.081 1.082 1.083 1.084

24.87 42.69 61.81 36.92

W2 Direct project costs

Year 1 2 3 4

Sales 13.82 21.96 29.44 16.28

Inflation 1.041 1.042 1.043 1.044

14.37 23.75 33.12 19.05

W3 tax saved on capital allowances

Year Savings

1 16 x 50% x 20% 1.6

2 16 -8 = 8 x 25% x 20% 0.4

3 0.4 x 75% 0.3

4 Difference 0.1

(16 - 4) x 20% 2.4

W4 working capital

Year 0 1 2 3 4

Sales 24.87 42.69 61.81 36.92

Total working capital 4.97 8.54 12.36 7.38 0

Cash flows - incremental (4.97) (3.57) (3.82) 4.98 7.38

 W5 Ungeared cost of equity
(i) Proxy beta = 1.5
(ii) Un-gear βa =

βa = 1.5 x (128/128 +31.96(0.8)) = 1.25

Equity value = 40 x $3.20 = $128
Debt value = 34 x 94/100 =$31.96
(iii) Cost of equity
Keu = 2% + 1.25(8%) = 12%
W6 present value of issue cost
42.97 x 2/98 = $0.88
W7 present value of tax saved on debt interest

Interest on Subsidised loan = 60% x 42.97 x 1.5% = $0.39

Interest on normal loan = 40% x 42.97 x 4% = $0.69

Total interest = $1.08

Tax saved = $1.08 x 20% = $0.216

Present value of tax saved on debt interest at cost of debt of 4%. (you can also use the risk free rate as the discount
factor):
Present value of tax saved on debt interest = $0.216 x3.630 =$0.78
W7 present value of tax saved on debt interest
60% x 42.97 x (4% - 1.5%) x 0.8 x 3.630 =$1.89
(b)
Correction made:
(iv) Nominal and real analysis
The net present value was calculated using real analysis by discounting the real cash flows by real discount factor.
This approach can only be used if all the cash flows are subject to one inflation rate. However, sale and direct
project costs have different inflation rate, hence the nominal approach should be used. The nominal approach
involves inflating each cash flow item with it corresponding inflation rate and discounting them using the nominal
discount factor.
(v) Interest
Interest amount of $1.2 million is not a relevant cash flow and should be eliminated as it effect is included in the
discount factor in calculating net present value. In adjusted present value calculations, the effect of interest is
included in the finance effect cash flows.
(vi) Depreciation
Depreciation is not a relevant cash flow as it does not involve movement of cash. It is therefore correct to exclude it
in the net present value calculations. However, the tax savings on capital allowances should be included as it will
increase the cash flows of the project.
(vii) Working capital
Working capital cannot be ignored even though it will be recovered at the end of the project life. This is because of
the differences in the time value of money as a result of discounting them with different discount rate for different
years.
Adjusted present value Approach
 Adjusted present value is calculated as the base case net present value plus or minus the present value of the
finance effect cash flows; issue cost; tax savings on interest and net subsidy. The value of the project is initially
assessed considering only the business risk involved in undertaking the project by discounting the relevant cash flow
using ungeared cost of equity. The discount rate used is based on Lintu Co’s asset beta which measures only the
business risk of that company. The impact of debt financing and the subsidy benefit are then considered. In this way,
the company can assess the value created from its investment activity and then the additional value created from
the manner in which the project is financed.
Assumptions made
• It is assumed that all figures used are accurate and any estimates made are reasonable. The company may
want to consider undertaking a sensitivity analysis to assess this.
• It is assumed that the initial working capital required will form part of the funds borrowed but that the
subsequent working capital requirements will be available from the funds generated by the project. The
validity of this assumption needs to be assessed since the working capital requirements at the start of years
2 and 3 are substantial.
• It is assumed that Lintu Co’s asset beta and all-equity financed discount rate represent the business risk of
the project. The validity of this assumption also needs to be assessed. For example, Lintu Co’s entire
business may not be similar to the project, and it may undertake other lines of business. In this case, the
asset beta would need to be adjusted so that just the project’s business risk is considered.

Valuation and free cash flows, international investment and financing decisions

45. Fly4000 (Pilot paper 2012)

(a) Current cost of equity capital for FliHi
The cost of equity capital is derived from the CAPM, but given that this is an unquoted company, a proxy must be
taken for the company’s equity beta, then degeared and regeared to reflect the different financial risk exposure of
Fly4000.
Ideally, degearing and regearing a beta requires an estimate of the market values for gearing for both companies. In
the absence of that, the book value of gearing has, by necessity, been used in this case, since FliHi is unlisted. To
establish a proxy beta, use is made of the values for both the debt and equity in Rover Airways.

Book value BV of the equity of Rover = $3bn ÷ 1.25 = $2.4bn

Gearing (BV of debt ÷ BV of equity) = 1.5

BV of debt = $2.4bn × 1.5 = $3.6bn

Using the formula for the asset beta, where debt is assumed to be risk free, the degearing and regearing of the ß is
performed as follows:

When this estimated equity beta for FliHi is incorporated into the CAPM:
Required return = rf + (Erm – rf) ße = 4.5% + (3.5% × 1.8293) = 10.9%
The modelling of the equity cost of capital has embedded within it the assumptions implicit in CAPM that:
 – Investors are mean variance efficient;
– Markets are frictionless i.e. efficient;
– Expectations are homogenous; and
– A risk free asset exists.
However, of more practical significance we have also assumed that:
– The underlying exposure to market risk is the same for both companies (this is questionable given the differences in
the markets in which they operate);
– That the book gearing ratio is a reasonable approximation to the market gearing ratio. The use of book values can
seriously distort the cost of capital that is calculated. They convert it into a measure of the average cost of capital in
the company’s historical gearing ratio rather than in the ratio of the current capitalised values of the company’s
equity and debt;
– That FliHi Ltd does not carry a size or a default premium on its cost of capital. Default and size premia can be
included through the use of such variants on the standard CAPM as the “Fama and French three factor model”
which incorporates these elements of risk.
(b) Growth rates and estimate of required rate of return on equity
Gordon’s approximation requires a retention ratio which can be derived from the cash flow statement. The free cash
flow to equity (before reinvestment) is defined as operating cash flow less interest and tax:
For 2005, the Free Cash Flow to Equity (i.e. FCFE) is as follows:
FCFE = operating cash flow – net interest paid – tax
FCFE (£m) = 210m + 1.5m – 4.1m = $207.4m
N.B. During 2005, net interest received was $1.5m
During the current year $120.2m was reinvested. This implies a retention ratio (b) of:

Gordon’s approximation was originally developed to measure the growth in earnings assuming a given retention ratio
and rate of return. We can apply the same logic to the free cash flow model, but here we are looking at the rate of cash
generation by the business on new capital investment. The current rate of return is, in principle, the internal rate of
return on the current business portfolio. If we assume that the business is highly competitive then the internal rate of
return will be close to the company’s equity cost of capital of 10.9%.
Growth is therefore expected to be:
g = bre = 0.58 × 10.9% = 6.322%
If, instead, use is made of the company’s current rate of return on equity from the accounts we would have:

This would suggest a rate of growth of:

g = bre = 0.58 × 41.66% = 24.2%
However this growth rate seems unlikely in this industry and we continue thereafter by using the 6.322% calculated
above. Given that the growth rate for year 6 onwards is stated to be the GDP growth rate of 4% p.a., the anticipated
rate of growth will be 6.322% p.a. for years 1 to 5 and 4% p.a. for years 6 to infinity (∞).
These assumptions are embedded within the method of measuring growth. Gordon’s growth approximation will give
the following year’s value for the FCFE for the business on the assumption that the cost of capital (and no more) is
achieved. We have also assumed that the current figures for cash generation and reinvestment are typical and likely to
be replicated over the near term. In this context we would note the significant increase in operating cash flow from
2004 and question whether this is sustainable.
(c) Company valuation and limitations of the methods used
Using the free cash flow to equity (net of reinvestment) we have the free cash flow which is, in principle, distributable.
We build a valuation model expanding this free cash flow through the next five years. From year six onwards, the rate
of growth is a perpetuity and we use the free cash flow version of the dividend growth model to estimate this value.
Free cash flow to equity is initially established as follows:
 $m

FCFE, as established in part (b) of this solution 207.4

Less capital expenditure for 2005 (see question) (120.2)

FCFE for 2005 (net of reinvestment) $87.2m

t 1 2 3 4 5 6–∞ Total

Year 2006 2007 2008 2009 2010 2011 - ∞

Growth factor 1.06322 1.04

$m $m $m $m $m $m

FCFE (2005)

87.2 92.71 98.57 104.81 111.43 118.48

Discounted at 10.9% p.a. 83.60 80.15 76.84 73.67 70.63

PV YEARS 1 – 5 = $384.89m

PV at t5 (for year 6 to ∞): =1,785.73

PV at t0: (1,785.73 ÷ 1.1095) = $1,064.53m

Present value of the company’s equity $1,449.42m

The limitations of the method are that we assume:

– The current operating cash flows are sustainable;
– The stated growth patterns of operating cash flow will be achieved;
– The rate of return required by investors is constant throughout the life of the business;
– The business has an indefinite life beyond 2011.
These assumptions are unlikely to hold in practice and it should be noted that where the ultimate constant rate of
growth (in this case, 4%) is relatively low compared with the cost of equity we would not expect the perpetuity to be a
good approximation of residual value. It might be better to seek a likely breakup value of the net assets (as stated in
the accounts) as the residual value of the business i.e.

$m

PV of FCFE (net of investment) for 2006 to 2010, as above 384.89

Residual value of the business (based upon the net asset figure of $120m as specified in
the question)

$120m growing at 6.322% p.a. between 2005 and 2010, then at 4% p.a. thereafter;

PV at t6 ($120m × 1.063225 × 1.04) = $169.56

PV at t0 (169.56 ÷ 1.1096) = 91.15

Estimated value of the business 476.04

 This amount provides a close approximation to the market valuation established by applying the PE ratio of Rover
Airlines to the profit after tax figure of FliHi i.e. Valuation = (11.0 × $50m) = $550m
(d) Brief report
To whom it may concern:
The proposed acquisition of FliHi represents a substantial capital investment for your airline. However, there are a
number of issues which you might wish to consider before making a bid. These issues have been separated into
synergies, risk exposure, future options, financing and valuation.
Synergies: From the perspective of your respective markets, there would appear to be considerable advantages in
integration. From the synergistic perspective these can be categorised as:
Revenue synergies: Is there likely to be an enhancement in your ability to capture market share in a way that will add
shareholder value? Simply acquiring the business as it stands will not be sufficient as investors can achieve the same
benefits at a lower cost by diversifying themselves. Synergies only arise if a market opportunity presents itself which
would not exist if both companies remain independent. One example would be where the domestic and European
service can be used as a feeder system for an expanded long-haul business from your principal hub at Stanstead.
Cost synergies: Are there opportunities to save cost through more efficient operations? Economies of scale and scope
are available in the airline business in the areas of in-flight catering, fuel supplies, maintenance and ticketing. The
larger fleet size would also present operational opportunities.
Tutorial note:
Economies of scale occur through such factors as fixed operating costs being spread over a larger production volume;
equipment being used more efficiently with higher volumes of production; or bulk purchasing reducing both ordering
and raw material costs. Economies of scope may arise from reduced advertising and distribution costs in cases where
companies have complementary resources. Economies of scale and scope relate mainly to horizontal acquisitions and
mergers.
Financial synergies: Would the company have greater opportunities in the domestic and international capital market to
acquire finance at more favourable rates and under better conditions?
Risk exposure: The larger operation would not necessarily improve the company’s exposure to market risk and indeed
is likely to leave it unchanged as we would expect the underlying asset beta of both companies to be roughly the
same. There are a number of other risk areas that could be improved, such as operational risk may be mitigated by the
company’s increased ability to hedge its operations (see the notes on the real options available below). Other risk
effects include: economic, political, transaction and translation risk. Economic and transaction risks are minimised
largely because your business is principally in the domestic market, although this may change if you decide, for
example, to develop your European network as a feeder system to your hub.
Future options: An acquisition of this type can create real options to expand, redeploy and exchange resources which
add value to the proposition, not easily captured with conventional valuation procedures. A real option is a claim upon
some future course of action which can be exercised at your discretion. The availability of the new Airbus 380 offers
potential not only within the long-haul business, but also to medium-haul holiday destinations at peak seasons. Access
to your fleet of short or medium-range aircraft offers the possibility of opening the European market to your long-haul
business. When and how you exercise these real options depends on circumstances at the time, but paradoxically the
more uncertain the underlying business, the greater the value that attaches to this flexibility.
Financing: An acquisition of this type would require substantial extra financing. FliHi would appear to have a high level
of off-balance sheet value, partly because of the scale of their operational leasing of aircraft, but more significantly
because of their business name and the quality of their operations. A substantial sum is likely to be paid for the
goodwill of this business, which suggests that this may not be a proposition that would be attractive to the debt market.
Your own substantial cash resources and the level of retained earnings suggest that this may be the route to financing
this acquisition, through a cash offer plus shares.
Valuation: We estimate the value of FliHi (based upon its current cash flow generation) to be of the order of $1,450
million. Using market multiples, a lower figure of $550 million is obtained. The key point of this valuation process is to
determine the lowest likely figure that the owners of FliHi would be prepared to accept. Our judgement is that the figure
is likely to be closer to the upper end of this range. The free cash flow model relies upon our best forecast of future
cash flow and reinvestment within the business. We believe that the owners of FliHi would have access to similar
advice. The key question now to resolve is what would be the value of FliHi to your company. This business
combination has most of the characteristics of a type II acquisition, where the financial risk of the business is likely to
be disturbed. For this reason, we would need to value your current business using available market data and revalue it
on the basis that the bid goes ahead (using your preferred financing package). The potential increase in the value of
your company will reveal the potential control premium at any proposed offer price that may be decided upon.
46. Burcolene
 (a) The first step in the valuation is to calculate each company’s weighted average cost of capital. The cost of capital is
calculated post-tax and using the relevant market values to calculate the market gearing ratio:

Burcolene PetroFrancais

Market value gearing: $bn $bn

Equity (E) 9.9 6.7

Debt (D) 3.3 5.8

E+D $13.2bn $12.5bn

Ke (using 3% + (4% × 1.85) = 10.4% 3% + (4% × 0.95) = 6.8%

CAPM)

Kd 3% + 1.6% = 4.6% 3% + 3% = 6.0%

WACC

= 8.605% = 5.7328%

Valuation

Point 1. in the question states that free cash flow = (NOPAT – net reinvestment)

Burcolene

$bn

Valuation (prior to share option scheme adjustment)

13.107

Share option scheme adjustment (see working)

(17,421,860 shares to be issued × $14.43 premium per share) (0.251)

$12.856bn

PetroFrancais

$bn

Valuation (prior to defined benefits pension scheme adjustment)

12.304

Defined benefits pension scheme adjustment (0.430)

$11.874bn

Workings
 $

Option premium per share:

Actual share price = = 29.12

Less Exercise price 22.00

Intrinsic value of option 7.12

Time value of option (given) 7.31

Option price or premium per share $14.43

Number of options likely to be exercised:

Share options outstanding 25,400,000

5% attrition rate for members leaving between 1 December 2007

and 30 November 2010, i.e. a 3 year period (1 – 0.05)3 0.857375

Members expected to achieve standard (1 – 0.2) 0.8

Number of share options likely to be exercised:

(25.4m × (1 – 0.05)3 × 0.8) 17,421,860

(b) Report to management

Subject: Valuation and Financial Implications of an Acquisition of PetroFrancais
This is potentially a type III acquisition, where both the company’s exposure to business risk and to financial risk
changes. As a consequence, the value of the combined entity will depend upon the post-acquisition values of the
component cash streams: (i) the cash flow from the existing business, (ii) the cash flow from the acquired business,
and (iii) any synergistic cash flows; less the cost of acquisition.
However, estimating the value of these cash flows relies upon an estimate of the post-acquisition required rate of
return – which cannot be estimated until we know the value of the component cash flows. This problem requires an
iterative solution, which can be solved using a spreadsheet package.
Validity of the Free Cash Flow to Equity Model
The estimates of the value using NOPAT as a proxy for free cash flow produces values that are reasonably close to the
current market valuation of both companies. The model values Burcolene at $12.856 billion and PetroFrancais at
$11.874 billion compared with current market valuations of $13.2 billion and $12.5 billion respectively. The estimation
error is 2.7% and 5.3% respectively (see working). Although minor, the differences can be explained by any of the
following:
– The model used may incorrectly specify the valuation process. In either case, NOPAT may not be a sufficiently close
approximation to free cash flow;
– The underpinning models in the cost of capital calculations may not be valid. The capital asset pricing model, for
example, does not capture fully all the risk elements that are priced into competitive markets;
– The estimates of growth may be over-optimistic (both valuations are highly sensitive to variation in the implied level
of growth);
– The markets may have reacted positively to rumours of an acquisition; and
– The capital markets may be inefficient.
However, on the basis of this preliminary analysis, the low levels of error suggest that the NOPAT based model should
form the basis for valuing a combined business.
Deriving a bid price
In preparation of an offer, a due diligence process should (as part of its brief) consider the likely growth of each cash
 flow stream within the context of the combined business and the variability associated with the future growth rates of
each cash flow stream. This information could then be used to estimate the company’s future cash flows (i), (ii) and (iii)
above, using a cost of capital derived from the current required rates of return and market values. An iterative
procedure can then be employed to bring the derived values into agreement with those used to estimate the
company’s cost of capital. This valuation less both the cost of acquisition and the company’s current debt gives the
post-acquisition equity value. The maximum price that should be paid for PetroFrancais is that which leaves the equity
value of Burcolene unchanged. This estimation process, whilst procedurally complex, does reinforce a key point with
type III acquisitions that the combined equity valuation of both parties is not a good indication of the value of the
combined business.
Providing the management of Burcolene can come to a reliable valuation of the combined business then, providing
they remain within the bid-price parameters, the acquisition should increase shareholder value. Good valuation
methods should capture the benefits and the consequential costs of a combined operation. It is important that
management recognises this point and does not double-count strategic opportunities when negotiating a bid price. In
this case, improving equity value for the Burcolene investors depends upon a number of factors. A simulation of the
most important parameters in the valuation model are forward growth, the cost of equity, default premiums and the cost
of debt. These should allow Burcolene to estimate the likely equity value at risk given any chosen bid price. A
simulation would also provide an estimate of the probability of a loss of equity value for Burcolene’s investors at the
chosen bid price.
Implications for gearing and cost of capital
Financing an acquisition of this magnitude through debt will raise the book gearing of the business, although its impact
upon the market gearing of the company is less easy to predict. Much depends on the magnitude of any surplus
shareholder value generated by the combination and how it is distributed. An acquisition such as this will increase
market gearing if the benefits accrue to the target shareholders. The reverse may occur if the bulk of the acquisition
value accrues to the Burcolene investors. Similarly the impact upon the company’s overall cost of capital, the impact of
the tax shield and the exposure to default risk again all depend upon the agreed bid price and the distribution of
acquisition value between the two groups of investors.
Working
The estimation errors are calculated as follows:

47. Kodiak Company

(a) The projected cash flows for next three years are as follows:

Year 1 Year 2 Year 3

Revenue (9% increase) 5,450 5,941 6,475

Less: cost of sales (9% increase) 3,270 3,564 3,885

Gross profit 2,180 2,377 2,590

Less: operating expenses

Variable cost (9% increase) 818 891 971

Fixed cost (6% increase) 1,060 1,124 1,191

Depreciation (W1) 135 144 155

2013 2159 2317

Operating profit 167 218 273

Less: interest 74 74 74

93 144 199

Less: tax at 30% -one year in arrears 15 28 43

Add back depreciation 135 144 155

Less: incremental working capital (W2) 20 21 24

Less: investment in non-current assets (W1) 79 95 114

Free cash flows to equity 114 144 173

Workings
(i) Non-current assets and depreciation

Year 1 Year 2 Year 3

Non-current assets b/f 1,266 1,345 1,440

Additional non-current assets (20% increase) 79 95 114

Non-current assets c/f 1,345 1,440 1,554

Depreciation at 10% 135 144 155

(ii) Working capital

Year 1 Year 2 Year 3

Total working capital (270 - 50 cash)

@ 9% growth 240 261 285

Incremental working capital 240-220 261-240 285-261

= 20 = 21 = 24

(b) The value of the company will be estimated as the present value of the free cash flows using the cost of equity as the
discount factor.

Year 1 Year 2 Year 3

Free cash flows to equity 114 144 173

Discount factor (10%) 0.909 0.826 0.751

Present value 1 - 3 104 119 130 353

Present value 4 – infinity

The value of the firm is therefore (353 + 1,912) = $2,265m

(c) The valuation is based on many assumptions including the following;
– The assumption that the required return on equity of 10% reflects the market rate of return required for investment of
this risk. The return should reflect the business risk of the project.
– The assumption that the free cash flows to equity will grow at a constant rate of 3% after year three up to infinity. This
may not be the case in reality.
– The cash flow figures used are assumed to be certain. The assumption that sales, cost of sales, variable cost and
working capital will all increase by 9% may not be realistic. A consideration of their underlying variability should be
included in the analysis.
– The assumption that the company is a going concern and will operate up to infinity.
(d) The value calculated above is the fair value of company based on the future free cash flows to equity and it
represents the fair value of the company’s assets less it liabilities.
 A limited liability gives rise to a call option on the value of the business to shareholders against the lenders. This is
because when the value of equity falls to zero, the company can liquidate and lenders will bear the loss. This
additional value is termed its ‘structural value’ and it is at its maximum when the value of the assets of the firm
approximate to the value of the outstanding debt, though it diminishes as that differential widens. A structural valuation
of your firm could be undertaken but would need estimates of the volatility of the returns generated by the firm’s assets
and the length of time which the debt will be held to maturity.
48. AggroChem Co (June 2010)

Tutor's Tips
The answer should be presented in a report format.

(i) Estimating the market value of equity for AggroChem Co

The market value of equity for AggroChem Co is calculated as the present value of free cash flows to equity (as it is
all equity financed) using its cost of equity as the discount factor.
Market value of equity = FCFequity(1 + g) / (Ke – g)
○ FCFequity = Operating profit – interest – tax + depreciation – increase in working capital – fixed capital
investments.
From the information in the question, the free cash flow to equity can be calculated as: FCFequity = NOPAT – Net
investment (580 – 180) = $400m
○ The cost of equity is calculated using the CAPM as: Ke = 5% + 1·26 x 6% = 12·56%
○ The growth rate ‘g’ can is calculated using the Gordon’s growth model = rb
r = cost of equity/return on equity = 12.56%
b= proportion of funds retained = (180/580) x 100% = 31.03%
g = 12.56% x 31.03% = 3.9%
Market value of equity = 400(1.039) / (0.1256 – 0.039) = £4,799m
Assumptions
○ There is a constant growth rate and retained earnings can be invested at the cost of equity.
○ The cost of equity remains constant to infinity.
○ The company is a going concern and the market value represents the present value of future free cash flows to
infinity.
(ii) The Black Scholes Option Pricing (BSOP) model provides a basis for corporate valuation in cases where traditional
methods are either inappropriate, or where they fail to fully reflect the risks involved. Given the gearing of the two
companies, the low levels of trading in each company’s equity, and their future growth potential, including its
volatility, it is appropriate to handle the valuation by focusing upon the real option value attributable to the post-
acquisition business.
The usual determinants in the valuation of options need to be redefined, when the valuation of equity is treated as a
call option written by the lenders on the underlying assets of the business.

Determinants Possible appropriate measures

Valuation of the underlying The fair value of the assets of the company

Exercise price Settlement values of outstanding liabilities

Volatility of the underlying Standard deviation of underlying assets

Risk-free rate of interest Current yield on company debt

Time to expiry Average period to settlement of company liabilities

Where the assets of the company are actively traded and easily liquidated, their current market value would be
appropriate. In the case of most companies, fair value will normally be based upon the present value of the future
 cash flows that the company’s assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to estimate accurately. One approach is
to estimate the probabilities of the likely future cash flows of the company and generate a distribution of their present
values from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the company’s liabilities consist
entirely of debt in the form of a zero coupon bond. If the company’s debt includes other types of bond, adjustments
are necessary as shown in the following illustration.
(iii) Maximum price and premium
The five determinants for Black-Scholes valuation are;
○ Time to expiry (t) = 5 years
○ Volatility (standard deviation) (s) = 35%
○ Risk free rate (r) = 5%
○ Underlying assets of the business (assuming fair values) = $8·6 million
○ Exercise price is determined by an equivalent zero coupon bond as:
$3 million x 1·08–5 = $2·04175 million
d1 = [ln(8·6/2·04175) + (0·05 + 0·5 x 0·352) x 5]/(0·35 x 51/2)= 2·548
N(d1) = 0.5 + 0.4946 = 0·9946
d2 = 2·548 – (0·35 x 51/2) = 1·765
N(d2) = 0.5 + 0.4616 = 0·9616
Call value = ($8·6m x 0·9946) – ($2·04175 x 0·9616 x e–0·05 x 5) =$7·025m
The value of the combined business is therefore $7.025m.
The maximum premium payable to take over LeverChem should be difference between the total combined value
and the sum of the current market values of AggroChem and LeverChem.
Market value of LeverChem = $1.2 x 1·3333 = $1.6
Maximum premium = $7·025m – ($4·799m (from i) + $1.600) = $0.626 million
The maximum price payable to take over LeverChem is therefore the current market value of LeverChem plus the
maximum premium.
Maximum price = $1.600m + $0.626m = $2·226m
(iv) The Black-Scholes model is based on many assumptions and the model should be expected to provide an
indication of value and not the exact or definite value of a company. The model is applicable to only European
options, that is, options which can be exercised only on the exercise date. It is assumed that the value of the assets
of the business change randomly around a rising trend and are thus log-normally distributed. Despite these
criticisms the model is very useful in estimating the value of company where traditional techniques are not
appropriate.
49. Pursuit Co (June 2011)

Tutor's Tips

The answer should be presented in a report format. Professional marks will be awarded for the appropriateness and
format of the report.

(i) The acquisition of Fodder Co would be beneficial to Pursuit Co if it would increase the wealth of its shareholders.
This can be achieved when the total synergistic benefit from the acquisition is higher than the premium payable to
the shareholders of Fodder. The total estimate of the benefits from the acquisition is $9,076,000 and the premium
payable to Fodder Co shareholders’ is $9,021,000, resulting into a net benefit of $55,000 to Pursuit Co
shareholders. Even though Pursuit shareholders’ wealth may increase by $55,000, this amount is minimal relative to
the size of the company and also depends on the assumptions used in the calculations. Pursuit shareholders may
consider the acquisition to be risky and not beneficial to them and the company.
(ii) The limitations of the estimated valuations in part (i) above are mainly due to the assumptions made which include
the following:
 ○ The growth rates for both Fodder and the combined business within the next four years and after 4 years may
not be realistic. For example, the free cash flow may not grow at a constant rate after year four to infinity.
○ Operating profit margin is assumed to be a constant proportion of sale over the period.
○ There is no guaranteed that the combined business may operate to infinity.
○ The cost of capital of the combined business may be inaccurate as it is subject to the assumptions made by
Modigliani and Miller. For example, the assumption that debt is risk free.
○ Other unforeseen costs during the post-acquisition period may reduce the present value.
(iii) The amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co is the difference
between how much is payable to Fodder Co and the amount of money available. The total amount payable to
Fodder Co is its current market value of $40,094,000 plus the premium of $9,021,000 = $49,115,000. The total
additional debt finance needed will be $49,115,000 minus the cash reserve of $20,000,000 = $29,115,000.
Given that the combined corporate value is $189,170,000 with 50:50 debt/equity, the market value of debt post-
acquisition will be (50% x 189,170,000) = $94,585,000. However, as before, the debt value of Pursuit is only
$70,000,000 (140,000,000 x 50%) which means that the company has already borrowed $24,585,000, ($94,585,000
- $70,000,000). Therefore the extra amount to borrow is $4,530,000 ($29,115,000 - $24,585,000). Given additional
debt of $4,530,000 the capital structure cannot be maintained at 50:50 debt/equity.
(iv) The capital structure of the combined business will change if the acquisition of Fodder Co is financed by debt and
cash reserves, as indicated in point (iii) above. As the market value of the company is calculated as the present
value of the free cash flows using the combined WACC as the discount factor, the change in the capital structure
would lead to a change in the debt/equity ratio resulting in a change in the WACC and therefore the market value of
the combined business. As the capital structure changes there will be inconsistency between the debt/equity ratio
used to calculate the WACC and the debt/equity ratio derived from the resulted market value.
To resolve this problem there is the need to use the iterative revaluation procedure to achieve consistency between
the WACC and the corporate value. This would involve a recalculation of βe, using weightings that are closer to
those derived from the valuation. This procedure would be continuously repeated until the assumed weightings and
the weightings ultimately derived from the corporate valuation are reasonably consistent. Thankfully this iterative
process is not performed manually, since it can be calculated in Excel (shown in Tools > Options > Calculation).
(v) The Chief Financial Officer’s suggestion that the most effective way to reduce the possibility of the takeover would
be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend. The tactic of
selling off certain highly valued assets of the company subject to a bid is called ‘selling the crown jewels’. The
intention is that, without the ‘crown jewels’, the company will be less attractive. This tactic is acceptable within the
regulatory framework of mergers and acquisitions as the bid has not officially been announced.
The large amount of cash reserves in the company may not be acceptable to Pursuit shareholders, which may
explain the recent fall in its share price. If this argument holds true then distributing the cash reserves to them by
way of special dividend may increase Pursuit Co’s share price and make it expensive for SGF Co. This may make
the acquisition less appealing to SGF Co.
If Fodder Co is acquired using only debt, the company’s overall debt would increase by the $20,000,000 cash
reserves (the cash reserve is distributed as dividend). This would lead to a substantial increase in gearing and
financial risk, reducing the ability of Pursuit Co to raise further capital to finance future investment projects. The
suggestion that increases in gearing will increase the company’s share price can be argued on the basis of the
capital structure decision. Modigliani and Miller argued that in the world of tax, an increase in gearing will decrease
the WACC and increase market value.
Whether the suggestion is suitable would depend on the level of gearing acceptable by Pursuit Co, its shareholders
and the financial markets.
Appendix

Valuation of Fodder Co
The market value of Fodder Co is the present value of the free cash flows using its WACC as the discount factor.
FCF = Operating profit – tax + depreciation – increase in working capital – fixed capital investments.
However, it is assumed that the tax allowable depreciation is equivalent to the amount of investment needed to maintain
current operational levels (working capital).

Years 1 2 3 4

$000 $000 $000 $000

 Sales 17,115 18,142 19,230 20,384

Operating profit 5,477 5,805 6,154 6,523

Less: tax (28%) 1,534 1,626 1,723 1,826

Less: additional investment (22% of increase in sales revenue) 213 226 239 254

Free cash flows 3,730 3,953 4,192 4,443

Discount factor 13% 1.13-1 1.13-2 1.13-3 1.13-4

Present value 3,301 3,096 2,905 2,725

$000

Present value years 1 –4 12,027

Present value years 5 – infinity = 4,443(1.03) x 1.13-4/(0.13 – 0.03) 28,067

Corporate value of Fodder Co 40,094

Workings:
(i) Sales revenue growth rate
= {(16,146/13,559)1/3 – 1} x 100% = 5·99%, say 6%
(ii) Operating profit margin
= (5,169/16,146) x 100% = 32.01%, say 32% of sales revenue
(iii) Cost of equity
Ke = 4·5% + 1·53 x 6% = 13·68%
(iv) WACC
= {13·68% x 0·9} + {9% x (1 – 0·28) x 0·1} = 12·96%, say 13%

Valuation of combined business

The market value of the combined business is the present value of the free cash flows using the WACC of the combined
business as the discount factor.

Years 1 2 3 4

$000 $000 $000 $000

Sales 51,952 54,965 58,153 61,526

Operating profit 15,586 16,490 17,446 18,458

Less: tax (28%) 4,364 4,617 4,885 5,168

Less: additional investment (18% of increase in sales revenue) 513 542 573 607

Free cash flows 10,709 11,331 11,988 12,683

Discount factor 9% 1.09-1 1.09-2 1.09-3 1.09-4

Present value 9,825 9,537 9,257 8,985

$000
 Present value years 1 –4 37,604

Present value years 5 – infinity = 12,683(1.029) x 1.09-4/(0.09 – 0.029) = 151,566

Corporate value of combined business 189,170

Workings
(i) Sales growth = 5.8%. Operating profit is 30% of sales revenue, all given in the question.
(ii) Combined company cost of equity
Equity beta - Pursuit = 1.18
Equity beta – Fodder = 1.53
Asset beta - Pursuit = 1·18 x 0·5/{(0·5 + (0·5 x 0·72)} = 0·686
Asset beta - Fodder Co = 1·53 x 0·9/{(0·9 + 0·1 x 0·72)} = 1·417
Combined business asset beta = {(0·686 x 140,000) + (1·417 x 40,095)}/(140,000 + 40,095) = 0·849
Equity beta of combined business = 0·849 x (0·5 + 0·5 x 0·72)/0·5 = 1·46
Combined business cost of equity (Ke) = 4·5% + 1·46 x 6% = 13·26%
(iii) WACC of combined business
13·26% x 0·5 + 6·4% x 0·5 x 0·72 = 8·93%, say 9%

Calculation of the synergistic benefit or maximum premium payable:

Value of combined business 189,170

Value of Pursuit (given) 140,000

Value of Fodder 40,094 180,094

Maximum premium payable (synergistic benefit) 9,076

Premium payable to Fodder shareholders (9,021)

(90% x 40,094 x 25%)

Net benefit to Pursuit shareholders 55

50. Byteen plc

(a) Byteen plc, a UK based manufacturer of personal computers wishes to expand its overseas sales by: increasing
exports; entering into a licensing agreement with a South Korean company or direct foreign investment in Basicland.
(i) Exporting is where the company exports its goods directly from the home country instead of establishing a
permanent set-up in the foreign country. The advantages and disadvantages of exporting are:
Advantages
o Low capital needs and start-up cost
o Use of spare capacity in the existing plant if any
o Low risk
Disadvantages
o High transportation cost to foreign markets
o Consumers may prefer locally produced goods
o Tariffs and trade taxes that are imposed by foreign governments may make export more expensive
o Little knowledge of local market gains
o Difficult to establish a good customer support system if there is no operational base in the overseas country.
 (ii) A licensing agreement permits a foreign firm to manufacture the company’s products in return for royalty payments.
The advantages and disadvantages of licensing are:
Advantages
o It does not require substantial financial resources
o Political risks are reduced since the licensee will probably be a local firm.
o It is often used where there is high import barriers
o Transportation cost are avoided as compared to exporting
Disadvantages
o Difficulty in maintaining quality standards, hence lower quality might affect the standing of a brand name in
international market
o Possibility of licensee competing with licensor by exporting the product to markets outside licensee’s area.
o The arrangement may give the licensee know-how and technology which it can use in competing with the
licensor after the licensing agreement has expired
(iii) Foreign direct investment requires the commitment of substantial amounts of capital and significant risk. It may
occur by establishing a new subsidiary or by acquiring an existing local company or entering into a joint venture.
Generally FDI may have the following advantages:
o to establish new markets and attract new demand
o to take advantage of relatively cheap foreign labour
o to avoid tariffs and trade restrictions
o to use foreign raw materials and avoid high transportation costs
o to benefit from economies of scale
o for international diversification.
(b) Net present value calculation
– Forecasting exchange rates using the purchasing power parity

Year Bf/£ Bf/$

0 281.5 189.4

1 281.5 × (1.4/1.02) 386.4 189.4 × (1.40/1.05) 252.5

2 386.4 × (1.28/1.03) 480.2 252.5 × (1.28/1.05) 307.8

3 480.2 × (1.2/1.04) 554.1 307.8 × (1.20/1.04) 355.2

4 554.1 × (1.14/1.04) 607.4 355.2 × (1.14/1.04) 389.3

5 607.4 × (1.10/1.04) 642.3 389.3 × (1.10/1.04) 411.8

6 642.3 × (1.10/1.04) 679.4 411.8 × (1.10/1.04) 435.5

Using the cross rate principle, the spot exchange rate between Basicland franc and USA dollar can be estimated as
follows:
$1.4865 = £1
Bf 281.5 = £1,
Therefore
$1 = Bf189.371 (281.5/1.4865)
– Sales
Year 1 2 3 4 5

Real selling price ($) 900 900 945 992.25 1031.94

USA inflation (previous year’s rate) 1 1.05 1.05 1.04 1.04

Nominal selling price ($) 900 945 992.25 1031.94 1073.2176

Units (000) 30 100 125 125 125

Sales $000 27,000 94,500 124,031.25 128,992.5 134,152.2

Exchange rate (Bf/$) 252.5 307.8 355.2 389.3 411.8

Sales Bf 000 6,817,500 29,087,100 44,055,900 50,216,780.25 55,243,876

– Variable cost
Local components

Year 1 2 3 4 5

Real V.C per unit Bf000 47,500 47,500 60,800 72,960 83,174.4

Inflation 1 1.28 1.2 1.14 1.1

Nominal V.C per units Bf 000 47,500 60,800 72,960 83,174.4 91,491.84

Units (000) 30 100 125 125 125

Total local variable cost Bf 000 1,425,000 6,080,000 9,120,000 10,396,800 11,436,480

– Imported components

Year 1 2 3 4 5

cost per unit £ 80

Transfer price adjustment 1.5

120 120 123.6 128.544 133.68576

Inflation 1 1.03 1.04 1.04 1.04

120 123.6 128.544 133.68576 139.03319

Units (000) 30 100 125 125 125

Total cost £000 3,600 12,360 16,068 16,710.72 17,379.1488

exchange rate Bf/£ 386.4 480.2 554.1 607.4 642.3

Total cost Bf000 1,391,040 5,935,272 8,903,278.8 10,150,091.33 11,162,627.3

– Royalties

Year 1 2 3 4 5

Royalties £000 2500

Adjustment 2
Total £000 5,000 5,000 5,000 5,000 5,000

exchange rate Bf/£ 386.4 480.2 554.1 607.4 642.3

Total Bf 000 1,932,000 2,401,000 2,770,500 3,037,000 3,211,500

– Working capital (‘000)

Year 0 1 2 3 4 5 6

Working capital 5,000 5,000 7,000 8,960 10,752 12,257

inflation 1 1.4 1.28 1.2 1.14 1.1

5,000 7,000 8,960 10,752 12,257 13,483

Cash flows Bf000 (5,000) (2,000) (1,960) (1,792) (1,505) (1,226) 13,483

– Contribution from components

Year 1 2 3 4 5

Price per unit £ 80

Transfer price adjustment 1.5

120

Variable cost 55

Contribution per unit 65 65 66.95 69.628 72.413

Inflation 1 1.03 1.04 1.04 1.04

65 66.95 69.628 72.413 75.309

Units (000) 30 100 125 125 125

Total contribution £000 1,950 6,695 8,703.5 9,051.64 9,413.705

– Lost exports

Year 0 1 2 3 4 5

Units 60

Lost unit 20% × 60 12 12 12 12 12

Inflated contribution Per units 150 153 157.59 163.89 170.45 177.27

Contribution lost 1,836 1,891.08 1,966.68 2,045.4 2,127.24

Less tax saved at 30% 550.8 567.324 590.004 613.62 638.172

Net contribution lost 1,285.2 1,323.756 1,376.676 1,431.78 1,489.068

Redundancy cost 4,000 0 0 0 0

5,285 1,324 1,377 1,432 1,489

Discount factor 14% 0.877 0.769 0.675 0.592 0.519

Present value 4,635.120 1,017.968 929.256 847.613 772.826

NPV of lost exports (£8202.785)

– Investment in Basicland

Year 0 1 2 3 4 5 6

Bf000 Bf000 Bf000 Bf000 Bf000 Bf000 Bf000

Sales 6,817,500 29,087,100 44,055,900 50,216,780 55,243,876

Variable
cost

Local 1,425,000 6,080,000 9,120,000 10,396,800 11,436,480

component

Imported 1,391,040 5,935,272 8,903,279 10,150,091 11,162,627

comp

Fixed cost 800,000 1,024,000 1,228,800 1,400,832 1,540,915

Royalties 1,932,000 2,401,000 2,770,500 3,037,000 3,211,500

Capital 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

allowance

Taxable (730,540) 11,646,828 20,033,321 23,232,057 25,892,354

profit

Tax at 45% holiday holiday holiday 10,454,426 11,651,559

Add back 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

cap
allowance

Cash flows 1,269,460 13,646,828 22,033,321 14,777,631 16,240,795

Initial
investment

Land and (12,000,

building 000)

Machinery (10,000,
000)

Working (5,000,000) (2,000,000) (1,960,000) (1,792,000) (1,505,280) (1,225,728) 13,483,008

capital

Remittable (27,000,000) (730,540) 11,686,828 20,241,321 13,272,351 15,015,067 13,483,008

cash flows

Exchange 281.5 386.4 480.2 554.1 607.4 642.3 679.4

rate Bf/£

£000 £000 £000 £000 £000 £000 £000

Remitted (9,5915) (1,891) 24,337.41 36,530.09 21,851.09 23,377.03 19,845.46

 cash flows

Contribution 1,950 6,695 8,703.5 9,051.64 9,413.706

from
components

Royalties 5,000 5,000 5,000 5,000 5,000

UK tax on 0 2,085 3,508.5 4,111.05 4,215.49 4,324.11

contribution
and royalty

Net cash (95,914. 2,974.3685 32,523.918 46,122.54 31,687.24 33,466.63 1,9845.46

flows 7425)

Discount 1 0.877 0.769 0.675 0.592 0.519 0.456

factor 14%

Present (95,914) 2,608.5 25,010.9 31,132.71 18,758.85 17,369.18 9,049.531

value

Net present £8,014

value

– Overall net present value (‘000)

Net present value of Basicland investment £8014.94

Net present value of lost exports (£8202.79)

Overall net present value (187.85)

The overall net present value is negative and the project should be rejected.
(c) The wider commercial and other issues that the company should consider, in addition to the financial appraisal, before
making its decision on whether to invest may include the following;
– The discount factor used is the company’s current WACC. The project discount factor should reflect the systematic
risk of the project and this might be different from the company’s current cost of capital.
– Byteen plc should consider whether it will be acceptable to increase the transfer price and royalty fee in order to
reduce tax in Basicland. Most governments would not allow this and would normally charge tax on the basis of the
arm’s length prices.
– No information is provided as to whether or not UK tax liability will exist during the period of tax holidays in Basicland.
– Byteen plc should also consider the accuracy of the cash flow projections, sales, costs and tax rate. Sensitivity
analysis or simulation analysis might be used to investigate the effect of changes in key cash flows.
– The cash flow projections are based on the assumption all cash flows will be remitted to UK without any restrictions.
Any exchange control restrictions or block remittances are likely to reduce the net present value.
– The exchange rate was determined on the basis that the purchasing power parity theory holds. Any deviation from
the forecasted rates will affect the net present value.
– Byteen should also consider whether or not the investment might lead to other opportunities. In that case, they
should determine the value of that option.
– Byteen plc should also consider the political situation (risk) of Basicland.
51. Partsea plc

Net present value calculation for foreign direct investment

$H million

Year 0 1 2 3 4 5
 Sales 150 405 437 472 510

Costs

Variable costs 76 174 188 203 219

Fixed costs 23 40 40 40 40

Component 51 52 54 55

Total cost 99 265 280 297 314

Net receipts 51 140 157 175 196

Tax @20% (10) (28) (31) (35) (39)

Tax savings on depreciation – 3 3 3 3

(17 × 20%)

– 41 115 129 143 160

Initial cost/residual value (120) 150

New machinery (68)

Land and buildings (70)

Working capital (35) (4) (3) (3) (4) (4)

Remittable cash flows (155) (101) 112 126 139 306

Exchange rate $H/£ 15.80 17.04 17.87 18.73 19.64 20.60

£ million

Remitted cash flows (9.81) (5.93) 6.27 6.73 7.08 14.85

Extra tax (0.30) (0.69) (0.75) (0.80) (0.87)

Incremental cash flow from machinery 1.00

Tax on profit (30%) (0.30)

Remittable from B 0.50 0.49 0.48 0.47

Lost exports (after tax) (0.50) (0.51) (0.53) (0.55) (0.56)

Net cash flows (9.81) (6.03) 5.57 5.94 6.21 13.89

DF (14%) 1.000 0.877 0.769 0.675 0.592 0.519

Present value (9.81) (5.29) 4.28 4.01 3.68 7.21

Net present value = £4.08 million

Notes and workings

• Cost of capital (discount factor)
Cost of capital = 5% + 1.3 (12% – 5%) = 14.1%
Say 14%
• Exchange rates

$H/£ Bt/£ $H/Bt

Spot 15.80 4.20 3.76

Year 1 17.04 4.32 3.94

Year 2 17.87 4.41 4.05

Year 3 18.73 4.49 4.17

Year 4 19.64 4.58 4.29

Year 5 20.60 4.67 4.41

• Lost exports
Assumed that lost exports increase in line with UK inflation.

Year 1 2 3 4 5

Net loss (0.7 × 70% = 0.49) 0.49 0.50 0.515 0.53 0.55

Inflation 1.02 1.03 1.03 1.03 1.03

0.50 0.51 0.53 0.55 0.56

• Extra UK tax

Year 1 2 3 4 5

Net receipts 51 140 157 175 196

Depreciation 4 × 17.04/4 years 0 17 17 17 17

51 123 140 158 179

Extra tax at 10% $H 5.1 12.3 14 15.8 17.9

Exchange rate 17.04 17.87 18.73 19.64 20.6

Extra tax £ 0.30 0.69 0.75 0.80 0.87

• Sales

Year 1 2 3 4 5

Price $H 150 150 162 175 189

Inflation 1 1.08 1.08 1.08 1.08

150 162 174.96 189 204.12

Units 1 2.5 2.5 2.5 2.5

Sales 150 405 437 472 510

• Variable cost

Year 1 2 3 4 5

Labour 35 28.6

Materials 33 32

Distribution 8 9

76 69.6 69.6 75.168 81.18

Inflation 1 1 1.08 1.08 1.08

76 69.6 75.168 81.181 87.674

Units 1 2.5 2.5 2.5 2.5

Variable cost 76 174 188 203 219

• Imported component cost

Year 1 2 3 4 5

Units 1 2.5 2.5 2.5 2.5

Price per unit Bt 0 5 5 5 5

Bt cost 0 12.5 12.5 12.5 12.5

Exchange rate $H/Bt 4.05 4.17 4.29 4.41

$H component cost 0 51 52 54 55

• Working capital

Year 0 1 2 3 4 5

35 35 38.5 41.58 44.91 48.5

Inflation 1 1.1 1.08 1.08 1.08 1.08

Working capital totals 35 38.5 41.58 44.906 48.502 52.38

Cash flows 35 4 3 3 4 4

• Remittance from B

Year 1 2 3 4 5

Units 1 2.5 2.5 2.5 2.5

Price per unit Bt 0 5 5 5 5

Bt cost 0 12.5 12.5 12.5 12.5

Profit at 25% 3.125 3.125 3.125 3.125

After tax profit (70%) Bt 2.187 2.187 2.187 2.187

Exchange rate 4.41 4.49 4.58 4.67

 Remitted to UK 0.50 0.49 0.48 0.47

Net present value calculation for Licensing

Year 1 2 3 4 5

Receipts in $H 40 43.2 46.66 50.39

£ million

Receipts from fees £ 2.24 2.31 2.38 2.45

Incremental cash flow from maintenance 0.25 0.25 0.25 0.25

Incremental cash flow from machinery 1.00

Staff costs (0.21) (0.22) (0.22) (0.23)

Taxable 1.00 2.28 2.34 2.41 2.47

Tax at 30% (0.30) (0.68) (0.70) (0.72) (0.74)

0.70 1.60 1.64 1.69 1.73

Lost exports (after tax) (0.51) (0.53) (0.55) (0.56)

Net cash flows 0.70 1.09 1.11 1.14 1.17

Discount factors (14%) 0.877 0.769 0.675 0.592 0.519

Present values 0.61 0.84 0.75 0.67 0.61

Net present value from licensing = £3,480,000.

Note and workings

• Receipts from fees

Year 1 2 3 4 5

Fee $H 20 20 21.6 23.328

Inflation 1 1.08 1.08 1.08

20 21.6 23.328 25.194

Units 2 2 2 2

Total fees $H 40 43.2 46.656 50.388

Exchange rate 17.09 17.87 18.73 19.64 20.6

Fees in £ 2.24 2.31 2.38 2.45

• There are no lost exports in year one.

• Staff cost

Year 1 2 3 4 5

Real cost 0.2 0.21 0.216 0.223

Inflation (UK) 1.02 × 1.03 1.03 1.03 1.03

 0.21 0.22 0.22 0.23

• Cash flows from maintenance

£500,000 – £250,000 cost of maintenance = £250,000
Conclusion:
The foreign direct investment appears to be better than the licensing option as the foreign direct investment has a higher
net present value.
Other information:
• Partseas plc should consider the accuracy of the cash flow projections, sales, costs, tax rate and the realisable value of
the asset. Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key cash
flows.
• It should also consider whether or not the investment might lead to other opportunities. In that case, they should
determine the value of those real options. These options may include options to delay, expand, redeploy and withdraw.
• The discount rate used is based on CAPM, which is subject to theoretical and practical limitations. Also licensing carries
lower risk than foreign direct investment and so may have to be discounted using a lower discount factor.
• Difficulty in maintaining quality standards might affect the standing of a brand name in international markets if Partseas
plc licenses to KBD.
• Possibility of KBD competing with Partseas by exporting the product to markets outside KBD’s area.
• The Partseas plc may give KBD know-how and technology which it can use in competing with them after the licensing
agreement has expired.
• Partseas plc should carefully consider which of the two alternatives best fit into its corporate strategy.
• Political and other non-financial risk associated with FDI should also be considered. FDI involves more risk than
licensing.
52. Mezza Co (June 2011)
The primary objective of the company is to maximise the shareholders’ wealth and therefore the directors should consider
whether the project would lead to the achievement of this objective. The shareholders’ wealth is increased when the
market value of the company is increased, for example if the project creates value through having a positive net present
value.
In order to determining the net present value the directors would have to do a proper assessment of the cash inflows and
outflows, the cost of capital and the number of years of the project. In arriving at the estimated cash inflows the director
should consider the demand for the product, potential competition and other products which may affect the future sales of
this product. An investigation should also be performed on the operating costs of producing the product by looking at both
direct and indirect material and labour costs as well as other overheads which may be incurred as a result of undertaking
the project.
A realistic planning period has to be decided to know how long it would take to commercialise the product by looking at
how other companies undertook similar products. The directors should also assess the adequacy of the available expertise
and the infrastructure costs required for the project. Lastly, the directors should determine the appropriate cost of capital
consistent with both the financial and business risk associated with the project. This can be done by looking for a beta from
a similar company producing similar products or from taking the new industry as a proxy to determine the appropriate beta,
which measures the business risk, and then include the financial risk element of the project.
This is a new project that the company is undertaking and may have significant level of risk and uncertainty associated to
its cash flows. The directors should therefore incorporate risk and uncertainty into the appraisal process. This can be done
by using techniques such as sensitivity analysis, probability distributions and expected values and simulation. This is very
important because it may help the directors to come out with contingency plans in order to manage the project to achieve
the anticipated value. It may also be a way of convincing the shareholders that proper due diligence has been undertaken
and that the directors are not taking unnecessary risk.
The directors should also consider the effect of undertaking the project on its reputation, bearing in mind the company’s
responsibilities towards its stakeholders. The major issue is the location of the plant. It appears that the location is brilliant
as it has a large area of warm, shallow waters providing the best environment for such product. Mezza Co has also been
operating in Maienar for many years and as a result, has a well-developed infrastructure to enable it to plant, monitor and
harvest the crop. This would reduce set-up costs and hence increase the net present value of the project. The company
directors also have strong ties with senior government officials in Maienar and the country’s politicians are keen to develop
 new industries, especially ones with a long-term future leading to possible reduction in legal and administration barriers
and costs.
However, there are two main concerns about the location of the plant. The first relates to the effect of the project on
fishermen, wildlife and environment. As it is thought that the high carbon-absorbing plant, if grown on a commercial scale,
may have a negative impact on fish stocks and other wildlife in the area there would be a decline in fish stocks making it
impossible for the fishermen to continue with their traditional way of life. The poor fishermen have low political power to
influence the decision and by undertaking the project they would lose their livelihood. All these may bring the ethical
behaviour of the company into question and may affect the company’s reputation. The second concern is the relationship
between the company and the government of Maienar. The strong relationship between them may be perceived as too
close and may reduce the bargaining power of the government, allowing the company to enjoy the most benefits of the
project at the expense of the country.
The director could take the following steps to reduce or eliminate the negative impact described above. With the first
situation, concerning fishermen and wildlife, the directors could:
• Explain to the fishermen the importance and benefits of the project to them and the society;
• Retrain the fishermen and offer them priority to alternative employment;
• Influence the government to partly develop the area for tourism in order to provide job opportunities for the fishermen;
• Avoid using the whole area for the project but to leave some for fishing. This depends on the size of the area required
by the project;
• Research and develop crops which are not harmful to fish and wildlife;
• Look for alternative areas to establish the plant.
With the second situation concerning the relation with the government, whilst it would make good business sense to forge
strong relationships as a means of competitive advantage, the company should ensure that the negotiation was
transparent and did not involve any bribery or illegal practice. If both the company and government can demonstrate that
they acted in the best interests of the company and the country respectively, and individuals did not benefit as a result,
then this should not be seen in a negative light.
The company needs to establish a clear strategy of how it would respond to public scrutiny of either issue. This may
include actions such as demonstrating that it is acting according to its ethical code, pre-empting media scrutiny by
releasing press statements, and using its influence to ensure the best and correct outcome in each case for the
stakeholders concerned.
In conclusion, the company should ensure that the project would result into a positive net present value in order to
increase its shareholders’ wealth and also improve its reputation as a good corporate citizen.
53. Tramont Co (December 2011)

Tutor's Tips
The answer should be presented in a report format. Professional marks will be awarded for the appropriateness and
format of the report.

Evaluation of Gamalan Project

The Gamalan project has been evaluated using the adjusted present value (APV) technique based on the information
provided. The adjusted present value is positive at $2,414,000 and is therefore recommended that the production should
be ceased in the USA and moved to Gamala immediately. In calculating the adjusted present value the cash flows from
Gamala were discounted using the cost of equity measuring only the business risk associated with the Gamalan project to
determine the base case net present value then adjusted by the present value of the cash flows in the USA and the
present value of the tax savings on interest and the subsidy received from Gamalan government loan.
The following assumptions were made:
• The cost of equity measuring business risk was calculated using our company’s (Tramont Co) asset beta as the proxy
adjusted by an 0.4 risk premium.
• Exchange rates were calculated based on the assumption that purchasing power theory holds true.
• Costs would increase in line with the respective country’s inflation rate and inflation rate will remain constant over the
four year planning period.
• Selling prices and sales units will remain as predicted over the four year period.
• Tax rates will remain constant and the double taxation agreement will be in operational over the period.
 • There will be no blocked remittances and all the cash flows would be remitted to USA each year.
• The cost of borrowing of 5% is appropriate to be used as the discount factor to calculate the present value of the tax
saved on interest and subsidy.

Change in government and other business factors

The change in government in six months’ time may have an effect on the outcome of the project and Tramont Co should
consider such effects before forming the final conclusion as to whether it should go ahead with the project or not.
If GR Party wins the election, it promises to increase taxes of international companies operating in Gamala. Tramont
should consider by how much the tax rate could be increased, noting that if the tax rate is increased beyond 30% it would
eliminate the double taxation benefit and the resulted adjusted present value would be less than expected.
Also Tramont may not receive the loan at a subsidised rate as the GR Party has promised to review all commercial deals
with foreign companies. This would have the effect of reducing the value of the project as a result of the loss in the present
value of the net subsidy received, even though this may lead to increases in the tax savings on interest.
In addition to the above, the new government may also want to block the annual remittances to USA in order to protect its
currency depreciating against the dollar. This would reduce the present value of the cash flows, though its effect will be
minimal as most of the cash flows occur in year 4.
In order to overcome these problems Tramont can delay the project until after the election. This option to delay would
create an additional value to the company by allowing the company to ascertain the true political position of the country
and to remove the associated political risk. In addition, by delaying the project, the company would reduce the opportunity
cost of the lost contribution, which would all lead to increases in the value of the project.
Tramont should also consider the option to expand. It should consider the possibility of a follow-on project as a result of
undertaking this initial project. The value of the option to expand should be included in the evaluation of this project.
The company should consider its reputation. As a result of moving the production from USA to Gamala, the company has
to make redundancies in the USA and needs to consider how this would be interpreted by its employees and other
stakeholders.
Tramont should also consider whether this project would strategically fit into its corporate objectives and whether it has got
the necessary experience to handle such a huge foreign investment.

Appendix

Present value of the cash flows from Gamalan Project

Year 0 1 2 3 4

GR000 GR000 GR000 GR000 GR000

Sales revenue 48,888 94,849 214,442 289,716

Local variable cost (16,200) (32,373) (75,385) (104,897)

Imported component (4,889) (9,769) (22,750) (31,658)

Fixed costs (30,000) (32,700) (35,643) (38,851)

Cash profit (2201) 20,007 80,664 114,310

Tax 0 0 (7,694) (18,862)

Initial investment and residual value (230,000) 450,000

Working capital (40,000) (3,600) (3,924) (4,277) 51,801

Net cash flows (270,000) (5,801) 16,083 68,693 597,249

Exchange rates 55.00 58.20 61.59 65.18 68.98

$000 $000 $000 $000 $000

Remitted cash flows (4,909) (100) 261 1,054 8,658

Discount factor (9.6%) 1.000 0.912 0.832 0.760 0.693

Present values (4,909) (91) 217 801 6,000

The net present value of the cash flows from Gamalan Project is $2,018,000
Adjusted present value

The net present value of the cash flows from Gamalan Project $2,018,000

The net present value of the USA cash flows (W(viii)) ($637,000)

Present value of tax savings and subsidy (W(xii)) $1,033,000

APV $2,414,000

Workings
(i) Sales revenue

Year 0 1 2 3 4

Selling price 70 70 70 70

Units (000) 12 22 47 60

Sales $000 840 1,540 3,290 4,200

Exchange rate 58.20 61.59 65.18 68.98

Sales GR000 48,888 94,849 214,442 289,716

(ii) Exchange rate

Year GR/$1

0 55

1 55 (1.09/1.03) = 58.20

2 58.20 (1.09/1.03) = 61.59

3 61.59 (1.09/1.03) = 65.18

4 65.18 (1.09/1.03) = 68.98

(iii) Local variable cost

Year 0 1 2 3 4

Variable cost/unit before inflation 1,350 1,350 1,350 1,350

Inflation 1 1.091 1.092 1.093

Variable cost/unit 1,350 1,471.5 1603.94 1,748.29

Units (000) 12 22 47 60

Cost GR000 16,200 32,373 75,385 104,897

 (iv) Imported component

Year 0 1 2 3 4

Cost/unit before inflation ($) 7 7 7 7

Inflation 1 1.031 1.032 1.033

Variable cost/unit 7 7.21 7.426 7.649

Units (000) 12 22 47 60

Cost ($000) 84 158.62 349.0361 458.94

Exchange rate 58.20 61.59 65.18 68.98

Cost GR000 4,889 9,769 22,750 31,658

(v) Taxation

Year 1 2 3 4 5

Cash Profit (2201) 20,007 80,664 114,310

Capital allowance (20,000) (20,000) (20,000) (20,000)

Taxable profit after cap allowance (22,201) 7 60,664 94,310

Taxable profit after carry forward loss 0 0 38,470 94,310

Tax 20% 0 0 7,694 18,862

Additional USA tax (10%) GR000 0 0 3,847 9,431

Exchange rate 65.18 68.98

$ 59 137

(vi) Working capital

Year 0 1 2 3 4

Total working capital after inflation of 9% 40,000 43,600 47,524 51,801 0

Cash flows (incremental) (40,000) (3,600) (3,924) (4,277) 51,801

(vii) Cost of equity ungeared

Tramont market value of equity = $2·40 x 25m shares = $60m
Tramont market value of debt = $40m x $1,428/$1,000 = $57·12m
Tramont Co equity beta = 1·17
Asset beta of Tramont = 1·17 x 60m/(60m + 57·12m x 0·7) = 0·70
Gamala asset beta = 0·70 + 0·40 = 1·10 (adding a 0.4 risk premium)
Cost of equity ungeared = 3% + 6%(1·1) = 9·6%
(viii) Present value of the USA cash flows

Year 0 1 2 3 4
 $000 $000 $000 $000 $000

Closure net cash flow 600

Additional USA tax (W(v)) (59) (137)

Additional contribution 34 63 140 184

Opportunity costs 0 (560) (448) (358) (287)

Net cash flows 600 (526) (385) (277) (240)

Discount factor (7%) 1.000 0.935 0.873 0.816 0.763

Present value 600 (492) (336) (226) (183)

The net present value of the USA cash flows = ($637,000)

(ix) Additional contribution

Year 0 1 2 3 4

Contribution/unit before inflation 4 4 4 4

Inflation 1 1.031 1.032 1.033

Contribution/unit 4 4.12 4.2436 4.3709

Units (000) 12 22 47 60

Contribution $000 48 90.64 199.45 262.25

Net contribution (1-tax)= 70% 34 63 140 184

(x) Opportunity cost (lost contribution)

Year 0 1 2 3 4

Contribution/unit 20 20 20 20

Units (000) 80% 40 32 25.6 20.48

Contribution $000 800 640 512 410

Net contribution lost 560 448 358 287

(1 –tax)=70%

(xi) Tax savings on interest and subsidy

Tax savings on interest per annum

= Interest x loan x tax rate = 6% x 270m x 20% = 3,240

Subsidy

= Subsidy x loan x (1 – tax rate) =7% x 270m x 0·8 = 15,120

Total = 18,360
 (xii) Present value of tax saved on interest and subsidy

Year 0 1 2 3 4

GR000 GR000 GR000 GR000

Savings 18,360 18,360 18,360 18,360

Exchange rate 58.20 61.59 65.18 68.98

$000 $000 $000 $000

Savings in $ 315 298 282 266

Discount factor 5% 0.952 0.907 0.864 0.822

Present value 300 270 244 219

Present value of tax savings and subsidy = $1,033,000

54. Blipton International Entertainment Group

(a) Projection of $ value cash flows for both the project investment and the project return
In projecting the cash flow for this project, a forecast has been created of the capital requirement, the six year
operating cash flow and the residual value of the property (net of repairs and renewals) at the end of the project. On
the basis of the specified occupancy rates and a target nightly rental of £60 a projection has been made of the
revenues for the hotel and the expected costs. These are projected at current prices to give a real cash flow with
subsequent conversion to nominal at the UK rate of inflation. Tax is calculated both in terms of the offset available
against the construction costs and also at 30% of the operating surplus from the project.
Finally, using purchasing power parity, future spot rates are estimated. The rate specified is indirect with respect to the
dollar and declines as sterling strengthens. It could have been specified direct in relation to the dollar and will increase
as the dollar weakens. Both approaches would be acceptable (see working 2 below).
The calculation which follows has separated the present value of the investment phase from that of the return phase to
assist in the subsequent calculation of the modified internal rate of return (MIRR).

Year no 1 2 3 4 5 6

Year to 31 2009 2010 2011 2012 2013 2014

Dec

£ £ £ £

Investment
phase

Nominal (6,200,000)
cash flow

Tax saved 930,000 310,000 310,000 310,000

on WDA

Nominal (5,270,000)
after-tax
cash flow
of
investment
phase

Divide by 0.6553 0.6409 0.6269 0.6131

Direct
Exch. rate
$ value of (8,042,118) 483,695 494,497 505,627
investment
phase

Return
phase

Occupancy 0.4 0.5 0.9 0.6 0.6

Rate (OR)

Rooms let 58,400 73,000 131,400 87,600 87,600

(400 × OR
× 365)

£ £ £ £ £

Revenue 3,504,000 4,380,000 7,884,000 5,256,000 5,256,000

(Rooms let
× £60)

Variable (1,752,000) (2,190,000) (3,942,000) (2,628,000) (2,628,000)

costs
(Rooms let
× £30)

Fixed costs (1,700,000) (1,700,000) (1,700,000) (1,700,000) (1,700,000)

Real 52,000 490,000 2,242,000 928,000 928,000

operating
cash flow

£ £ £ £ £

Nominal 54,633 527,676 2,474,749 1,049,947 1,076,195

operating
cash flow

Less Tax @ (16,390) (158,303) (742,425) (314,984) (322,858)

30%

Nominal 38,243 369,373 1,732,324 734,963 753,337

after-tax
cash flow

Terminal 8,915,309
value of
property

9,668,646

Divide by 0.6409 0.6269 0.6131 0.5997 0.5865

Direct Exch.
rate

$ value of 59,671 589,206 2,825,517 1,225,551 16,485,330

return phase

Workings
(i) Tax saved on writing down allowances at 31 December:

2009 (50% × £6.2m × 30%) = £930,000

 2010 (50% × £6.2m × 30%) ÷ 3 = £310,000

2011 (50% × £6.2m × 30%) ÷ 3 = £310,000

2012 (50% × £6.2m × 30%) ÷ 3 = £310,000

(ii) Rates of exchange shown as:

At Direct with respect to the US$ Indirect with respect to the US$

1.1.2009: 1 ÷ $1.4925 = £0.6700 $1.4925

31.12.2009: = £0.6553 = $1.5260

31.12.2010: = £0.6409 = $1.5602

31.12.2011: = £0.6269 = $1.5952

31.12.2012: = £0.6131 = $1.6310

31.12.2013: = £0.5997 = $1.6676

31.12.2014: = £0.5865 = $1.7051

In the above solution, the £ cash flows are divided by the direct rate of exchange to provide $ amounts. Alternatively
the £ cash flows could have been multiplied by the Indirect rate of exchange to provide similar $ figures. However
rounding will cause some differences in this alternative answer.
(iii) Nominal operating cash flow at:

31.12.2010 £52,000 × 1.0252 £54,633

31.12.2011 £490,000 × 1.0253 £527,676

31.12.2012 £2,242,000 × 1.0254 £2,474,749

31.12.2013 £928,000 × 1.0255 £1,049,947

31.12.2014 £928,000 × 1.0256 £1,076,195

(iv) Terminal value of property

Residual value of property acquired on 31.12.2009 (in money terms) £6,200,000 × (1.08 × 10,306,941
1.025)5

Less: Charge for repairs and renewals at disposal at end of six years £1,200,000 × 1.0256 (1,391,632)

Terminal value at 31 December 2014 £8,915,309

There may be tax consequences as a result of the capital gain arising on disposal.
 (b) Project evaluation
Net present value
Given that the Dubai ($US) rate of inflation is 4.8% per annum and the company’s real cost of capital is 4.2% per
annum, the nominal cost of capital is estimated using the Fisher formula i.e.
Nominal (i.e. money) cost of capital = (1 + real cost of capital) × (1 + inflation rate) – 1 = (1.042 × 1.048) – 1 =
0.092016 (say) 9.2%
Discounting the project cash flows (of both the investment phase and the return phase) at this money cost of capital
provides the following net present value:

31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec

2009 2010 2011 2012 2013 2014
$ $ $ $ $ $

Nominal project cash flow (8,042,118) 483,695 494,497 505,627 – –

Investment phase

Return phase – 59,671 589,206 2,825,517 1,225,551 16,485,330

Total cash flow (8,042,118) 543,366 1,083,703 3,331,144 1,225,551 16,485,330

Nominal cost of capital (1 ÷ 1.092) (1 ÷ (1 ÷ (1 ÷ (1 ÷ (1 ÷ 1.092)6

(Dubai) @ 9.2% 1.092)2 1.092)3 1.092)4 1.092)5

Discounted cash flow (7,364,577) 455,667 832,228 2,342,625 789,257 9,722,139

Net present value (NPV) +$6,777,339

A positive NPV of $6,777,339 strongly suggests that this project is viable and will add to shareholder value.
Modified internal rate of return
The modified internal rate of return can be estimated by calculating the internal rate of return of the sum of the return
phase cash flows compounded at the cost of capital to give a year six terminal value. The discount rate which equates
the present value of this terminal value of return phase cash flows with the present value of the investment phase cash
flows is the modified internal rate of return.

Where PVR is the present value of the return phase of the project, PV1 is the present value of the investment phase
and re is the company’s cost of capital.

31 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec

Dec 2010 2011 2012 2013 2014
2009 $ $ $ $ $ $

$ value of return phase 59,671 589,206 2,825,517 1,225,551 16,485,330

Nominal cost of capital (1 ÷ (1 ÷ (1 ÷ (1 ÷ 1.092)5 (1 ÷ 1.092)6

(Dubai) @ 9.2% 1.092)2 1.092)3 1.092)4

PV of return phase 50,040 452,480 1,987,044 789,257 9,722,139

Total PV of return phase $13,000,960

$ value of investment phase (8,042,118) 483,695 494,497 505,627

Nominal cost of capital

(Dubai) @ 9.2% (1 ÷ 1.092) (1 ÷ (1÷ 1.092)3 (1 ÷ 1.092)4

 1.092)2

PV of investment phase (7,364,577) 405,626 379,748 355,582

Total PV of investment ($6,223,621)

phase

The calculation of the MIRR is as follows:

Alternatively the modified internal rate of return can be found by compounding forward the return phase cash flows at
the company’s cost of capital and then calculating the internal rate of return using the terminal value of the return
phase and the present value of the investment phase as follows:

Year no. cash flow Terminal Value at 31 Dec. 2014

$

6 (to 31 Dec. 2014) = 16,485,330

5 (to 31 Dec. 2013) ($1,225,551 × 1.092) = 1,338,302

4 (to 31 Dec. 2012) ($2,825,517 × 1.0922) = 3,369,327

3 (to 31.Dec. 2011) ($589,206 × 1.0923) = 767,247

2 (to 31 Dec. 2010) ($59,671 × 1.0924) = 84,850

Terminal Value of return phase cash flows $22,045,056

PV of investment phase cash flows (as above) ($6,223,621)

The modified internal rate of return is the discount rate which solves the following equation:

(c) Recommendation and discussion of method

The plan for the proposed project has been examined and referring to the appendices (see above), it is clear that this
project is expected to deliver an increase in shareholder value of $6.78 million, at the company’s current cost of
finance. The increase in shareholder value has been estimated using the net present value (NPV) method. Net present
value focuses on the current equivalent monetary value associated with capital expenditure leading to future cash
flows arising from investment. The conversion to present value is achieved by discounting the future cash flows at the
company’s cost of capital – a rate designed to reflect the scarcity of capital finance, inflation and risk.
Although the net present value technique is subject to a number of assumptions about the perfection and efficiency of
the capital markets, it does generate an absolute measure of increase in shareholder value and as such avoids scale
and other effects associated with percentage performance measures. Given the magnitude of the net present value of
the project it is safe to assume that it is value-adding, provided that the underlying cash projections can be relied upon.
However, in certain circumstances it can be useful to have a ‘headroom’ percentage, which reliably measures the rate
of return on an investment such as this. In this case the modified internal rate of return of 23.47% is 14.27% greater
than the company’s cost of capital of 9.2%. MIRR measures the economic yield of the investment (i.e. the discount rate
which delivers a zero net present value) under the assumption that any cash surpluses are reinvested at the
company’s current cost of capital. The standard IRR assumes that reinvestment will occur at the IRR which may not, in
practice, be achievable.
Although MIRR, like IRR, cannot replace net present value as the principal evaluation technique it does give a
measure of the maximum cost of finance that the company could sustain and allow the project to remain worthwhile.
For this reason it provides a useful insight into the margin of error, or room for negotiation, when considering the
financing of particular investment projects. MIRR does not suffer from the multiple root problems that may occur when
calculating IRR from complex cash flows.
55. Mlima Co (June 2013)
(a) Report to BOD
This report is about the initial public offering and the price at which the shares are to be issued. It contains the
assumptions used in estimating the share price, including the cost of capital used, whether the debt holders will accept
debt for share swap and the justification for the public listing.
Cost of capital
The appropriate cost of capital should always reflect the business and financial risk associated with the company. As
Mlima Co will not issue any debt after public listing the company will face no financial risk, only business risk, hence its
overall cost of capital is its ungeared cost of equity which measures only business risk. Companies in the same
industry are said to have the same business risk, so since Mlima Co and Ziwa Co are in the same industry they will
face the same business risk. As ungeared cost of equity compensates for only business risk, the ungeared cost of
equity of Ziwa will be the same as the ungeared cost of equity of Mlima Co. The appropriate cost of capital of Mlima Co
is 11% (appendix 1).
Mlima Co’s value with and without Bahari project
The value of the company without Bahari project is estimated as $563·8m as the present value of the free cash flows
using the cost of capital of 11%, representing $5.64 per share ($563·8m/100m shares) before the 20% discount and
$4.51 ($5.64 × 80%) per share if the 20% discount if offered.
Taking into account the value of the Bahari project, the value of the company will increase by $21.6 to $585.4m
representing $5.85 per share without the 20% discount and $4.68 after discount.
Equity-for-debt swap
The unsecured bond holders would accept the equity-for-debt swap if the value of the equity to be received is more
than the value of their debt. The value of their debt is estimated at $56.8m, but the debt holders would be entitled to
receive only 10% of the equity value. This implies that they would only accept the swap if the share value of the
company is $585.4m.
Assumptions made in estimating the share price
The share price was estimated as the present value of the future free cash flows based on many assumptions such as
the growth of sales of 7.5% for the first four years. The 7.5% was based on past sale growth and adjusted by 120%
which may not be realistic. It was also assumed that operating profit margin and tax rate will remain constant, and free
cash flows will grow by 3.5% per year to infinity which may not realistic. It was assumed that the company is a going
concern and will be in operational existence up to infinity.
The cost of capital used was calculated based on the assumption that the business risk of Ziwa Co is the same as that
of Mlima Co as they are all in the same industry. The business risk faced by Mlima Co may not necessarily be same as
the business risk of Ziwa Co.
The Bahari project was accepted based on a positive adjusted present value, which was calculated on the assumption
that the government will provide the $150m required at a 4% subsidy. A discount factor of 7% was also assumed as
appropriate for discounting the financing effect cash flows. Political risk and other costs such as underwriting cost were
ignored.
Reasons for the public listing
The main objective of the company issuing the share through the stock exchange is to raise capital to pay off the debt.
In addition to this there are many other benefits for being a listed company. It makes it easier for companies to raise
new long-term finance to finance new projects than if they had to raise funds privately by contacting investors
individually. It allows owners to realise their shares. That is, it enables investors to sell their investments, should they
wish to do so. A better credit standing is obtained, so that it may be easier to borrow money. The reduction in the
perceived risk for shareholders and the greater marketability of shares may lead to a lower cost of equity. It enhances
the company’s image. The extra status and prominence given to public companies might help the company to
generate new business by attracting new customers.
Issuing shares at a discount
One main reason for issuing shares at a discount is to encourage potential shareholders to acquire the shares, hence
to ensure that all the available shares are fully subscribed. Mlima Co may not be well known to the investing public and
therefore to encourage them to buy the share it may be appropriate to issue the share at a discount. In addition to this
the company is intending to sell only 20% of the shares to the public and this may not go well with potential investors
as they will have only minority stake in the business which will prevent them from influencing decisions.
Conclusion
 Based on the calculation the issue price of the share should range between $4·51 and $5·86 per share depending on
whether the company will offer the discount or not. It should also be noted that being a listed company involves listing
cost and meeting restrictive conditions. I will recommend that Mlima Co consult its underwriters and potential investors
about the possible price they would be willing to pay before making a final decision.
Report compiled by:
Date:
Appendix 1
Cost of capital: Mlima Co
Ziwa Co
MV debt = $1,700m × 1·05 = $1,785m
MV equity = 200m × $7 = $1,400m
Ziwa Co, ungeared Ke
Keg = Keu + (1 − t) (Keu − Kd) D/E
16·83% = Keu + 0·75 × (Keu − 4·76%) × 1,785/1,400
16·83% + 4·55% = 1·9563 × Keu
Keu = 10·93% (say 11%)
Appendix 2
Mlima Co’s value with and without Bahari project
Value without Bahari project:
The value is the present value of the future free cash flow discounted using 11% (see above).
Historic mean sales revenue growth = (389·1/344·7)1/2 – 1 = 6·25%
Four years growth rate: 1.2 × 6.25% = 7·5%
Operating profit margin = (58·4/389·1) × 100% = 15%

Year (in $ millions) 1 2 3 4

Sales revenue (1.075) 418·3 449·7 483·4 519·7

Operating profit (15% of sales) 62·7 67·5 72·5 78·0

Less taxation (25%) (15·7) (16·9) (18·1) (19·5)

Less additional capital investment

(30c per $1 change in sales revenue) (8·8) (9·4) (10·1) (10·9)

Free cash flows 38·2 41·2 44·3 47·6

Df 11% 0.901 0.811 0.731 0.659

PV of free cash flows 34.4 33.4 32.4 31.4

PV Year 1 to Year 4 $131.6

PV year 5 to infinity = [(47·6 × 1·035)/(0·11 – 0·035)] × 0.658 $432·2m

Value of company $563·8m

Value of the Bahari project

The value of the Bahari project is the adjusted present value of the project as there is a subsidised loan.
Base case present value
 Year 0 1 2 3 4 5 6–15

Cash flows (millions) (150) 4 8 16 18.4 21.2 21.2

Df 11% 1 0.901 0.811 0.731 0.659 0.593 3.495

PV (150) 3.6 6.5 11.7 12.1 12.6 74.1

Base case NPV = −29.4 m

Annuity factor 6–15 years = 7.191 − 3.696 = 3.495
PV of the tax savings on interest (using 7% as the discount factor)
3% × $150m × 25% = $1·1m × 9.108 = $10.0m
PV of the subsidy (using 7% as the discount factor)
4% × $150m × (1 – 25%) × 9.108 = $41
APV = −29.4 + 10 + 41 = $21.6m
Appendix 3
Value of the unsecured bond
Value of a bond is the present value of the future cash flows using the redemption yield or yield to maturity as the
discount factor. Assume 7% as discount factor.

Year Cash flow Df 7% PV

1–10 Interest (13% × 40m) 5.2 7·024 36.5

10 Redemption value 40 0.508 20.3

Value of bond $56.8 m

(b) Relocation of farmers

For the purpose of the project, the farmers would have to be relocated to a new area where the land is not fertile. This
will have an effect on their livelihood and their standard of living. Mlima Co should consider how this may affect its
corporate reputation internationally and how subsequent negative actions of the farmers may impact its operations in
the area. However, if Mlima Co decide to reject the offer because of the farmers, the government is committed to the
project and the offer may be given to another company as the plight of the farmers will not be considered by the
government. As a result of this Mlima Co should negotiate with the government to offer alternative fertile land to the
farmers. The company can retrain some of the farmers in order for them to be employable by the company.
Bahari president and Mlima Co’s CEO
The company should not take advantage of the relationship between the president and the CEO to exploit the citizens
of the country. All transactions should be transparent and undertaken in the best interest of the company and the
country and not to meet the interest of the president or the CEO.
Mlima Co needs to decide how it would respond to public scrutiny of either issue. This may include actions such as
demonstrating adherence to its ethical code, releasing press statements periodically to prevent the media from prying,
and using its influence to ensure the best and correct outcome in each case for the stakeholders.
56. Mehgam (December 2013)
(a) The World Trade Organization (WTO) was set up in 1995, replacing another international organisation known as the
General Agreement on Tariffs and Trade (GATT). The WTO is an international body whose purpose is to promote free
trade by persuading countries to abolish protectionist measures such as import tariffs, quotas and other import
restrictions.
International trade is governed by very precise rules developed by the WTO’s members. Countries must apply these
rules when trading with one another. The WTO acts as the orchestra conductor, ensuring that rules are respected.
The WTO regularly reviews the trade policies of its members. These reviews assess whether WTO members are
abiding by WTO rules and measure the impact of their domestic policies on international trade. The purpose of these
reviews is not so much to solve problems as to prevent them from occurring in the first place.
One of the main roles of the WTO is to settle disputes between its members. The WTO plays the role of trade tribunal,
where members may file complaints against other members who fail to abide by the principles of international trade.
The WTO is a body designed to promote free trade through organising trade negotiations and acting as an
independent arbiter in settling trade disputes.
The main functions of the WTO are discussed below:
1. To implement rules and provisions related to trade policy review mechanism
2. To provide a platform to member countries to decide future strategies related to trade and tariff
3. To provide facilities for implementation, administration and operation of multilateral and bilateral agreements of world
trade
4. To administer the rules and processes related to dispute settlement
5. To ensure the optimum use of world resources
6. To assist international organisations such as the International Monetary Fund (IMF) and The International Bank for
Reconstruction and Development (IBRD) in establishing coherence in Universal Economic Policy determination
Mehgam could benefit from reducing protectionist measures as companies in Mehgam can enjoy economies of scale.
By encouraging free trade, firms can specialise and produce a higher quantity. This enables more economies of scale,
and is important for industries with high fixed costs.
Law of comparative advantage states that free trade will enable an increase in economic welfare. This is because
countries can specialise in producing goods where they have a lower opportunity cost.
Free trade encourages greater competitiveness. With more trade, domestic firms will face more competition from
abroad. Therefore there will be more incentives to cut costs and increase efficiency. It may prevent domestic
monopolies from charging very high prices.
As well as benefits for consumers importing goods, firms exporting goods where Mehgam has a comparative
advantage will also see a big improvement in economic welfare. Lower tariffs on Mehgam exports will enable a higher
quantity of exports, boosting Mehgam jobs and economic growth.
With the removal of trade barriers, structural unemployment may occur in the short term. This can impact large
numbers of workers, their families and local economies. Often it can be difficult for these workers to find employment in
growth industries and government assistance is necessary.
There is increased domestic economic instability from international trade cycles, as economies become dependent on
global markets. This means that businesses, employees and consumers are more vulnerable to downturns in the
economies of trading partners.
International markets are not a level playing field as countries with surplus products may dump them in Mehgam at
below cost. Some efficient industries may find it difficult to compete for long periods under such conditions.
Developing or new industries may find it difficult to become established in a competitive environment with no short-
term protection policies by governments, according to the infant industries argument. It is difficult to develop
economies of scale in the face of competition from large foreign firms. This can be applied to infant industries.
Free trade can lead to pollution and other environmental problems as companies fail to include these costs in the price
of goods in trying to compete with companies operating under weaker environmental legislation in some countries.
Report to the Board of Directors (BoD), Chmura Co
This report recommends whether or not Chmura Co should invest in the new investment in Mehgam. It considers the
value of the project with and without Bulud Co’s offer of buying the project after two years. The report concludes by
recommending a course of action for the board to consider further.
Estimated value of the Mehgam project
The net present value of the project without the offer from Bulud Co is negative $0.4 million (Appendix 1). This
suggests that the project is financially unacceptable.
Bulud Co’s offer gives Chmura Co a right to dispose of the project at the end of year two, hence an option to abandon,
a put option. The value of a put option is calculated using the Black-Scholes option pricing model. The value of the put
option is added to the initial net present value of the project without the option, to give the value of the project.
Although Chmura Co plc will not actually obtain any immediate cash flow from Bulud Co, the real option computation
indicates that the project is worth pursuing because the volatility may result in increases in future cash flows. After
taking account of Bulud Co’s offer and the finance director’s assessment, the net present value of the project is
positive at approximately $3 million (Appendix 2). This would suggest that Chmura Co should undertake the project.
 Assumptions
It is assumed that all the figures relating to variables such as revenues, costs, taxation, initial investments inflation
figures and cost of capital are accurate.
It is also assumed that working capital will remain constant and will be fully recouped at the end of year five.
It is assumed that future exchange rates will reflect the differential in inflation rates between the two countries. It is,
however, unlikely that exchange rates will move fully in line with the inflation rate differentials.
It is assumed that Chmura Co will enjoy the full benefit of the bi-lateral tax treaty and therefore will not pay any
additional tax in the country where it is based.
It is also assumed that all the cash flows will be remitted back to UK each year without any restrictions. That is, there is
no blocked remittance.
There is considerable uncertainty surrounding the accuracy of these, and in addition to the assessments of value
conducted in appendices 1 and 2, sensitivity analysis and scenario analysis are probably needed to assess the impact
of these uncertainties.
It is assumed that the short-dated $ treasury bills are equivalent to the risk-free rate of return required for the BSOP
model. And it is assumed that the finance director’s assessment of the 35% standard deviation of cash flows is
accurate.
It is assumed that Bulud Co will fulfil its offer to buy the project in two years’ time and there is no uncertainty
surrounding this. Chmura Co may want to consider making the offer more binding through a legal contract.
The Black-Scholes option pricing model makes several assumptions such as perfect markets, constant interest rates
and lognormal distribution of asset prices. It also assumes that volatility can be assessed and stays constant
throughout the life of the project, and that the underlying asset can be traded. Neither of these assumptions would
necessarily apply to real options. Therefore the board needs to treat the value obtained as indicative rather than
definitive.
Additional business risks
Chmura Co will also want to protect itself, as much as possible, against adverse changes in regulations. It will want to
form the best business structure, such as a subsidiary company, joint venture or branch, to undertake the project. Also,
it will want to familiarise itself on regulations such as employee health and safety law, employment law and any legal
restrictions around land ownership.
Risks related to the differences in cultures between the host country, Mehgam, and needs of employees and suppliers
The risk of the loss of reputation through operational errors would need to be assessed and mitigated. For example, in
setting up sound internal controls, segregation of duties is necessary. However, personal relationships between
employees in Mehgam may mean that what would be acceptable in another country may not be satisfactory in
Mehgam.
Investing in Mehgam may result in political risks. The current government may be unstable and if there is a change of
government, the new government may impose restrictions, such as limiting the amount of remittances which can be
made to the parent company. Chmura Co needs to assess the likelihood of such restrictions being imposed in the
future and consider alternative ways of limiting the negative impact of such restrictions.
Recommendation
It is recommended that the board proceed with the project, as long as the board is satisfied that the offer is reliable.
The sensitivity analysis/scenario analysis indicates that any negative impact of uncertainty is acceptable and the
business risks have been considered and mitigated as much as possible.
Report compiled by:
Date:
Appendix 1: Estimated value of the Mehgam project excluding the Bulud Co offer

Year 0 1 2 3 4 5

MP MP MP MP MP MP
million million million million million million

Sales 1,209.6 1,905.1 4,000.7 3,640.8 2,205.4

Production and selling costs (511.5) (844.0) (1,856.8) (1,770.1) (1,123.3)

Special package costs (160.1) (267.0) (593.6) (572.0) (366.9)

Training and development costs (409.2) (168.8) (0) (0) (0)

128.8 625.3 1,550.3 1,298.7 715.2

Tax (1) (125.1) (356.3) (293.3) (116.3)

Initial invest (2,500)

Residual value (80% × 1250) + 0 0 0 0 0 1,500

500)

Working capital (200) 0 0 0 0 200

(2,700) 127.8 500.2 1,194.0 1,005.4 2,298.9

Exchange rate 72 76.24 80.72 85.47 90.5 95.82

$m $m $m $m $m $m

(37.5) 1.7 6.2 14.0 11.1 24.0

Discount factor (12%) 1 0.893 0.797 0.712 0.636 0.567

Present value (37.5) 1.5 4.9 10.0 7.1 13.6

Net present value (0.40)

Workings

Sales

Year 1 2 3 4 5

Selling price (115200 × 1.05) 120,960 127,008 133,358 140,026 147,028

Units (millions) 0.01 0.015 0.03 0.026 0.015

Sales MP Million 1,209.6 1,905.12 4,000.74 3,640.676 2,205.42

Production and selling costs

Year 1 2 3 4 5

Production (46,500 × 1.1) 51,150 56,265 61,892 68,081 74,889

Units (millions) 0.01 0.015 0.03 0.026 0.015

Cost MP Million 511.5 843.975 1,856.76 1,770.106 1,123.335

Special package costs

Year 1 2 3 4 5

Cost (200 × 1.05) $ 210 220.5 231.5 243.1 255.3

Units (millions) 0.01 0.015 0.03 0.026 0.015

Cost $ Million 2.1 3.3075 6.945 6.3206 3.8295

Exchange rate 76.24 80.72 85.47 90.5 95.82

Cost MP Million 160.104 266.9814 593.5892 572.0143 366.9427

 Exchange rate

Year MP

0 72

1 72 × 1.08/1.02 76.24

2 76.24 × 1.08/1.02 80.72

3 80.72 × 1.08/1.02 85.47

4 85.47 × 1.08/1.02 90.5

5 90.5 × 1.08/1.02 95.82

Tax

Year Cash profit Capital allowances Taxable profit Tax 25%

1 128.796 125 3.796 0.949

2 625.3636 125 500.3636 125.0909

3 1,550.391 125 1,425.391 356.3477

4 1,298.556 125 1,173.556 293.3889

5 715.1423 250 465.1423 116.2856

Appendix 2: Estimated value of the Mehgam project including the Bulud Co offer
Risk free rate of interest (r) = 4% (assume government treasury bills rate)
Volatility of underlying asset (s) = 35%
Time to expiry of option (t) = 2 years
Pe = $28,000,000
Pa = present value of cash flows from year 3 to year 5: 10 +7.1 +13.6 = $30.6
d1 = [ln(30.6/28) + (0·04 + 0·5 × 0·352) × 2]/[0·35 × 21/2] = 0·589
d2 = 0·589 – 0·35 × 21/2 = 0·094
N(d1) = 0·5 + 0·2220 = 0·7220
N(d2) = 0·5 + 0·0375 = 0·5375
Call value = $30.6 × 0·7220 – $28 × 0·5375 × e–0·04 × 2 = $8.0 million
Put value = $8.2 – $30.6 + $28 × e–0·04 × 2 = $3.4 million
Overall value of project = $3.4 – 0.4 =$3 million.

Acquisitions and mergers, Valuations, Regulatory Framework

57. Demast Ltd

(a) Growth by acquisition is said to allow companies to expand much more rapidly than by organic growth. Rapid
increases in size may offer:
 – Economies of scale in production, marketing, R & D and finance
– A reduction in the company’s risk, and cost of capital
– Greater market share and market power. In some markets to operate effectively requires the achievement of a
‘critical mass’ size.
Additionally acquisitions may allow:
– Improvements in gearing
– Purchase of patents, brands or skilled management
– Synergistic effects
– Entry into a new market quickly
– Acquisition of undervalued assets or companies, as is the stated strategy of BZO International. This may encompass
the removal of relatively inefficient management.
However, there is evidence that many acquisitions are financially unsuccessful. There is often some abnormal return
for the shareholders of the target company (in the form of high prices received for their shares), but very little for the
bidding company’s shareholders. Acquisitions often experience difficulties in integrating the operations of the
companies concerned (unless asset-stripping is the motive for the acquisition).
(b) Demast is an unlisted company, with no market price. Ideally the valuation of the company should be based upon the
expected net present value of future cash flows, but accurate estimates of this value will rarely be available in an
acquisition situation. Valuation could in practice be based upon either assets or earnings. For Nadion, which is likely to
be purchasing Demast as a going concern, an earnings valuation is appropriate. BZO International has a strategy of
acquiring what are perceived to be undervalued companies. If the intention is to quickly dispose of all or part of the
company, the realisable value of Demast’s assets would provide a useful guide, but if asset stripping is not to occur an
earnings valuation would once again be recommended.
Asset valuations
No precise estimate of the realisable value of assets is possible. Net asset value, adjusted for a 10% decrease in the
value of inventories, is £5,950,000 or 149 pence per share. This, however, ignores important factors including:
– Land and buildings have not been revalued since 1989. In the light of the subsequent recession and fall in
commercial property prices, the realisable value could be less than the book value of £4 million.
– No information is provided regarding the difference between book and realisable values of other fixed assets.
– The patents are not valued in the statement of financial position. These could have substantial value if they have a
number of years to run.
Earnings valuations
Two common methods of ‘earnings’ based valuations are the P/E ratio and the dividend valuation model.
P/E ratio model
As Demast is not listed a P/E valuation must be based upon the P/E of a similar (pure play) company. The only
available information for a company in the same industry is for Nadion, a much larger company.
The EPS of Demast is 80.5 pence (given in question). The EPS of Nadion is 58 pence. The P/E of Nadion is 320p ÷
58p = 5.52
If this is used for Demast the estimated value per share is: 5.52 × 80.5p = 444 pence. Although Nadion is listed and
much larger than Demast, the much higher growth rates of Demast might justify the use of the P/E of Nadion, without
any adjustment for lack of marketability.
Dividend valuation model

At 9% growth the expected net dividend is 37.5 × 1.09 = 40.875p

All of these estimates are subject to considerable margins of error.

Value of the bids
 7 September – BZO bids 710 × 2/3 = 473 pence per share
2 October – Nadion bids 170 pence plus effectively £4 per share (£100 debentures at par for £6.25 nominal value or 25
ordinary shares), amounting to 570p per share plus the conversion opportunity. The conversion is currently at an
implied price of £100 ÷ 26 = 385 pence per share.
This is only 14.9% above the current share price of Nadion (335p), and the opportunity for substantial capital gains on
conversions exists as there are up to five years before the final conversion date. A rise in market price could mean that
Nadion issues new shares on conversion at well under market price to Demast’s old shareholders.
19 October – BZO cash offer of 600 pence per share.
Commentary
Although all offers are significantly above the estimated asset valuation, the final successful bid is only 16 pence above
the dividend valuation model figure. If this is accurate, the bid would seem to be financially prudent. However, BZO’s
strategy is to acquire undervalued companies. Unless BZO has knowledge of how to significantly increase the value of
Demast e.g. by disposing of part of the operations, or the land, the acquisition of Demast does not appear to be in line
with this strategy. Additionally, financing the 600 pence cash offer with a £24 million term loan increases the book value
of BZO’s gearing (measured by loans and overdraft to shareholders’ funds) from its already high level of

If the stock market is efficient the significant falls in BZO’s share price on the occasions of both the company’s bids
illustrate that the acquisition is not regarded as financially beneficial by the company’s shareholders.
(c) Corporate governance is the system by which companies are directed and controlled. The board of directors should
act on behalf of the shareholders, taking note of other interest groups such as the government, creditors, customers
and employees.
In an acquisition situation the actions of directors are constrained by the City Code on Takeovers and Mergers, a set of
self-regulatory rules administered and enforced by the Panel on Takeovers and Mergers. The directors of both the
bidding and target companies should disregard their own personal interests when advising shareholders.
It is questionable whether BZO’s directors’ actions are in the best interests of the company’s shareholders, given the
market reaction to the bid and the likely adverse effects on the company’s gearing and interest cover. The company
appears short of liquidity (current ratio 0.79:1), and may be trying to maintain its high growth in Revenue through
acquisitions.
The directors of Demast advised shareholders to reject the bid of Nadion worth 570 pence plus a likely capital gain on
conversion, and accept the bid from BZO of 600 pence, which also offered them seats on subsidiary boards within
BZO. It could be argued that the directors were acting in their own interests to retain well-paid employment, and not in
the interests of the owners of the 75% of the shares not controlled by the directors and their families, although the
value of the conversion option is difficult to quantify.
Acceptance of the bid by BZO might also affect the operations and employment levels of Demast, if part of the
operation or the patents were sold. Continuity of current operations would be more likely under the ownership of
Nadion, a company in the same industry, though some cost-saving might occur, with loss of employment.
58. Paxis Plc
(a) Synergy occurs if the value of the combined entity is more than the value of the individual firms.

Value of A plc > Value of A plc operating independently + Value of B plc operating independently
and B plc combined

Free cash flows = Profit before interest and tax (PBIT), add non-cash items such as depreciation, less taxation, less
capital expenditure, less increase or add decrease in net working capital
Value of Paxis plc

Year 1 2 3 4
$000 $000 $000 $000

EBIT 3,360 3,528 3,704 3,890

Tax @30% 1,008 1,058 1,111 1,167

Add back depreciation 1,523 1,599 1,679 1,762

Replacement capital expenditure 1,680 1,764 1,852 1,945

Free cash flows 2,195 2,305 2,420 2,540

Discount factor (10%) 0.909 0.626 0.751 0.683

Present value 1,995.255 1,442.93 1,817.42 1,734.82

PV of 1 - 4 6,990.425

PV 5 - infinity × 0.683 30,070

PV 1 to infinity 37,060

Cost of equity = 4% + (11% - 4%)1.18 = 12.26%

WACC = 12.26% (70%) + 6%(1-0.3)(30%) = 9.8% = 10%

Value of Wragger

Year 1 2 3 4
$000 $000 $000 $000

EBIT 3,035 3,233 3,443 3,666

Tax @30% 911 970 1,033 1,100

Add back depreciation 1,172 1,248 1,328 1,415

Replacement capital expenditure 1,321 1,406 1,498 1,595

Free cash flows 1,975 2,105 2,240 2,386

Discount factor (9%) 0.917 0.842 0.772 0.708

Present value 1,811.075 1,772.41 1,729.28 1,689.288

PV of 1 – 4 7,002.053

PV 5 – infinity 2,386(1.05) × 0.708 44,344

0.09 -0.05

PV 1 to infinity 51,346

Cost of equity = 4% + (11% – 4%)1.38 = 13.66%

WACC = 13.66% (45%) + 7.5%(1-0.3)(55%) = 9.03= 9%

Value of combined business

Year 1 2 3 4
$000 $000 $000 $000

sales 24,097 25,543 27,075 28,700

EBIT (30%) 7,229 7,663 8,122 8,610

Tax 30% 2,169 2,299 2,437 2,583

Add depreciation 2,703 2,865 3,037 3,219

Replacement capital expenditure 3,010 3,191 3,382 3,585

Free cash flow 4,753 5,038 5,340 5,661

Discount factor 10% 0.909 0.826 0.751 0.683

Present values 4,320.477 4,161.388 4,010.34 3,866.463

PV of 1 - 4 16,359

PV 5 - infinity 5,661(1.05) × 0.683 81,196

0.1 -0.05

PV 1 to infinity 97,555

Paxis Equity value = 7m × 2.98 = $20.86 million

Paxis Debt value = 20.86 × 0.3 / 0.7 = $8.94 million
Wragger Equity value = 8 × 4 × 2.98 / 5 = $19.07 million
Wragger Debt value = 8 × 1.92 × 0.55/0.45 =$18.77 million

Cost % Value Weighted average

Paxis equity 12.26 20.86 255.7436

Paxis debt 4.2 8.94 37.548

Wragger equity 13.66 19.07 260.4962

Wragger debt 5.3 18.77 99.481

67.64 653.2688

WACC = 653.27/67.64 = 9.7% = 10%

Synergy = $97,555 – (51,346+ 37,060) = $9,149

(b) The limitations of the above analysis include:
– The expected future growth rate for Paxis (5% and 4%), Wragger (6.5% and 5%) and the combined business (6%
and 5%) may not be achieved.
– Sales, operating cost, depreciation, replacement investment and dividend may not increase by the same percentage.
– The expected reduction of operating cost from 76% to 70% of sales may not be achieved.
– There is no guaranteed that the combined business will operate to infinity.
– The cost of capital of the combined business may be inaccurate.
– Other unforeseen cost during the post-acquisition period may reduce the present value.
(c) The success of the bid would mainly depend on the bid price and the method of payment, whether cash or share
exchange. The shareholders of Wragger will not accept any price less than the current market price and for them to be
encouraged to sell Paxis would have to pay a premium above their current market price.
Paxis have offered a share exchange as the purchase consideration. The advantage of share exchange to Wragger
shareholders are:
– Capital gains tax is delayed.
– The shareholders of the Wragger will participate in the control and profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange as the movements in the market price will
change their wealth.
 An alternative method of payment would be a cash offer. The advantages of a cash offer to the target entity’s
shareholders are that:
– The price that they will receive is clear. It is not like a share exchange where the movements in the market price will
change their wealth.
– The cash purchase increases the liquidity of the Wragger shareholders who are in position to alter their investment
portfolio to meet any changing opportunities.
A disadvantage to Wragger shareholders of receiving cash is that if the price that they receive is more than the price
paid when purchasing the shares, they may be liable to capital gains tax.
(d) The maximum premium Paxis plc should pay without its shareholders suffering any loss in their wealth would be to
give all the synergistic gain from the business combination to Wragger’s shareholders. The current bid values Wragger
at $19,070,000 (from a), a premium of $3,710,000 above their current market value of $15,360,000. Given the total
synergy of $9,149,000, the bid can be increased by $5,439,000 (9,149,000 -3,710,000), representing a total offer price
of $306.36 cent (15,360,000 + 9,149,000)/8,000,000)
If this information is accurate the business combination would generate reasonable amounts of synergy and it will be
recommended that Paxis plc should proceed with the bid.
(e) Wragger can adopt the following tactics to defend itself against a possible takeover by Paxis:
– Appeal to its own shareholders by convincing them that the terms of the offer are unacceptable. This can be done by
arguing that Wragger’s shares are undervalued and the Paxis’s shares are overvalued. Profit forecasts and
revaluation of assets can be used to justify why the Wragger’s shares are undervalued.
– Wragger can appeal to the Competition Commission. This will at least delay the takeover process and may prevent it
completely.
– White knight defence. Wragger can find more acquirers to compete with the predator company.
– Pac-man defence. This is a reverse takeover where Wragger makes a counter offer to acquire Paxis.
59. Stanzial plc
(a) Estimate the value of Besserlot Ltd using:
(i) Asset based valuation
Under the asset valuation method, the value of shares is equal to total assets (fixed and current) minus total
liabilities (current liabilities and long-term debt, including preference shares).
There are several possible assets-based methods including:
o Net book value
o Net realisable value
o Replacement cost valuation.
The information provided in the question allows us to use net realisable value basis by adjusting the book values of
patents and inventory.

Total assets minus total liabilities 6,286,000

Inventory (30% × 3,400,000) (1,020,000)

Patent 10,000,000

Value of shares 15,266,000

The asset valuation has a number of problems when used to value a company and it tends to underestimate a
company’s value. Some of the problems are:
o Some key assets such as a well-trained and highly motivated workforce, network of suppliers and distribution
systems are omitted.
o Apart from inventory and patents all other assets and liabilities are assumed to have economic value equal to
their book values.
o Assets and liabilities can be manipulated through numerous accounting conventions.
 o Future profitability expectations are ignored.
(ii) P/E ratios
The P/E ratio produces an earnings-based valuation of shares. This is done by deciding a suitable P/E ratio and
multiplying by the EPS for the shares to be valued.
Value per share = EPS × P/E ratio.
For a given EPS, a higher P/E ratio will result in a higher price. A higher P/E ratio may indicate expectations that the
earnings will grow rapidly in the future, so that a high price is being paid for future profit prospects and that the
company is a lower risk company than a company with a lower P/E ratio.
Generally, the P/E ratio of a quoted company operating in the same industry as the company to be valued or the
industry average is used for the valuation. However, adjustments could be made to reflect risk and expectation of
earnings.
The exceptional item in the profit and loss account is a one-off item and therefore is ignored in the calculation below:
Revised profit

$000

Profit before tax (983)

Add back exceptional item 2,005

Revised profit before tax 1,022

Less tax @30% 307

Profit after tax 715

Given industry average P/E ratio of 30.1, the value of Besserlot Co can be estimated as;
$715,000 × 30 = $21,450,000
The P/E ratio valuation method has some problems:
o It uses earnings, which can be manipulated.
o The EPS is based on historical information.
o This approach is not so useful for loss-making companies.
o It is often very difficult to identify a similar quoted company as a comparison.
(iii) Dividend based valuation
The dividend valuation model is based on the premises that the value of a share represents the total expected future
dividend flows to infinity discounted to their present value.

Year Expected dividend Discount factor Present Value

14%

1 250 0.877 219.25

2 313 0.769 240.697

3 391 0.675 263.925

4 -infinity 0.675 7,257.94

Market value of shares 7,981.812

The dividend valuation model has the following problems:

o Uncertainty over the choice of an appropriate discount rate.
 o Difficulties in forecasting future dividend growth rate. Dividends may not grow at the same rate as turnover.
(iv) The present value of expected future cash flows
Discounted cash flow techniques are theoretically superior to earnings-based calculations since they are based on
cash flows, which more fundamentally determine value than earnings. The reason that earnings-based valuations
are used is that the information is easier to obtain and use than cash flows.
The present value of future cash flows will be estimated using the free cash flows to equity, which is the cash flow
available to be distributed to equity holders.
Free cash flow to equity can be calculated from the information as operating profit – interest – taxes + non-cash
expenses (depreciation) – capital expenditure – increase in working capital.

Year 1 2 3

Sales 28,100 35,125 43,906

Operating Profit 8% 2,248 2,810 3,512

Less interest 350 438 547

Profit before tax 1,898 2,372 2,965

Less Tax 30% 569 712 890

Add non-cash expenses 1,025 1,281 1,602

less capital investment 1,250 1,563 1,953

less increase in working capital 172 214 268

Free cash flow 932 1,164 1,456

Discount factor 0.877 0.769 0.675

Present values 817.364 895.116 982.8

PV 1–3 2695.28

PV 4 to infinity × 0.675 27,027

PV 1–infinity 29,722.28

The main problems include:

o Operating profits may not be the same at 8% of sales forever.
o Dividends, interest, capital investment, non-cash expenses and working capital may not increase at the same
percentage as turnover.
o This method ignores any real options that may arise as a result of the acquisition.
o Difficulties in determining appropriate discount factor and the growth rates in turnover.
On the basis of the above valuation, the minimum price that Besserlot would accept as a private company would be
its adjusted asset value of $3.82 ($15,266,000/4,000,000) and the maximum price would be based on the present
value of free cash flows to equity of $7.43 ($29,722,280/4,000,000). However, the above analysis has not taken into
consideration any synergistic gains that may arise as a result of the combination.
(b) Besserlot is currently owned 35% by senior managers, 30% by a venture capital company, 25% by a single
shareholder on the board of directors and 10% by another 100 people. The success of the bid will depend on how
Stanzial Inc will be able to satisfy each of the shareholder groups in terms of the offer price and the method of
payment, either cash or share exchange.
Most venture capital companies will invest in a company with the view of making capital gains by selling their shares if
company become a listed company. This will imply that Stanzial will have to offer a reasonable amount higher than
 what the venture capital company would have got should Besserlot go public. The venture capital company might be
more willing to take cash offer rather than a shares exchange if the offer price is right to them. The senior managers
would want some assurance about their jobs if Stanzial takes over Besserlot while the single investor will also want to
be represented on the board of the newly combined business. Both senior managers and the single investor are more
likely to accept a share exchange as they will be liable to immediate capital gains tax when they receive cash.
(c) The actions that might influence the medium-term success of the acquisition include:
– Decide on and to communicate the initial reporting relationships. This will reduce uncertainty. The decision needs to
be made on whether to impose relationships at the beginning, although these may be subject to change, or wait for
the organisation structure to become more established.
– Achieve rapid control of key factors, which will require access to the right accurate information. Control of information
channels needs to be gained without dampening motivation.
– The resource audit. Both physical and human assets are examined in order to get a clear picture.
– Re-define corporate objectives and to develop strategic plans, to harmonise with those of the acquirer company as
appropriate. It depends on the degree of autonomy managers have to develop their own systems of management.
– Revise the organisational structure. Successful post-acquisition integration requires careful management of human
factors to avoid loss of motivation. Employees in the acquired company will want to know how they and their
company are to fit into the structure of the amalgamated company. Morale can hopefully be preserved by reducing
uncertainty and providing appropriate performance incentives, staff benefits and career prospects.
60. Minprice
(a) Views of Savealot plc shareholders
The bid will only be accepted by shareholders of Savealot plc if the value of the bid is at a premium over the current
share price. The premium required for acceptance will obviously differ between shareholders.
At current market prices, the bid of four Minprice plc shares for three Savealot plc shares value Savealot plc shares at
[(4 × 232c) ÷ 3] = 309 pence per share – a premium of 14 pence or 4.7 per cent above the current market price. This is
only a small premium, and unless acceptance of the bid is recommended by Savealot plc directors, is unlikely to be
attractive to any of Savealot plc shareholders.
Using the dividend valuation model,

, the intrinsic value of Savealot’s shares may be estimated at

, where the current dividend is (£5m ÷ 40m) = 12.5cents per share.

This would suggest that Savealot plc shares are currently overvalued, and might encourage shareholders to sell. Such
a conclusion would imply that the market is inefficient, and is not correctly pricing Savealot plc’s shares. Most evidence
suggests that the market is semi-strong form efficient (although not at all times).
Factors that might influence the decision include:
(i) Savealot plc currently has higher growth in dividends and earnings per share than Minprice plc. Similarly, the Price
Earnings ratio of Savealot is 14.75 and of Minprice is 13.9, indicating the market expectations of Savealot plc is
displaying slightly better prospects.
Workings:

Minprice Inc Savealot Inc

EPS = = 16.7p = 20p

PE Ratio = = 13.9 = 14.75

(ii) If the shareholders are considering keeping Minprice plc’s shares after the acquisition they may be concerned that
Minprice plc is much more highly geared than Savealot plc.
 Measured by long-term loans to shareholders’ funds, gearing levels (measured by book value) are 141% for
Minprice plc and 32% for Savealot plc. Whilst gearing levels (measured by market value) are 52% for Minprice plc
and 14.8% for Savealot plc.
Interest cover is 2.9 times for Minprice plc and 7 times for Savealot plc.
The shareholders of Savealot plc may be reluctant to accept the extra financial risk. Naturally, they would have the
opportunity to sell Minprice plc shares if they accepted the offer, but this would involve transactions costs and would
be at an unknown price.
Workings:

Book value gearing Minprice plc Savealot plc

£m £m

Debt (200 + 114) 314 17.5

Equity 222 54.7

Gearing = = 141% = 32%

Market value gearing

= 364 17.5

Equity (300 × 2.32) = 696 (40 × 2.95) = 118

Gearing = = 52% = 14.8%

Interest cover

= = 2.9 times = 7 times

(iii) The difference in the dividend policy or the two companies may be important to shareholders. The net dividend
yields of the two companies are:

Minprice plc Savealot plc.

= or = or = 4.2%
3.4%

Views of Minprice plc shareholders

Following the business combination, the share price of Minprice plc will barely increase. The current price of
Minprice plc shares is 232 pence. Following the acquisition of Savealot plc, the price of Minprice plc shares will
increase to 232.5 pence.
In terms of the effect on share value, Minprice plc shareholders are likely to be neutral. If, however, there are other
synergies or growth opportunities as a result of the acquisition (for example, if employing some of Savealot plc’s
more able managers can improve the cash flows and growth of Minprice plc), then Minprice plc’s shareholders are
likely to welcome the bid.
Workings
Combination of current values:

£m

Minprice plc (300m @ 232p) 696

Savealot plc (40m @ 295p) 118

Expected synergies:

£m

Sale of warehouse 6.8

Redundancy costs (9.0)

PV of wage savings for five years at Minprice plc 9.73

WACC of 12% (£2.7m × 3.605) = 7.53

£821.53m

Expected number of shares:

[300m + (40m × 4/3)] 353.33m

Expected post-combination price of Minprice plc shares

232.5 pence

(b) Possible effects of improved offer terms

A cash offer of 325 pence per share is at a 10% premium above the current market price. This is better than the initial
share offer, but as explained below is significantly worse than the expected premium with the zero coupon bond. With
this cash offer, Savealot plc’s shareholders will know exactly how much they will receive, which is not the case if they
receive securities. However, with cash consideration they might be liable to taxation on capital gains that they have
made since purchasing the shares. No immediate capital gains tax liability would exist if payment were made in shares
or bonds.
The financial attraction of the zero coupon debenture can be assessed by estimating the redemption yield and/or likely
immediate capital gain. At the current price of 295 pence, a zero coupon debenture is being offered for the equivalent
of (10 × 295 pence) = £29.50.
This is redeemable at £100 in 10 years’ time. The gross redemption yield on the debenture may be estimated as
follows:

Accordingly, shareholders in Savalot may prefer to accept this offer and retain the bond for the full 10 year term, since
the resulting redemption yield of 13% p.a. is significantly higher than the current 10% yield on new 10 year loan stock
(and might thus be attractive to Savalot plc’s shareholders).
Alternatively they may prefer to accept this offer and immediately sell the bond for the present value of the £100
redemption value in 10 years’ time. The result would be:

Immediate disposal value, using a PV factor for 10 yearsat the normal 10% yield, (£100 × 0.386) 38.60
i.e. 0.386

Current value of a holding of 10 shares (10 × 295 29.50

pence)

Immediate capital gain £9.10

This represents a bid premium per share of (£9.10 ÷ 10) 91

 pence

Which provides an immediate bid premium of (91p ÷ 295p) 31%

This alternative is therefore far superior to both the initial bid in a) above and the cash alternative discussed above.
(c) Comment on the possible takeover defence measures
The defence tactics used by a listed company to repel a takeover bid must not only be legal, but must also comply with
the City Code on Takeovers and Mergers and with the Stock Exchange Listing Rules.
(i) If profits are indeed likely to double, such an announcement is perfectly acceptable. Obviously such a claim must be
justifiable. It would certainly be likely to either cause the bid to fail or secure a better offer.
(ii) After a bid has been made, Savealot plc would be prohibited from altering its articles of association to require 75%
of shareholders to approve the acquisition.
(iii) It would be illegal to pay a fee to a third party to purchase the company’s shares. It would be an illegal method of
purchasing the company’s own shares. This would represent a share price support scheme reminiscent of the
tactics employed many years ago by the former Guinness company, when four people were found guilty of this
offence. Three people received prison sentences (although one was allowed early release on compassionate
grounds due to illness – it is understood that he is still alive and well today). The fourth was considered too old to
serve time, instead he lost his knighthood!
(iv) Savealot plc could mount an advertising campaign criticising the management of Minprice plc, but this must be
substantiated, otherwise a libel action could result.
(v) Non-current assets could be revalued by an independent external valuer. Whether this has any effect on the
perceived market value of Savealot plc would depend upon market efficiency. If the market is efficient the current
value of non-current assets would already be known and would form part of the existing market price. In such
circumstances, a professional revaluation would not result in shareholders placing a higher value on the company.
However, since this is a commonly employed defence tactic, many company directors must consider it plausible.
61. Romage Plc
(a) 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 (for example after an acquisition,
such as when Granada plc sold off part of the assets acquired in the take-over of Forte plc).
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 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.
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.
The key question for Romage plc is whether or not it wishes to maintain control of all of its assets. If it does then a
demerger is more appropriate form of restructuring than a sell-off.
(b) Expected real cash flows (£million)
Manufacturing

Year 1 2 3 4 5 6 onwards

Net operating cash flows 45.0 48.0 50.0 52.0 57.0 60.0

Central costs (6.0) (6.0) (6.0) (6.0) (6.0) (6.0)

Tax allowable depreciation (10.0) (8.0) (7.0) (8.0) (8.0) (8.0)

29.0 34.0 37.0 38.0 43.0 46.0

Taxation (31%) (9.0) (10.5) (11.5) (11.8) (13.3) (14.3)

Add back depreciation 10.0 8.0 7.0 8.0 8.0 8.0

 One-off cost (8.0) 0 0 0 0 0

Overall cash flows 22 31.5 32.5 34.2 37.7 39.7

39.7 × 0.621

Discount factor (10%) 0.909 0.826 0.751 0.683 0.621 0.1

Present value 20.0 26.0 24.4 23.4 23.4 246.5

The expected NPV to infinity is £363.7 million.

If a 15 year time horizon is used the present value of cash flows from year six onwards is:
39.7 × 6.145 (the PV of annuity for 10 years at 10%) × 0.621 = £151.5 million
The expected NPV using 15 year time horizon is £268.7 million.

Property sales

Year 1 2 3 4 5 6 onwards

Net operating cash flows 32.0 40.0 42.0 44.0 46.0 50.0

Central costs (6.0) (6.0) (6.0) (6.0) (6.0) (6.0)

Tax allowable depreciation (5.0) (5.0) (5.0) (5.0) (5.0) (5.0)

21.0 29.0 31.0 33.0 35.0 39.0

Taxation (31%) (6.5) (9.0) (9.6) (10.2) (10.9) (12.1)

Add back depreciation 5.0 5.0 5.0 5.0 5.0 5.0

One-off cost (8.0) 0 0 0 0 0

Overall cash flows 11.5 25.0 26.4 27.8 29.1 31.9

31.9 × 0.681

Discount factor (8%) 0.926 0.857 0.794 0.735 0.681 0.08

Present value 10.6 21.4 21.0 20.4 19.8 271.5

The expected NPV to infinity is £364.7 million.

With a 15 year time horizon the PV of cash flows after year 5 are:
31.9 × 6.71 × 0.681 = £145.8 million.
The expected NPV using a 15 year time horizon is £239.0 million.
The total of the two divisions to infinity is £363.7m + £364.7m = £728.4 million
The total using a 15 year time horizon is £268.7m + £239.0m = £507.7 million
The current market value of Romage is £592 million equity plus £125.5 million debt.
From these estimates it appears that, if the market is efficient, the value of the two divisions floated separately should
marginally exceed the current value of Romage plc if present value to infinity is used, but will be less than the current
value using a 15 year time horizon. Given only a marginal potential benefit with the present value to infinity, and the
fact that no replacement capital expenditure has been incorporated into the above cash flows, it does not appear to be
financial advantageous for Romage plc to separately float the two divisions.
Supporting calculations:
Discount factors:
 The two divisions will have their own systematic risk, and it is not accurate to use Romage’s discount rate. Separate
rates will be estimated for each division.
Manufacturing division:
It is assumed that the systematic risk of the division may be estimated using the manufacturing beta.

Gearing by

market values: Equity (£m) % Debt (£m) %

Romage 592 (2m × 296) 82.5 125.5 17.5

Manufacturing 325.6 (55% × 592) 84.4 60 15.6

Property sales 266.4 (45% × 592) 80.3 65.5 (50 × 1.31) 19.7

As the gearing of the manufacturing division differ from that of the comparator industry it is necessary to ungear the
industry beta, and to regear the resultant asset beta to take into account the capital structure of the manufacturing
division.
Assuming corporate debt to be risk free:

Cost of equity = Rf + (Rm – Rf) beta

= 5.5% + (14% – 5.5%) 1.128 = 15.09%
The cost of debt may be estimated from the redemption yield on the debenture.
Solving:

Try 6%

8.97 × 9.712 = 87.12

100 × 0.417= 41.70

128.82

Try 5%

8.97 × 10.38 93.11

100 × 0.481 48.10

141.21

Interpolating

The weighted average cost of capital is:

 However, this is the money or nominal weighted average cost of capital. As real cash flows have been used the
discount rate should also be real.

A discount rate of 10% will be used.

Property sales Division
As the gearing of the property sales division is almost identical to that of the property sales industry, the industry beta
may be used without ungearing and regearing.
Ke = 5.5% + (14% - 5.5%) 0.9 = 13.15%
Kd has been estimated at 5.82%
The weighted average cost of capital for the property sales division is;

A discount rate of 8% will be used.

(b) Additional information and analysis might include:
– Information on the accuracy of the projected cash flows.
– Estimates of future price changes in individual elements of the cash flows. Different costs and revenues might be
subject to different levels of price change. This would allow an estimate of expected NPV using nominal rather than
real cash flows.
– Better estimate of the risk of the two divisions. The industry comparisons might not accurately reflect divisional risk.
– More accurate estimate of the gearing of the two divisions.
– Sensitivity analysis, best/worst NPV estimate, or estimate using Monte Carlo or other simulation techniques’ in order
to see possible outcomes using different assumptions of cash flows and discount rates.
– Valuations using alternative techniques. It is often argued that valuation should be based upon corporate free cash
flows rather than total cash flows, or upon other measures such as EVA (Economic Value Added).
– NPV analysis does not take account of future options that might arise. It would be useful to know what different
options might exist as a result of the separate floats.
– A demerger might result in adverse effects, such as greater difficulty raising capital for the smaller companies, or
greater vulnerability to takeover bids. Such effects might not have been taken into account.
– The views of existing shareholders would be important, especially major institutional shareholders.
62. Doubler Inc
(a) P/E ratio is calculated as the current market price divided by the earnings per share of the last reporting date.

Earnings per share

Doubler Fader

Profit after tax 4.41 2.87

Number of shares (4/01) 40 (3/0.1) 30

Earnings per share (pence) 11.03 9.57

P/E ratio

Doubler Fader

Current market price (pence) 290 180

Earnings per share 11.03 9.57

P/E ratio 26.29 times 18.81 times

(b) The post-acquisition earnings per share can be calculated as the post-acquisition earnings, the sum of the earnings of
Doubler and Fader plus any synergistic effects as a result of the combination, divided by the number of shares post-
acquisition.

Earnings post acquisition/combined earnings

£ million

Doubler 4.41

Fader 2.87

Synergistic effect – savings in operating cost 0.75

Total post acquisition earnings 8.03

The redundancy cost is a one-off cost and is therefore ignored in this analysis.

Post-acquisition number of shares

The purchase consideration is 2 Doubler shares for every 3 Fader shares.

Million

Doubler shares pre-acquisition 40

Share exchange = (30 × 2)/3 20

Post-acquisition number of shares 60

Post-acquisition earnings per share

Post-acquisition earnings 8.03

Post-acquisition number of shares 60

Post-acquisition earnings per share 13.38 pence

The assumed objective in financial management is to maximise shareholders wealth and this can be achieved if the
share price is increased. If the target company’s shares are bought at a lower P/E ratio than that of the predator
shares, the predator shareholders will benefit from a rise in EPS. This is called bootstrapping EPS. As Doubler’s P/E
ratio is more than Fader’s P/E ratio the shareholders of Doubler will benefit from a rise in EPS post-acquisition (from
11.03 pence to 13.38 pence).
Even though increase in earnings is important, this is not the same as increasing shareholders’ wealth and therefore
the most important factor should be the effect of the acquisition on the market price of Doubler shares.
(c) (i) Using P/E ratio
The P/E ratio produces an earnings-based valuation of shares. This is done by deciding a suitable P/E ratio and
multiplying by the EPS for the shares to be valued.
Value per share = EPS × P/E ratio.
Therefore using the P/E ratio base valuation the value of the combined business can be calculated as the weighted
average P/E ratio of the two companies multiplied by the post-acquisition earnings per share on the basis that the
market is efficient.
Weighted average P/E ratio
 = 23.34 times
On the basis of this, the market price post-acquisition = 23.34 × 13.38 = 312.29 pence, and market value =
£187.37m (312.29p × 60m).
The sum of the individual companies is £170 million (40 shares × 290 + 30 shares × 180).
The value of the combined business is more than the value of the individual companies by £17.37 million (187.37
-170), meaning the acquisition would increase shareholders’ wealth by 17.37 million.
Another assumption could be that the P/E ratio of Doubler will not change after acquisition. In this case the share
price post-acquisition will be 26.29 × 13.38 = 351.76 pence.
(ii) Cash flow basis
Under this method, a value of the entity is derived by estimating the future annual after-tax cash flows of the entity,
and discounting these cash flows at an appropriate cost of capital.
If the market is efficient then the market value of the combined business will increase by the present value of the
synergistic effects. That is the present value of operating cost savings and the redundancy cost.

£ million

Present value of operating cost savings 0.75/0.12 6.25

Present value of net redundancy cost (0.7 × 1) (0.7)

Increase in market value 5.55

The market value of the combined business should therefore increase by £5.55 million. This is substantially less
than the synergy calculated using the P/E ratio method.
(d) Limitations of P/E ratio method:
– It uses earnings which can be manipulated.
– The EPS is based on historical information.
– It is often very difficult to determine the P/E ratio to use
Limitations of cash flow method:
– It is difficult to forecast cash flows accurately. The cost savings of £750,000 per annum to infinity is unrealistic.
– It is difficult to determine an appropriate discount rate. The cost of capital of Doubler is likely to change as a result of
the acquisition.
(e) The proposed terms of the takeover are payment of 2 Doubler shares for every 3 Fader shares.
The advantages of share exchange to target shareholders include:
– Capital gains tax is delayed
– The shareholders of the target company will participate in the control and profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange whereby the movements in the market price
may change shareholders’ wealth.
The advantages to the predator company are that:
– It preserves the liquidity position of the company as there are no outflows of cash.
– Share exchange reduces gearing and financial risk. However, this may depend on the gearing of the target company.
– The predator company can bootstrap earnings per share if its price-earning ratio is higher than that of the target
company.
The main disadvantages of share exchange are that:
– It causes dilution in control.
– It may cause dilution in earnings per share.
 – Equity shares are issued and is these are more expensive than debt capital.
63. International Enterprises
(a) A short-form cash flow statement is as follows (note: a more detailed analysis of operating cash flow is not required).

$m

Operating profit 108.8

Add Depreciation (112 – 84) 28.0

Decrease in inventories (3.7 – 3.2) 0.5

Decrease in receivables (29.1 – 25.6) 3.5

Increase in trade payables (8.8 – 7.7) 1.1

Operating cash flow 141.9

Less Interest paid (2.3)

Tax paid (see working) (25.6)

Free cash flow before reinvestment 114.0

Capital expenditure (200 – 280) (80.0)

Dividends paid (28.0)

Financing – loan repayments (35 – 45) (10.0)

Net cash decrease (151.8 – 155.8) (4.0)

Working

Tax paid ($m)

Bal c/d – Corporation tax 28.5 Bal b/d – Corporation tax 25.6

Deferred tax 20.6 Deferred tax 17.0

CASH PAID 25.6 Income Statement 32.1

74.7 74.7

(b) Dividend capacity is determined by the free cash flow available to equity investors after net reinvestment.
Reinvestment is that which is required to maintain the operating capacity of the business at the planned rate of growth
specified by management as necessary to achieve the company’s strategic goals. Where new capital has been
introduced this is deducted from the capital expenditure during the year to give the amount of investment financed from
the free cash flow.

$m

Free cash flow before reinvestment is 114.0

Less: Capital expenditure (a reinvestment rate of approx 70% × $114m) (80.0)

Planned repayment of debt is: (10.0)

Thus, maximum dividend capacity (excluding working capital increase) 24.0

Extra sums required to finance the working capital cycle (see working) (5.68)
Therefore, reduced dividend capacity is $18.32m

Given the actual dividend is $28 million; this implies that the company has over- distributed given its free cash
generation during the year and its necessary reinvestment. The shortfall has been taken from the company’s cash
reserves. Whether the company has over-distributed in terms of its capital account depends upon the company’s level
of earnings for the year and its target rate of retention.
Working
Increase in working capital cycle:

Days

Inventories × 365 = 8

Receivables × 365 = 32

Payables × 365 = (22)

18 Days

Extra sums required to finance the working capital cycle:

(c) The necessary calculations for this report are as follows:

(d) Ke = 3% + (5% × 1.4) = 10%
Market value gearing (based upon current values)

Vd = $45m Ve = (100m × $16.20) = $1,620m

WACC = = 9.82%

Economic value added

2007 2008
$m $m

NOPAT [$102.3m × (1 – 0.3)] 71.61 [$108.8m × (1 – 0.3)] 76.16

Imputed charge re capital consumed

[9.82% × ($179m + $45m)] 22 [9.82% × ($253.9m + $35m)] 28.37

EVA 49.61 47.79

% EVA on capital employed

Return on capital employed (based upon EBIT ÷ average capital employed)

Average capital employed (2006/2007) = 199.5

 Average capital employed (2007/2008) = 256.45

ROce 2007 2008

= 51.3% = 42.4%

EVA margin

= 18.94% = 16.59%

Operating profit margin

= 39.1% = 37.8%

Report to Management should include the following:

On the basis of the forecast for the next 12 months we estimate that profit before tax should rise from the current level
of $102.3 million per to $108.8 million - an increase of 6.35%. An estimate of the Economic Value Added for 2007 and
2008 (projected) shows a small decrease from $49.61 million to $47.79 million which is accounted for by an increase in
the expected NOPAT figure from $71.61 million to $76.16 million, offset by an increased capital charge incurred by the
expected increase in the book value of capital employed. Overall, the EVA return on capital employed is expected to
fall from 22.15% to 16.54% and the EVA margin from 18.94% to 16.59%. This deterioration in the EVA figure is
attributable to an increase of ($36.1m – $27m) $9.1 million in the other operating costs of the business and an
increase in the equity capital of the company which, on the current projections, will not lead to a commensurate
increase in the company’s value generation. A similar picture is presented by the expected decline in the company’s
return on capital employed from 51.3% to 42.4%.
It is likely that the market will regard an outcome in line with our projections as a deterioration in the economic
performance of the company and this will inevitably have a negative impact upon both the price of the company’s
equity and the company’s cost of capital. In order to surmount this difficulty the board should consider why the
increased capital base of the company is not being fully reflected in increased turnover, profitability and value
generation. Part of the explanation lies in the expected rate of increase of turnover which is expected to grow at a
slower rate than the level of capital invested. However, there is also an anticipated deterioration in margins (operating
profit margin deteriorates from 39.1% to 37.8%) suggesting that further measures to control costs are necessary.
The underlying difficulty we face is the speed with which new capital is generating returns. This is largely governed by
our actual reinvestment. Cash generation is well ahead of our planned rate of reinvestment and servicing of finance. In
the medium term we need to review the use of this cash, either in terms of new capital projects, acquisitions or
repayment of capital.
64. Nente Co (June 2012)

Tutor's Tips

Nente Co question relates to mergers and acquisitions. Mergers and acquisitions are examined in P4 exams every
sitting and you have to pay particular attention on this topic.
(a)
• The free cash flows method is the most common examined method of business valuation. It is examined almost
every sitting.
• Remember that corporate value is calculated as the present value of the future free cash flows (FCF) using WACC
as the discount factor.
• FCF = PBIT – tax + non cash flows – cash investment.
• The growth rate, g, can be calculated using the past profit before interest and tax growth adjusted by the 25%, as
stated in the question.
 • Also remember that value of equity is the difference between the total corporate value and the value of debt and that
share price is the equity value divided by the number of shares.
(b)
• The question requires the estimate of the percentage gain in value to a Nente Co share and a Mije Co share under
each payment offer: cash or share exchange.
• For the cash offer the gain/loss is the difference between the current market price of Nente Co’s shares and the
cash paid to Nente Co’s shareholders per share.
• For Mije Co, the gain/loss is the difference between the current market price and the post-acquisition market price
using the P/E ratio method of share valuation. Remember to deduct the cash paid out (the purchase consideration)
as this reduces the company’s wealth and remember to increase the earnings by the amount of the synergies
arising.
• For the share exchange the gain/loss is still the difference between the current market price and the post-acquisition
market price of Mije Co shares, using the P/E ratio method of valuation.
• But remember, the number of shares of Mije Co will increase by the Mije shares issued to acquire Nente Co’s
shares.
• For Nente Co shareholders, remember to compare the value of their current three shares to the post-acquisition
value of two shares in Mije Co.
(c)
• The value of the option to follow up is a call option and can be calculated using the Black-Scholes model.
• It is nesccessary to identify the five variables needed for the call value, and substitute them in the formula given on
the formula sheet.
(d)
• Discuss the outcome of the calculations by analysing whether the shareholders would prefer a cash offer or share
exchange. The deciding factor is which one provides the best gains.
• The calculations in requirements (a) and (c) are fairly straightforward and candidates should be able to obtain good
marks.
• The answer should be presented in a report format. Professional marks will be awarded for the appropriateness and
format of the report.

Reaction of Nente Co and Mije Co shareholders to the takeover offer

The shareholders of Nente Co and shareholders of Mije Co would accept the acquisition proposal and the method of
payment based on whether their wealth would increase, that is if it would increase the value of their shares and/or
cash holdings.
Nente Co shareholders
Under the cash offer, Nente Co shareholders would make a gain of 5 cents per share representing only a 1.7%
increase in wealth. Even though the cash offer is certain, the shareholders would not be part of the combined
business, and given the minimal increase in wealth they are unlikely to accept this cash offer. However, the share-for-
share exchange would increase their wealth by approximately 18%, and given the general acceptable premium level of
about 20%, and the fact that this 18% is greater the value of the option to delay (follow-up product) they may prefer the
share-for-share exchange.
Mije Co shareholders
Mije co shareholders would be happy for either payment options as either lead to an increase in the share price.
However, the cash offer produces a better increase in wealth (9.4%) than the share for share exchange (6.4%), and
given that fact the control would not be diluted using the cash offer, they may prefer the cash offer to the share-for-
share exchange. They may also be concerned about whether there are other investment opportunities that are better
than acquiring Nente Co.

The major assumptions made in the estimations include:

– The calculation of Nente Co’s current market price was based on the assumption that the free cash flows would grow
at a constant growth rate of 2.06% to infinity, the cost of capital used is consistent with the risk of the company, and
that the company would be in operational existence to infinity.
 – In calculating the post-acquisition market price the P/E ratio method was used, on the assumption that the P/E ratio
of the combined business would remain constant at 15 times earnings. It was also assumed that the combined
activities would reduce costs by $150,000 per year, resulting in an increase in market value of the combined
business.
– The calculation of the value of option to delay was based on the principles of Black-Scholes model, on the
assumption that the option can only be exercised at the end of the two years but it appears that the option could be
exercised any time during the period. It was also assumed that the risk associated with the present value of the cash
flows are accurately measured by the standard deviation of 32% and that all the variables used remain constant
over the period.
How the follow-on product’s value can be utilised by Nente Co
The option relating to the follow-on product has a value of $609,021 and Nente Co can use that value to convince Mije
Co to increase the initial cash offer by that amount. This would increase the wealth of Nente Co shareholders by 26.7%
(17.9% + 8.8%).
It can be concluded that Nente Co shareholders should opt for the share-for-share exchange as it would increase their
wealth and also convince Mije Co to increase the original cash offer by the value of the right to the follow-on product.
Appendix 1
Estimating the current value of a Nente Co share, using the free cash flow to firm methodology:
Corporate value is the present value of free cash flow using the WACC as the discount factor:

FCF = PBIT – tax + non cash flows – cash investment

FCF = $1,230,000 – ($1,230,000 x 20%) + $1,206,000 – $1,010,000 = $1,180,000
The growth rate g can be calculated using the past profit before interest and tax growth adjusted by the 25% as stated
in the question;
g = (1,230/970)1/3 – 1 = 0·0824
Adjusting by 25%, 0.0824 x 25% = 0·0206.
WACC is given in the question as 11%.

Equity value = corporate value – debt value

Equity value = $13,471,000 – $6,500,000 = $6,971,000
Price per share = $6,971,000/2,400,000 shares = $2·90
Appendix 2
Estimating the percentage gain in value to a Nente Co share and a Mije Co share under each payment offer:
Cash offer:
Nente Co shareholders will receive $2.95 per share upon the takeover against the current share price of $2.90.
Gain per share = $2.95 - $2.90 = $0.05 per share, = 0.05/2.90 = 1.7% increase.
Mije Co shareholders gain/loss can be calculated by comparing the current market price to the market price
immediately after the acquisition of Nente co.
Current share price =$4·80
Revised share price after acquisition using P/E ratio method of valuation:

Combined earnings of two companies = $3,200,000+ $620,000 = $3,820,000

Add cost savings (synergy) = $150,000

Total combined earnings after acquisition = $3,970,000

P/E ratio post-acquisition given as 15 times

Value of company post-acquisition before payment of Nente shares

= 15 x $3,970,000 = $59,550,000

Less cash paid to Nente shareholders ($2·95 x 2,400,000 shares) = $(7,080,000)

Value of company post-acquisition =$52,470,000

Total number of shares after acquisition (same as that of Mije Co) = 10,000,000 shares

Market price post-acquisition = $52,470,000 /10,000,000 = $5.25

Gain to Mije shareholders = 5.25 – 4.8 = 0.45 = 0.45/4.8 = 9.4% increase.
Under a share-for-share exchange where Nente Co shareholders would receive two Mije Co shares for three of their
shares:
Number of shares in combined company:

Mije shares before acquisition = 10,000,000

New shares issued to acquire Nente (2,400,000 x 2/3) =1,600,000

Total number of shares after acquisition = 11,600,000

Total combined earnings after acquisition (see above) = $3,970,000

Market value post-acquisition = $3,970,000 x 15 (P/E ratio) = $59,550,000

Market price post-acquisition = $59,550,000/11,600,000 = $5.13
Gain to Mije shareholders = 5.13 – 4.8 = 0.33 = 0.33/4.8 = 6.9% increase.
Gain to Nente’ shareholders:
Value of the current three shares = 3 x $2.90 = $8.7
But the three shares will give two shares in the new business with a value of = 2 x $5.13 =$10.26
A gain of =$10.26 – $8.7 = $1.57. As a percentage, 1.57/8.7 = 17.9%
Appendix 3
Estimates the percentage gain upon the option to delay: Follow-On Product:
The value of the option to delay should be calculated using the Black-Scholes option pricing model.

Pa = PV of future positive cash flows = $2,434,000

Pe = Initial cost of project = $2,500,000

T = Time to expiry of option = 2 years

R = Risk free rate (estimate) = 3·2%

S = Volatility = 42%

d1 = [ln(2,434/2,500) + (0·032 + 0·5 x 0·422) x 2]/(0·42 x 21/2) = 0·36

N(d1) = 0·5 + 0.1406 = 0·6406
d2 = 0·359 – (0·42 x 21/2) = – 0·24
N(d2) = 0·5 – 0.0948 = 0·4052
Value of option to delay the decision = 2,434,000 x 0·6406 – [2,500,000 x 0·4052 x e–(0·032 x 2)]
= $1,559,220 – $950,199 = $609,021
Gain per share = $609,021/2,400,000 = 25.4 cents = 0.254/2.90 = 8.76%
65. Prospice Mentis University (December 2010)
A joint venture is a strategic alliance between two or more individuals or entities to engage in a specific project or
undertaking. Parties enter joint ventures to gain individual benefits, usually a share of the project returns.
The benefits of PMU entering into a joint venture, instead of setting up independently in Kantaka, may include the
following:
• PMU may have access to greater resources, including specialised staff and technology when it enters into the joint
venture. The company would have access to the partner’s infrastructure and systems and may also be able to utilise
the expertise of the local academic and administrative staff. This would lead to a decrease in the initial capital
requirement and also the costs of training academic staff.
• Joint ventures can be flexible. For example, the joint venture is of a limited life span and PMU will only cover part of the
venture operations, thus limiting both the company’s commitment and the business' exposure.
• Any risk associated with the joint venture would be shared between PMU and the venture partner. For example, a well-
constructed contract could be instrumental in effective risk sharing in case the demand and revenues do not grow as
expected.
• PMU may have access to the experience of the venture partner when it enters into the joint venture arrangement. The
company has no operational experience in Kantaka and the venture partner may provide valuable guidance with
respect to pricing and effective marketing of the degree programmes.
• The joint venture arrangement may enable PMU to gain access to the local capital markets in Kantaka. This can even
help in managing exchange rate risk as the amount raised in the local currency together with its interest would be
matched with the same local currency the revenue is generated (a natural hedge).
The disadvantages of PMU entering into a joint venture instead of setting up independently in Kantaka may include the
following:
• It takes time and effort to build the right relationship and partnering with another business can be challenging. This may
be due to the fact that the objectives of the venture are not 100 per cent clear and communicated to everyone
involved. To resolve this problem PMU should have legal representation and there should be clear communication
channels between senior managers of the parties, clear terms and conditions, clear definition of roles and
responsibilities of each party, together with the ownership percentages agreed and the profit sharing arrangements.
• There may be differences in cultures and management styles, resulting in poor integration and co-operation. This can
be resolved through staff exchange programmes and secondments as well as other training programmes to help
expatriate staff settle into Kantaka.
• The joint venture may lead to loss of reputation. It seems that, due to historical reasons, the Kantaka government may
not treat the joint venture favourably by not recognising the degrees issued and not allowing the graduates to seek
employment in government controlled organisations. In addition to this, joint ventures have a low reputation with the
local population. PMU needs to consider its wider reputation as well. For example, there may be negative publicity if
the institution chosen has a poor reputation. In order to mitigate this, PMU needs to choose a partner carefully through
detailed due diligence. It should consider linking with an institution with a high reputation and perhaps meet with and
petition the government to give public and official backing to its degree programmes. However, this may take
considerable time and effort. PMU also needs to consider whether the government will recognise its degrees if it sets
up its own site. It is not clear from the question whether this is the case.
• The joint venture may also lead to a loss of control. The management of PMU would not have total control over the
operations of the venture as they would have to share the control with the management of the venture partner. This
may result into conflicts of interest, as each party’s managers may try to pursue the objectives of their respective
company against the objective of the venture. This problem can be mitigated by establishing clear guidelines, properly
communicated to prevent managers from any dysfunctional behaviour.
• There may be some government restrictions which would reduce the potential success of the joint venture. For
example, there may be visa restrictions preventing staff from Rosinante to travel to Kantaka and also the government
may block PMU from repatriating funds from Kantaka to their shareholders. PMU would need to meet with government
officials or seek legal advice to clarify situations such as these.
• There may be difficulties in maintaining quality standards and any lower quality might affect the standing of the brand
name in international markets. This is particularly the case if local teaching staff would be used to deliver on the degree
programmes. To resolve this problem local staff must be properly trained to ensure that the correct standards are
achieved. If this isn’t possible staff may be brought from Rosinante. PMU should consider the cost of training local staff
against the cost of bringing them from Rosinante and choose the best option.
When embarking on a joint venture it’s imperative that PMU should set out the terms and conditions agreed upon in a
written contract. This will help prevent misunderstandings and provide both parties with strong legal recourse in the event
the other party fails to fulfil its obligations under the contract. A written agreement should cover:
 • The parties involved.
• The objectives of the joint venture .
• Financial contributions each will make and whether any assets or employees will be transferred to the joint venture.
• Intellectual property developed by the participants in the joint venture.
• Day-to-day management of finances, responsibilities and processes to be followed.
• Dispute resolution, how any disagreements between the parties will be resolved.
• How, if necessary, the joint venture can be terminated.
• The use of confidentiality or non-disclosure agreements is also recommended to protect the parties when disclosing
sensitive commercial secrets or confidential information.
66. Sigra Co (December 2012)
(a) Current market price of Dentro’s shares
The current market price of Dentro shares can be calculated using the price-earnings ratio method. The question
stated that Dentro Co’s price to earnings ratio is 12·5% higher than Sigra Co’s current price to earnings ratio.
Sigra Co’s P/E ratio = Market value/Earnings
Market value of Sigra = Number of shares × Market price per share
Number of Sigra Co shares = 4,400,000/0·4 = 11,000,000 shares
Market value of Sigra = 11,000,000 × $3.6 =$39,600,000
P/E ratio = $39,600,000/4,950,000 = 8 times.
Dentro PE ratio = 8 × 1·125 = 9
Dentro Market price = P/E ratio × Earnings per share
Dentro Co number of shares = $500,000/0·4 = 1,250,000 shares
Dentro Co EPS = $625,000/1,250,000 = 50c per share
Dentro Co market price per share = $0·5 × 9 = $4·50/share
Cash offer

Cash offered $5

Current market price $4.5

Gain per share $0.5

Percentage gain per share = ($0.5/$4.5) × 100% = 11.11%

Share exchange

Market value of Sigra Co shares = 11,000,000 × $3·60 = $39,600,000

Market value of Dentro Co shares = 1,250,000 × $4·50 = $5,625,000

Synergy savings = 30% × $5,625,000 = $1,688,000

Market value of combined company = $46,913,000

Number of Sigra shares = 4,400,000/0·4 = 11,000,000 shares

Number of shares to buy Dentro = 1,250,000 × 3/2 = 1,875,000 shares
Total number of shares of the combined business = 12,875,000 shares
Market price of combined business = $46,913,000/12,875,000 shares = $3.64 per share.
Percentage gain:
Dentro’s three shares in combined business value = 3 × $3.64 = $10.92

Denton’s two shares values before acquisition = 2 × $4.5 = $9.00

Gain = $1.92

Percentage gain = (1.92/9) × 100% = 21.33%

Bond offer
Note: The market value of the bond was not given but Sigra Co has other bonds with a coupon rate of 6% and market
value of $104 per $100 par value.
The market value of redeemable bond is the present value of interest and redemption value using cost of debt
(redemption yield or internal rate of return) as the discount factor. We are assuming the cost of the 6% bond is the
same as the cost of the 2% bond.
Cost of 6% bond (IRR)

Year Cash flows DF (5%) PV DF (3%) PV

0 market price (104) 1.000 (104) 1.000 (104)

1 – 3 Interest 6 2.723 16.34 2.829 16.97

3 Redemption value 100 0.864 86.4 0.915 91.5

NPV (1.26) 4.47

IRR = Cost of debt = 3% + (4.47/4.47 + 1.26) × (5% − 3%) = 4.56%

Value of the 2% bond:

Year Cash flow DF (4.56%) PV

1 interest 2 0.956 1.912

2 interest 2 0.915 1.830

3 interest + redemption value (2 + 100) = 102 0.875 89.25

MV = 92.992 say $93.00

Using bonds with a value of $93 to pay for 16 shares represents a price per share of: $93/16 = $5.81 per share.

Price offered $5.81

Current price $4.50

Gain per share $1.31

Percentage gain = (1.31/4.5) × 100% = 29.11%

The cash offer generated a gain of 11.11%. With the cash offer the price that Dentro Co shareholders will receive is
obvious. It is not like a share exchange where movements in the market price may change their wealth. The cash
purchase will increases the liquidity of Dentro shareholders who are in position to alter their investment portfolio to
meet any changing opportunities. A disadvantage to Dentro shareholders’ of receiving cash is that they will be liable to
capital gains tax immediately. For Sigra Co, the cash offer may represent a quick and easily understood approach
when resistance is expected and the value of the bid is known, which may encourage Dentro’s shareholders to sell
their shares. Also the shareholders of the Dentro Co are bought out and will have no further participation in the control
and profits of the combined entity. However, Sigra Co will deplete the company’s liquidity position and may increase
gearing.
 The share-for-share exchange generated a gain of 21.33% for Dentro’s shareholders. In addition, capital gains tax is
delayed and the shareholders will participate in the control and profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange, where the movements in the market price
may change their wealth. For example, the market price after acquisition is dependent on the value of synergy,
estimated as 30% of the value of Dentro Co. For Sigra Co, the share exchange will preserve the liquidity position of the
company as there are no outflows of cash. However, it will result in a dilution of control. Also, under the share
exchange, more of the synergy gains of $1,199,813 (1,250,000 shares × 21.33% × $4.50) would be transferred to
Dentro Co’s shareholders compared to $624,937 (1,250,000 × 11.11% × $4.5).
The bond offer provides the highest return of 29.11% to the shareholders of Dentro Co and at the same time Sigra Co
would not have to deplete its liquidity position nor dilute its control, as the debt will be paid in three years’ time and no
shares would be issued. It appears this may be attractive to both parties.
(b) The regulation of takeovers varies from country to country and mainly concentrates on controlling directors in order to
ensure that all shareholders are treated fairly.
Proposal 1
This proposal gives Sigra Co ‘squeeze-out rights’, where Sigra Co can force minority shareholders to sell their shares
if it obtains a majority of the shares above the squeeze-out rights limits. Different countries have different squeeze-out
rights limits. For example, the limit in Germany and the Netherlands is 95%; it is 80% in Ireland and 90% in the UK.
This implies that Sigra Co will need a very large proportion of Dentro Co’s shareholders to agree to the acquisition
before they can force the rest of Dentro Co’s shareholders to sell their shares. Dentro Co’s minority shareholders may
also require Sigra Co to purchase their shares, known as sell-out rights.
Proposal 2
Takeover regulations require that all shareholders must be treated equally and fairly with respect to timing and
availability of information as well as the terms offered to them. As a result, both minority and majority shareholders
must be given the same terms by Sigra Co. Therefore Sigra Co cannot offer extra 3 cents per share, in addition to the
bid price, to 30% of the shareholders of Dentro Co on a first-come, first-serve basis, as an added incentive to make the
acquisition proceed more quickly. This is because the remaining 70% would not receive the extra 3 cents per share
and the requirement for equal and fair treatment of shareholders will not be met.
67. Strom Co (December 2012)
(a) International Monetary Fund (IMF), founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting
world trade and maintaining global monetary stability. It assists countries with balance of payments problems by
making loans in the form of Special Drawing Rights. Such loans are normally dependent upon the country concerned
making strict internal financial adjustments to solve their economic problems.
The IMF promotes international monetary cooperation through a permanent institution which provides the machinery
for consultation and collaboration on international monetary problems. It facilitates the expansion and balanced growth
of international trade, and contributes thereby to the promotion and maintenance of high levels of employment and real
income and to the development of the productive resources of all members as primary objectives of economic policy.
The IMF also promotes exchange stability, to maintain orderly exchange arrangements among members, and to avoid
competitive exchange depreciation. It assists in the establishment of a multilateral system of payments in respect of
current transactions between members and in the elimination of foreign exchange restrictions which hamper the
growth of world trade. It also gives confidence to members by making the general resources of the Fund temporarily
available to them under adequate safeguards, thus providing them with the opportunity to correct maladjustments in
their balance of payments without resorting to measures destructive of national or international prosperity.
In addition to financial assistance, the IMF also provides member countries with technical assistance to create and
implement effective policies, particularly economic, monetary, and banking policy and regulations.
The IMF makes any loan given to a country conditional on the implementation of certain economic policies, which
typically include the following: reducing government borrowing (higher taxes and lower spending); higher interest rates
to stabilise the currency; allowing failing firms to go bankrupt; and structural adjustments (privatisation, deregulation,
reducing corruption and bureaucracy). Austerity policies have worked at times but always extract a political toll, as the
impact on average citizens is usually quite harsh when deflationary pressures cause standards of living to fall and
unemployment to rise.
The austerity measures have affected Strom Co negatively, as its sales revenue has decreased by 15% and profit has
decreased by 25% in 2011, and remained constant in 2012. The reasons could be attributable to the fact that as the
austerity measures increased unemployment, disposable income of customers are reduced and therefore customers
have reduced their expenditure on clothes in order to finance food and other more pressing needs. In addition to this,
government may have increased taxes, which has the effect of reducing the net pay of the remaining few customers
who are still in employment.
 Strom Co may also have undertaken an aggressive marketing campaign and reduced prices in order to encourage
customers to buy their products. Given that the percentage fall in sales revenue was less than the percentage fall in
profit, this an indication that the company embarked on aggressive marketing, increasing selling and distribution costs
and therefore resulting in a massive fall in profit.
(b) Clothing retailers at low price range
The austerity measures will increase unemployment and tax charges, therefore reducing disposable income of the
population, especially low income and middle income earners. The austerity measures may be beneficial to the low
price range retailers, as the population of middle and low income groups may prefer to buy low price clothes, due to
lower earnings, which thereby increases the sales revenue of low price range retailers.
Clothing retailers at high price range
The austerity measures are less likely to affect the high price range retailers as most of the population who buy
expensive clothes are rich and are not normally affected by austerity measures. They are also brand sensitive and are
not likely to change their preference from the high price range to middle or low price range clothes.
(c) Quality control seeks to integrate all organisational functions to focus on meeting customer needs and organisational
objectives. Reduction in the cost of quality control would lead to less inspection and monitoring of the company’s
activities, which may have many risks and consequences such as the following:
Defective products
Quality control has a strong emphasis on improving quality within a process, rather than introducing quality into a
process. This not only reduces the time needed to fix errors, but makes it less necessary to employ a team of quality
assurance personnel. By reducing the resources allocated to quality control, defective products sold may increase and
the cost of processing returned goods and refunds may be higher.
Staff engagement
By reducing the resources allocated to quality control, the company is not likely to engage more of its employees in
becoming responsive to the needs and requirements of its customers. This may reduce staff morale and employees
may also be less aware of, and encouraged to achieve the company’s objectives. Employing turnover may be high,
hence increasing the cost of hiring and training new employees.
Customer satisfaction
Reducing the cost of quality control may reduce customer satisfaction, as defective product sales increases. Lower
quality and defective clothes could seriously harm the company’s reputation, as there will be more customer
complaints leading to lower sales and reduction in market share. The company loses customer goodwill and their
reputation is damaged when the customer relates his/her experience to others. In extreme cases, litigation may result,
adding even more cost and loss of goodwill.
Supplier practices
By reducing the cost of quality control the company may reduce the inspection and monitoring of supplier practices in
relation to employment, sourcing of raw materials and general working conditions. The company may not be able to
meet industry standards and regulations and hence may be seen as unethical, leading to loss of investors, customers
and negative publicity from the press.
Reduction of the detrimental impact
Reducing the cost of quality control may have several detrimental effects on the company as stated above. The
company should have a robust and well-structured procedure to ensure that such cost reduction will not damage the
reputation of the company. To achieve this, the company should review the current quality control procedures to
identify and eliminate all duplicated processes, as well as unnecessary procedures. The company can also assess
alternative processes which are more cost effective (requiring less resource) and are efficient in ensuring that product
quality, customer satisfaction and company reputation are not compromised. The risk factors affecting the process
should be identified and analysed by management before implementing any new procedures. The new processes
must be monitored regularly to ensure that they are achieving their intended purpose.
68. Hav Co (June 2013)
(a) The main reason why companies combine is to maximise shareholders’ wealth. This implies that combination would
take place only if the value of the combined entity is more than the value of the individual firms. This is called synergy.
Synergy occurs in situations where two or more activities or processes complement each other to the extent that their
combined effect is greater than the sum of the part.
Value of A plc and B plc combined > Value of A plc operating independently + Value of B plc operating independently
There are three types of synergies: revenue, cost and financial.
Revenue synergies
Revenue synergies refer to the ability to sell more products/services or increase prices as a result of the combination.
 Examples of revenue synergies are:
• Selling complementary products
• Sharing channels of distribution
• Reduction in competition
• Cross-selling to new customer base
Hav Co’s management can help market Strand Co’s products more effectively by using their sales and marketing
talents, resulting in higher revenues and longer competitive advantage. Research and development activity can be
combined to create new products using the technologies in place in both companies, and possibly bringing innovative
products to market quicker.
Cost synergies
Cost synergies refer to the ability of the combined entity to reduce costs, as a result of the consolidation of operations.
Examples of cost synergies are:
• Reduced workforce due to redundancies
• Reduced overheads due to functions such as accounting and IT being combined
• Increased bargaining power due to the increased size of the company
From the scenario it can be realised that costs associated with duplication of functional areas such as in research and
development and head office could be reduced and thus costs saved. Cost synergies may also arise from the larger
company being able to negotiate better terms and lower costs from their suppliers.
Financial synergies
Financial synergies relate to the financial aspects of the acquisition. Examples are:
• The accumulated tax losses of one company being made available to the other
• Surplus cash of the combination being used for expansion
• Diversification reduces the variance of operating cash flows, leading to lesser risk of going bankrupt and
therefore making borrowing cheaper. That diversification reduces risk is however a suspect argument, as it
reduces total risk but not systematic risk for well-diversified shareholders).
From the scenario, it can be seen that Hav Co has cash reserves. However, Strand Co has developed a number of
technically complex products and is constrained by the lack of funds to develop its innovative products further. As a
result of the combination Hav Co’s cash reserve could be utilised to finance the innovative products to the advantage
of the combined business. The acquisition may also reduce the perceived risk of the combined business, hence the
cost of capital of the combined business. In addition, the combined company may enjoy increase in debt capacity,
enabling it to raise more finance to fund new projects.
(b) Maximum premium based on price-to-earnings (PE) ratio method
The maximum premium is the difference between the value of the combined business and the sum of the current
values of the individual companies.
Value of combined business: Combined P/E ratio × Combined earnings

Combined earnings:

Hav Co profit after tax = $1,980m × 0·8 = $1,584·0m

Profit after tax Strand Co: $397m × 0·8 = $317·6m

Synergy earnings after tax = $140·0m

Earnings of combined business = 2041.6

Combined P/E ratio = 14.5

Value of combined business (14.5 × 2041.6) = $29,603·2m

Current market value of Strand Co

P/E ratio of Strand Co = 1·10 × 16·4 = 18·0 times
 Profit after tax Strand Co: $397m × 0·8 = $317·6m
Current market value of Strand Co = $317·6m × 18·0 = $5,716·8m
Current market value of Hav = $9·24 × 2,400 shares = $22,176·0m
Maximum premium = $29,603·2m – ($22,176·0m + $5,716·8) = $1,710·4m
Maximum premium based on excess earnings
The maximum premium is calculated as the present value of the average after tax excess earnings.
Average capital employed (capital employed = total assets – current liabilities)
= {(882 + 210 – 209) + (838 + 208 – 180) + (801 + 198 – 140)}/3 years = $869·3m
Average pre-tax earnings: (397 + 370 + 352)/3 years = $373·0m
Excess annual earnings before tax = 373m – (20% × $869·3m) = $199·1m
Excess annual earnings after tax = $199·1m × 0·8 = $159·3m
Maximum premium = $159·3m/0·07 = $2,275·7m
(c) Only cash offer:

Price offered per share: $5.72

Current price per share ($5,716·8m/1,200m shares) = $4·76

Premium per share $0.96

Percentage premium = (0.96/4.76) × 100% = 20.2%

Cash and share offer:

Cash offer per share $1·33

Share offer (1 Hav Co share for 2 Strand Co shares, but Hav share is at the price of $9.24).

Strand 2 shares are valued at $9.24, hence price per Strand share (9.24/2) $4.62

Total value offered per share 5.95

Current price of Strand Co 4.76

Premium per share 1.19

Percentage premium = (1.19/4.76) × 100% = 25%

Cash and bond offer:

Cash offer per share $1·25

Bond offer

Each share has a nominal value of $0·25, therefore $5 is $5/$0·25 = 20 shares

Bond value per share ($100/20 shares) $5.00

Total value offered per share 6.25

Current price of Strand co 4.76

Premium per share 1.49

Percentage premium = (1.49/4.76) × 100% = 31.3%

 From the above calculation the cash and bond offer provides the highest premium as compared to only cash or cash
and share offer. It can be argued that the shareholders of Strand Co are more likely to accept the cash and bond offer
because the convertible bond has the right to be converted into shares in the future, hence if the combined company’s
share price increases in the future they can convert the bonds into shares. However, if the share price falls in the
future, they can redeem and collect cash. Accepting the share exchange carries some uncertainty as the share price
may fall in the future.
69. Makonis Co (December 2013)
(a)

Year 1 2 3 4

Free cash flow before synergy (216 × 1.05) 226.8 238.14 250.05 262.55

Synergy 20 20 20 20

Total free cash flow 246.8 258.14 270.05 282.55

DF 9% 0.917 0.842 0.772 0.708

PV of FCF 226.32 217.35 208.48 200.05

PV 1 – 4 $852.20

PV 5 to infinity (262·55 × 1·0225)/(0·09 – 0·0225) × 0.708 =$2,815·82

Total value of company (corporate value) = $852.2 + $2,815·82 =$3668.02

Less value of debt (40% × $3668.02) =$1467.21

Value of equity (60% × 3668.02) =$2200.82

Workings
Combined cost of capital:
Combined Asset beta = (1·2 × 480 + 0·9 × 1,218)/(480 + 1,218) = 0·985
Combined Equity beta = 0·985 × (60 + 40 × 0·8)/60 = 1·51
Combined Cost of equity 2% + 1·51 × 7% = 12·57%
Combined Cost of capital (12·57% × 0·6) + (4·55% × 0·8 × 0·4) = 9·00%
Comment
The equity value of the combined business ($2,200.82) is higher than the equity value of the individual companies
$1,664 ($5.8 × 200 + $2.4 × 210). This is as a result of the $20 million synergy per year for the first four years.
Assumptions:
1. It is assumed that growth rates, tax rates, free cash flows, risk free rate of return and risk premium are accurate and
constant.
2. It is assumed that the combined company’s asset beta is the weighted average of Makonis Co’s and Nuvola Co’s
asset betas, weighted by their current market values.
3. It is assumed the combined business is a going concern and will be in operational existence into infinity.
(b) Value of Nuvola equity = $2·40 × 200m shares = $480m
Extra premium payable = (50% − 30%) × $480 = $96m
Number of shares post acquisition = 210m + ½ × 200m = 310m
Makonis Co shareholder will lose = $96/310 = $0.31 per share, representing 5.3% of the current market price of $5.8
(0.31/5.8 × 100%).
(c) Additional funds required = (50% − 30%) × $480 = $96m
 Makonis Co could raise the extra $96 million from debt or by issuing equity shares. Debt is a cheaper source of capital
than equity as debt holders take less risk and debt interest is a tax allowable expense. However, raising debt capital
will increase the gearing and financial risk of the company, hence will have an effect on the company’s cost of capital.
Raising equity capital may lead to dilution in control and possible dilution in earnings per share. This may not be
acceptable to the existing shareholders.
Alternatively, Makonis Co could issue more shares under the share-for-share exchange in order to pay the extra
premium. This will also dilute control and may not be acceptable to the Makonis Co shareholders. The company
should also consider what the target shareholders may prefer, taking into account immediate capital tax implications.
70. Vogel Co (June 2014)
(a)
A benefit of acquisition is the opportunity to realize synergies between the merged companies. In other words, are
there areas where the combined enterprise will benefit in ways that neither company could have benefitted on its own?
Increased efficiency, lower overhead, greater scale and shared resources are a few examples of these types of
synergies. Reducing your costs and overheads through shared marketing budgets, increased purchasing power and
lower costs.
Through acquisition the company can oobtain quality staff or additional skills, knowledge of your industry or sector and
other business intelligence.
Accessing funds or valuable assets for new development. Better production or distribution facilities are often less
expensive to buy than to build. Look for target businesses that are only marginally profitable and have large unused
capacity which can be bought at a small premium to net asset value.
Accessing a wider customer base and increasing your market share. Your target business may have distribution
channels and systems you can use for your own offers.
Diversification of the products, services and long-term prospects of your business. A target business may be able to
offer you products or services which you can sell through your own distribution channels.
Reducing competition. The company may be buying a competitor who will no longer be competitor against it and its
competitive position should be improved.
Organic growth, ie the existing business plan for growth, needs to be accelerated. Businesses in the same sector or
location can combine resources to reduce costs, eliminate duplicated facilities or departments and increase revenue.
(b)
Vogel Co can take the following actions to reduce the risk that the acquisition of Tori Co fails to increase shareholder
value. Since Vogel Co has pursued an aggressive policy of acquisitions, it needs to determine whether or not this has
been too aggressive and detailed assessments have been undertaken. Vogel Co should ensure that the valuation is
based on reasonable input figures and that proper due diligence of the perceived benefits is undertaken prior to the
offer being made. Often it is difficult to get an accurate picture of the target when looking at it from the outside. Vogel
Co needs to ensure that it has sufficient data and information to enable a thorough and sufficient analysis to be
undertaken. The sources of synergy need to be properly assessed to ensure that they are achievable and what actions
Vogel Co needs to undertake to ensure their achievement. This is especially so for the revenue-based synergies. An
assessment of the impact of the acquisition on the risk of the combined company needs to be undertaken to ensure
that the acquisition is not considered in isolation but as part of the whole company. The Board of Directors of Vogel Co
needs to ensure that there are good reasons to undertake the acquisition, and that the acquisition should result in an
increase in value for the shareholders. Research studies into mergers and acquisitions have found that often
companies are acquired not for the shareholders’ benefit, but for the benefit or self-interest of the acquiring company’s
management. The non-executive directors should play a crucial role in ensuring that acquisitions are made to enhance
the value for the shareholders. A post-completion audit may help to identify the reasons behind why so many of Vogel
Co’s acquisitions have failed to create value. Once these reasons have been identified, strategies need to be put in
place to prevent their repetition in future acquisitions. Procedures need to be established to ensure that the acquisition
is not overpaid. Vogel Co should determine the maximum premium it is willing to pay and not go beyond that figure.
Research indicates that often too much is paid to acquire a company and the resultant synergy benefits are not
sufficient to cover the premium paid. Often this is the result of the management of the acquiring company wanting to
complete the deal at any cost, because not completing the deal may be perceived as damaging to both their own, and
their company’s, reputation. The acquiring company’s management may also want to show that the costs related to
undertaking due diligence and initial negotiation have not been wasted. Vogel Co and its management need to guard
against this and maybe formal procedures need to be established which allow managers to step back without loss of
personal reputation. Vogel Co needs to ensure that it has proper procedures in place to integrate the staff and systems
of the target company effectively, and also to recognise that such integration takes time. Vogel Co may decide instead
to give the target company a large degree of autonomy and thus make integration less necessary; however, this may
result in a reduction in synergy benefits. Vogel Co should also have strategies which allow it sufficient flexibility when
 undertaking integration so that it is able to respond to changing circumstances or respond to inaccurate information
prior to the acquisition. Vogel Co should also be mindful that its own and the acquired company’s staff and
management need to integrate and ensure a good working relationship between them.
(c)
The maximum premium is the difference between the post-acquisition value and the pre-acquisition value.
Total Value obtained:
(i) Net amount realised from sale of department C

Proceeds from sale of Non-current assets = 98.2 x 20% x 100% 19.64

Proceeds from sale of Current assets = 46.5 x 20% x 90% 8.37

Total proceeds from sale of department C 28.01

Less cost associated with sale of department (3.00)

Less payment of other non-current and current liabilities (20.20)

Net benefit from sale of department C 4.81

(ii) Value of combined business

Market value of Vogel Co equity = $3 x (190/0.5) $1140

P/E ratio of Vogel Co 1140/158.2 x0.8 9

P/E ratio of combined Vogel Co and department A = 9 x 1.15 10.36

Earnings of combined Vogel Co and department A

Vogel Co earnings (158.2 x 0.8) 126.56

Department A’s earnings (50% x 23 x 0.8) 9.20

Synergy 7.00

Post combination earnings 142.76

Value of combined Vogel Co and department A = 142.76 x 10.36 = 1479

(iii) Value created from spinning off Department B into Ndege Co
Free cash flow of Ndege Co
FCF = PBIT – tax + Capital allowances – working capital – capital expenditure

PBDIT (0·4 x $37·4m) 14·96

Less: attributable to Department C (10%) (1·50)

13.46

Less: tax allowable depreciation (0·4 x 98·2 x 0·10) (3·93)

PBIT 9·53

Tax (20%) (1·91)

Free cash flows 7·62

 Value is the present value of future free cash flows:

Year FCF DF 10% PV

1 (7.62 x 1.2) 9.14 0.909 8.31

2 to infinity 9.14 (1.052) 0.909

0.1 – 0.052 182.09

Total PV = corporate value 8.31 + 182.09 = 90.40

Less value of debt = 40.00

Value of equity of 150.40

(iv) Total value post-acquisition

Value of combined Vogel Co and department A 1479.00

Value of equity of Ndege Co 150.40

Net benefit from sale of department C 4.81

1634.21

(v) Pre-acquisition value of the two companies:

Market value of Vogel Co equity = $3 x (190/0.5) $1140

Market value of Tori equity (9 x 1.25 x 23 x 0.8) $207

1347

(vi) Value created

Total value post-acquisition 1634.21

Pre-acquisition value of the two companies: 1347.00

Value created $287.21

Assumptions made:
○ It is assumed that Ndege Co is a going concern will be in operational existence to infinity.
○ The cost of capital of Ndege Co will remain constant to infinity.
○ The free cash flows will increase by 20% in first year and then by 5.2% to infinity.
○ The P/E ratios used to calculate the values are accurate.
○ The net synergy of $7 is also accurate.

Corporate reconstruction and reorganisation, Treasury function

71. Dricom plc

 For a reconstruction to be successful the following principles are to be followed:
• Creditors must be better off under reconstruction than under liquidation. If this is not the case they will not accept the
reconstruction as their agreement is a requirement for the scheme to take place.
• The company must have a good chance of being financially viable and profitable after the reconstruction.
• The reconstruction scheme must be fair to all the parties involved, for example preference shareholders should have
preferential treatment over ordinary shareholders.
• Adequate finance is provided for the company’s needs.

Position under liquidation

If Dricom plc is to liquidate, it would have to sell its assets and use the proceeds from the sale to pay its liabilities and any
balance left (if any) would be given to the ordinary shareholders. The position under liquidation would be as follows:

£000 £000

Land and buildings 1,200

Plant and machinery (net) 1,600

Stocks 670

Debtors 1,090

Cash at bank and in hand 35

4,595

Secured debt

9% Debentures 2010 500

8% convertible debenture 1999 1,000

Term loan(from BXT Bank) 800

2300

Amount available after secured debt 2,295

Redundancy payment 1,000

1,295

Unsecured debt

10% Loan stock 2005 500

Overdraft 620

Other creditors 940

2060

It can be seen from the above table that the secured debt holders will receive their capital under liquidation, but the
unsecured debt holders will receive only 63% (1295/2060 × 100%) of their capital, on the assumption that all the
unsecured debt are ranked equally. The ordinary shareholders will not receive anything upon liquidation. Remember a
company is limited liability.

Sufficiency of the amount of finance

£000
 Inflows

Sale of machinery 300

Venture capital organisation 1,000

Directors and employees 750

Additional bank loan (2000 – 800) 1,200

3250

Outflows

Purchase of new machinery 2,250

Redundancy payment 500

Purchase of ordinary shares 280

3,030

Net cash flows 220

Balance b/f 35

Balance c/d 255

The reconstruction scheme would provide sufficient cash resources to finance the reconstruction, but the analysis above
have ignored any increase in working capital needed to finance the anticipated increase in sale.

Position after reconstruction

£000

Land and buildings 1,200

Old plant and machinery (net) 1,300

New machine 2,250

Stocks 670

Debtors 1,090

Cash at bank and in hand 255

6,765

Secured debt

9% Debentures 2010 500

Overdraft 620

Term loan (from BXT Bank) 2,000

(3120)

Amount available after secured debt 3,645

Redundancy pay (500)

 Unsecured debt

10% Loan stock 2005 500

Other creditors 940

(1440)

Amount remaining 1,705

The position of debt holders have improved under reconstruction if the realisable values of the asset are not less than the
figures used in the above table.

Assessing the fairness of the scheme and the possible reactions of the parties
Existing ordinary shareholders
The existing shareholders will receive nothing under liquidation but under the reconstruction scheme they are offered 28
pence per share which represents a premium of 22% over the current market price of the shares and therefore it may be
attractive to them to sell their stake in the company. The major concern will be that after selling the shares the existing
shareholders are bought out and will not be involved in future control and share of profits of the new reformed company.
They may prefer an offer of new shares to cash and may lead to their rejection of the scheme.
BXT Bank
Dricom plc currently owes BXT bank, term loan of £800,000 and an overdraft of £620,000. If the company is to liquidate,
the bank will receive the full amount of the term loan but will lose 37% of the overdraft amount, whereas under
reconstruction the bank will receive the full amount of both overdraft and the term loan. The position is better under
reconstruction than under liquidation. However, the reconstruction depends on the bank increasing the loan to £2m and
whether the bank will be prepared to provide the additional loan will depend upon the assessment of the future
performance of the company in terms of their ability to pay interest and principal. Given an interest cover of 1.8 times
immediately after reconstruction, the bank may not be satisfied to provide the extra loan.
Straight debenture holders
The position of the straight debenture holders remains the same. In either liquidation or reconstruction they are likely to
receive their full amount and therefore may require an incentive, such as warrants, on the debenture before agreeing to
the reconstruction.
Loan stock holders
The position of loan stock holders is better under reconstruction than under liquidation. Being an unsecured debt, they are
likely to receive the full amount under reconstruction but will only receive 63% of their capital under liquidation. As a result,
loan stock holders are likely to accept the reconstruction.
Other creditors
The position of other creditors is also better under reconstruction than under liquidation. They are likely to receive their full
payment under reconstruction but would lose 37% of the amount under liquidation, just like loan stock holders. Other
creditors are likely to accept the reconstruction scheme.
Convertible debenture holders
Convertible debenture holders are likely to receive the full amount of their capital upon liquidation but have been asked to
take new risky ordinary share under reconstruction. In addition they are asked to pay a higher effective price of 157 pence
(94/60) per share. The directors and employees will be paying 150 pence per share and the venture capital organisation
will be paying 143 pence (£1 million/700,000) per share. Even if they were willing to exchange their debentures into
shares, which is unlikely due to the risk, they would not be prepared to pay a price higher than the directors/employees
and venture capital organisation. They are not likely to accept the reconstruction.
Directors and employees
Although the directors have presumably agreed to participate in purchase of the shares the attitude of the employees is
not known. The employees may not be willing to buy the shares or may lack money to subscribe to the amount of shares
on offer.
Venture capital organization
Under the proposed reconstruction scheme 1.8 million new 25 pence par value shares would be issued, of which the
venture capital organization would own 700,000 shares, representing about 39%. They would bear a major risk and may
not accept the reconstruction.

Post-reconstruction financial viability and profitability

 Given the information available, the earnings per share, interest cover, and price earnings ratio of the company
immediately after the reconstruction can be calculated as follows:

No Tax Tax

£000 £000

Profit before interest and tax 750 750

Interest (W1) 417 417

Profit before tax 333 333

Tax @33% 0 110

Profit after tax 333 223

Profit before interest and tax 750 750

Interest (W1) 417 417

Interest cover 1.8 1.8

Profit after tax 333 223

Number of shares 1,800 1,800

Earnings per share 18.5 pence 12.4 pence

Interest W1

9% Debenture 45

Bank term loan 260

Overdraft 62

10% loan stock 50

417

Assuming a share price of 150 pence, the P/E ratio will be:

No Tax Tax

Market price 150 150

EPS 18.5 12.4

P/E ratio 8.1 12.1

The P/E ratio under the tax option is equivalent to the industry average. However, given the company’s history and a low
interest cover after reconstruction, it is unlikely that investor would be willing to pay 150 pence per share.

Conclusion
The reconstruction scheme is unlikely to succeed as the existing shareholders, convertible debenture holders, venture
capital organization and BXT bank are unlikely to accept the scheme.
72. Mercury Training
(a) Cost of equity capital and weighted average cost of capital
 Firstly, the gearing proportions of Jupiter, the financial services sector and Mercury Training must be extracted from the
question. Furthermore, available beta estimates must be established.

Jupiter Financial Mercury

% Services sector %
%

Debt (D) – given 12 25 30

Equity (E) – balance 88 75 70

E + D – given 100 100 100

ße, provided by the question 1.5 0.9 Not available

It is assumed in all cases that debt is risk-free!

Training accounts for two-thirds (2/3) of the total revenues of Mercury, whilst financial services provides for the other
one-third (1/3) of that company’s total revenue.
The ßa of a training business can be established from the data relating to Jupiter:

The ßa of the financial services sector is as follows:

The proxy asset beta for Mercury is therefore:

The proxy equity beta for Mercury can now be calculated:

The pre-tax cost of debt of Mercury (and Jupiter) is:

The estimated cost of equity of Mercury Training, using CAPM is:

The weighted average cost of capital of Mercury Training is therefore:

The equity cost of capital is used for valuing income flows (such as dividends or free cash flow to equity) which accrue
directly to the equity investor.
The weighted average cost of capital is used for valuing flows attributable to the business entity, such as project cash
flows or net operating profit after tax (NOPAT).
(b) Advice on the likely range of prices
The lowest possible value of the company’s net assets at fair value would be the realisable value of the equity between
a willing buyer and willing seller. This is ($65m ÷ 10m) i.e. $6.50 per share which would represent the lowest level of
any negotiating range.
 Using the dividend valuation model, we estimate the share price at the upper end using the latest dividend per share
(DPS) of 25c per share and the cost of equity capital of 9.68%. Three potential growth rates present themselves:
– The historical earnings growth at 12% p.a. is greater than the company’s equity cost of capital and is therefore not
sustainable over the very long term;
– The anticipated growth rate of the two sectors – weighted according to the company’s revenue from each source i.e.
(⅔ × 6% + ⅓ × 4%) i.e. 5.33%; and
– The rate implied from the company’s reinvestment i.e.:
g = bre = 0.75 × 9.68% = 7.26%
where: b = (1 – DPS) ÷ EPS = (100 – 25) ÷ 100 = 0.75, and
re = 9.68%
The value of the company, using the growth model and the higher of the two feasible growth rates is:

In addition, the share price gives a spot estimate of the value of a dividend stream in the hands of a minority investor. If
the option to float is taken, then a share price of $11.08 could be achieved, especially if a portion of the equity and
effective control are retained. However, if a sale is made to a private equity investor, it may be appropriate to value the
company taking into account the benefits of control. These can be substantial if the purchaser is able to generate
significant synergistic benefits in terms of either revenue enhancement, cost efficiency or more favourable access to
the capital market. Control premiums can be as much as 30% – 50% of the spot price of the equity. In this case an
opening negotiation may start with a share price of ($11.08 × 1.5) = $16.62
(c) Comparison between public listing and private equity finance
To: The Directors of Mercury Training
The two principal sources of large-scale equity finance are either through a public listing on a recognised stock
exchange or through the private equity market.
A public listing represents the traditional approach for a company which has grown beyond a critical size, where the
owners wish to release (in whole or in part) their equity stake in the company, or where they wish to gain access to
new, large scale equity finance. The procedure for gaining a public listing is lengthy and invariably requires
professional sponsorship from a company that specialises in this type of work. Dependent upon the jurisdiction, there
are three stages that may have to be fulfilled before a company can raise capital on a recognised stock exchange i.e.
– Formalise the company’s status as a public limited company, with authority to issue its shares to the general public.
In some jurisdictions, this requires re-registration, whilst in others it is implicit in the conferment of limited liability.
– Seek regulatory approval for admission to an Official List of companies who have met the basic criteria required for
entry to a recognised stock exchange. In the UK, this process falls under the jurisdiction of the Financial Services
Authority.
– Fulfil the requirements of the exchange concerned, which may entail the publication of a prospectus (which is an
audited document) containing, among other things, projections of future earnings and profitability.
The disadvantage of a public listing is that the company will be exposed to stake building by predators; regulatory
oversight by the stock exchange and greater public scrutiny. Stock exchanges require that quoted companies not only
comply with company law (as a matter of course) but they must also adhere to various codes of practice associated
with good governance and takeover procedures. They must also comply with stock exchange rules with respect to the
provision of information to (and their dealings with) shareholders.
Private equity finance (PEF) is the name given to finance raised from investors acting through the mediation of a
venture capital company, or through a private equity business. As the name suggests, these investors do not operate
through the formal equity market, but instead act within the context of the wider capital market for high risk finance.
Because of its position, PEF does not impose the same regulatory regime as the public market. Transaction costs tend
to be lower and there is evidence to suggest that private equity finance offers companies the ability to restructure and
take long-term decisions which may have adverse short-term consequences. In some jurisdictions, there are
favourable tax advantages for private equity investors.
73. Aston Co
(a) Default is defined as that point at which the company is unable to discharge its interest and/or principal payments
when they fall due. From the monthly average cash flow we deduct the monthly interest payment. The monthly
payment is based upon the effective monthly rate as follows:

The expected monthly cash flow will then be:

cm = $14,400 – (0.006434 × $1,500,000) $4,749

To give an annual expected cash flow after interest of (12 × $4,749) $56,988

We now need to determine the probability over the course of 12 months that this figure will fall below zero. For this we
need to calculate the annual volatility of cash flows. Given that the monthly volatility before interest is 13%, we must
translate this to volatility after fixed interest in two stages. First, calculate the gearing, i.e. the proportion of fixed
interest to monthly cash flow (G):

And second, calculate the monthly volatility after interest (σm) as follows:

The annualised volatility is as follows:

Annualised volatility = 0.3942 × 136.55%

Standard deviation of annual cash flows = 136.55% × $56,988 $77,817

Given a critical cash value of zero (i.e. if the cash flow less interest falls below zero), the expected cash difference to
default including the cash in hand or on deposit is:

Annual expected cash flow after interest (see above) 56,988

Plus: Cash in hand or on deposit 8,500

$65,488

This figure represents ($65,488 ÷ $77,817) = 0.842 standard deviations.

Using the standard normal distribution tables, this shows a value between 0.84 (i.e. 0.2995) and 0.85 (i.e. 0.3023).
This indicates a value of 0.3 or a cumulative probability that the cash flow plus reserve will be above the default
probability of 0.8. This shows that there is a 20% chance of failure within the next 12 months.
This may instead be stated as ‘distance to default’:
(12 months × 0.8) = 9.6 months.
(b) Making a loan of this type involves:
– an estimate of the probability of default;
– the potential default loss; and
– the rate the lender needs to charge (to cover the cost of finance in the inter-bank market plus an additional charge
for bearing the risk attaching to the loan).
The probability of default on interest payments is determined by the expected annual cash flow (after interest
payments) and the volatility of that residual cash flow. If (on an annual basis) that cash flow falls below zero, then
default is deemed to occur.
 The next most important issue for a lender is the potential recoverability of its borrowing. This will be governed by a
number of factors:
– the percentage of the loan covered by the company’s net assets (excluding the loan);
– the liquidity of those assets under forced sale;
– the market demand for these assets (and hence their price); and
– any director’s or other guarantees that may be in place.
If the net assets exceed the value of the outstanding loan, then default will not occur as it would be possible for the
company to liquidate some of the surplus asset value to service the debt.
In this case the probability of recovery is 90%, which implies a loss of 10% of the loan in the event of default.
When estimating its potential loss, the bank will calculate the present value of the outcomes over a year of each £1
invested discounted at the risk free rate plus the additional rate of return it requires as compensation for bearing the
risk of default.
Using the following decision tree:

Where: Pr is the probability of default, rd is the rate of return required to compensate for the loss on default, rf is the risk
free rate and rc is the additional return required by the bank for bearing the risk attaching to this loan.
The logic of this calculation is that the bank has put at risk (over 12 months), the value of its original loan (£1) and the
rate of interest it decides to charge (rd). If the bank was indifferent to the outcomes, i.e. it is risk neutral with respect to
those outcomes, then it would discount each of the possibilities at the risk free rate (rf).
However, it is not risk neutral, and rc is the premium it requires to offset its risk aversion.
Putting the information given in the question into an equation:

The equation is then rearranged by multiplying both sides by (1 + rf +rc) and dividing both sides by (1 – pr) + (pr ×
Recovery), and finally by subtracting 1 from both sides, to provide:

To summarise, the bank requires the following:

To cover its own cost of finance on the money market 5.50

To compensate for carrying the risk attaching to the loan 0.34

To cover the expected loss on the loan given the probability 2.16
of default and the potential for recovery

8.00

In practice, the estimation of default probability and recoverability will depend upon a number of judgements about the
credit-worthiness of the business, an assessment of its business plan and the willingness of the lender to finance a
high risk business of this type.
74. Doric Co (December 2010)
The answer should be presented in a report format. Professional marks will be awarded for the appropriateness and format
of the report.
For any of the proposals to be successful all the stakeholders involved must be treated fairly. The stakeholders in this case
are the ordinary shareholders, unsecured bond holders, other unsecured loans, payables, the bank (overdraft) and
executive directors and managers.

Existing ordinary shareholders

The existing shareholders will receive nothing under liquidation, as the amount raised from the sale of assets is not even
enough to pay the existing liabilities. Under restructuring proposal the existing shareholders will lose control as they would
have to contribute extra $40 million to buy new shares for only 13% (40/310) control. Their equity value after restructuring
will be $33.3 million (13% x $256.3m) and this is less than the $40 million injection. However, after restructuring, the
financial position of the company would improve with a cash balance of $20 and no overdraft. This may result in less
restrictive covenants and may make the company more successful in the future. The existing shareholders would benefit
from the management buyout as they would receive a premium on their share price.
The existing shareholders would therefore have to weigh the balance between selling their shares under the management
buyout and contributing $40 million for future growth prospects under restructuring. It appears they might opt for the
management buy-out.

Unsecured Bond holders

The unsecured bond holders will receive only 55.7% of the amount owed to them under liquidation. Under restructuring
they would become majority shareholders with 87% of the total share holdings of the company for total investment of $210
million. This may give them a representation on the board and enable them to influence management decisions. Their
equity value after restructuring will be $222.98 million (87% x $256.3m) which is more than the $210 million investment. In
addition to the above, they would receive the shares at a discount by paying $210 million for 270 million shares,
representing 77 cent for every $1 nominal value. They would also benefit from future returns from investments undertaken
by the company post restructuring. However, turning from debt holders to equity holders exposes them to more risk. Under
management buy-out, the bond holders would be paid the amount due to them immediately but cannot participate in any
future benefit that the management buyout would bring. From the above it appears that the unsecured bond holders may
opt for restructuring instead of the management buy-out.

Executive directors and Managers

The obvious benefit of the restructuring to the managers and directors is that their jobs would be preserved, unlike under
liquidation. The directors of the restructured company will get 4 million $1 share options for an exercise price of $1·10,
which will expire in four years. This option will only be exercised when it is in the money - where the share price exceeds
the exercise price. Given the equity value of $256.3m and 310 million shares, each share will have a value of 82.67 cents
indicating that the share price should increase by at least 33.1% (110 -82.67/82.67) before the option would be in the
money. This may encourage the managers to take decisions to influence the share price. Under the management buy-out,
the directors who are not involved in the buy-out are likely to lose their jobs when the fridge division is sold.

Conclusion
From the above it appears that the shareholders and the participating managers may prefer the management buy-out
whilst the bond holders and non-participating managers may prefer restructuring. No stakeholder will prefer liquidation as it
would not be beneficial to them. The management buy-out is more likely as it has more advantages to both shareholders
and participating managers and those who oppose it may have little influence on the final decision.

APPENDIX:

Proposal 1: Cease Trading

If the company cease trading its assets have to be sold at their net realisable values and the proceeds used to pay off its
liabilities, in order of priority from secured to unsecured liabilities.

$m

Land and Buildings 60

Machinery and Equipment 40

Inventory 90
 Receivables 20

210

Less: redundancy and other costs (54)

Amount available to pay liabilities 156

Current and non-current liabilities

Payables 70

Bank overdraft 60

Unsecured Bonds 120

Other unsecured loans 30

280

The amount available to pay liabilities is less than the liabilities payable and therefore this limited amount should be shared
in a pro-rata basis (the question did not indicate any priority of payment). Therefore the current and non-current liabilities
will receive 55·7% (156/280) of the amount owed to them. The ordinary shareholders will receive absolutely nothing.

Proposal 2: Restructure

Cash position post restructuring $m

Inflows:

Issue of shares to existing shareholders 40

Issue of shares to unsecured bond holders 90

130

Outflows:

Purchases of machinery and equipment 80

Payment of other unsecured loans 30

110

Net cash flow (130 -110) and balance c/d 20

Financial Position post restructuring $m

Non-current Assets

Land and buildings 70

Machinery and equipment (assuming all new investment is here) 130

200

Current Assets

Inventory 180
 Receivables 40

Cash ($40m + $90m – $80m – $30m) 20

240

Total Assets 440

Current Liabilities

Payables 70

Non-Current Liabilities

Bank loan (7% interest) 60

Share capital ($1 per share par value (40m + 270m) 310

Total equity and liabilities 440

Income statement $m

Sales revenue (510 x 1·07) 545.7

Costs prior to depreciation, interest payments and tax (490)

Tax allowable depreciation (15% x 200) (30)

Profit before interest and tax 25.7

Finance cost (interest) (7% x 60) (4.2)

21.5

Tax (20% x 21.5) (4.3)

Profit 17.2

Note: Even after the 7% growth, the fridge division is still loss-making.
Revenue = $340 x 1·07 = $363·8m, costs (unchanged) = $370m.

Free cash flows $m

Profit before interest and tax (from above income statement) 25.7

Tax (20% x 25.7) (5.14)

Net cash flow 20.56

Depreciation is ignored as it cancels the amount of capital investment required to maintain operations.

Value of company after restructuring

The corporate value of the company after restructuring is calculated as the present value of the future free cash flows
using 6.5% cost of capital as the discount factor.
$20·56m/0·065 = $316·3m
Equity value is therefore the difference between the corporate value and value of debt.
Equity Value = $316·3 – $60m (bank loan) = $256·3m
Proposal 3: Management Buy-out
The amount of additional finance needed if the management buy-out proposal is selected can be calculated by comparing
the net cash inflows from the sale of the fridge division and any payment required under the scheme.

$m $m

Proceeds from the sale of fridge division (2/3 x 210 (proposal 1)) 140

Fridge division redundancy and other costs (2/3 x 54) (36)

Net cash inflow from sale of fridge division 104

Amount of current and non-current liabilities 280.0

(proposal 1)

Payment to shareholders under MBO 60.0

Equipment needed to increase sales by 7% (1/3 of 80m) 26.7

Cost of new venture 50.0

416.7

Additional finance needed for MBO 312·7

Value of new company after buy-out

The corporate value of the company after management buy-out is calculated as the present value of the future free cash
flows, using 11% cost of capital as the discount factor.

$m

Sales revenue (70%* x 170m x 1·07) 127·3

Costs (70%* x 120) (84.0)

Profits before depreciation 43.3

Growth in profits due to new venture (5% x 43.3) 2.2

Depreciation (1/3 x 200 x 15%) (10)

35.5

Tax (20% x 35.5) (7.1)

Free cash flows 28.4

Assumptions
• Depreciation is equal to the capital investment needed for operations.
• No additional investment in working capital and non-current assets are needed despite the increase in sales.
• Initial working capital requirement is part of the new venture investment of $50m.
• *30% of the sales revenue is lost due to the closure of the fridge division
Corporate value = $28.4/(0·11 – 0·05) = $473·3m.
75. Proteus Co (December 2011)
(a) The possible benefits to Proteus Co of disposing Tyche Co through a management buy-out include:
– It may be the quickest method of raising cash to improve liquidity.
– If the subsidiary is loss-making, sale to the management will often be better financially than liquidation and closure
costs.
 – There is a known buyer.
– There would be less resistance from the managers and employees, making the process smoother and easier to
accomplish.
– Better publicity can be earned by preserving employees’ jobs rather than selling the business, which may lead to
redundancies.
– It is better for the existing management to acquire the company rather than it falling into enemy hands.
(b) A covenant on the loan states that the company should meet some percentage debt/equity ratios over the next five
years. Book value of equity is the ordinary share capital plus reserves, of which the reserves include retained earnings.
The debt value is said to be decreasing by $3,000,000 per year.
Workings
(i) Book value of debt and interest payments
Amount to borrow from bank = $81,000 – 12,000 – 4,000 = $65,000

Years 1 2 3 4 5

Balance b/f 65,000 62,000 59,000 56,000 53,000

Repayment 3,000 3,000 3,000 3,000 3,000

Balance c/d 62,000 59,000 56,000 53,000 50,000

Interest (9% x balance b/f) 5,850 5,580 5,310 5,040 4,770

(ii) Current operating profit before management service charge

Current operating profit = $60,000,000 – $12,000,000 - $22,000,000 - $4,000,000 =$22,000,000
This is subject to an 8% increase per year for the next five years.
(iii) Management fees = $12,000 first year subject to an 8% increase per year for the next five years.
(iv) The forecast income statement for the next five years:

Years 1 2 3 4 5

$000 $000 $000 $000 $000

Operating profit before management fees 23,760 25,661 27,714 29,931 32,325

Management fees (12,000) (12,960) (13,997) (15,117) (16,326)

Interest payable (W2) (5,850) (5,580) (5,310) (5,040) (4,770)

Profit before tax 5,910 7,121 8,407 9,774 11,229

Tax (25%) (1,478) (1,780) (2,102) (2,443) (2,807)

Profit after tax 4,432 5,341 6,305 7,331 8,422

Dividend (25%) (1,108) (1,335) (1,576) (1,833) (2,106)

Retained earnings for the year, to reserves 3,324 4,006 4,729 5,498 6,316

Book value of equity

Years 1 2 3 4 5

Balance b/f (share capital plus reserves) 16,000 19,324 23,330 28,059 33,557

Retained earnings for the year 3,324 4,006 4,729 5,498 6,316
 Balance c/d 19,324 23,330 28,059 33,557 39,873

Debt/equity ratio

Years 1 2 3 4 5

Debt (balance c/d) 62,000 59,000 56,000 53,000 50,000

Equity (balance c/d) 19,324 23,330 28,059 33,557 39,873

Ratio 321% 253% 200% 158% 125%

Covenant 350% 250% 200% 150% 125%

Covenant breached? No Yes No Yes No

(c) It can be deduced from the above calculations that the covenant will be met in years three and five but will be
breached in years two and four. It is only year one that the company will be operating below the target gearing of
350%. The implication of breaching the covenant may be that the bank will request the debt to be repaid instantly. The
company should therefore establish how the bank may react and the consequences of the bank’s reaction on the
operations of the company. As the figures relate to the future there is uncertainty attached to them so the company
should perform sensitivity analysis to ascertain how much the variables (sales, operating costs and tax rate) could
change before it can meet the covenant percentages, in order to assist management to develop contingency plans to
prevent the company from breaching the covenant.
The possible actions Tyche Co may take if the covenant is in danger of being breached may include the following:
• Reduce the initial debt amount by persuading the venture capitalist to provide more than $4 million equity capital.
• Agree with the shareholders and reduce the amount of dividend payments. This will increase the retained earnings and
therefore the equity capital, which will in turn reduce the gearing ratio.
• The company can also decide to increase the annual amount of the debt repayments from cash reserves in order to
reduce the outstanding debt balance at the end of each year.
• The company can also negotiate with the bank for more flexible terms than those provided now.
76. Multimedia company (Pilot paper 2012)
(a) Procedure for obtaining a listing
Normally, obtaining a listing consists of three steps: legal, regulatory and compliance. In the UK (as in many other
jurisdictions) a company must ensure that it is entitled to issue shares to the public, as opposed to an issue by private
treaty. In the UK, a company seeking listing must register as a public limited company. This entails a change in its
memorandum and articles of association, agreed by the existing members at a special meeting of the company.
The company must then meet the regulatory requirements of the Listing Agency, which is part of the Financial Services
Authority (FSA). These requirements impose a minimum size restriction on the company and other conditions
concerning the period of time for which the company has been trading. Once these requirements are satisfied, the
company is placed on the Official List and is allowed to make a public offering of its shares.
Once the company is on the Official List, it must then seek the approval of the Stock Exchange for its shares to be
traded. In principle, it is open to any company to seek a listing on any exchange where shares are traded. The London
Stock Exchange imposes strict requirements and invariably the applicant company will need the services of a
sponsoring organisation that specialises in that type of work.
(b) Advantages and disadvantages for a medium-sized company
The advantages of seeking a public listing include the opening of the capital markets to the company. It offers the
company access to equity capital from both institutional and private investors and the sums that can be raised are
usually much greater than could be obtained through private equity sources. The presence of the company as a listed
company on a major exchange also enhances its credibility, as investors and the general public are aware that by
doing so it has opened itself to a much higher degree of public scrutiny than is the case for a company that is privately
financed.
The disadvantages are significant. A wide spread of shareholdings places the company in the market for corporate
control, increasing the likelihood that the company will be subject to a takeover bid. There is also a much more public
level of scrutiny with a range of disclosure requirements. Financial statements must be prepared in accordance with
 IFRS or FASB and with the relevant GAAP as well as the Companies Act 2006. Under the rules of the London Stock
Exchange, companies must also comply with the corporate governance requirements of the UK Corporate
Governance Code and also have in place an effective and ongoing business planning process. Much of this may be
regarded as desirable within a privately owned company, but the requirements to comply or explain that are imposed
on a public company can create a significant regulatory burden and exposure to critical comment.
(c) Ethical considerations or concerns
There is an ethical dimension to the request made by Martin Pickle. He is, of course, entitled to acquire or dispose of
his equity claim as he sees fit. However, his position as a large shareholder does impose on him certain duties with
respect to the other shareholders. He should not undertake any action which is prejudicial to them – moving to a listed
status would require their consent. It may well be that the private equity firm involved has in mind its own exit strategy
and that his proposed course of action would be acceptable to them. If the decision was made to go public, his own
intentions would be a material factor in the valuation of the company and the offer price made to subscribers. An
immediate intention to divest would need to be disclosed. There would appear to be nothing wrong at this stage with
asking the CFO to investigate the matter on a confidential basis. However, the request that the CFO should seek to
enhance the earnings of the business should be resisted, since it obviously represents an instruction to engage in
earnings distortion and would prevent the disclosure of a true and fair view of the affairs of the business.
Earnings manipulation techniques, whereby revenues and costs are accelerated or decelerated to achieve desired
earnings figures, are severely limited by GAAP and in the USA, for example, could lead to arraignment (i.e. an
accusation or charge) under the Sarbanes Oxley Act. The proposal that the CFO would be offered share options adds
to the impropriety of the discussion. The CFO is in a difficult position, but does need to make clear that he or she must
act to preserve the interests of all of the shareholders and all of the directors. An invitation to participate in a share
option scheme is a fairly crude attempt to win support for the proposed course of action (since the shares are not yet
quoted) and should therefore be resisted.
77. Serty
(a) Differing views exist about the effect of dividends on a company’s share price. Several authors, including Modigliani
and Miller (M & M), have argued that dividend policy is irrelevant to the value of a company. Such arguments are
formulated under very restrictive assumptions. If such conditions existed then shareholders would not value an
increase in dividend payments. However, there are several real world factors that are likely to influence the preference
of shareholders towards dividends or retentions (and hence expected capital gains). These include:
– Taxation. In some countries dividends and capital gains are subject to different marginal rates of taxation, usually
with capital gains being subject to a lower level of taxation than dividends.
– Brokerage fees. If shareholders have a preference for some current income and are paid no (or low) dividends their
wealth will be reduced if they have to sell some of their shares and incur brokerage fees in order to create current
income. Shareholders, especially institutional shareholders, often rely on dividends to meet their cash flow needs.
– The corporate tax treatment of dividends may favour a higher level of retention.
– If the company needs to finance new investment it is usually cheaper to use retained earnings. This is because most
forms of external finance involve issue costs, which in the case of equity finance can be three percent or more of the
funds raised.
– Information asymmetry may exist between shareholders and directors. If the market is not strong-form efficient
shareholders may have less complete knowledge of the likely future prospects of the company than directors, which
may influence the shareholders’ desire for dividends or capital gains.
The implications of an increase in dividends need to be considered by the company. Dividends are often regarded as
an unbiased signal of a company’s future prospects - an increase in dividends signaling higher expected earnings. A
company should be careful to inform its shareholders of the reason for any increase in dividends (e.g. announcing a
special dividend i.e. a one-off dividend following the sale of a division of the group).
A further factor is the use that the company can make of funds. If the company has a number of possible positive NPV
investments then shareholders will normally favour undertaking these investments (at least on financial grounds), as
they will lead to an increase in shareholder wealth. As previously mentioned internal finance is cheaper than external
finance and this factor would probably lead to a preference for retentions. If however, the company has relatively few
projects and can only invest surplus cash in money market or other financial investments at an expected zero NPV,
relative high dividends or share repurchases might be preferred.
(b) The current wealth of the shareholder (cum div) is:
1,000 shares @ 400 cents = $4,000
(i) After a cash dividend is paid the expected wealth is:

$
 1,000 shares @ 385 cents 3,850

Cash dividend: 1,000 @ 15 cents 150

4,000

(ii) A 5% scrip dividend would mean the issue of two million new shares.
The total market value of the company of 40 million shares @ 400c or $160 million would be unchanged, but would
be split between 42 million shares leading to a new expected share price of:

The shareholder would receive 50 new shares, giving 1,050 shares in total.
The expected wealth of the shareholders would be unchanged i.e.
1,050 @ $3.81 = $4,000
(iii) Repurchase of 10% of the ordinary share capital would cost 10% × $160 million = $16 million, presumably provided
from the cash at bank. This would reduce the company’s value by $16million to $144 million, but the share price
would be expected to remain unchanged:

The shareholder’s wealth would remain at $4,000 whether or not the shareholders disposed of the holding. If no
shares were sold the situation is as i) above i.e.:
After a cash dividend is paid the expected wealth is:

1,000 shares @ 385 cents 3,850

Cash dividend: 1,000 @ 15 cents 150

4,000

If the shares were sold an investor would receive proceeds of $4,000.

These estimates are unlikely to be accurate. If the market perceives that these policies are conveying significant
new information about the company’s future prospects, either positive or negative, the share prices will differ from
the above expected figures.
78. Solar Supermarkets
The directors of Solar Supermarkets face a number of issues which may reflect a lack of understanding of the
consequences:
• The company’s more hostile competitive environment with pressure on prices and costs;
• The need to offer management compensation that will provide an incentive to seek value-adding business
opportunities;
• The investor pressure to release the value in property assets with the implied concern that if they do not acquiesce a
private equity team may well do the job for them; and
• The willingness of the company to support the potential liabilities of a final salary pension scheme for its employees.
In reviewing these issues it is important to bear in mind the overarching duty of the directors which is to maximise the value
of the company and to act in its (i.e. the company’s) best interests. Traditionally this concept of duty to the company has
been taken to mean the same as duty to existing shareholders. However, this is neither the legal nor arguably the moral
duty of directors.
The threat of a private equity acquisition may be real or it may simply be a ploy by institutional investors to liquidate a part
of the value of the company on the assumption that the company will be able to operate just as effectively without owning
its premises.
 Leaving aside the issue of whether such leases would be financial or operational, the investors do not appear to recognise
that the market has valued the company currently on the basis that its value generation is both retail and property driven.
Disinvestment of the property portfolio will simply skew the risk of the business towards retail and given the increasing
international competition in the sector this may result in the company’s value falling even if the company manages to
maintain its current levels of profitability and growth. As things stand the investors (and other stakeholders) in Solar
Supermarkets benefit from its diversified value generation with the added benefit that management can focus on the
difficult job of retailing and leave the property market to look after itself.
Disinvestment of the property portfolio could increase the risk of the business and in this context it is worth reviewing the
share option proposal. Currently, senior management and directors are compensated by a mix of salary, perks and profit-
related bonuses. To this extent there is a degree of risk sharing between owners and managers. The problem with share
options schemes is that they tend to increase the risk appetite of managers in that the holder is no longer so concerned
about downside risk in the company’s performance which is shifted to the writer (effectively the shareholders). However, to
the extent that the company is financed by debt, the shareholders in their turn hold a call option written by the lenders on
the underlying assets of the company and so the lenders are the ones who bear the ultimate risk. The combination of
limited liability and equity options in the hands of directors may well create a wholly unacceptable appetite for risk and a
willingness to take on new projects that they would otherwise have rejected.
Finally, the move to a money purchase pension scheme may be suggestive of a less than generous approach to the
company’s future employees who, in the retail sector, tend to be poorly paid with incomes of shop floor workers close (in
the UK and Europe) to the minimum hourly wage. It is safe to assume that the pension fund is principally designed for the
various management grades within the company. The move from a final salary scheme to a money purchase scheme
brings benefits in terms of fund management and financing but passes risk to the beneficiaries of the fund particularly in
terms of their exposure to future investment returns and annuity rates. The maintenance of the final salary scheme for
existing staff will no doubt be welcomed by them, but the company should recognise that it may be more difficult to appoint
staff of the same quality as currently at existing rates of pay. In so far as the labour market is efficient, we would anticipate
wage rates to rise to compensate for the reduction of pension benefit and so the gains from this move may well be illusory.
From an ethical perspective, the directors are in the position of attempting to balance the interests of a range of different
stakeholders as well as satisfying their own compensation requirements. It is clear that all four options involve the transfer
of risk from one stakeholder group to another in ways which are not immediately obvious. The duties of directors in this
case can be summarised as ones of transparency, effective communication and integrity in the choices that they make. It
is important that the directors should not be seen as taking a more advantageous position with respect to other groups,
without their consent, either in terms of the return they take or the risk they bear.
79. Marengo Co (December 2010)
(a) Delta is a measure of how much an option premium (price) changes in response to a change in the security/share
price and therefore can be used to determine the number of option contracts needed to protect against a fall in the
share price.
The number of contracts to purchase to protect a fall in the share price can be calculated as:

The delta value for put option is estimated as the N(–d1).

d1 = [ln(Pa/Pe) + (r + 0·5s2)t]/(st1/2)
d1 =[ln(340/350) + ((0·04 + 0·5 x 0·42) x 1/6)]/(0·4 x 1/60·5) = –0·055
–d1 = 0·055
N(–d1) = 0·5 + 0.0239 = 0·5239
Number of put contracts to purchase = 200,000/(0·5239 x 1,000) = 381·75, say 382 contracts.
(b) Wenyu was of the opinion that Marengo’s shareholders would benefit most if no action were taken. Wenyu is
therefore suggesting that the company should not hedge its risk. In an efficient capital market, where all relevant
information is reflected in security prices, having a well-balanced portfolio will eliminate unsystematic risk and hedging
corporate risk will have no effect on shareholders’ wealth, as hedging will not reduce any unsystematic risk further. In
addition, the cost of reducing systematic risk will exactly be equal to the benefit in an efficient market and therefore
shareholders will gain nothing through hedging. It is even argued that where there is a transaction cost, the overall cost
of hedging may exceed the benefits and will result in a reduction in shareholders’ wealth. However, it has also been
argued that in an imperfect market hedging may result in an increase in shareholders’ wealth, as the hedging will
reduce the volatility of earnings and therefore lead to increases in cash inflows.
Lola proposes that Arion Co’s shares should be sold on the basis that when the shares are sold the company will not
be exposed to the risk of a fall in the share price. However, selling these shares may have other implications for the
company. Firstly, the company might have invested in the shares with the aim of generating returns and when sold the
 proceeds should be reinvested elsewhere to generate a return at least equal to the return on the shares. Otherwise
there will be no financial justification for that action. Secondly, selling the shares may affect the company’s investment
portfolio with consequences on risk diversification. The company should also consider the effect on the share price of
selling large number of shares and whether there is sufficient liquidity in the market for such a large sale.
Sam suggested that the investment should be hedged using an appropriate derivatives product. As no exchange-
traded derivative products exist on Arion Co’s shares, the company can enter into over-the-counter (OTC) option
contracts at an exercise price of 350 cents per share in a contract size of 1,000 shares each, for the appropriate time
period, with the bank. This arrangement is usually expensive as it involves payment of a premium, often upfront, which
is payable whether or not the option is exercised. However, the option will give the company the right to, if the share
price moves in an adverse direction, exercise the right to take advantage of the option. If the share price increases the
company will let the option lapse and take advantage of the more favourable cash market price, as the exercise of
options is not obligatory.
Hedging this risk with options may have some risk as the delta value is likely to change during the period of the option,
and so the option writer may need to change his or her holdings to maintain the delta hedge position. This can be
measured using the option’s Gamma.
There is no clear-cut decision as to whether to hedge or not to hedge and therefore the company should base its
hedging decision in relation to its overall risk management strategy.
80. Nubo Co (December 2013)
(a) Selling the supermarket division as a going concern
The value of the division can be calculated using the P/E ratio method as P/E ratio × earnings.
P/E ratio of supermarket industry: 7
Earnings attributable to supermarket division = $166 × ½ = $83 million
Market value of the supermarket division = $83 million × 7 = $581 million
Selling the assets separately
Supermarket division current assets = 70% × $122 = $85.4 million
Supermarket division non-current assets = 70% × $550 = $385.0 million
Sale proceeds from sale of supermarket division assets:
($85·4m × 0·80) + ($385m × 1·15) = $511·07m
Total value of current and non-current liabilities = $387m + $95m = $482m
Both methods of sale generate enough cash to pay off the total liabilities of the company. However, the selling of the
division as a going concern generates more cash flows than selling the assets separately, hence selling the division as
a going concern is recommended.
Additional cash and debt funds which could be available to the new, downsized company:
The excess cash after payment of liabilities = $581m – $482m = $99m
Total asset for the remaining aircraft parts division before excess cash = $550m + $122m = 672 × 30% = $201.6
million.
Total asset value after excess cash = $201.6 million + $99m = $300.6 million
Maximum amount of cash that could be borrowed (debt capacity) = 100% × 300.6 million = $300.6 million
Total cash available after borrowing: $300.6 million + $99m = $399.6 million.
(b) Demerger involves splitting a company into two or more separate parts of roughly comparable size which are large
enough to carry on independently after the split. Each company would probably have a separate management but the
shareholders of the original company would hold shares in both companies.
Demergers have many benefits. A demerger can increase the value of the shareholders as management of each
separate company can concentrate on creating value for each company separately.
A demerger may be better than sale because it will still maintain the shareholders’ portfolio of investment and lead to
reduction of unsystematic risk. Some shareholders of Nubo Co might have invested in the company because of the
risk profile of the aircraft business and supermarket business. Selling the supermarket business will reduce their
portfolio and hence increase their risk. With the demerger, since the equity holders will retain an equity stake in both
companies, the benefit of diversification is retained.
 A demerger may be better than sale because demerger can still maintain a good relationship between the separated
companies.
A demerger may be beneficial if the current company’s value is less than the combined values of the separated aircraft
business and supermarket business.
The demerger may have some problems. The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced. The new aircraft parts production company can only borrow 100% of its
asset value, then its borrowing capacity and additional funds available to it for new investments will be limited to
$201.6m instead of $399.6m. There will be lower revenue, profits and status than the group before the demerger. The
demerger may be an expensive process and may reduce the value of the company.
(c) A mudaraba contract, in Islamic finance, is a partnership between one party that brings finance or capital into the
contract and another party that brings business expertise and personal effort into the contract. The first party is called
the owner of capital (Ulap Bank), while the second party is called the agent, who runs or manages the business (Pilvi
Co). The mudaraba contract specifies how profit from the business is shared proportionately between the two parties.
Any loss, however, is borne by the owner of capital (Ulap Bank), and not by the agent managing the business. It can
therefore be seen that three key characteristics of a mudaraba contract are that no interest is paid, that profits are
shared, and that losses are not shared. In effect, Ulap Bank’s role in the relationship would be similar to an equity
holder.
A musharaka transaction arises when one or more entrepreneurs approach an Islamic bank for the finance required for
a project. The bank, along with other partners, provides complete finance. All partners, including the bank, have the
right to participate in the project. They can also waive this right. The profits are to be distributed according to an agreed
ratio, which need not be the same as the capital proportions. However, losses are shared in exactly the same
proportion in which the different partners have provided the finance for the project. All parties provide capital as well as
skills and expertise and share the profits and losses on agreed basis. Partners have unlimited liability. In effect, the role
adopted by Ulap Bank would be similar to that of a venture capitalist. Ulap Bank can also take the role of an active
partner and participate in the executive decision-making process.
It appears that Ulap Bank may prefer a musharaka contract because of the conflict of interest associated with a
mudaraba contract. As in mudaraba contract, Ulap Bank will not participate in day-to-day running of the project. There
may be differences in objectives, separation of ownership and control as well as information asymmetry between the
bank and Pilvi Co.
Nubo Co should be concerned about how it can work with Ulap Bank and the cost and time required to undertake the
project. It should be concerned about the terms given to Pilvi Co by Ulap Bank before providing the capital and how
such terms may affect profit/loss sharing and management of the project. Nubo Co should also question the integrity of
Pilvi Co, as Pilvi Co did not consult them before contacting Ulap Bank.

The use of financial derivatives to hedge against forex risk

81. Currency Futures

Importer Situation
• Forward Market Hedge

• Futures Market Hedge

Situation a)
The UK importer requires protection against a weakening £. As the $ strengthened to $ 1.5000 = £1 by October, he would
have to pay ($297,500 ÷ 1.5000) £198,333 to clear his obligation.
Obviously he could protect his exposure to foreign exchange risk by SELLING 14 December £ futures contracts NOW at
$1.70, and then closing his position by BUYING a similar number of December £ futures when the price has moved to
$1.50. Clearly the ($0.20 × £12,500) $2,500 gain on each of the 14 futures contracts i.e. $35,000 would be converted at
the then spot rate $1.5000 to provide £23,333, which would compensate for the adverse movement on the foreign
exchange market i.e.
Cash Market
Payment to supplier ($297,500 ÷ 1.5000) = 198,333

Futures Market

Now: Sell 14 contracts 1.70

In October: Buy 14 contracts 1.50

Gain per £ $0.20

$35,000

In £: ($35,000 ÷ 1.5000) = (£23,333)

Total Cost (198,333 – 23,333) £175,000

Situation b)

Cash Market

Payment to supplier ($297,500 ÷ 1.7800) 167,135

Futures Market

Now: Sell 14 contracts 1.70

In October: Buy 14 contracts 1.78

Loss per £ $(0.08)

$14,000

In £: ($14,000 ÷ 1.7800) = £7,865

Total Cost £175,000

As can be seen from the above calculations, hedging with a futures contract means that any profit or loss on the
underlying will be offset by any loss or profit made on the futures contract. In practice, a perfect hedge is unlikely because
of:
• The “round sum” nature of futures contracts, which can only be bought or sold in whole numbers, and
• Basis risk i.e. the possibility of variability in the prices of the two related securities in the hedging arrangement. For
example, if changes in the price of the currency future do not perfectly match the change in the price of the underlying
security then a profit or loss may occur on the hedge position. This potential variability in the outcome of a hedge is
referred to as “basis risk”.
Since this example had a precise number of contracts and there was no basis risk, the total cost is the same whatever the
actual exchange rate.
82. Retilon plc
(a) Any hedging should be based upon expected net receipts and payments.

Net receipts/payments Receipts Payments

In two months €393,265

In three months: (1,997,651 + 60,505 – 491,011 – 890,271) Kr8.6m €676,874

Forward market hedge

Two months €393,265 ÷1.433 = (£274,435) payment

Three months €676,874 ÷1.431 = (£473,008) payment

Kr8.6 million ÷10.83 = £794,090 receipt

Money market hedge

Two months hedge
To have €393,265 available to meet the expenditure requirements in two months, we can borrow sterling for two
months, convert the sterling into euros at the spot rate and invest the euros for two months at 3.5% per year, which is
0.5833% for the two month period, multiplying by 2/12.
The amount of euros invested to earn €393,265 after two months = (393,265 ÷ 1.005833) = €390,984. To buy these
euros at the spot rate will cost (at 1.439) £271,705.
The interest cost at 7.5% for two months is (£271,705 × 7.5% × 2/12) = £3,396. The total cost in sterling is therefore
£271,705 + £3,396 = £275,101.
The hedge is therefore arranged as follows:
(i) Borrow £271,705 at 7.5% for two months, total cost £275,101
(ii) Convert at spot to €390,984
(iii) Invest at 3.5% for two months to yield €393,265 (390,984 × 1.005833), which will be used to make the payment
The forward market is marginally cheaper.
Three months hedge for euros payment
Tutorial note: the calculations are not shown, but the technique is similar to the two month hedge.
Borrow £466,298 at 7.5% for three months. Interest is £466,298 × 7.5% × 3/12 = £8,743. Total cost =£466,298 +
£8,743 = £475,041.
Convert at spot to €671,003.
Invest €671,003 at 3.5% for 3 months (0.875% for the three months) to yield €676,874 (€671,003 × 1.00875), which
will be used to make the payment.
The forward market is cheaper.
Three months hedge for kroner receipts
Borrow Kr8,431,373 at 8% per annum for three months (2% for the three-month period) to repay Kr8.6m (8,431,373 ×
1.02) with the receipts in three months’ time.
Convert at spot rate (10.71) to £787,243. Invest £787,243 at 5.5% for three months. Interest = £787,243 × 5.5% × 3/12
= £10,825. Total yield after three months = £798,068.
The money market offers the better alternative in this case.
Futures hedge
Two months (€393,265 ÷ 125,000 = 3.15 contracts, or three contracts
Three months (€676,874 ÷125,000) = 5.42 contracts, or five contracts.
Note: Six contracts could be used, over-hedging the risk
Two months
 The June contract will be used as it has the closest maturity date after the payment date (20 June).
Buy three June contracts at £0.6964/€1. This hedges 3 × €125,000 = €375,000.
The success of the futures hedge will depend upon the spot rate when the contracts have to be closed out. If there is
zero basis risk when the futures contracts are closed out, the exchange rate for the euros payment will effectively be
locked into the futures rate of £0.6964/€1.
This can be illustrated with two examples:
(i) If the spot exchange rate moves from € 1.439/£1 (£0.6949/€1) to €1.35/£1 £0.7407/€1)
(ii) If the exchange rate moves from € 1.439/£1 (£0.6949/€1) to 1.50/£1(£0.6667/€1).
(iii) Spot €1.35 (£0.7407/€1)
Cost in the cash market is 375,000 × 0.7407 = £277,762.50
Futures market:
20 April, buy three June contracts at 0.6964
20 June, sell three contracts at 0.7407 (assuming zero basis)
Futures profit is 375,000 × (0.7407 – 0.6964) = £16,612.50
Overall cost is £277,762.50 - £16,612.50 = £261,150 or £0.6964/€1.
(iv) Spot €1.50 (£0.6667/€1)
Cost in the cash market is 375,000 × 0.6667 = £250,012.50
Futures market:
20 April, buy three June contracts at 0.6964
20 June, sell three contacts at 0.6667 (assuming zero basis)
Futures loss is 375,000 × (0.6964 – 0.6667) = £11,137.50
Overall cost is £250,012.50 + £11,137.50 = £261,150 or £0.6964/€1
The additional €18,265 (€393,265 – €375,000) not hedged may be bought at spot or via the forward market.
The forward market would cost = £ 12,746
The total cost would be £261,150 + £12,746 = £273,896
This is cheaper than the forward market hedge.
Three months
Five September futures contracts will be bought and the exchange rate will effectively be locked into the futures price
of £0.6983/€1, giving a cost of 625,000 × 0.6983 = £436,437.50
This leaves a deficit of (€676,874 – €625,000) = €51,874. These may be bought at the forward rate at a cost of
€51,874 ÷1.431 = £36,250
The total cost, assuming no basis risk, is (£436,437.50 + £36,250) = £472,687.50
This is slightly cheaper than the forward market.
In conclusion, the money market should be used for the Danish kroner hedge and the futures market for the two month
and three month euro hedges, although in reality the futures hedges will also involve basis risk which might make the
forward market the preferred alternative for the euro hedges.
Day one – a movement from 0.6916 to 0.6930 would produce a loss of (125,000 × 0.0014) = £175. You would need to
provide an extra £175 to maintain the margin at £1,000, otherwise the contract will be closed out by the Clearing
House.
Day two – The price change is the same and a further £175 would need to be provided to maintain the required
margin.
Day three – A profit is made (from the fall in price) of 125,000 × (0.6944 – 0.6940) = £50, which may be taken in cash.
(b) Forward contracts
Advantages:
– Forward contracts are tailored to the needs of the parties concerned, and are flexible in terms of size and maturity.
– No payments are required until the contracts are settled.
 – Contracts are available in a very wide range of currencies.
Disadvantages:
– Forward contracts have two prices, a buying and a selling price, which means that companies must bear the cost of
the spread between these prices.
– Prices can vary according to the size of deal and the status of the customer.
– Long maturity contracts are rare, and some currencies do not have a forward market.
Currency futures
Advantages:
• There is a single specified price, which is transparent.
• Default risk is minimal as contracts are marked-to-market daily by the Clearing House, with the protection of the margin
payment.
Disadvantages:
• Futures contracts are not flexible. Contracts are only of a specified size and maturity, and are only available for a very
limited number of currencies.
• An initial margin (deposit) is required, and further variation margin may be necessary.
83. Letout SA
(a) Transaction exposure is a short-term component of economic exposure. It is the exposure to gains and losses at some
future date from foreign exchange rate changes. Such changes might affect the payments or receipts associated with
exporting or importing, from borrowing and lending in foreign currencies, from foreign dividend payments or unfulfilled
foreign exchange rate contracts. As transaction exposure has a potential impact on the cash flows of a company, most
companies choose to hedge against such exposure. Measuring and monitoring transaction exposure is normally an
important component of international treasury management.
Translation exposure arises due to the need to periodically consolidate the activities of overseas subsidiaries with the
parent company’s accounts. Consolidated group financial statements must be prepared in terms of home currency
units in accordance with the accounting rules of the country concerned. Translation exposure is measured by the
difference between a company’s exposed foreign currency liabilities and assets, and may result in a change in the
book value of shareholders’ equity as a result of exchange rate changes. Translation exposure is an accounting
measure, which may not reflect realised cash flows, and hence will not normally measure the likely cash flow
consequences for a company of exchange rate changes. Unless managers believe that the company’s share price will
fall as a result of showing a translation exposure loss in the company’s accounts, translation exposure will not normally
be hedged. The company’s share price, in an efficient market, should only react to exposure that is likely to have an
impact on cash flows.
(b) Sterling transactions
Only the net amount of receipts and payments should be hedged, which is a net payment of £2.8 million in three
months’ time. This may be hedged using the forward market or currency options. As Letout does not wish to take
significant risk, not hedging is an unacceptable alternative.
Forward market
Buy £2.8 million three months forward at MF5.6190/£1 = MF15,733,200
Currency options
If Letout wishes to protect against changes from the current spot rate of MF5.5910/£1 for buying sterling, or
£0.1789/MF1, the company should use options with a 0.180 exercise price. As sterling is required, Letout must buy put
options. As payment is due on 1 September, the September contract should be used.
At £0.180/MF, £2.8 million equals MF15,555,556.
With 125,000 francs per contract, 125 contracts would have to be purchased.
The premium cost will be 125,000 × 125 × 0.314 pence, or £49,063
The premium is payable now and will cost £49,063 × 5.5910 = MF274,311
In order to compare currency options over the same time period as the forward contract, the cost of financing this
upfront payment must be included. At an overdraft cost in Mordiana of 7% per year, the total cost of the upfront
payment, including interest, will be:
MF274,311 × 1.0175 = MF279,111
 The overall sterling cost of using a currency option hedge is unknown. It will depend on the spot MF/£ rate in three
months’ time, and whether or not the option is exercised.
The worst case scenario may be estimated, and this will occur if in three months the exchange rate is higher than
MF5.5556/£1 (= 1 ÷ 0.180). At any spot rate in three months’ time more than MF5.5556/£1, for example MF6.0000/£1,
the option will be exercised and the total sterling cost will be:
125 contracts at £0.180/MF = £2,812,500
This is £12,500 more than the amount required for payment (which is £2.8 million). The £12,500 may be sold forward
at MF5.5880/£1 to yield MF69,850 in three months’ time (N.B. this would be a binding contract whether or not the
option was exercised), or sold at the spot rate in three months’ time.
Total worst case franc costs are:

MF

Contract cost: 125 × 125,000 francs = 15,625,000

Surplus francs from the contract (69,850)

Premium cost 279,111

Total cost 15,834,261

As the payment date is before the expiry date of the option, the option is likely to have some remaining time value, and
it may be advantageous to sell the option back to the market rather than exercise it.
An alternative would be to purchase put options at 0.185
At £0.185/MF, £2.8 million equals 15,135,135 francs
With 125,000 francs per contract, 121 contracts would have to be purchased (15,135,135 ÷ 125,000 = 121.08)
The premium cost will be 125,000 × 121 × 0.691 pence, or £104,514
The premium is payable now and will cost £104,514 × 5.5910 = MF584,338
The total cost of the upfront payment, including interest, will be:
584,338 × 1.0175 = MF594,564
The worst case scenario will now occur if the MF/£ spot rate in three months is higher than MF5.4054/£1 (1 ÷ 0.185).
At any rate more than MF5.4054/£1 the option will be exercised and the total sterling cost will be:
121 contracts at £0.185/MF = £2,798,125
This is £1,875 less than the amount required for payment. The £1,875 may be bought forward at MF5.6190/£1 at a
cost of MF10,536 in three months’ time, or bought at the spot rate in three months’ time.
Total worst case franc costs are:

MF

Contract cost: 121 × 125,000 francs = 15,125,000

Additional francs needed 10,536

Premium cost 594,564

Total cost 15,730,100

This is cheaper than taking out a forward contract, and allows Letout to take advantage of the possibility of the franc
appreciating to less than MF5.4054/£, in which case the option would not be exercised, and pounds would be
purchased in the spot market at the time.
It is recommended that Letout uses £0.185 currency options to hedge against the company’s sterling risk.
Euro transactions
 Once again only the net amount of receipts and payments should be hedged, which is a net receipt of €1.7 million in
six months’ time. This may be hedged using the forward market or the money market.
Forward market
Sell €1.7 million six months forward at MF3.2978/€1 = MF5,606,260
Money market
Borrow euros now for six months at 9.8% per year (4.9% for the six months), to repay €1.7 million in six months’ time.
The net euro receipts will be used to repay this loan. To repay €1.7 million in six months, we would have to:

Convert these euros at spot to francs: € 1,620,591 × 3.3260 = MF5,390,086

Invest the francs for six months in Mordiana at 5.25% per year (2.625% for the six months), to yield at the end of six
months:
MF5,390,086 × 1.02625 = MF5,531,576
This is less than the net receipts using a forward contract.
A better alternative would be to use the MF5,390,086 to pay off almost all of Letout’s overdraft. Assuming the overdraft
is at six months’ interest rates, this would save 7.25% p.a. for six months (i.e. 3.625% over this period), and effectively
yield MF5,390,086 × 1.03625 = MF5,585,477.
However, in both cases the money market hedge would produce lower franc receipts than the forward market hedge.
(c) If the German customer defaults upon payment, Letout will still be obliged to undertake any contractual commitments.
For example:
Forward market hedge: €1.7 million will still need to be sold. Letout would probably need to purchase euros spot, and
face whatever foreign exchange loss (or profit) existed on the transaction.
Money market: The euro loan would still need to be repaid. Again it is likely that euros would be purchased spot for this
purpose.
84. MJY plc
It would be appropriate for the group to net off receipts and payments in the same currency so that only the net amount is
hedged in order to reduce transaction cost. For example, dollar receipts should be offset against dollar payments. As MJY
is a UK-based company it has no currency exposure to sterling receipts and payments and need not hedge sterling.
From the view point of the group, the net dollar and euro exposure are as follows:

Total dollar receipts 90 + 50 + 40 + 20 + 30 230

Total dollar payments 170 + 120 + 50 340

Net payment $110

Total euro receipts 75 + 85 + 72 + 20 + 52 + 35 339

Total euro payment 72 + 35+ 50 + 20 + 65 242

Net receipt €97

Forward market hedges:

Buy $ 3 months forward:

Sell € 3 months forward:

 Currency options:
The most suitable contract will be the contract that matures at the nearest date after the transaction date 31st March. This
is the May contract. Pounds need to be sold to purchase dollars, therefore MJY will need to purchase put options.
No of contracts
1.8:
$110,000/1.8 = £61,111/ 62,500= 0.977 = 1 contract, over hedge
1.78:
$110,000/1.78 = £61,798/ 62,500 = 0.989 = 1 contract, over hedge
Premium payment
1.8:
62,500 × 1 contract × 5.34cent = $3,338 exchanged at spot rate of 1.7982 = £1,856
1.78:
62,500 × 1 contract × 4.20cent = $2,625 exchanged at spot rate of 1.7982 = £1,460
Over hedge (using forward contract)
1.8:
1.8 × 62,500 = $112,500 – $110,000 = $2,500 exchanged at forward rate of 1.7861 = £1,400
1.78:
1.78 × 62,500 = $111,250 – $110,000 = $1,250 at forward rate of 1.7861 = £700

Overall outcome

Exercise price Basic cost Premium Over hedge Net cost

£ £ £ £

1.8 62,500 1,856 (1,400) = 62,956

1.78 62,500 1,460 (700) = 63,260

Conclusion
The option is more expensive than the forward contract and the forward contract should be selected. However, should the
dollar weaken more than the relative strike price the company could let the option lapse in order to take advantage of the
market exchange rate.
85. KYT
(a)
– What contract? The appropriate contract will be the contract that matures immediately after the transaction date of
1st September. This is the September contract, which matures at the end of September.
– Buy/sell? KYT plc should buy yen future contracts in order to sell at a higher price if the yen strengthens.
– Number of contracts: Each contract size is 12.5m yen and the amount involved is 140m yen. Therefore the number of
contracts to be bought are = 140/12.5 = 11.2 contracts. However, contract cannot be bought or sold in fractions (it
should be a whole number), therefore it can enter into 11 whole contracts. This means 0.2 × 12.5 = 2.5 million yen is
left unhedged under the futures contract. The company can either hedge this 2.5m yen by using a forward contract
or leave it unhedged.
– Calculation of closing price. This can be done, by using the basis and basis risk. Basis is the difference between
current spot rate and the future price.

Yen

Spot rate = 128.15

Future price (September) = $0.007985 to yen = 1/0.007985 125.23

Basis 2.92 yen

 If the 2.92 yen is assumed to decline in linear manner, and that the basis will be zero on the maturity date then the
expected basis on 1st September = (2.92 × 1)/3 = 0.973 yen as there is only one month to maturity.
Closing price (expected):

Yen

Spot rate 120

Basis 0.973

Future price 119.027 or $0.008401 (1/119.027)

- Calculation of profit or loss:

Entered by buying 11 future contract each at 0.007985

Will close by selling the 11 contracts each at 0.008401

Profit on futures position for each contract 0.000416

Total profit on future position = 0.000416 × 11 × 12.5m = $57,200

– Expected result of the hedge

1st September - spot market (140/120) 1,166,667

Profit from the future position 57,200

Net payment 1,109,467

– Hedge efficiency. This is to check whether the hedge is a perfect hedge:

Spot market

30th June - spot market (140/128.15) 1,092,470

1st September - spot market (140/120) 1,166,667

Loss in the spot market 74,197

Hedge efficiency = 57,200/74,197 = 77%

This result may not occur as basis is not likely to decrease in a linear manner.
(b) Future contracts differ from forward contracts in a number of ways including the following:
– Size Of The Contract
Future contracts are for multiples of standard-size contracts whereas forward contracts with a bank can be
negotiated for any size desired.
– Maturity
Future contracts are available only for a set of fixed maturities, the longest of which is typically for less than a year. A
bank will write a forward contract for maturity up to a year and occasionally for longer than a year.
– Location
Futures trading is conducted by brokers on the flow of an organised exchange, where orders from all buyers and
sellers compete in one central place. Forward contracts are negotiated with banks at any location in person or by
 telephone.
– Price
Future prices are determined through an open outcry process at the ‘pit’ in which the particular contract is traded.
Forward contracts prices are quoted by the bank in the form of bid and offer.
– Counter Parties
Purchasers and sellers of futures contracts are unknown to each other, since the opposite party to every trade is the
exchange clearing house. Purchasers and sellers of forward contracts deal with the bank where they are known,
either personally or by reputation.
– Margin
Futures contracts require payment of margin while no payments are made under forward contract apart from
settlement payment.
86. Lammer plc
(a) Report on how the five-month currency risk should be hedged.
Lammer is a UK based company and will have no currency exposure on sterling payments and receipts. Therefore,
only the net dollar receipts and payments should be hedged. From the information given in the question Lammer may
hedge the net dollar exposure using forward contract, money market hedge, futures and options.
Forward contract
Interpolation of the three month and one year forward rates for buying dollars will be needed to calculate the five
month forward rate. This may be estimated as:

3 month rate 1.9066

1 year rate 1.8901

Difference 0.0165

Assuming the rate declines in a linear manner:

5 month forward rate = 1.9066 – (0.0165 × 2/9) = $1.9029
Forward contact will fix the £ payment at:

Money market hedge

With a money market hedge involving payment of dollars, the company should borrow an appropriate amount in
pounds sterling today, convert it immediately at the spot rate to dollars, place it on deposit and repay the loan plus its
interest on the due date. How much will be borrowed depends on how much is to be invested in order to get the
amount of the exposure.
Lammer plc should buy dollars now and put them into a deposit account for 5 months in order to get $1,150,000.
= $1,150,000 / (1+ (0.02 × 5/12) = $1,140,496
Convert into pounds sterling at the spot rate: $1,140,496/1.9156 = £595,373
This means the company has to borrow £595,373 in the UK for 5 months at an interest rate of 5.5%. The total amount
payable in sterling is
£595,373 × (1 + (0.055 × 5/12)) = £609,017
The effective lock-in rate = $1,150,000/£609,017 = $1.8883
This is more expensive than the forward contract.
Futures
– What contract? The appropriate contract will be the contract that matures immediately after the transaction date ie
1st November. This is the December contract, which matures at the end of December.
– Buy/Sell? Lammer plc should sell December sterling futures
– Basis
 Spot rate 1.9156

Future price (December) 1.8986

Basis 0.017

Assuming the basis will decline in a linear manner over the seven months, then the expected basis in five month =

Therefore the expected lock-in futures rate may be estimated by: 1.8986 + 0.00486 = 1.9035 representing a total
payment of £604,150 (1,150,000/1.9035). This is more favourable than the forward market.
However, futures contracts are standardised and there may be an over- or under-hedge. For example, the number of
contract needed is:

Also currency futures require margin payments and there exists basis risk.
Options~
What date contract? – The appropriate contract will be the contract that matures at the nearest date after the
transaction date, which is the December contract.
Call/Put option? Since the contract size is denominated in pounds sterling, the company will need to sell pounds for
dollars, therefore it needs to buy a put option to get the right to sell pounds.

No of contracts

(a) (b) c=(b/a) (d) e=(c/d)

Exercise price $ £ Contract size £ Number of contracts

1.8800 1,150,000 611,702 31,250 19.57 = 19 Under hedged

1.9000 1,150,000 605,263 31,250 19.37 = 19 Under hedged

1.9200 1,150,000 598,958 31,250 19.17 = 19 Under hedged

Premium payment
1.8800= 31,250 × 19 contracts × 2.96c = $ 17,575 at spot rate of 1.9156 = £9,175
1.9000= 31,250 × 19 contracts × 4.34c = $25,769 at spot rate of 1.9156 = £13,452
1.9200= 31,250 × 19 contracts × 6.55c = $38,891 at spot rate of 1.9156 = £20,302
Under hedge (using forward contract)
1.8800 1.8800 × 31,250 × 19 = $1,116,250 – $1,150,000 = $37,750 at forward rate of 1.9029 = £17,736
1.9000 1.9000 × 31,250 × 19 = $1,128,125 – $1,150,000 = $21,875 at forward rate of 1.9029 = £11,496
1.9200 1.9200 × 31,250 × 19 = $1,140,000 – $1,150,000 = $10,000 at forward rate of 1.9029 = £5,255
Overall outcome
Basic cost = 31,250 × 19 contracts = £593,750

Exercise price Basic cost (£) Premium Underhedged £ at forward Total

1.8800 593,750 9,175 17,736 620,661

1.9000 593,750 13,452 11,496 618,698

1.9200 593,750 20,302 5,255 619,307

 The option is more expensive than the other hedging methods. However, should the dollar weaken more than the
relative strike price the company could let the option lapse in order to take advantage of the market exchange rate.
(b) The estimated effect on market value can be calculated as:

Exchange £ value of £ difference DF (11%) PV of difference

Rate $/£ $4.2m

Spot 1.9156 2,192,525 0 1 0

1 year 1.8581 2,260,374 67,849 0.901 61,132

2 1.8024 2,330,226 137,701 0.812 111,813

3 1.7483 2,402,334 209,809 0.731 153,370

4 1.6959 2,476,561 284,036 0.659 187,180

5 1.6450 2,553,191 360,666 0.593 213,875

727,370

The present value of future cash flows is expected to decrease as the dollar appreciates in value. This will therefore
reduce the market value of the company by £727,370.
(c) Economic exposure, also called operating or competitive exposure or strategic exposure, measures the changes in
the present value of the firm resulting from any changes in the future operating cash flows of the firm caused by an
unexpected changes in exchange rates. The change in value depends on future sale volume, price and costs.
Economic exposure may be managed through international diversification whereby the company can diversify
production, supply of its products and finance. For example, if it had established production plants worldwide and
bought its components worldwide it is unlikely that the currencies of all its operations revalue at the same time, so that
losses in some may be compensated by gains from the others. Lammer plc may also manage the economic exposure
through a natural hedge by borrowing funds in the USA, and using cash flows in USA to pay interest and principal.
87. Sydonics Engineering
(a) Memorandum
Our FOREX risk exposure is primarily driven by our European and US businesses and the variability of the Sterling
Euro and Sterling Dollar exchange rates. The volatility of the former exchange rate is of the order of 22 per cent
(annualised) which indicates significant Value at Risk in any forward commitment to this currency.
Value at Risk (VaR) is the value which can be attached to the downside of a value or price distribution of known
standard deviation and within a given confidence level. Value at Risk and related measures give an indication of the
potential loss in monetary value which is likely to occur with a given level of confidence. The setting of the confidence
level is necessary because, in principle, if a price distribution is normally distributed for example, the downside loss is
potentially infinite.
There are arguments for and against the use of derivative contracts to manage this transaction’s risk exposure.
In principle, nothing is added to the value of the company if we attempt to do something which the investors can easily
achieve - possibly at lower cost. If the capital markets are perfect then investors should be indifferent to company
specific risk (which they can diversify away) and will only be concerned about the market driven risks as reflected in
the company’s beta value. Arguably investors can diversify away the foreign exchange risk exposure within their
portfolio much more efficiently and at lower cost than the company can through hedging. Hedging also brings costs:
there are the direct costs of the treasury management function and the indirect costs of developing the in-house
expertise required to assess hedging alternatives. There are also compliance costs in that any imperfect hedging
agreement must be valued and shown in the accounts. Finally, hedging through derivative contracts can be avoided by
the creation of internal hedging arrangements whereby finance is raised in the country of operations and hence
borrowing costs are currency matched with the revenue streams.
On the other hand the market perfection argument can be turned on its head. In so far as hedging is a means of
reducing the company’s exposure to exchange rate volatility (a market-wide phenomenon) then its impact will be to
reduce the company’s beta and thus its cost of capital. This is a general argument for hedging but does not necessarily
imply that we should use the derivative markets to manage our exposure to exchange rate risk. The empirical evidence
on practice in industry is surprisingly sparse although Geczy, Minton and Schrand, (1997) found that 41 per cent of
their sample of 370 US companies actively used derivative instruments to manage their foreign exchange risk. The
 benefits of hedging through the use of derivatives is that with care, risk exposure can be tightly controlled, although the
use of exchange traded derivatives still leaves a residual ‘basis risk’ because of differences between the closeout rates
and the underlying rates of exchange. Basis risk can be avoided through the use of OTC agreements where these are
available.
Hedging foreign exchange risk using derivatives can be expensive, especially, as in this case, when the exposure is
uncertain. Where the exposure is certain the use of futures or forward contracts can eliminate a large element of
uncertainty at much lower cost. Any policy must therefore address the following issues:
– What is the magnitude of the risk exposure? (in this case the very high volatility and long-term exposure creates a
very high hedging cost). Value at Risk (VaR) may be an appropriate method for measuring the likely financial
exposure.
– The materiality of the exposure in terms of the magnitude of the sums involved.
– To what extent can the risk be mitigated by matching agreements (borrowing in the counter currency to mitigate
CAPEX for example)?
– To what extent has the exposure crystallised? If it is uncertain, foreign exchange options allow the hedging of the
downside risk, but at a high cost.
A policy would then lay down the principles that should be followed to cover the following:
– Risk assessment – an assessment of the likelihood and impact of any given risk upon the financial position of the
company. Derivative positions can be highly geared and the firm may be exposed to very high liabilities under
certain exchange rate and/or interest rate conditions. It is recommended that derivatives should only be used for the
management of specific risks and that no speculative or uncovered position should be taken;
– Cost of hedging – measured not only in terms of the direct costs involved, but also in the use of scarce management
time in establishing the positions and operating the internal control procedures appropriate where derivatives are
used as a means of hedging risk. It is recommended that hedging costs should be minimised to an agreed
percentage of the Value at Risk through the unhedged position;
– Contract and approval procedures – where OTC products are purchased and specific contracts are raised then the
company needs to establish policies with respect to the legal aspects of the contracting process. With both OTC and
exchange traded products the company should also establish an approval process with clear lines of responsibility
and sign-off on contracts up to and including board level. It is recommended that the board appoint a risk
management committee to review and monitor all hedging contracts where the Value at Risk is in excess of an
agreed amount;
– Hedge monitoring – a policy needs to be established as to the monitoring of derivative positions and the conditions
under which any given position will be reversed. It is recommended that the risk management committee actively
monitor all open positions.
(b) (i) This part of the question focuses on the use of options for foreign exchange hedging and deploys the Grabbe
variant of the Black-Scholes model.
The question is providing the “direct quote” needed for the Grabbe variant, since a euro is worth around 69p i.e.
£0.69 = €1.
The prices of the ‘at the money’ options are as follows:

3 months 9 months

Sterling Euro spot (direct) (£ = €1) 0.6900 0.6900

Sterling Euro spot (indirect) (€ = £1) 1.4493 1.4493

Euro Libor % p.a. 2.76563 3.05194

Sterling Libor % p.a. 4.62313 4.73031

Sterling Euro forward (direct) 0.6932 0.6985

Annual volatility of 0.2200 0.2200

d1 0.0971 0.1595

-0.0129 -0.0310
d2

N(d1) and N(-d1) i.e. the delta values 0.5398 0.4364

N(d2) and N(-d2) 0.4960 0.5120

3 month call and 9 month put price (pence per €) 3.1582 4.6766

(i.e. the price of a call or put to buy or sell one euro spot)

Premium cost per contract in £ (contract size of €100,000) 3,158.2 4,676.6

FORWARD RATES (using interest rate parity)

Three months
(1 + h) = (0.0462313 × 3/12) + 1 = 0.0115578 + 1 = 1.0115578
(1 + f) = (0.0276563 × 3/12) + 1 = 0.0069141 + 1 = 1.0069141

Nine months
(1 + h) = (0.0473031 × 9/12) + 1 = 0.0354773 + 1 = 1.0354773
(1 + f) = (0.0305194 × 9/12) + 1 = 0.0228895 + 1 = 1.0228895

GRABBE VARIANT (3 MONTHS)

Using standard normal distribution tables:

d1=0.0971 (i.e.0.10) gives 0.0398
N.B. A more accurate, but time consuming method would be to use linear interpolation to arrive at 0.0387, as follows:

0.09 0.0359

0.1 0.0398

0.09 0.0359

× 0.0039 = 0.0028

0.0387

d2= -0.0129 (i.e. -0.01) gives -0.004

N.B. Again, linear interpolation could be used to arrive at -0.0052, as follows:

0.01 -0.0040

0.02 0.008

0.01 0.004
 × 0.004 = -0.0012

-0.0052

GRABBE VARIANT (9 MONTHS)

Using standard normal distribution tables:

d1= 0.1595245 (i.e.0.16) gives +0.0636
N.B Again, linear interpolation could be used to arrive at 0.0634, as follows:

0.15 0.0596

0.16 0.0636

0.15 0.0596

95,245 × 0.0040 = 0.0038

100,000

0.0634

d2 = -0.031001 (i.e.-0.03) gives -0.012

N.B. Again, linear interpolation could be used to arrive at -0.0124, as follows:

0.03 -0.012

0.04 0.016

0.03 0.012

1,001 × 0.004 = -0.0004

100,000 -0.0124

The call should be exercised if the exchange rate rises above 0.6900 (thus making the sterling equivalent more
expensive) and the nine month put should be exercised if the spot rate is below 0.6900 at the exercise date.
The key points here are to note that the rates within the formula must all be direct and that the volatility and interest
rates are employed on an annual basis (these have either been quoted as such in the question or can be
established from the data provided).
(ii) The hedge ratio N(d1) and N(-d1) reveals the inverse of the number of option contracts we require to hedge a one
euro exposure. Therefore the number of contracts we will require to hedge the exposures are as follows:

3 months 9 months

Number of contracts 2,779 1,719

Cost of hedge £8,776,638 £8,038,075

As percentage of £ value (at spot rate) 8.48% 15.53%

 Calculations for three month call options

Calculations for nine month put options

The issues to be borne in mind are:

o Hedging with options eliminates downside risk (unlike futures) and is particularly useful when exposure is
uncertain;
o The cost of this type of hedge can be very high (especially for the long-dated put), although the company may
wish to reduce the cost by purchasing ‘out of the money’ options. This will not eliminate the downside risk
completely, but will allow a hedge to a known exposure;
o An alternative approach would be to hedge the three month exposure, which is where the option is most
valuable given the uncertainty over whether the bid will be accepted and then, if it is accepted, to enter into a
futures contract at that date to lock into the prevailing spot rate. Alternatively, purchasing the put option may be
held back until the contract is won;
o Given the set contract sizes, it is not possible to create a perfect hedge. The position would need continual
monitoring and adjustment to offset gamma risk (i.e. the change in the delta value in response to movements
in exchange rates), which is likely to be high for near-the-money options.
o There is timing risk given that the currency options are of European style. Early sale of the option (if the
requirement materialised early) will create basis risk, if the requirement materialises late the residual time delay
will be unhedged.
88. Asteroid Systems
Currency hedging
The objective is to fix (Euro/SFr) currency exchange rates for two months for an expected remittance of SFr 2,429,925.
This is achieved with a money market hedge for two months.
(a) Hedging the two month Swiss franc exposure
Forward contracts in the money market are the most straightforward way of eliminating transaction risk. The exposure
to movements in the Swiss Franc can be eliminated by entering into a forward contract to purchase the currency at
Euro/SFr 1.61995 (see note 1). Alternatively, given access to fixed rate finance in the Swiss market, a reverse money
market hedge can be established by borrowing in SFr and depositing in Euros. Given that the interest rates can be
locked in, this would offer a better forward rate at two months at any borrowing rate less than SFr LIBOR + 9 (note 2).
Supporting notes
Note (1)
The current expectation of remittances is based upon an estimate of the two month forward rate as a simple average
of the one-month and three-month mid-point forward rates i.e. (1.6223 + 1.6176) ÷ 2 = 1.61995 for the Swiss Franc.
Swiss Francs = 1.61995 × €1.5m = SFr 2,429,925 in two months, using the forward rate above.
 Note (2)
The money market hedge is based upon interest rate parity and using the IRP formula (given on the formula sheet),
we can calculate the maximum rate of interest that can be borne for the money market hedge to be worthwhile.
The technique for a reverse money market hedge is identical to that for a conventional hedge, except that the counter-
currency is borrowed in the foreign market, converted at spot and deposited in the domestic market. However, for
money market hedge to work, the company must be able to secure short-term money market finance in both the base
and the counter-currency areas. With the SFr exposure, it is possible to borrow fixed rate in the Swiss market. Using
the ‘no arbitrage’ condition of the interest rate parity formula, we can determine the maximum rate of interest the
company should agree in creating a money market hedge. The interest rate to use in the base currency is the best rate
for depositing in the Euro market:

× 1.6242 = 1.61995

× 1.6242 = 1.61995

= x 1.006209

= 1.003576

= 0.003576

ic = 0.0214562 (i.e. 2.15%)

Since the two-month forward rate used in this calculation is based upon mid-point quotes, the spot rate employed is
also (for consistency) based upon the closing mid-point.
If the company can borrow at less than spot Swiss LIBOR plus 9 (i.e. 2.06% + 0.09% = 2.15%, as calculated above) in
the Swiss market then the money market hedge will be preferred to a forward sale of SFr 1.5m.
The money market hedge (using the interest rate of 2.14562% as above) would be as follows:
1. Borrow SFr (SFr 2,429,925 ÷ 1.003576*) = SFr 2,421,266.5
2. Sell SFr (@ Spot) (SFr 2,421,266.5 ÷ 1.6242) = €1,490,744
3. Invest € (€ 1,490,744 × 1.006209#) = €1,500,000
4. Repay the SFr loan in two months’ time with the receipts of SFr 2,429,925
*2.14562% × 2/12 = 0.3576% # 3.72538% × 2/12 = 0.6209%
(b) The relative advantages and disadvantages of the use of a money market hedge compared with exchange traded
derivatives
A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified rate without
recourse to the forward foreign exchange market. If a company is able to achieve preferential access to the short term
money markets in both the base and the counter-currency zones, then it can be a cost effective substitute for a forward
exchange agreement. However, a money market hedge is difficult to reverse quickly and is cumbersome to establish,
since it requires borrowing and lending agreements to be established, denominated in the two currencies.
Exchange traded derivatives (e.g. foreign exchange futures and options) offer a rapid way of creating a hedge and are
easily closed out. For example, currency futures are normally closed out and the profit or loss on the derivative position
used to offset the loss or gain in the underlying. The fixed contract sizes for exchange traded products mean that it is
often impossible to achieve a perfect hedge and some gain or loss on the unhedged element of the underlying or the
derivative will have to be borne. Also, given that exchange traded derivatives are priced in a separate market to the
underlying, there may be discrepancies in the movements of each and the observed delta may not equal one. This
basis risk is minimised by choosing short maturity derivatives, but cannot be completely eliminated unless maturity
coincides exactly with the end of the exposure. Furthermore, less than perfectly hedged positions require disclosure
under IFRS 39.
 Although quick and convenient to establish, currency hedging using the derivatives market may also involve significant
cash outflows in meeting and maintaining the margin requirements of the Exchange. Unlike futures, currency options
will entail the payment of a premium, which may be an expensive way of eliminating the risk of an adverse currency
movement.
With relatively small amounts, the OTC market represents the most convenient means of locking into exchange rates.
Where cross-border flows are common and business is well diversified across different currency areas, then currency
hedging is of questionable benefit. Where (as in this case) relatively infrequent flows occur, then the simplest solution
is to engage in the forward market for hedging risk. The use of a money market hedge as described may generate a
more favourable forward rate than direct recourse to the foreign exchange market. However, the administrative and
management costs in setting up the necessary loans and deposits are a significant consideration.
(c) Extent to which currency hedging can reduce cost of capital
The only risk which will impact on a company’s cost of capital is that risk which is priced in either the equity or the debt
markets. Considering these two markets in turn:
– Currency risk forms part of a company’s exposure to market risk and will impact on a company’s cost of capital
through its beta value and, as a result, its equity cost of capital. The extent to which this is significant depends on the
exposed volume of currency transactions conducted in a given period, the average duration of the exposure and the
correlation of the currency with the market. If a given currency has the same correlation with the market as the
company, then removing currency risk will have no impact on the company’s overall exposure to market risk and as
a result no impact on the company’s cost of capital. The greater the difference in the relative correlations, the higher
the potential improvement in shareholder value from hedging.
– The impact on the cost of debt is more complex. The most significant impact is through the company’s exposure to
default risk. If currency transactions are significant and the foreign currency is highly correlated with the domestic
currency, then the impact is unlikely to be significant and the benefits from hedging modest. Where the degree of
correlation is low or indeed negative, then eliminating currency risk may significantly alter the company’s default risk.
However, unlike market risk, default risk is related to the overall volatility of a company’s underlying value and its
ability to finance its debt.
The elimination of currency risk is therefore likely to have at least some impact on the volatility of the company’s cash
flows and therefore on its cost of capital.
89. Importer of Stone Chippings
(a) The requirement is to discover the fixed exchange rate for an agreed monthly delivery of Euros (€) over six months to
settle a contract for 10,000 tonnes of aggregate (i.e. stone chippings) at an agreed price of €220 per tonne.
The calculation required is to equate the present value of a single agreed forward rate with the present value of the six
forward rates specified in the question.
The procedure is to calculate the present value of the variable forward rates, using discount rates derived from the
yield curve data. The sum of the discounted forward prices is then divided by the sum of the discount rates, to obtain
an equivalent fixed forward rate on the swap. The calculations are as follows:

Month 1 2 3 4 5 6 Total

Forward Rates (€ per $) 0.8326 0.8314 0.8302 0.8289 0.8278 0.8267

$ short zero coupon yield curve 3.25% 3.45% 3.50% 3.52% 3.52% 3.52%

Discount factors (W1) 0.9973 0.9944 0.9915 0.9886 0.9857 0.9828 5.9403

Prepaid forward price (W2) 0.8304 0.8267 0.8231 0.8195 0.8160 0.8125 4.9282

Fixed forward rate per $:

This represents a single exchange rate, which provides the same present value as the individual forward rates and is
therefore the rate which should be used for the swap.
W1 Discount factors
As rates change continuously, the monthly discount factor should be calculated on a continuous time basis:
 DFn = e-rt

DF1 = e-0.0325 ÷ 12 = 0.9973

DF2 = e-0.0345 ÷ 12 = 0.9971 × 0.9973 = 0.9944

DF3 = e-0.0350 ÷ 12 = 0.9971 × 0.9944 = 0.9915

DF4 = e-0.0352 ÷ 12 = 0.9971 × 0.9915 = 0.9886

DF5 = e-0.0352 ÷ 12 = 0.9971 × 0.9886 = 0.9857

DF6 = e-0.0352 ÷ 12 = 0.9971 × 0.9857 = 0.9828

The use of discrete time discounting, whilst less accurate, would be acceptable.
W2 Prepaid forward price

Month Forward Discount Prepaid

rate factor forward price

1 0.8326 × 0.9973 = 0.8304

2 0.8314 × 0.9944 = 0.8267

3 0.8302 × 0.9915 = 0.8231

4 0.8289 × 0.9886 = 0.8195

5 0.8278 × 0.9857 = 0.8160

6 0.8267 × 0.9828 = 0.8125

(b) Currency swaps can be for the exchange of different currencies at an agreed rate, or for the swap of interest rate
liabilities on borrowing in different currencies. This currency swap entails an agreement to swap a constant dollar sum
in exchange for a sequence of currency payments in Euros at the agreed amount each month.
The attraction of a currency swap (such as this) is that it avoids having to enter into a sequence of forward contracts (a
forward strip) with a currency dealer (bearing in mind the associated charges and the budget variability which would be
entailed).
The two rates quoted assume a zero arbitrage swap rate and no commission on the swap. Inevitably, a higher rate will
be quoted on the swap to cover the required commission.
A disadvantage of swap agreements is the relatively complex contract procedure which must be pursued to ensure
that the counterparties to the swap are in agreement as to the terms. Forward contracts tend to be less cumbersome to
both negotiate and contract with the currency dealer.
90. Multidrop (June 2010)
(a) Inter-group and inter-company currency transfers
– To determine inter-group and inter-company currency transfers that will be required for settlement by Multidrop
(Europe) the following two steps can be followed:
Convert all the currencies into a common base currency (in this case the Euro) using the relevant exchange rate.

Currency Original amount Relevant exchange rate Amount in Euro

Million €1 to Millions

US$ 6.4 1.3706 4.67

S$ 16 2.0649 7.75
 US$ 5.4 1.3706 3.94

€ 8.2 1 8.20

US 5 1.3706 3.65

Rm 25 4.9901 5.01

£ 2.2 0.9387 2.34

S$ 4 2.0649 1.94

Rm 8.3 4.9901 1.66

Prepare the receipts and payments matrix

Owed to: Read down

Europe US Malaysia Singapore UK Owed by: totals

€m €m €m €m €m €m

Europe 0 4.67 1.66 0 0 6.33

Owed by: US 8.2 0 0 0 0 8.2

Read Malaysia 0 3.94 0 0 2.34 6.28

across Singapore 7.75 3.65 5.01 0 0 16.41

UK 0 0 0 1.94 0 1.94

Owed to: totals 15.95 12.26 6.67 1.94 2.34 39.16

Owed by: totals 6.33 8.2 6.28 16.41 1.94 39.16

Net Receipts/ 9.62 4.06 0.39 -14.47 0.4 0

(Payments)

Singapore has to pay €14.47 million to Multidrop (Europe) and Multidrop (Europe) has to pay UK 0.4million, US 4.06
million and 0.39 million to Malaysia leaving a balance of 9.62 for Multidrop (Europe).
(b) Netting is setting the receipts and payments of all the companies in the group, or between group members and other
parties, resulting from transactions between them so that only net amount is either paid or received. The centre, rather
than the individual subsidiaries, is responsible for effecting payment. As only one payment is made to/from each
subsidiary in their local or preferred currency the number of transfers is reduced, lowering cross border transfer
charges. Individual subsidiaries no longer pay expensive foreign currency commissions, as the net purchases and
sales are effected by the centre or outsource partner. Frequent use of the system will also ensure that currency
exposures are settled on a timely basis reducing foreign exchange risk and time taken to reconcile intercompany
balances.
Although multilateral netting offers a host of advantages to member parties, it also has some disadvantages. To begin
with, risk is shared; hence, there is less incentive to carefully evaluate the credit worthiness of each and every
transaction. Secondly, there are sometimes legal issues to consider. Not all closeout netting arrangements are
recognized by law and there may be taxation and other cross border issues to resolve. In fact, some argue that such
arrangements undermine the interests of third-party creditors. There will be costs in establishing the netting agreement
and where third parties are involved this may lead to re-invoicing or, in some cases, re-contracting. Also the subsidiary
company’s results may be distorted if the base currency is weakened in the sustained period.
91. Casasophia Co (June 2011)
(a) Based on the information provided in the question, Casasophia Co can hedge the $20 million receipt through forward,
currency futures and currency option contracts.
 Forward contracts:
Enter into four months, forward contract and fix the rate at $1.3623/€1:
Guaranteed receipt = US$20,000,000/1·3623 = €14,681,054
Currency futures contracts:
Enter into the 5 months expiry contract as it matures immediately after the transaction date of 4 months. The contract
should be entered by buying (long position) the Euro futures contracts so that when the dollar depreciates against the
Euro (Euro appreciate against dollar), the contract will be closed by selling to make a gain to reduce the loss in the
currency market.
The locked in rate/effective rate = Futures price ± basis at transaction date.
Current basis:

Spot rate 1·3618

Futures price 1·3698

Current basis -0.0080

Basis at transaction date = -0.0080 x 1/5 = -0.0016

The lock-in rate/effective rate = 1·3698 - 0.0016 =$1.3682
Amount receivable under futures contract = $20,000,000/1.3682 = €14,617,746
Number of contracts = €14,617,746/€125,000 = 116.9 approximately 117 contracts - a slight over-hedge.
The forward rate of $1.3623/€1 is better than futures contract rate of $1.3682.
Currency option contracts:
The company would have to purchase 5 months expiry Euro call options in order to have the right to buy the Euros at
the exercise price when the Dollar depreciate against the Euro.
Calculation of number of contracts

Exercise price $ $ € Contract size € Number of contracts

1.36 20,000000 14,705882 125,000 117.65 117 Under- hedge

1.38 20,000000 14,492754 125,000 115.94 115 Under- hedge

Calculation of premium

Exercise Contract Number of Premium per contract Premium Spot Premium

price $ size € contracts (cents) in $ rate in €

1.36 125,000 117 2.80 409,500 1·3585 301,435

1.38 125,000 115 2.23 320,563 1·3585 235,968

Forward contract for under-hedge

Exercise Number of Contract Amount Amount Exposure $ Under – Forward Outcome

price contracts size hedged € hedged $ hedge $ rate €

1.36 117 125,000 14,625000 19,890,000 20,000,000 110,000 1.3623 80,746

1.38 115 125,000 14,375,000 19,837,500 20,000,000 162,500 1.3623 119,284

Overall outcome if the option is exercised

Exercise Price Basic Receipt € Premium cost € Under-hedge outcome € Total Receipt €
1.36 14,625000 (301,435) 80,746 14,404,311

1.38 14,375,000 (235,968) 119,284 14,258,316

Both option exercise prices are worse than the forward and futures contracts. However, if the underlying cash market
rate moves in favour of the company, it can let the option lapse and take advantage of the more favourable cash
market rate as options are not obligatory.
From the above calculations the forward contract provides the highest net receipts and will therefore be recommended
to the company.
(b) The extra amount to be borrowed in Euros to finance Mazabia’s project should be calculated as the difference
between the amount required for that investment and the amount available to the company.
– Amount required for the project in six months’ time = MShs2·64 billion. To determine this amount in Euros in six
months’ time we need to estimate the six months’ exchange rate through the purchasing power parity theory using
the two countries inflation rate as:
Mazabia six months’ inflation = 9.7% x 180/360 = 4.85%
Euro six months’ inflation = 1.2% x 180/360 = 0.6%
Six month’s spot rate = 116 x (1.048/1.006) = 120.90
Amount of investment in Euros = MShs2·64 billion/120.90 = €21.84 million
– Amount available is the Euro equivalent of the $20 million plus the interest for 2 months (6months - 4 months).

Net receipts from Forward contract from (a) above €14,681,054

Interest for 2 months (€14,681,054 x (60/360) x 1.8%) €44,043

Amount available €14,725,097 = €14.73 million

The loan finance required in Euros = €21.84 million - €14.73 million = €7.11 million
(c) The net present value of the project is calculated as follows:

Years 0 1 2 3

MShs (millions) MShs (millions) MShs (millions) MShs (millions)

Cash flows (2,640) 1,500 1,500 1,500

Exchange rate 120.90 144.67 156.84 170.04

€ (millions) € (millions) € (millions) € (millions)

Remitted cash flows (21.83) 10.37 9.56 8.82

DF (12%) 1.000 0.893 0.797 0.712

PV (21.83) 9.26 7.62 6.28

Net present value = €1.33 million

Workings:
The swap rate is calculated through the interest rate parity theory, using the two countries government base rates;
Six months’ interest rate – Mazabia = 10.80% x180/360 = 5.4%, Euro = 2.2% x 180/360 = 1.1%

Current spot rate MShs128

Six month spot rate = 128 x (1.054/1.011) = 133.44

(year zero of project life)
 Year 1 of project life = 133.44 x (1.1080/1.022) = 144.67

Year 2 of project life = 144.67 x (1.1080/1.022) = 156.84

Year 3 of project life = 156.84 x (1.1080/1.022) = 170.04

According to the interest rate parity theory, a country with a higher nominal interest rate will have its currency
depreciating against a country with a lower nominal interest rate. As illustrated in the above calculation of the swap
rates, the Mazabian Shillings (MShs) is depreciating against the euro, as the Mazabia interest rate is higher than the
Euro interest rate. However, these rates are fixed in the swap agreement and are the rates at which the currencies
would exchange regardless of the actual spot rate in the future. Given that Mazabia inflation rate is likely to be
between 5% and 15%, the purchasing power parity indicates that the Mazabian Shillings (MShs) will depreciate
against the Euro and the swap agreement should be beneficial to the company unless Mazabia inflation rate is lower
than 9.7%. However, the company should consider the risk of default by the Mazabian local bank and should ask the
Mazabian government to guarantee against any non-payment.
The net present value of the project is positive, and holding all assumptions constant, the project is financially
acceptable.
92. Lignum Co (December 2012)
To: Treasury Division
Subject: Foreign currency exposure
This report relates to how the treasury division can manage the foreign currency exposure of the company.
Foreign currency exposure:
In case one, the company faces transaction exposure because it is expecting to receive ZP 140 million, a foreign currency,
in four months’ time and any movement in the exchange rate between the ZP and the Euro between now and the fourth
month will result into the company receiving less or more in Euros.
In case two, the company is facing translation exposure as it would have to prepare consolidated financial statements to
include Maram’s subsidiary, by converting the foreign currency assets and liabilities into Euros. Any movement in the
exchange rate between the MR and the Euro would result into the assets and liabilities being more or less in the
consolidated financial statements.
In case three, the company is facing economic or competitive exposure, as the present value of future cash flows may
change due to changes in sale revenue from changes in selling price resulting from changes in exchange rate.
Managing currency (transaction) exposure in case 1
The company has been offered two derivative products by Medes Bank as the transaction exposure relates to short-term
cash flow movements. The company can enter into four months forward contracts and fix the exchange rate now with the
bank which would be used to convert the ZP 140 million into Euros irrespective of the actual exchange rate in four months’
time. In this case the company would receive a guaranteed sum of €963,988. Alternative, the company can enter into the
over-the-counter option by paying a premium of €48,601 to have the rights to exchange the ZP 140 million into Euros if the
actual exchange rate is worse than ZP 142. With this option contract the company would receive a net amount of
€936,715, which is less than the net receipts from the forward contract. The company should therefore select the forward
contract. However, the forward contract is obligatory and the company would have to honour the contract irrespective of
the exchange rate in the fourth month.
The company could also explore other hedging strategies such as a money market hedge, leading and lagging, and
matching. Matching involves setting payments against receipts of the same currency. This is facilitated if the company
opens a bank account in ZP so that its ZP payments are made out of its ZP receipts. Leading and lagging is a mechanism
whereby a company accelerates (leads) or delay (lags) payment or receipt in anticipation of exchange rate movements.
This technique can be used only when exchange rate forecasts can be made with some degree of confidence. Money
market hedging involves borrowing an appropriate amount in ZP today, converting it immediately to Euros and placing it on
deposit account in France. Upon the receipt of the ZP 140 million, the company will pay the loan and its interest.
Managing currency (translation) exposure in case 2
The importance of translation exposure to financial managers is often questioned. In financial management terms we ask
the question ‘does translation loss reduces shareholders’ wealth? The answer is that it is unlikely to be of consequence to
shareholders who should, in an efficient market, value shares on the basis of the firm’s future cash flows, not on asset
values in the published accounts. Unless management believes that translation losses will greatly affect shareholders
there would seem little point in protecting against them. The devaluation of the MR would reduce the consolidated net
assets by €1,018,000. The most efficient way to hedge translation exposure is to match the assets and liabilities, for
example converting non-current liabilities from loans in Euros to loans in MR, will reduce the translation exposure
 Managing currency (economic) exposure in case 3
Economic exposure is really the long-run equivalent of transaction exposure and should be hedged using long term
hedging strategies, like currency swaps. As the economic exposure may cause a substantial negative impact to a
company’s cash flows and value over a long period of time, the company may diversify the production into countries with
favourable exchange rates and cheaper raw material and labour inputs or setting up a subsidiary company in the USA to
create a natural hedge for the majority of the US$ cash flows.
In conclusion, the company should hedge against both transaction and economic exposures as they have direct effects on
cash flows and therefore shareholders’ wealth.
Prepared by:
Date:
Appendices
Appendix 1: Hedging the transaction exposure of ZP 140 using the derivative products offered by Medes Bank
Forward contract
Note: The forward rate is to be calculated on the basis of interest rate parity theory using the interest rates of the two
countries as follows:
Zuhait Interest for 4 months = (0·085 + 0·0025) × 4/12 = 0.0292
France Interest for 4 months = (0·022 − 0·0030) × 4/12 =0.0063
Forward rate = ZP 142 × (1.0292/1.0063) = ZP 145.23
Guaranteed receipt = ZP 140,000,000/145.23 = €963,988
OTC options contract
Purchase call options to cover for the ZP rate depreciating and fixing the exchange rate at ZP 142 per €1. Options would
involve payment of a premium.
Underlying receipts= ZP 140,000,000/142 = €985,915
Premium cost
ZP 7 × €985,915 = ZP 6,901,405
Exchange at the spot rate to € = ZP 6,901,405/142 = (€48,601)
Assuming that the premium amount would be borrowed at 3.7%:
Total cost of premium = €48,601 × (1 + 0·037/3) = (€49,200)
Net receipt = €985,915 − €49,200 = €936,715
Appendix 2: Hedging the translation exposure
Current MR exchange rate = MR 35
Devalue by 20% = Increase by 20% to devalued rate of = MR 35 × 1·20 = MR 42 per €1

MR ’000 €’000 at current rate of MR 35 per €1

Non-current assets 179,574 100% exposed 5,131

Current assets 146,622 60% exposed 2,514

Non-current liabilities (132,237) 20% exposed (756)

Current liabilities (91,171) 30% exposed (781)

Net assets 102,788 6,108

Current net assets = MR 6,108

Revised net assets after devaluation (MR 6,108/1.2) = MR 5,090
Translation loss = €6,108 – €5,090 = €1,018
93. Kenduri Co (June 2013)
(a) The US $ cash flows Kenduri Co is due to receive or pay in three months, from Lakama Co:
Payment: US $4·5m
 Receipt: US $2·1m receipt
Net payment = US $2·4m
This can be hedged using forward contract, money market hedge and currency options based on the provided
information in the question.
Forward market:
Guaranteed payment US$2,400,000/1·5996 = £1,500,375
Money market:
Invest in US$:
US $2,400,000/(1 + 0·031/4) = US $2,381,543
Convert £ into US $ at spot:
US $2,381,543/1·5938 = £1,494,255
Borrow in £:
£1,494,255 × (1 + 0·040/4) = £1,509,198
Currency options
Kenduri Co need to enter into three months put option contract in order to have the right to sell £.
Number of contracts

Exercise US $ Exposure in Contract size Number of

price exposure £ £ contracts

1.60 2,400,000 1,500,000 62,500 24 24 Exact

1.62 2,400,000 1,481,481 62,500 23.7 23 Under

hedge

Premium

Exercise Number of Contract Amount Premium Premium Spot Premium

price contracts size £ hedged cents in $ rate in £

1.60 24 62,500 1,500,000 2.08 31200 1·5938 19,576

1.62 23 62,500 1,437,500 3.42 49163 1·5938 30,846

Under hedge using forward contract

Exercise Amount to Amount hedged Amount under Forward Amount under

price hedge $ hedged in $ rate hedged in £

1.62 2,400,000 £1,437,500 × 1.62 = 2,400,000 – 1·5996 $71,250/1·5996

$2328750 $2,328,750 = £44,542
= $71,250

Net outcome

Exercise price Amount hedged £ Premium in £ Amount under hedged in £ Net outcome

1.60 1,500,000 19,576 0 1,519,576

1.62 1,437,500 30,846 £44,542 1,512,888

From the above calculations the forward contract is recommended as it gives the lowest net payment.
(b) Convert all the currencies into £ using the following exchange rate:
 US$1·5950/£1; CAD1·5700/£1; JPY132·75/£1

Owed by Owed to Amount Amount in £000

Kenduri Co Lakama Co US $4·5/US $1·5950 = 2,821.3

Kenduri Co Jaia Co CAD 1·1/CAD1·5700 = 700.6

Gochiso Co Jaia Co CAD 3·2/CAD1·5700 = 2038.2

Gochiso Co Lakama Co US $1·4/US $1·5950 = 877.7

Jaia Co Lakama Co US $1·5/US $1·5950 = 940.4

Jaia Co Kenduri Co CAD 3·4/CAD1·5700 = 2,165.6

Lakama Co Gochiso Co JPY 320/JPY132·75 = 2,410·5

Lakama Co Kenduri Co US $2·1/US $1·5950 = 1316.6

Net by setting off payment against receipt using the following matrix:

Paying Total receipts £

Receiving UK USA Canada Japan

UK 0 1,316·6 2,165·6 0 3,482·2

USA 2,821·3 0 940·4 877.7 4,639·4

Canada 700·6 0 0 2,038·2 2,738·8

Japan 0 2,410·5 0 0 2,410·5

Total payments 3,521·9 3,727·1 3,106·0 2,915·9

Total receipts 3,482·2 4,639·4 2,738·8 2,410·5

Net receipts/(payments) (39·7) 912·3 (367·2) (505·4)

Kenduri Co (UK), Jaia Co (Canada) and Gochiso Co (Japan) will make payments of £39·7, £367·2 and £505·4 to
Lakama Co (USA).
Netting is setting the receipts and payments of all the companies in the group resulting from transactions between
them so that only net amount is either paid or received. Transaction cost will be lower as a result of fewer transactions,
and regular settlements may reduce intra-company exposure risk. This would limit the fees that banks receive for
undertaking the transactions. Governments who do not allow multilateral netting, therefore, want to maximise the fees
their local banks receive. However, disallowing netting might discourage multinational companies from establishing
subsidiaries in the country, leading to loss of business. Countries allowing netting believe that the effect of lost bank
fees is compensated by the amount of business multinational companies create by operating in the country.
(c) Gamma measures the amount by which the delta value changes as underlying security prices change. This is
calculated as:

A delta value ranges between 0 and +1 for call options, and between 0 and −1 for put options. The actual delta value
depends on how far it is in-the-money or out-of-the-money.
The absolute value of the delta moves towards 1 (or −1) as the option goes further in-the-money and towards 0 as the
option goes out-of-the-money. At-the-money calls have a delta value of 0.5, hence the gamma is highest for a long call
option which is at-the-money. The gamma is also higher when the option is closer to expiry.
94. Cocoa-Mocha-Chai (CMC) (June 2014)
(a) Exposure of $5,060,000 can be hedged using the following techniques:
(i) Forward contract
• Guaranteed payment = US$5,060,000/1·0677 = CHF4,739,159
(ii) Currency futures
• Enter into six month’s expiry contract by selling CHF futures contract to hedge against the CFH weakening.
• Lock-in rate
1.0659 ± [(1.0635 – 1.0659) x 2/6] = $1.0651
• Amount = $5,060,000/$1.0651 = CHF4,750,728
• Number of contracts = CHF4,750,728/CHF125,000 = 38 contracts
(iii) Currency options
• Enter into six month’s expiry put contract to have the right to sell CHF, to hedge against the CFH weakening.
• Number of contracts

Exercise price Exposure Number

1.06 $5,060,000 CHF4,773,585/125,000 38.18 38 – UH

1.07 $5,060,000 CHF4,728,972 /125,000 37.83 37 – UH

• Premium

Exercise price $ Spot rate CHF

1.06 38 x 125,000 = CHF4,7500,000 x 2.16/100 102,600 1.0635 96474

1.07 37 x 125,000= CHF4,625,000 x 2.63/100 121,638 1.0635 114375

• Under hedge

Exercise price $ Forward rate CHF

1.06 CHF4,7500,000 x 1.06 – 5060000 25,000 1.0677 23415

1.07 CHF4,625,000 x 1.07 - 5060000 111,250 1.0677 104196

• Net outcome

Exercise price Underlying payment CHF Premium under hedge Net Payment

1.06 CHF4,7500,000 CHF 96474 CHF 23415 CHF4,869,889

1.07 CHF4,625,000 CHF 114375 CHF104196 CHF 4,843,570

The forward contract is recommended as it gives the lowest net payment.

(b) Arbitrage gain

Fixed rates Floating rate

CMC Co 2.20% Yield + 0.40%

Counterparty 3.80% Yield + 0.80%

Difference - 1.6 - 0.4

 Arbitrage gain = -1.6 – (-0.4) = -1.2 = 1.2%
The arbitrage gain will be shared equally between the two companies.

CMC Co Counterparty

Arbitrage Gain 0.6 0.6

Bank fee 0.2 0.2

Net gain 0.4% 0.4%

As a result, CMC co will save 0.4% x CHF60,000,000 = CHF240,000 per annum.

CMC Co Counterparty

Actual interest (2.20%) (Yield + 0.40%)

Swap arrangement

CMC to counterparty (Yield) Yield

counterparty to CMC 2.40% (2.40%)

Net interest with swap (Yield -0.2%) (3.20%)

Interest without swap Yield + 0.4% 3.80%

Arbitrage Gain 0.6 0.6

Bank fee 0.2 0.2

Net gain 0.4 0.4

Full marks will be given where the question is answered by estimating the arbitrage gain of 1·2% and deducting the
fees of 0·4%, without constructing the above table.
(c)

Year Cash Flows Df 2% PV

X F FX

1 15756303 0.98 15441176.94 15441176.94

2 15756303 0.961 15141807.18 30283614.37

3 15756303 0.942 14842437.43 44527312.28

4 15756303 0.924 14558823.97 58235295.89

60,000,000 148487400

Duration = 148487400/60,000,000 =2.47

Modified duration = 2.47/1.02 =2.42
Duration measures the average time it takes for a bond/loan to pay its coupons/interest and principal and therefore
measures the maturity of a bond.
It recognises that bonds/loans which pay higher coupons/interest 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 values are less sensitive to interest rate
changes and will have a lower duration.
 Modified duration determines how much the value of a bond or loan will change when there is a change in interest
rates. The equation linking modified duration (D), and the relationship between the change in interest rates (∆i) and
change in price or value of a bond or loan (∆P) is given as follows:
∆P = [–D x ∆i x P]
(P is the current value of a loan or bond)
Bond/loan with lower modified duration has it value less sensitive to changes in interest rate
Duration assumes that the relationship between the change in interest rates and the corresponding change in the
value of the bond or loan is linear. In fact, the relationship between interest rates and bond price is in the form of a
curve which is convex to the origin (i.e. non-linear).
Therefore, duration can only provide a reasonable estimation of the change in the value of a bond or loan due to
changes in interest rates, when those interest rate changes are small.
(d)
To: The Board of Directors, CMC Co
From
Date:
Subject: Discussion of the proposal to manage foreign exchange and interest rate exposures, and the proposal to
move operations to four branches and consequential agency issues
The memo discusses proposal one in light of the concerns raised by the non-executive directors concerning the
management of currency risk and interest rate risk and discusses the agency issues related to proposal two, moving
operations, the agency issues and how these can be mitigated.
Proposal 1: Hedging foreign currency risk and interest rate risk.
The opinion that hedging foreign currency risk and interest rate risk would reduce shareholder value because the costs
related to undertaking the proposal are likely to outweigh the benefits is correct if the market is an efficient capital
market. In an efficient capital market, where all relevant information is reflected in security prices, having a well-
balanced portfolio will eliminate unsystematic risk and hedging corporate risk will have no effect on shareholders’
wealth, as hedging will not reduce any unsystematic risk further. In addition, the cost of reducing systematic risk will
exactly be equal to the benefit in an efficient market and therefore shareholders will gain nothing through hedging. It is
even argued that where there is transaction cost, the overall cost of hedging may exceed the benefits and will result in
a reduction in shareholder’s wealth.
However, it has also been argued that in an imperfect market hedging may result in an increase in shareholders’
wealth, as the hedging will reduce the volatility of earnings and therefore lead to increase in cash inflows. Active
hedging may also reduce agency costs. For example, unlike shareholders, managers and employees of the company
may not hold diversified portfolios. Hedging allows the risks faced by managers and employees to be reduced.
Additionally, hedging may allow managers to be less concerned about market movements which are not within their
control and instead allow them to focus on business issues over which they can exercise control. This seems to be
what the purchasing director is contending. On the other hand, the finance director seems to be more interested in
increasing his personal benefits and not necessarily in increasing the value of CMC Co. A consistent hedging strategy
or policy may be used as a signalling tool to reduce the conflict of interest between bondholders and shareholders, and
thus reduce restrictive covenants.
Proposal 2: Moving operations to four branches, agency issues and mitigation measures.
The agency problem relating to proposal two is the conflict of interest between head office managers and the branch
managers. The conflict of interest may come because head office managers’ objectives may be different from the
objectives of the branch managers. Branch managers’ may be more concern about the branch performance whereas
the head office managers’ may be more concerned about the performance of the company as a whole.
Agency problem may also arise because of differences in culture, religion and information asymmetry, where branch
managers may not be aware of all relevant information at the corporate level.
To resolve these agency issues, the company can use the principle of goal congruence. This is done by instituting
incentive schemes so that the branch manager trying to achieve it selfish objective ends up achieving the company
overall objective. Introduction of performance related pay linked to the performance of the whole company, not branch
only performance, can be introduced.
There must be effective communication system put in place to ensure that both head office managers’ and branch
managers’ are aware of what is happening at corporate level so that branch managers’ can know how their decisions
and actions affect other branches.
 Targets should also be set for each branch based on achieving the company’s objectives. These target needs to be
monitored regularly to ensure that they are being achieved.
Conclusion
There is no clear-cut decision as to whether to hedge or not hedge and therefore the company should base its hedging
decision in relation to its overall risk management strategy. Any intended change in policy should be communicated to
the shareholders. Shareholders can also benefit from risk management because the risk profile of the company may
change, resulting in a reduced cost of capital.

The use of financial derivatives to hedge against interest rate risk

95. Nonap plc

(a) (i) The General Election is due in late October, after the expiry of the September contract.
The interest rate risk will, therefore, be hedged using the December contract.
Nonap plc will hedge a possible increase in interest rates leading to a potential ‘cash market’ loss by selling futures
contracts now. If interest rates rise, the futures price will fall and Nonap plc will make a futures profit by closing its
position in buying back (after the interest rate rise) the same number, type and maturity of futures contract at a lower
price than it sold the futures contracts now.
For a four-month exposure the company would need to sell:

(ii) Basic risk is the difference between the futures price and the current ‘cash market’ price of the underlying security.
Basis may be found by comparing the futures price with three month LIBOR.

Current LIBOR (100 – 7.50) 92.50

December futures price 92.10

0.40 = 0.40% or 40 basis points.

The futures price and cash market price will converge to the same value at the maturity date of the contract, i.e. the
basis will be zero at the maturity date at the end of December.
If the basis reduces steadily over the next six months as the maturity date approaches, (assuming that the futures
contract would be closed out at the end of November when the loan commences), the basis at the end of November
is expected to be:

Accordingly, (40 – 7) i.e. 33 basis points will have steadily reduced between the end of June and the end of
November.
On this occasion the expected movement in basis will be disadvantageous to Nonap plc. If interest rates increase,
the gain on the futures market is expected to be the movement in interest rates less the 33 basis points change from
the time the contract is sold in June to the time it is closed out in November. For example, if interest rates increase
by 2%, the theoretical price of the future would be (92.50 – 2.00) i.e. 90.50, whilst the actual futures price (adjusted
for seven basis points) would be expected to move to 90.43 at close out:

Cash market loss (2% × £6m × 4/12) (40,000)

Futures market:

Now (End of June) Sell 92.10

 End of November Buy 90.43

1.67 × 100 = 167 ticks

Gain on futures market (16 contracts × 167 ticks × £12.50) 33,400

Net loss (being 16 contracts × 33 ticks × £12.50) £6,600

The overall net loss is caused by the gradual disappearance of 33 basis points whilst the contracts remain open.
They were sold when 40 basis points existed at the end of June and bought back when only 7 basis points existed
at the end of November.
There is, however, no guarantee that the basis at the end of November will be 7. If there are significant movements
in yield curves between June and November a lower or higher basis could exist, and the effective interest rate could
differ from this estimate.
(b) Swaptions are hybrid derivative products that integrate the benefits of swaps and options. The buyer of a swaption
has the right, but not the obligation, to enter into an interest rate or currency swap during a limited period of time and at
a specified rate. Swaptions are available on the over-the-counter market and involve the payment of a premium,
normally upfront. They may be ‘European style’, exercisable only on the maturity date or ‘American style’ exercisable
on any business day during the exercise period.
Nonap plc is interested in protection against interest rate volatility, but wishes to maintain the flexibility to benefit from
falls in interest rates. A swaption would offer the opportunity to do this.
Nonap plc is currently paying 8.2% on its Euro loan. The swaption offers a swap from floating rate to fixed rate finance
for the remaining three year period of the Euro loan. (N.B. the four year loan was raised nine months ago and the
swaption will not commence until another three months have elapsed).
The fixed rate is 0.3% per annum above the current floating rate payable by Nonap plc.
The premium payable of €50,000 is 2.5% of the total value of the loan, or ignoring the time value of money, 0.833%
per year over the remaining three year period of the loan.
If Euro interest rates rise during the next nine months by more than 0.3% the swaption is likely to be exercised. For the
swaption to be beneficial to Nonap plc, the average floating rate payable by Nonap plc without the swap over the three
year period would have to exceed:
8.2% + 0.3% + 0.833% = 9.333%
This is a 13.8% increase on the current EURIBOR payable rate (i.e. over 8.2%).
If interest rates fall then the swaption would not be exercised and Nonap plc would benefit from borrowing at the lower
floating rates. If the swaption is not exercised the premium is still payable, and Nonap plc would be worse off by the
amount of the premium than if no swaption had been agreed.
However, this premium is the price that must be paid for the flexibility of being able to take advantage of the lower
interest rates in the future.
Furthermore it should be noted that once the swaption is exercised this action cannot be reversed. Therefore if interest
rates subsequently fall, Nonap plc will continue to pay the fixed rate of interest set out in the agreement.
96. PZP plc
(a)

Fixed rate Floating rate

% %

Foreten 7.80 LIBOR + 1.35

PZP 6.35 LIBOR + 0.60

Difference 1.45 0.75

The overall possible arbitrage saving is 1.45 – 0.75 = 0.70% or 70 basis points. (PZP wants floating rate finance and
would borrow fixed and swap to floating. Foreten wants fixed rate finance and would borrow at a floating rate and swap
to fixed).
 PZP requires a minimum of 40 basis points or 0.40%, the bank 0.25%, leaving an arbitrage gain of only (70 – 40 – 25)
5 basis points or 0.05% for Foreten. A swap could therefore be arranged which satisfies all parties, but Foreten might
not be happy to receive only a 5 basis point gain as compared to the rate at which it could borrow directly in the
market.
(b) To give PZP an arbitrage gain of 40 basis points, when it could borrow in the cash market at LIBOR plus 60 basis
points, its net costs with the swap need to be LIBOR plus 20 basis points.
It will borrow at a fixed rate in the cash market at 6.35%. If it pays the floating rate in the swap at LIBOR it must receive
6.15% fixed in the swap.
The overall cost to PZP will be:

Borrow fixed (6.35%)

Swap

Pay floating (LIBOR)

Receive fixed 6.40%

Pay bank (0.25%)

Net cost (LIBOR plus 0.20%)

Regardless of how LIBOR moves, up or down, PZP will gain 0.40% per annum through the swap arrangement
compared to borrowing at LIBOR plus 0.60% in the cash market. On borrowings of £15 million, this represents an
interest saving of (£15 million × 0.40%) = £60,000 each year for the five years of the swap.
The present values of these annual interest savings will be discounted at the current effective floating rate swap rate
(LIBOR plus 0.20% = 5.5% + 0.20% = 5.7%) until interest rates change. Rates could move to 6.8%, in which case the
discount rate would rise to 7%, or fall to 4.8%, in which case the discount rate will fall to 5%.
(i) PV of interest savings: LIBOR rises to 6.8% after the first year:

Year Interest saving Discount rate Discount factor Present

£ % value
£

1 60,000 5.7 0.946 56,760

2 60,000 7.0 0.873 52,380

3 60,000 7.0 0.816 48,960

4 60,000 7.0 0.763 45,780

5 60,000 7.0 0.713 42,780

246,660

Total present value of savings is £246,660

(ii) PV of interest savings: LIBOR falls to 4.8% after the three years:

Year Interest saving Discount rate Discount factor Present

£ % value
£

1 60,000 5.7 0.946 56,760

2 60,000 5.7 0.895 53,700

3 60,000 5.7 0.847 50,820

 4 60,000 5.0 0.823 49,380

5 60,000 5.0 0.784 47,040

257,700

Total present value of savings is £257,700

If PZP decides to borrow at a floating rate, using a swap will result in large savings, regardless of the discount rate
used to establish the present value. From the point of view of managing interest rate risk, PZP might decide in
retrospect that borrowing at a fixed rate might be better if interest rates rise, because the fixed borrowing rate would
lock in the interest cost and the company would not be affected by any subsequent increase in LIBOR.
97. Tayquer plc
A collar will involve Tayquer arranging both a floor and a ceiling (lower and upper limits) on its interest yield. This may be
achieved by buying a call option on futures and selling (or writing) a put option on the same futures contract, but with a
different exercise price.
As protection is required for the next eight months, to cover the full period, March contracts will be used.
If Tayquer wishes to protect its current interest yield, the company is likely to fix the floor at the current yield, i.e. it will buy
call options at 9250, which implies an interest rate of 7.5%.
The option would be exercised if interest rates fall below 7.5% and the futures price rises above 9250. In order to reduce
the net premium cost, the potential gain on the interest from short-term investments (if interest rates were to rise) may be
reduced by selling March put contracts at a lower exercise price than 9250.
For example, if the interest rate rose to 9% and the put option had been sold at the 9150 exercise price, the buyer of the
put option would exercise the option at any futures price lower than 9150. A 9% interest rate implies a futures price of
9100.
The 1.5% gain in interest rate rises would be split 1% to Tayquer and 0.5% to the buyer of the put option. Any further
interest rate rises will result in the extra interest earned by Tayquer being equal to the increased loss on the puts.
Hence Tayquer will only benefit from the first 1% of interest rate increases, but will be protected from any reduction in
interest rates. Tayquer, in this example, has fixed the minimum interest received at 7.5%, and the maximum at 8.5%.
To protect £9.75 million for eight months, the following number of contracts are required:

The net percentage premium payable at various combinations of collar are:

Buy Premium Write Premium Net premium cost Net premium cost
call paid put received (%) (£)

1) 9250 0.68 9200 0.13 0.55 35,750

2) 9250 0.68 9150 0.06 0.62 40,300

3) 9250 0.68 9100 0.02 0.66 42,900

The net premium cost is calculated as follows:

• 0.55 × 100 = 55 ticks
52 contracts × 55 ticks × £12.50 = £35,750
• 0.62 × 100 = 62 ticks
52 contracts × 62 ticks × £12.50 = £40,300
• 0.66 × 100 = 66 ticks
52 contracts × 66 ticks × £12.50 = £42,900
The choice of exercise price at which to sell the put option will depend upon Tayquer’s views on how far interest rates
could rise, and the potential gains if rates do rise.
 Interest Put Net Interest Net gain or loss Net gain or loss
rate exercise premium gain % £
price cost % %

8% 9200 (0.55) 0.50 (0.05) (3,250)

8½% 9150 (0.62) 1.00 0.38 24,700

9% 9100 (0.66) 1.50 0.84 54,600

The net sterling gains and losses are calculated as follows:

52 contracts × (0.05) × 100 × £12.50 = £(3,250)

52 contracts × 0.38 × 100 × £12.50 = £24,700

52 contracts × 0.84 × 100 × £12.50 = £54,600

The best potential gains are from a put option exercise price of 9100, but Tayquer may not be willing to lose the £7,150
premium income relative to 9200 put option exercise price.
The £7,150 premium income that would be lost is calculated as follows:

9200 premium income = 52 × 0.13 × 100 × £12.50 8,450

9100 premium income = 52 × 0.02 × 100 × £12.50 1,300

£7,150

Alternatively, compare the net premium cost in 3) above of £42,900 with the net premium cost in 1) above of £35,750.
The difference between these two amounts is £7,150.
In reality trading costs may make any option strategies more expensive than they appear to be from the figures
presented.
98. HYK Communications
(a) Futures
(i) Increases by 150 basis points
o what contract? 3 months contracts – March futures contract
o what type? sell future contract as interest rates are expected to rise.

o Calculate the closing future price using basis and basis risk.
Calculate opening basis as:

Current LIBOR = 6.5% (100 – 6.5) = 93.50

Future price 93.10

Basis 0.40

This will fall to zero when the contract expires, and it is assumed that it will fall at an even or linear manner.
There are four months until expiry and the funds are needed in two months’ time, therefore the expected basis
at the time of borrowing is:
0.4 × 2/4 = 0.2
Closing futures price

LIBOR = 6.5% + 1.5% = 8% (100 – 8) = 92.0

Basis 0.2

Future price 91.8

Calculate profit or loss

Selling price 93.10

Buying price 91.80

Gain per contract 1.3 = 130 ticks

Total profit 130 × 0.01% × 500,000 × 3/12 × 48 = £78,000

OR
130 × 12.5 × 48 = £78,000

Overall outcome (total cost) £

Interest cost (8 + 0.75) = 8.75% × 4/12 × 18m 525,000

Profit on future position (78,000)

Net cost 447,000

Effective rate of interest = (447,000/18,000,000) × 12/4 × 100% = 7.45%

(ii) Decreases by 50 basis points.

o If interest rate decreases by 50 basis points the same future contract will be used and the basis will still be 0.2
on 1st February.
Closing future price will therefore be estimated as:

LIBOR = (6.5% - 0.5%) = 6% (100 – 6) = 94.0

Basis 0.2

Future price 93.8

o Calculate profit or loss

Selling price 93.10

Buying price 93.80

Loss per contract 0.7 = 70 ticks

Total loss 70 × 0.01% × 500,000 × 3/12 × 48 =£42,000

OR
70 × 12.5 × 48 = £42,000
o Overall outcome (total cost)

£
Interest cost (6 + 0.75) = 6.75% × 4/12 × 18m = (405,000)

Loss on future position = (42,000)

Net cost (447,000)

Effective rate of interest = (447,000/18,000,000) × 12/4 × 100% = 7.45%

The effective rate of futures hedge will be 7.45% no matter what the interest rate will be and this is less than the
maximum rate the company wants to pay.
Option
(i) Increases by 150 basis points
o What date contract = March contract
o Put = buy put option to have the right to sell sterling futures
o Calculate premium

Exercise price Premium cost

93.00 18,000,000 × 0.20% × 4/12 = £12,000

93.50 18,000,000 × 0.60% × 4/12 = £36,000

94.00 18,000,000 × 1.35% × 4/12 = £81,000

The premium cost is annual % so it should be expressed to 4/12, to reflect the period of borrowing.
o Calculate profit or loss
If interest rate increases, the option will be exercised and the futures contract sold at the exercise price;

Exercise price Profit

93.00 (93.00 –91.80) ×100 × 48 × 12.5 = £72,000

93.50 (93.50 –91.80) ×100 × 48 × 12.5 = £102,000

94.00 (94.00 –91.80) ×100 × 48 × 12.5 = £132,000

o Calculate total cost

Exercise Cost of Premium Profit Net Effective

price borrowing at cost on future cost rate
8.75% for 4 months

£ £ £ £ %

93.00 525,000 12,000 (72,000) = 465,000 7.75

93.50 525,000 36,000 (102,000) = 459,000 7.65

94.00 525,000 81,000 (132,000) = 474,000 7.9

(ii) Decreases by 50 basis points.

o If interest rate decreases by 50 basis point the same future contract will be used and the basis will still be 0.2
on 1st February and the closing price will be 93.8. The premium will be same as above.
o Calculate profit or loss
If interest rate increases, the option will be exercised and the futures contract sold at the exercise price;
 Exercise price Profit?

93.00 (93.00 – 93.80) = loss so will not be exercised

93.50 (93.50 – 93.80) = loss so will not be exercised

94.00 (94.00 – 93.80) × 100 × 48 × 12.5 = £12,000

o Calculate total cost

Exercise Cost of Premium Profit Net Effective

price borrowing cost on future cost rate
at 6.75% for 4 months

£ £ £ £ %

93.00 405,000 12,000 0 =417,000 6.95

93.50 405,000 36,000 0 =441,000 7.35

94.00 405,000 81,000 (12,000) =474,000 7.9

Conclusion
If the finance director does not want to pay anything more than 7.5% then futures should be selected. If interest
rates increase all the options contract cost will exceed the maximum target interest payment of 7.5%.
(b) The future market outcome might be different because of basis risk. This result may not occur as basis is not likely to
decrease in a linear manner. The basis at the future closing date might not be the same as the expected basis. Also
future contracts require margin payments and interest payments on such margin payments are not considered in the
calculations.
99. Malva plc
(a) The borrowing rates for each company are as follows:

Fixed Floating
% %

Malva plc 6.0 LIBOR + 0.5

Genista plc 7.8 LIBOR + 1.2

Difference 1.8 + 0.7

The following table shows how these differences in interest rates can be used to the benefit of both companies.

Difference between fixed and floating rates (1.8 – 0.7) 1.1

Less bank commission 0.2

Available for division between the two companies 0.9

Malva plc required savings 0.4

Genista plc required savings 0.5

0.9
 The table shows that a swap arrangement can be devised to meet the requirements of both companies concerning
future savings.
(b) Malva plc has the larger comparative advantage with fixed-rate borrowing and so should borrow at the fixed rate.
Interest payments and receipts for the company will be as follows:

£m £m

Interest paid on fixed rate loan (£100m at 6.0%) to its own bank 6.0

Interest received from swap bank (balancing figure) (5.9)

Interest paid (LIBOR) to swap bank 6.2 0.3

Total interest cost (Variable at LIBOR + 0.1%) 6.3

Interest payments and receipts for Genista plc will be as follows:

£m £m

Interest on floating rate loan (£100m at 7.4%) paid to own bank 7.4

Interest received from swap bank (LIBOR) (6.2)

Interest paid to swap bank (balancing figure) 6.1 (0.1)

Total interest cost (fixed at 7.3%) 7.3

(c) If LIBOR increases by 1.4% in the second year, the annual interest payments and receipts for each company will be
as follows:

Malva plc

£m £m

Interest paid on fixed rate loan (£100m at 6.0%) to its own bank 6.0

Interest received from swap bank (balancing figure) (5.9)

Interest paid (LIBOR) to swap bank 7.6 1.7

Total interest cost (variable at LIBOR + 0.1%) 7.7

Genista plc

£m £m

Interest on floating rate loan (£100m at 8.8%) paid to own bank 8.8

Interest received from swap bank (LIBOR) (7.6)

Interest paid to swap bank (balancing figure) 6.1 (1.5)

Total interest cost (fixed at 7.3%) 7.3

Malva plc may, with hindsight, regret entering into the swap agreement. The effective rate of interest for the second
and subsequent years is 7.7% and the company could have borrowed at a fixed rate of 6.0%. However, Malva plc may
be able to reswap with another counterparty during the period of the swap agreement if it wishes.
Genista plc will continue to pay the same effective rate of interest.
(d) Interest rate swaps have a number of advantages including:
 – Flexibility. They can be designed to suit the particular requirements of the customer concerning the time period,
amount etc.
– Low cost. Transaction costs such as the fees of swap banks and legal fees are usually low, largely due to the degree
of competition among swap banks.
– Arrangement/reversion. Swaps are usually easy to arrange and to reverse. A swap bank may be prepared to act as
a counterparty to the swap agreement and so it may not be necessary to find another company to act as a
counterparty.
Swap agreements may be reversed before the maturity date of the agreement by re-swapping with other
counterparties, as mentioned above. However, there will be financial consequences if a swap is reversed.
The main disadvantage of swap agreements is the risk that the counterparty to the agreement will default on its
commitments.
However, a swap bank will often be prepared to act as a guarantor to both parties to the agreement (as in this
problem) for a fee.
100. Shawter plc
Futures
• what contract? = 3 months contract – March futures contract
• what type? = sell interest rate futures as interest rates are expected to rise
•

• Ticks size? = 0.01% × 500,000 × 3/12 = 12.5 (given)

• Calculate the closing future price using basis and basis risk.
Calculate opening basis as:

Current LIBOR = 6% (100 –6) = 94.00

Futures price 93.79

Basis 0.21

This will fall to zero when the contract expires, and it is assumed that it will fall at an even or linear manner.
There are three and half months until expiry and the funds are needed in three months’ time, therefore the expected
basis at the time of borrowing is:
0.21 × 1/7 = 0.03
Closing future price

LIBOR = 6.5% (100 – 6.5) = 93.5

Basis 0.03

Future price 93.47

• Calculate profit or loss

Selling price 93.79

Buying price 93.47

Gain per contract 0.32 = 32 ticks

Total profit 32 × 0.01% × 500,000 × 3/12 × 40 = £16,000

OR
 32 × 12.5 × 40 = £16,000 (40 Contracts × 32 Ticks × £12.50)
• Overall outcome (total cost)

Interest cost (6.5 + 0.9) = 7.4% × 2/12 × 30m 370,000

Profit on future position (16,000)

Net cost 354,000

Options
• What date contract? = March contract
• Call or put? = buy put option to have the right to sell sterling futures
• Calculate premium

Exercise price Premium cost

93750 0.085% × 30,000,000 × 2/12 =£4,250

94000 0.225% × 30,000,000 × 2/12 =£12,750

94250 0.480% × 30,000,000 × 2/12 =£24,000

• Calculate profit or loss

If interest rates increase, the option will be exercised and the futures contract will be sold at the exercise price:

Exercise price Profit

93750 (93.75 – 93.47) × 40 × 12.5 × 100 =£14,000

94000 (94.00 – 93.47) × 40 × 12.5 × 100 =£26,500

94250 (94..25 – 93.47) × 40 × 12.5 × 100 =£39,000

• Calculate total cost

Exercise price Cost of Premium Profit Net

borrowing cost on future cost
at 7.4% for 2 months

£ £ £ £

93750 370,000 4,250 (14,000) = 360,250

94000 370,000 12,750 (26,500) = 356,250

94250 370,000 24,000 (39,000) =355,000

FRA
FRAs are OTC instruments, which allow the rate on borrowing at some future period to be fixed today (similar to a forward
contract in the foreign exchange market). As with futures, FRAs do not allow the buyer or seller to take advantage of
favourable interest rate movements. Unlike futures, FRAs have no margin requirement.
As the company wants to borrow funds in three months’ time for a period of two months, the appropriate FRA would be the
3 v 5 contract. The outcome would be as follows:

£
 Interest paid based upon the revised LIBOR of 6.5% plus the risk premium of 0.9% (7.4% × 2/12 × 370,000
£30m)

Compensation from bank (16,000)

(7.08% - 7.4%) × 2/12 × £30m

i.e. (7.08% × 2/12 × £30m) £354,000

Alternatively, since the compensation from the bank would be received at the time when the borrowing starts, it could be
argued that this amount of £16,000 should be discounted back to that date, using the LIBOR of 6.5% per annum i.e.

Conclusion
The futures hedge and the FRA have the same expected total cost. However, because of basis risk the futures cost is not
certain, and the futures contracts require margin payments. For these reasons the FRA might be preferred to futures. If
there is believed to be a chance of a fall in interest rates the 94250 option might be selected for the hedge.
101. FNDC plc
(a) Short-term interest rate futures
Short-term interest rate (STIR) futures offer protection against adverse movements in interest rates in the underlying
cash market. If losses do occur they should, in theory, be offset by gains on the futures market at the time the futures
contracts are closed out. However, such hedges are rarely perfect, because of the following factors:
– Basis risk
This is the risk that the movement in the futures price may not change to the same extent as the movement in the
underlying interest rate.
– “Round-sum” nature of contracts
The terms of futures contracts, the sums involved and the durations of such contracts are standardised. Hedge
inefficiencies would be caused by the “round-sum” nature of contracts, thus too many contracts or too few contracts
may be entered into and the risk may be overhedged or underhedged. Thus, one has to consider the action to be
taken with the unhedged amount.
– LIBOR
A Euronext.liffe futures contract is based upon LIBOR. The underlying risk might however, be based on a short-term
interest rate with different characteristics to LIBOR.
Futures contracts require the up-front payment of initial margin. However, this cost is likely to be lower than the
expense of an over-the-counter forward rate agreement or the premium for any type of option. Further payments of
variation margin could be demanded by the Clearing House if interest rates move in an adverse direction. Futures
contracts are highly standardised and have a limited number of expiry dates.
Market traded options on short-term interest rate futures
The major benefit of options is that the buyer is protected from adverse movements in the interest rate, but can take
advantage of any favourable interest rate movements. A traded interest rate option would provide a borrower with the
right (but not the obligation) to borrow a specified amount at a predetermined interest rate. Up until the date of expiry
of the option, the buyer must decide whether or not to exercise that right. The option would only be exercised if actual
interest rates had risen above the interest rate specified by the option.
Furthermore, investors may also make use of traded interest rate options to protect against falls in interest rates, which
would reduce their investment income.
The major disadvantage of such option contracts is the payment of a fairly substantial premium, which must still be
paid whether or not the option is exercised.
Options offer a wide choice of level of interest rate that may be used to protect against adverse movements. The rate
chosen will depend upon the expectation of the extent of interest rate movements and the size of the premium for each
option.
(b) (i) Use of a futures hedge
 It is now 1 December. The company is planning to borrow in five months’ time, by which date both the December
and March contracts will have matured. Accordingly, FNDC plc would now sell June Euronext.liffe STIR contracts
(with a £12.50 tick value). June contracts would be used since it has the first available maturity date after the period
of risk commences. Futures are now sold in order to profit if interest rates were to rise. The period of the risk is two
months, thus the number of contracts sold is calculated as follows:

Estimation of the futures price at close-out

At 1 December, the June contract has 7 months to expiry, whilst LIBOR is currently 4% (which implies a futures price
of 96.00). At 1 December, the June contract is priced at 95.55
Thus the basis in the June contract on 1 December is (96.00 – 95.55) i.e. 45 ticks. The close-out date is expected to
be 1 May, thus:

1 May (2 months to expiry): 45 × 2/7 = 13 ticks UNEXPIRED, alternatively expressed as:

1 May (5 months now expired): 45 × 5/7 = 32 ticks EXPIRED

Price at 1 Dec when Expired Futures price Close-out (buying

futures sold basis change price) at 1 May

If LIBOR rises 95.55 + 0.32 – 0.5 (FALL) = 95.37

to 4.5%

If LIBOR falls 95.55 + 0.32 + 0.5 (RISE) = 96.37

to 3.5%

These close-out prices are then used below as the buying prices on 1 May.
Therefore the results of the hedge specified by the question are:

Futures market

0.5% increase 0.5% decrease

Outcomes of interest rate changes:

At 1 December: Sell 60 contracts at 95.55 95.55

On 1 May : Buy 60 contracts at 95.37 96.37

0.18 (0.82)

Tick movement (multiplied by 100) 18 (82)

Gain/(Loss): 60 contracts × tick movement × £12.50 £13,500 £(61,500)

Net result

£ £

Payment in cash market (4 + 0.5 + 1.25)% × £45m × 2/12 (431,250)

(4 – 0.5 + 1.25)% × £45m × 2/12 (356,250)

Gain/(Loss) in futures market 13,500 (61,500)

 Net cost of loan (417,750) (417,750)

The effective interest cost is (£417,750 ÷ £45,000,000) × (12 months ÷ 2 months) i.e. 5.57%. However, this assumes
that basis declines in a linear manner (which may not actually be the case).
(ii) Use of options on interest rate futures
Options are required to sell interest rate futures, therefore June put options must be bought. All three possible
exercise prices are considered below. The number of contracts to be purchased remains at 60 contracts, as
calculated earlier in this part of the solution. Since the tick size is now 0.005% and the tick value is £6.25, all
calculations must be based upon (2 × £6.25) i.e. £12.50.
The option premium for each available exercise price is as follows:

Exercise price

9500: 60 contracts × (0.015 × 100) i.e. 1.5 ticks × 12.50 = £1,125

9550: 60 contracts × (0.165 × 100) i.e. 16.5 ticks × 12.50 = £12,375

9600: 60 contracts × (0.710 × 100) i.e. 71 ticks × 12.50 = £53,250

The close-out prices remain at 95.37 (in the event of an interest rate increase) and 96.37 (in the event of an interest
rate decrease) as previously calculated.

In the event of an interest rate rise, the results of the hedge will be:

Exercise price 9500 9550 9600

Put option strike price 95.00 95.50 96.00

June futures close-out price on 1 May 95.37 95.37 95.37

(0.37) 0.13 0.63

Exercise option? (prefer to sell at the higher price) No Yes Yes

Gain in ticks (multiplied by 100) N/A 13 63

Gain: (60 contracts × tick movement × £ 12.50) – £9,750 £47,250

Net result

Exercise price 9500 9550 960

£ £ £

Actual interest paid (as calculated above) (431,250) (431,250) (431,250)

Gain on exercise of put options – 9,750 47,250

Premium paid (1,125) (12,375) (53,250)

Net cost of loan £(432,375) £(433,875) £(437,250)

Effective interest cost

(Net cost of loan ÷ £45m) × (12 months ÷ 2 months) 5.77% 5.79% 5.83%

In the event of an interest rate fall, at the June futures close-out price on 1 May (at each of the exercise prices) all
options would be abandoned or traded at any remaining time value i.e.
 Exercise price 9500 9550 9600

Put option strike price 95.00 95.50 96.00

June futures close-out price on 1 May 96.37 96.37 96.37

(1.37) (0.87) (0.37)

Exercise option? (prefer to sell at the higher price) No No No

Net result

Exercise price 9500 9550 960

£ £ £

Actual interest paid (as calculated above) (356,250) (356,250) (356,250)

Premium paid (1,125) (12,375) (53,250)

Net cost of loan £(357,375) £(368,625) £(409,500)

Effective interest cost

(Net cost of loan ÷ £45m) × (12 months ÷ 2 months) 4.77% 4.92% 5.46%

All of these results are much better than the futures hedge, but they rely on interest rates falling rather than rising.
The market does not anticipate rate falls! The 9500 strike price is probably the most attractive of the option contracts
since it is relatively low cost and provides a favourable outcome if interest rates rise. However, it is still (£432,375 –
£417,750) i.e. £14,625 more expensive than the futures hedge.
(c) Use of a collar hedge
If FNDC plc requires a maximum interest rate of 5.75%, this implies a LIBOR rate of (5.75 – 1.25)% i.e. 4.5%, and thus
a put option strike price of 9550.
If the company seeks a minimum interest rate of 5.25%, this implies a LIBOR rate of (5.25 – 1.25)% i.e. 4.0%, and
accordingly a call option exercise price of 9600.
FNDC plc would create the collar hedge by
– Buying : 60 put option contracts with June expiry at a 9550 exercise price, and
– Writing: 60 call options contracts with June expiry at a 9600 strike price.
The net premium payable is as follows:

Payment : 60 puts × (0.165 × 100) × £12.50 (12,375)

Receipt : 60 calls × (0.070 × 100) × £12.50 5,250

£(7,125)

If interest rates rise by 0.5%

The 9550 put options would be exercised, and the result would be as follows:

Actual interest paid (as calculated above) (431,250)

Gain on exercise of put options (as calculated above) 9,750

Net premium paid (7,125)

 Net cost of loan £(428,625)

Effective interest cost (£428,625 ÷ £45m) × (12 months ÷ 2 months) 5.72%

If interest rates fall by 0.5%

The 9550 put options would be abandoned, but the gain would be restricted by the buyer of the call exercising that
option. FNDC plc would pay interest at LIBOR of 4% + 1.25% i.e. 5.25%:

Actual interest paid (5.25% × 2/12 × £45m) (393,750)

Net premium paid (7,125)

Net cost of loan £(400,875)

Effective interest cost (£400,875 ÷ £45m) × (12 months ÷ 2 months) 5.35%

The collar hedge reduces the amount of the premium, however if the expected interest rate rise occurs, the result is
still much more expensive than hedging with futures.
(d) Writing (selling) options would certainly increase the income of the company, since the writer would receive an option
premium from buyers of those options. However, unless the option writer employs appropriate hedging techniques,
he/she would be exposed to unlimited losses. Writing options (particularly uncovered options) is effectively speculation,
involves very high risk and requires specialist financial expertise. This course of action is definitely not recommended
as a strategy for a manufacturing company such as FNDC plc.
102. Somax
(a) The discount rate should be a weighted average cost of capital, which takes into account the systematic risk of the
new investment.
Somax proposes to establish a new production plant in the eastern region of Switzerland. As this involves diversifying
into a new industry, the company’s existing equity beta is unlikely to reflect the systematic risk of the new investment.
The project systematic risk may be estimated using the equity beta of the main Swiss competitor in the same industry
as the new proposed plant. This will be ungeared and then the capital structure of Somax applied to find the WACC to
be used for the discount rate.
Ungearing of Swiss equity beta:

Market values of Somax equity and debt

£m £m

Equity = (450m × 3.76) 1692.00

Debt : Bond = (75m × 119.50/100) 89.63

Bank loan 135.00 224.63

Total 1,916.63

Regearing equity beta:

Cost of equity = Rf + (Rm – Rf) beta

= 7.75% + (14.5% - 7.75%) 1.13 = 15.38%
Cost of debt (Kd) Term loan: (8.25% + 1%) × (1 - 0.33) = 6.20%
 Cost of debt (Kd) Bond:

Year Try 5% Try 4%

£ Df PV Df PV

0 (119.50) 1.000 (119.50) 1.000 (119.50)

1 – 5 (14 × 0.67) 9.38 4.329 40.61 4.452 41.76

5 100 0.784 78.40 0.822 82.20

(0.49) 4.46

Interpolating

The weighted average cost of capital is:

= 13.5575 + 0.2291 + 0.4367 = 14.24%

(b) (i) The proposed swap is based upon Somax issuing a five year fixed rate sterling bond. The cost of such a bond is
not given, and must be estimated. The best estimate is provided by the yield to redemption of this existing fixed rate
bond which has five years to maturity. The gross yield on the fixed rate bond can be estimated as:

Year Try 9%

£ Df PV

0 (119.50) 1.000 (119.50)

1–5 14 3.890 54.46

5 100 0.650 65.00

(0.04)

Fixed rate = 9% (approximately)

Swap

Somax Swiss Company

% %

Unwanted deal (9) (SF, LIBOR + 1.5)

Somax pays floating (SF, LIBOR + 1) SF, LIBOR + 1

Somax receive fixed 9.5 (9.5)

Required deal (SF, LIBOR +0.5) (10)

Compared with

Direct borrowing (SF, LIBOR + 0.75) at least (10.5)

(NB, SF LIBOR = 5%)

Savings with swap 0.25 0.5

 Fee to bank (0.20) (0.2)

Net annual benefit of swap 0.05% at least 0.3%

The swap would benefit both parties, although most of the arbitrage gains are enjoyed by the bank and the Swiss
company. The actual savings from the swap will slightly differ from the above figures as the Swiss francs is
strengthening relative to the pound. Any percentage receipts/payments in pounds will not be as large as the same
percentage receipts/payments in Swiss Francs. If the Swiss franc continues to strengthen, the overall gain to Somax
could be eliminated.
(ii) The benefits of Swaps include:
o Access to markets in which it might be impossible to borrow directly, because of an inadequate credit rating.
This particularly relates to some fixed rate markets.
o The opportunity to alter the proportion of debt on which fixed and floating rate interest is paid, without physically
redeeming debt or issuing new debt.
o Long-term hedges against both interest rate risk and currency risk. In this case Somax and the Swiss company
are protected against currency risk for the full five years of the swap. The main benefit for the bank is of course
the fees from the swap, but the publicity from acting as the arranger might also be important.
The main risks of swaps are:
o Credit risk or default risk if the counterparty to the swap default.
o Position risk or market risk. This relates to the gain or loss from movements in interest rates and exchange
rates relative to the position if the swap had not been undertaken.
o Spread risk. If a bank temporarily ‘warehouses’ a swap with two companies, spread risk exists as interest rates
may change during this time lag. There may also be a mismatch in the size and desired duration of the swap
between companies, which would expose banks to further risk and necessitate the bank arranging offsetting
hedges.
103. Phobos Co
(a) (i) This question covers interest rate hedging using interest rate futures and options.
Step 1: Calculate the current interest commitment
Current interest
= (LIBOR + 0.5%) × Exposure period × Principal sum
= 6.5% × 4/12 × £30million
= £650,000
Step 2: Select that futures contract with a maturity which ceases shortly after the commencement of the borrowing.
Since Phobos Co is a borrower, sell March contracts with an open price of 93.800 and a settlement price of 93.880.
Step 3: Calculate the number of contacts sold

Step 4: Calculate the current basis

Basis = Spot price – Futures price = (100 – 6) – 93.88 = 94.00 – 93.88
= 12 basis points (ticks)
Assuming that convergence occurs on a linear pattern, (12 ticks ÷ 3 months) i.e. 4 basis points will disappear during
each of the three months to the maturity of the contract at the end of March. Therefore, between closure at the start
of March and maturity at the end of March, 4 basis points will remain (since the contracts will have one month to run
at the date of close-out).
Step 5: The estimate of close-out price
If interest rates increase by 100 basis points, close-out price should be:
 (94.00 – 1.00 – 0.04) = 92.96
If interest rates decrease by 100 basis points, close-out price should be:
(94.00 + 1.00 – 0.04) = 94.96
Step 6: Calculate the gain/loss on the futures market and the equivalent cost

Interest rate at close-out: 7.00% 5.00%

£ £

Cash market cost (7.5% × 4/12 × £30m) 750,000 (5.5% × 4/12 × £30m) 550,000

Futures market

Sell now 93.88 93.88

Buy at 1 March 92.96 94.96

0.92 (1.08)

No. of ticks (× 100) 92 (108)

(Gain)/loss (80 × 92 × £12.50) (92,000) (80 × 108 × £12.50) 108,000

Net cost £658,000 £658,000

Annual % 6.58% 6.58%

(ii) Traded options allow the management of this type of risk, but the hedge requires payment of a premium. Given the
current LIBOR of 6% and a borrowing which commences in March, the puts which expire at the end of March at
94000 are best suited for this type of exposure. A put option allows the holder, at exercise, the right to short the
futures at the stated price. These options are exercised (or sold back to the market) if the March futures rate is less
than the stated exercise price.
Step 1: Choose the most effective option strategy to:
o Minimise the basis risk from the point of exposure to the contract exercise date on the underlying borrowing;
and
o Minimise time value.
Therefore, buy March puts on three month futures at a 94000 exercise price
Step 2: Calculate the required number of contracts:
This calculation is identical to that used for interest rate futures i.e. 80 contracts
Step 3: Calculate the premium payable:
Premium = [80 × (0.168 × 100) × £12.50] = [80 × 16.8 × £12.50] = £16,800
Step 4: Calculate the basis on the underlying at close-out (as before) = 4 ticks
Step 5: Test outcomes against expected movements in interest rates:

Interest rate at close-out: 7.00% 5.00%

£ £

Cash market cost (as before) 750,000 (as before) 550,000

Option market

Exercise (selling) price 94.00 94.00

Close-out (buying) price 92.96 94.96

 1.04 ABANDON

Less Premium 0.168 0.168

0.872 (0.168)

No. of ticks (× 100) 87.2 16.8

(Gain)/loss (80 × 87.2 × £12.50) (87.200) (80 × 16.8 × £12.50) 16,800

Net cost £662,800 £566,800

Annual % 6.63% 5.67%

Expected payoff assuming equal likelihoods: (6.63% + 5.67%) ÷ 2 = 6.15%

In this calculation, we have ignored the time value of the option at close out and have assumed that it will only have
an intrinsic value. With one month before close out (with the volatilities implied in this example) the time value of the
in-the-money options could be significant and should strictly be calculated.
At 6.63%, the effective cost is just above the required threshold (of 6.6%), but with an expected payoff of 6.15%
(given equal likelihoods of a rise or a fall in interest rates). Given the absence of a time value estimate on close out
(and the possibility of capturing the benefit of a fall in rates) the use of options should be the preferred alternative.
It would, of course, have been perfectly acceptable to select one of the other available exercise prices i.e.
If the 93750 strike price were selected (thus paying a smaller premium and accepting the prospect of a potentially
higher interest rate):

Interest rate at close-out: 7.00% 5.00%

£ £

Cash market cost (as before) 750,000 (as before) 550,000

Option market

Exercise (selling) price 93.75 93.75

Close-out (buying) price 92.96 94.9

0.79 ABANDON

Less Premium 0.045 0.045

0.745 (0.045)

No. of ticks (× 100) 74.5 (4.5)

(Gain)/loss (80 × 74.5 × £12.50) (74,500) (80 × 4.5 × £12.50) 4,500

Net cost £675,500 £554,500

Annual % 6.76% 5.55%

Expected payoff assuming equal likelihoods: (6.76% + 5.55%) ÷ 2 = 6.15%

If the 94250 exercise price were chosen (thus paying a larger premium and accordingly enjoying the prospect of a
potentially lower interest rate):

Interest rate at close-out: 7.00% 5.00%

 £ £

Cash market cost (as before) 750,000 (as before) 550,000

Option market

Exercise (selling) price 94.25 94.25

Close-out (buying) price 92.96 94.96

1.29 ABANDON

Less Premium 0.30 0.30

0.99 (0.30)

No. of ticks (× 100) 99 (30)

((Gain)/loss (80 × 74.5 × £12.50) (99,000) (80 × 30 × £12.50) 30,000

Net cost £651,000 £580,000

Annual % 6.51% 5.8%

Expected payoff assuming equal likelihoods: (6.51% + 5.8%) ÷ 2 6.15%

(b) Derivatives offer an opportunity for a company to vary its exposure to interest rate risk at a given rate of interest on
the underlying principal amount (i.e. hedging) or to decrease the rate of interest on its principal sum at an increased
level of risk exposure. For hedging purposes derivatives permit the management of exposure either for the long term
(swaps) or for the short term [Forward Rate Agreements (FRAs), Interest Rate Futures (IRFs), Interest Rate Options
(IROs) and hybrids].
With forward and futures contracts, the mechanism of hedging is the same in that an offsetting position is struck such
that both parties forego the possibility of upside in order to eliminate the risk of downside in the underlying rate
movements.
Where the option to benefit from favourable rate movements is required (or in situations where there is uncertainty
whether a hedge will be required), then an IRO may be the more appropriate (but higher cost) alternative.
Such hedging can be more or less efficient depending upon the ability to set up perfectly matched exposures with zero
default risk. Matching depends upon the nature of the contract. With OTC agreements the efficiency of the match may
be perfect, but the risk of default remains. With traded derivatives, the efficiency of the match may be less than perfect
(either through size effects or because of the lack of a perfect match on the underlying) – for example, the use of a
LIBOR derivative against an underlying reference rate which is not LIBOR. There will also be basis risk where the
maturity of the derivative does not coincide exactly with the underlying exposure.
Where a company forms a view that future spot rates will be lower than those specified by the forward yield curve, they
may decide to alter their exposure to interest rate risk in order to capture the benefit of the reduced rate. This can be
achieved through the use of IROs.
Alternatively, leveraged swap or leveraged FRA positions can be taken to avoid the upfront cost of an IRO. For
example, taking multiples of the variable leg of swap (i.e. agreeing to swap fixed for variable) where a higher than
market fixed rate is swapped for ‘n’ multiples of the variable rate. However, as a number of cases have demonstrated,
it may be very difficult with these types of arrangement to gauge the degree of risk exposure and to ensure that they
are effectively managed by the company. During the 1990s a number of companies in the US (and elsewhere) took
leveraged positions, without recognising the degree of their exposure – and took losses that threatened the survival of
the firm.
104. Katmai Company
(a) Katmai Company can use the following to hedge their interest rate exposure:
(i) Redemption of existing floating debt and reissuing a fixed rate debt. In this case the company will issue a fixed rate
bond and use the proceeds from the issue to redeem the current floating interest debt. The advantage of this policy
is that it eliminates the exposure to an increase in interest rates in the future. However, this approach may be
 expensive as it will require the company to incur issue costs. There is the possibility that the issue will not be fully
subscribed.
(ii) Do nothing. This is where the company will gamble on the assumption that interest rates will remain the same over
the period. The problem of this approach is that if interest rate increases the company will be called upon to pay
more interest.
(iii) A fixed for variable interest rate swap: with this strategy the company will enter into a swap agreement with a
market maker for the term of the loan. Normally this will entail swapping the liability for the variable component of the
swap for a fixed rate. The advantage of a swap agreement is that it is easy to establish through the highly organised
OTC swap market. The disadvantage is that the company will be committed for the term of the swap, which means
that the company would have to reverse out of the swap if it found itself in a position to retire the loan notes earlier
than planned.
(iv) The company can use interest rate futures and interest rate options if these instruments are available to them.
From an equity investor point of view therefore, given the costs of hedging, (ii) may be the preferred strategy. From the
perspective of other stakeholders (iii) is likely to be the least costly alternative for achieving stability in future financing
flows. From a managerial perspective (iii) is the recommended course of action.
(b) Given that the company is to borrow, a swap rate of 5.40% will be agreed. The six monthly interest rate under a
vanilla swap given the quoted spread (120 basis points) would be as follows:

Payments LIBOR/2 + 1.2/2 = (LIBOR/2 + 0.6%)

Receipt under a vanilla swap LIBOR/2 = LIBOR/2

Payment on fixed leg 5.4%/2 = (2.7%)

Net payment 3.30%

The effective annual rate = 1.0332 – 1 = 6.71%

(c) Using Z =

and establishing Z from the normal distribution tables i.e. at a 95% confidence level, 1.645 is the value for a one-tailed
5% probability.

Annual interest volatility = 1.5%

Six month interest volatility = S6 months = S1 year × √(1/2)

= S6 months = 1.5% × √(1/2)

= 1.061%

Therefore, the value at risk is calculated as:

$150 million × 1.061% × 1.645 = $2.62 million
Value at Risk (VaR) is the value which can be attached to the downside of a value or price distribution of known
standard deviation and within a given confidence level. Value at Risk and related measures give an indication of the
potential loss in monetary value which is likely to occur with a given level of confidence. The setting of the confidence
level is necessary because in principle, if a price distribution is normally distributed for example, the downside loss is
potentially infinite. Currently the relevant interest rate is LIBOR plus 120 basis points. Let us assume for the moment
that LIBOR is 5% per annum, so 6.2% is the relevant annual rate including 120 basis points. The six-monthly interest
on this loan will be 3·1% or $4·65 million. There is a 5% chance that the actual interest paid would be greater than
($4.65 million + $2.62 million) $7.27 million or, to put it another way, there is a 95% likelihood that the actual interest
payable will be less than this figure.
105. GoSlo Motor Corporation (June 2010)
(a) The expected return can be calculated by looking at the cash inflows from the pool of assets and the cash payments
against the various liabilities created by the securitisation process.
 Net Cash inflows

Income from loans ($200 million x 10·5%) 21·00

Less annual service charge 0.24

Total net receipts 20.76

Net Cash outflows

Interest on A rated bonds (200 x 95% x 80% x 1.4%) 2.13% + LIBOR

Interest on B rated bonds (200 x 95% x 10% x 11%) 2.09% + 0

Swap arrangement

Swap Receipt LIBOR 0 - LIBOR

Swap Payment (8.5% x 200 x 95% x 80%) 12.92% + 0

Total net payments 17.14%

Balance to the subordinated certificates 3.62

The subordinated certificate holders will have a return of $3.62 million out of a $19 million total (200 x 95% x 10%)
representing 19.05% (3.62/19) even though it carries a higher level of risk.
The sensitivity of the subordinated certificates
A 1% reduction in the cash inflows will result into an annual reduction of receivables to $20.79 million (99% x 21m).
This will then reduce the amount available to subordinated certificate holders from $3.62 million to $3.41 million,
representing a fall of 5.8%.
(b) Securitisation normally involves the setting up of a special-purpose vehicle, which will buy the asset from the owners
and will then undertake the issue of securities (e.g. 10-year fixed-rate bonds) to the market. The bonds will be serviced
by the income received from the underlying assets and, on the maturity of the bonds, the amounts owing may be
repaid in various ways, including the income generated from the underlying assets, the issue of new bonds or by the
repayment of the underlying claims (e.g. where mortgage obligations provide the asset backing).
Individual securities are often split into tranches, or categorized into varying degrees of subordination. Each tranche
has a different level of credit protection or risk exposure than another: there is generally a senior (“A”) class of
securities and one or more junior subordinated (“B,” “C,” etc.) classes that function as protective layers for the “A”
class. The senior securities are typically AAA rated, signifying a lower risk, while the lower-credit quality subordinated
classes receive a lower credit rating, signifying a higher risk.
In order to improve the marketability of the securitisation issue, investors may be offered protection against the risk that
the underlying assets are of poor quality. This may be done in various ways such as providing credit insurance from a
third party or offering underlying assets of greater value than the value of the security issue. In the securitisation
process a rating agency would normally advise on the structure of the liabilities created, such that the AAA tranche will
attract investors such as banks, and other financial institutions, who demand a low level of risk exposure. This
reduction in risk for the senior and intermediate level notes is balanced by a significant transfer of risk to the
subordinated certificate holders. Tranching the issue rather than creating a single issue of an asset backed security is
the most important mechanism for credit enhancement.
Securitisation may be of benefit to a business in reducing credit risk. Where, for example, a bank has been engaged in
heavy borrowing to a particular sector of industry, it may reduce its risk by selling some of the loans through a
securitisation issue. The effect of such a move will also result in releasing tied-up capital and may enable the bank to
use the capital for more profitable purposes. Securitisation can also be helpful to a business in overcoming short-term
cash flow problems, as the sale of the assets results in an immediate injection of funds. Investors may find a
securitisation issue attractive because the securities are marketable and, for reasons already mentioned, the
underlying assets provide good security.
(c) There are many risk associated with securitisation to the investor including the following:
Credit/default risk: Default risk is generally accepted as a borrower’s inability to meet interest payment obligations on
time. Default may occur when maintenance obligations on the underlying collateral are not sufficiently met, as detailed
 in its prospectus. A key indicator of a particular security’s default risk is its credit rating.
Correlation risk: It is often assumed that defaults on the asset side of the securitisation process are uncorrelated.
However, if a degree of positive correlation is present (such as defaulting car loans and repossessions being positively
associated with rising unemployment) then this can create higher than anticipated volatility in the receivables.
Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This
risk is mitigated by having a backup servicer involved in the transaction.
Liquidity risk: The question only refers to average returns which presumably consist of a mixture of repayments,
interest and possibly the anticipated recovery from repossessions. Modelling the cash flow ‘waterfall’ is a difficult issue
where the timing of the cash receipts is crucial in fulfilling the commitments to the various tranches.
Moral hazard: Investors usually rely on the deal manager to price the securitization’s underlying assets. If the manager
earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of
interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.
106. Alecto Co (December 2011)
(a) A collar hedge involves a cap and a floor. As the name implies, a ‘cap’ is the upper-level interest rate, and a ‘floor’ a
lower-level interest rate. With a collar a company enters into an arrangement such that it will borrow for a period of
time with a floating interest rate, but it knows it will not have to pay more than the ‘cap’ rate, but on the other hand it will
not be able to pay less than the ‘floor’ rate. The cap involves a payment of a premium and the floor involves receipt of
a premium and therefore the premium payable under the collar hedge is the difference between the premium paid on
the cap and the one received on the floor making the overall premium cheaper than under normal option.
The advantage of the collar hedge compared to a normal option hedge is that the collar hedge has a lower overall
premium cost, due to the potential benefit of the floor to the bank.
The main disadvantage of the collar hedge is that the company is exposed to the risk of the interest rate falling below
the floor rate. If the interest rate falls below the floor rate the company would be required to pay the difference between
the floor rate and the actual interest rate to the bank.
(d) Futures contracts
The company should enter into June contracts as they matures immediately after the transaction date of 1st May. As
interest rates are expected to increase, the company should sell the futures contract and close out by buying in the
future.

Profit/loss LIBOR Increase by 0·5% LIBOR Decrease by 0·5%

Selling 96.16 96.16

Buying (W1) 96.02 97.02

Profit/(loss) 0.14% (0.86%)

Total: (14 x 37 x €25) €12,950 (86 x 37 x €25) €79,550

Net outcome (cost) LIBOR Increase by 0·5% LIBOR Decrease by 0·5%

Actual cost

(3.3 + 0.5 + 0.8) =4·6% x 5/12 x €421,667

€22,000,000 =

(3.3 - 0.5 + 0.8) =3·6% x 5/12 x €330,000

€22,000,000 =

Futures (profit)/loss (€12,950) €79,550

Net cost €408,717 €409,550

Effective rate 408,717/22,000,000 x 12/5 = 409,550/22,000,000 x 12/5 =

 4·46% 4·47%

The effective rate (net cost) should be same. The difference is due to the rounding of the number of contracts.
Workings
Current Basis

LIBOR (100 - 3.3) 96.70

Futures price 96.16

Current basis 0.54

Basis at transaction date = 2/6 x 0·54 = 0·18

Closing price LIBOR Increase by 0·5% LIBOR Decrease by 0·5%

LIBOR {100 – (3.3 + 0.5)} = 96.20

LIBOR {100 – (3.3 - 0.5)} = 97.20

Futures closing price (difference) 96.02 97.02

Basis at transaction date 0.18 0.18

Option on future contracts

The company should buy 37 June put contracts as interest rates are expected to increase.

Profit/loss LIBOR Increase by 0.5%

Exercise price selling buying

96.00 96.00 96.02 No

96.50 96.50 96.02 = 0.48 48 x 37 x 25 = €44,444

Net outcome (cost) - LIBOR Increase by 0·5%

Exercise price Actual cost Premium Profit Net cost Effective rate

96.00 €421,667 (16.3 x €25 x 37) = €15,078 0 €436,745 4.76%

96.50 €421,667 (58·1 x €25 x 37) = €53,743 (€44,444) €431,010 4.70%

Profit/loss LIBOR Decrease by 0.5%

Exercise price selling buying

96.00 96.00 97.02 No

96.50 96.50 97.02 No

Net outcome (cost) - LIBOR Decrease by 0·5%

Exercise price Actual cost Premium Profit Net cost Effective rate
96.00 €330,000 (16.3 x €25 x 37) = €15,078 0 €345,078 3.76%

96.50 €330,000 (58.1 x €25 x 37) = €53,743 0 €383,743 4.19%

Collar hedge
The company should buy June put options at a premium of 0.163 and sell June call options and receive a premium of
0.090. Net premium payable is = 0.163 – 0.090 = 0.073.
The total net premium = 7.3 x €25 x 37 = €6,753

Profit - LIBOR Increase by 0·5% Buy put option Sell call option

Exercise price 96.00 96.50

Futures closing price 96.02 96.02

No No

Net outcome (cost) - LIBOR Increase by 0·5%

Actual cost (from above) €421,667

Premium €6,753

Net cost €428,420

Effective rate 4.67%

Profit/loss – LIBOR Decrease by 0·5% Buy put option Sell call option

Exercise price 96.00 96.50

Futures closing price 97.02 97.02

No (0.52%)

Total 52 x €25 x 37 = €48,100

Net outcome (cost) - LIBOR Increase by 0·5%

Actual cost (from above) €330,000

Premium €6,753

Compensation to bank (loss on exercise) €48,100

Net cost €384,853

Effective rate 4.20%

Conclusion
From the above calculations it can be deduced that if LIBOR should increase by 0.5% then the hedging using futures
contracts gives the cheapest net interest payment. However, if LIBOR should decrease by 0.5% the option on the
interest rate futures will give the cheapest interest payment. To remove the uncertainty it would be better for the
company to hedge using the futures contract as it will fix the effective rate at 4.47% regardless of the increase or
decrease in the LIBOR rate. However, the decision is based on the assumption that there is no basis risk and margin
requirement.
(e) Basis risk may arise from the fact that the price of the futures contracts may not move as expected in relation to the
value of the underlying item which is being hedged. Basis is the difference between the futures price and the current
cash market price of the underlying security. At final settlement date itself, the futures price and the market price of the
 underlying item ought to be the same, otherwise speculators would be able to make an instant profit by trading
between the futures market and spot cash market.
Most futures positions are closed out before the contract reaches final settlement, hence a difference between the
close out futures price and the current market price of the underlying item. For example, the basis at the transaction
date is 0.18 and this was calculated on the assumption that the current basis of 0.54 will decline in a linear manner,
which may not be the case in reality. As a result the actual futures closing price may be more or less than expected,
hence the effective rate may also be more or less than predicted above.
107. Sembilan Co (June 2012)

Tutor's Tips

Sembilan Co question relates to interest rate hedge. Hedging is one of the most important topics in P4 and has been
examined in every sitting.
(a)
• The amount Sembilan Co has to pay or receive from the bank depends on the swapped fixed rate and the yield
curve rate.
• Compare swapped fixed rate and the yield curve rate (the forward rates for years 2, 3 and 4).
• If the yield curve rate is less than this fixed rate, Sembilan Co should pay Ratus Bank the difference and if the yield
curve rate is more than the fixed rate then Sembilan Co should receive the difference from Ratus Bank, as shown
below.
(b)
• The question wants a demonstration so assume a base rate and increase or decrease this bank rate by some
percentage.
• The bank has guaranteed the fixed swapped rate and whatever the actual rate would be the company would pay
that fixed amount.
(c)
• This is a source of finance question, raising equity capital to pay off some debt capital.
• Discusses the effect of such proposal in relation to gearing and financial distress, tax savings on interest, capital
structure effects and cost of capital, repayment of debt and requirement of collateral security.
• Section (c) is a straightforward discussion question on sources of finance and your F9 knowledge should be able to
answer that. Easy marks can also be obtained from section (b).

(a) The amounts Sembilan Co expects to pay or receive every year on the swap
Sembilan Co has fixed the rate at 3·76¼% per annum and therefore if the yield curve rate is less than this fixed rate
Sembilan Co should pay to Ratus Bank the difference. If the yield curve rate is more than the fixed rate then Sembilan
Co should receive the difference from Ratus Bank as shown below. The forward rate for years two, three and four
should be used.

Year Fixed interest payment at Variable yield curve Payment to Ratus Receipt from Ratus
3·76¼% rate Bank Bank
(1) (2) (1 – 2) (1 – 2)

1 3·76¼% x $320m = $12·04m 2.5% x $320m = $4·04m 0

$8.0m

2 3·76¼% x $320m = $12·04m 3.7% $0·20m 0

x$320m=$11·84m

3 3·76¼% x $320m = $12·04m 4.3% 0 $1·72m

x$320m=$13·76m

4 3·76¼% x $320m = $12·04m 4.7%x$320m= 0 $3m

$15·04m
 The equivalent fixed rate of 3·76¼% is less than the 3·8% four-year yield curve rate because the 3·8% rate represents
the rate payable in year four, but bonds pay interests/coupons at different time periods when the yield curve rates are
lower.
(b) After taking the swap and fixing the rate, Sembilan Co’s net interest would be the same irrespective of whether
interest rates increase or decrease. This is because Sembilan Co would have to be compensated, or has to
compensate the bank, with the difference between the spot rate and the fixed rate. Therefore the effective interest
payable should be the fixed rate of 3·76¼% plus the spread of 60 basis point = 3·76¼% + 0.6% = 4·36¼%.
For example, we assume that yield curve rate is currently 3.5% and interest rates decrease or increase by 0.5%. The
outcome of the swap would appear as follows:

% interest If interest rate decrease by If interest rate increase by

payable 0.5% to 3% 0.5% to 4%

Actual interest payment on (Yield + spread of (3 + 0.6)% x 320m (4 + 0.6)% x 320m =

borrowing 0.6%) = ($11.52) ($14.72)

SWAP arrangement

Payment to Ratus bank (3·76¼%) 3·76¼% x 320 3·76¼% x 320

=($12·04m) =($12·04m)

Receipt from Ratus Bank Yield 3% x 320 4% x 320

=$9.6 =$12.8

Bank arrangement fee 0.2% 0.2% x 320 0.2% x 320

=($0.64) =($0.64)

Net payment (4·56¼%) $14.6m $14.6m

(c) The capital structure of the company will change if Sembilan Co raises money through equity to pay off the floating
rate debt. The company should consider the following factors:
In accordance with capital structure theories, such as Modigliani and Miller in the world of corporation tax, decreasing
debt in the capital structure by replacing it with equity will lead to increase in the weighted average cost of capital as
equity is more expensive than debt, leading to a decrease in the company’s market value. One reason why debt is
cheaper than equity is that debt is higher in the creditor hierarchy than equity, since ordinary shareholders are paid out
last in the event of liquidation. Debt is even cheaper if it is secured on assets of the company. The cost of debt is
reduced even further by the tax efficiency of debt, since interest payments are an allowable deduction in arriving at
taxable profit but dividends on equity are an appropriation of profit and not tax allowable.
However, having more debt in the capital structure leads to gearing and financial risk and its associated costs.
Companies with high levels of financial distress would find it more costly to contract with their stakeholders. The
company may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods
or larger discounts, and may have to accept supplies on more onerous terms. In addition, higher financial risk reduces
the company’s ability to borrow more debt capital and even equity capital, to finance profitable investments, which thus
reduces the company’s debt capacity. Even though debt holders have no right to vote there are normally covenants
attached to debt and this restricts the company from certain decisions and reduces its ability to raise additional finance.
Raising equity finance to pay the debt will reduce the financial distress and therefore reduce the restrictive covenants,
increase debt capacity and improve the company’s credit rating. The company can also benefit from lower costs of
contracting with stakeholders and enhanced ability to raise additional capital to finance future investment. When the
company raises the equity capital it will not have the obligation to pay annual dividend as dividend payments are
discretionary unlike interest on debt, which is compulsory whether the company makes a profit or not. Also, equity
finance is permanent capital and the company has no obligation to repay equity, unlike debt which is normally
redeemable. Furthermore equity capital does not require an asset as a collateral security.
However, the process of raising equity capital is more difficult and expensive than issuing debt, especially if the shares
are offered to new shareholders. There are costs associated with underwriting the issue and communicating or
negotiating the share price. Also, the company should consider the effect on share ownership and control as a result of
issuing shares. If it decides to raise the equity capital by a rights issue this will not dilute control unless existing
shareholders don’t exercise their right. However, the rights issue has got its own challenges, such as deciding how
much discount should be given on the current market price and the effect on the share price after the rights issue (it is
possible to estimate this using the Theoretical Ex-rights Price).
 Sembilan Co should also consider whether there are early redemption penalties associated with repaying the debt
early.
As the primary financial objective is to maximise the wealth of shareholders, the company should seek to minimise its
weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in its capital
structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (where WACC
can be decreased) or too much gearing (the company suffers from the costs of financial distress).
108. Awan Co (December 2013)
(a) Forward rate agreement (FRA)
If interest rates decrease by 0·9%
Actual inter-bank rate at date of investing = 4.09% − 0.9% = 3.19%

Actual interest (3.19 − 0.2 = 2.99% × 48,000,000 × 4/12) $478,400

Compensation from Voblaka Bank (4·82% − 3·19%) × $48,000,000 × 4/12 $260,800

Net receipt $739,200

Effective annual interest rate 739,200/48,000,000 × 12/4 = 4·62%

If interest rates increase by 0·9%
Actual inter-bank rate at date of investing = 4.09% + 0.9% = 4.99%

Actual interest (4.99 − 0.2 = 4.79% × 48,000,000 × 4/12) $766,400

Compensation to Voblaka Bank (4·99% – 4·82%) × $48,000,000 × 4/12 $(27,200)

Net receipt $739,200

Effective annual interest rate 739,200/48,000,000 × 12/4 = 4·62%

Futures contract
The most suitable contract will be the contract that matures at the nearest date after the transaction date 1st February.
This is the March contract, which matures at the end of March.
Enter by buying a futures contract as interest rate is expected to decrease.
Number of contracts: ($48,000,000/$2,000,000) × (4 months/3 months) = 32 contracts.
Basis at transaction date/unexpired basis = (100 – 4·09) – 94·76 = 1·15 × 2/5 × 1·15 = 0·46
Closing future price:
If interest rate decreases: (100 – 3·19) – 0·46 = 96·35
If interest rate increases: (100 – 4·99) – 0·46 = 94·55

Profit/loss If interest rate increases If interest rate decreases

Buy 94.76 94.76

Sell 94·55 96·35

Loss 0.21% Profit 1.59%

Total loss = 0.21% × 32 × 2,000,000 × 3/12 = $33,600

Total profit = 1.59% × 32 × 2,000,000 × 3/12 = $254,400

Net outcome: If interest rate increases If interest rate decreases

Investment return (from FRA) $766,400 $478,400

Futures profit/(loss) ($33,600) $254,400

Net outcome $732,800 $732,800

Effective annual interest rate = $732,800/$48,000,000 × 12/4 = 4·58%

Options on interest rate futures
The most suitable contract will be the contract that matures at the nearest date after the transaction date 1st February.
This is the March contract, which matures at the end of March.
Buy a call option as interest rate is expected to decrease.
Number of contracts: 32 – same as under futures
Calculate premium

Exercise price

94·50 0·00432 × $2,000,000 × 3/12 × 32 $(69,120)

95·00 0·00121 × $2,000,000 × 3/12 × 32 $(19,360)

Calculate profit or loss

If interest rate increases

Exercise price Buy Sell Profit

94·50 94·50 94·55 = 0.05% × 32 × 2,000,000 × 3/12 = $8000

95·00 95·00 94·55 = No

If interest rate decreases

Exercise price Buy Sell Profit

94·50 94·50 96·35 = 1.85% × 32 × 2,000,000 × 3/12 = $296000

95·00 95·00 96·35 = 1.35% × 32 × 2,000,000 × 3/12 = $216000

Net outcome:
If interest rate increases

Exercise price Actual interest Premium Profit Net outcome

94·50 $766,400 (69,120) 8000 705,280

95·00 $766,400 (19,360) 0 747,040

Net outcome:
If interest rate decreases

Exercise price Actual interest Premium Profit Net outcome

94·50 $478,400 (69,120) 296000 705,280

95·00 $478,400 (19,360) 216000 675,040

Conclusion
 The forward rate agreement (FRA) is better than the futures contract as it gives a higher interest return. However, if
interest rate should increase the option on interest rate futures will give a higher interest return. If the company wants
to hedge against decrease in interest rate then the forwards rate agreement should be selected. However, there is
default risk associated with FRAs.
(b) Delta is a measure of how much an option premium changes in response to a change in the security price.
For each option held, the delta value can be established i.e.

For instance, if a change in share price of 5p results in a change in the option premium of 1p, then the delta has a
value of (1p/5p) 0.2.
Therefore, the writer of options needs to hold five times the number of options than shares to achieve a delta hedge.
The delta value is likely to change during the period of the option, and so the option writer may need to change his
holdings to maintain his delta hedge position.
The option delta is equal to N(d1) from the Black-Scholes Option Pricing (BSOP) formula. This means that the delta is
constantly changing when the volatility or time to expiry change.