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Professional Level Options Module

Advanced Financial Management


Thursday 6 December 2007

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This paper is divided into two sections: Section A BOTH questions are compulsory and MUST be attempted Section B TWO questions ONLY to be attempted Formulae tables are on pages 913. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper P4

Section A BOTH questions are compulsory and MUST be attempted 1 You are the chief financial officer of International Enterprises, a multinational company with interests in Europe and the Far East. You are concerned about certain aspects of the companys financial management. The company has enjoyed a high rate of growth over the last three years as a result of a single products development. This product has had a big impact in the fast moving mobile communications industry. However, the company does not have any new products in development and is relying on expanding its market share and developing upgraded versions of the current product. As part of your preparation for the board meeting to discuss the 2007 draft accounts, you have prepared a projected income statement and balance sheet for the year ending 31 December 2008. These projections are based upon a number of agreed assumptions taken from the companys strategic plan. As part of the agenda, the board will also consider its dividend target for the forthcoming year. International Enterprises Income statement for the year ended 31 December 2008 (projected) $m 2881 1432 1449 361 1088 18 1070 321 749 2008 (projected) $m 1680 32 256 1518 1806 3486 2007 (draft) $m 2619 1326 1293 270 1023 23 1000 300 700 2007 (draft) $m 1160 37 291 1558 1886 3046 2006 (actual) $m 2200 1040 1160 240 920 23 897 269 628 2006 (actual) $m 960 23 196 1217 1436 2396

Revenue Cost of sales Gross profit less other operating costs Operating profit Finance costs Profit before tax Income tax expense (at 30%) Profit for the period

Balance sheet as at 31 December

Non-current assets (see note) Buildings, plant and machinery Current assets Inventories Receivables Cash Total current assets Total assets Equity and liabilities Paid up share capital Ordinary shares (25c) Other reserves Retained earnings less dividends payable Total equity Balance sheet continued on the next page.

250 120 2169 00 2169 2539

250 120 1700 280 1420 1790

200 100 1200 200 1000 1300

Balance sheet continued 2008 (projected) $m Current liabilities Trade payables Tax payable Dividends payable Interest payable Total current liabilities Non-current liabilities Loans Provisions (deferred tax) Total non-current liabilities Total liabilities Total equity and liabilities Note Non-current assets less accumulated depreciation Net book value of non-current assets 88 285 00 18 391 350 206 556 947 3486 2008 $m 2800 1120 1680 2007 (draft) $m 77 256 280 23 636 450 170 620 1256 3046 2007 $m 2000 840 1160 2006 (actual) $m 64 233 200 23 520 450 126 576 1096 2396 2006 $m 1600 640 960

The projected figures assume: (i) $10 million of the existing loans will be repaid during the year. (ii) Capital investment in plant and equipment of $80 million will be undertaken. The company is quoted on an international stock exchange and its beta value (based upon three years of monthly return data) is 140. The current risk free rate is 3% and the equity risk premium is 5%. The current share price is $1620 and the sector price/earnings ratio is 24. The companys cost of debt capital remains at its current rate of 5%. You may assume that the current cost of equity capital remains unchanged over the term of the projection. Required: (a) Prepare a cash flow forecast for the year ended 31 December 2008. Note: the format does not need to comply with accounting standards. (6 marks)

(b) Estimate the companys maximum dividend capacity after the target level of capital reinvestment is undertaken and making any working capital adjustments you deem necessary. (6 marks) (c) Draft a brief report for senior management reviewing the potential performance of the business in the year ended 31 December 2008 if the expectations contained within the strategic plan are fulfilled. You should use the Economic Value Added (EVA) and any other performance measures you think appropriate. Note: requirement (c) includes 2 professional marks. (18 marks) (30 marks)

[P.T.O.

Burcolene is a large European-based petrochemical manufacturer, with a wide range of basic bulk chemicals in its product range and with strong markets in Europe and the Pacific region. In recent years, margins have fallen as a result of competition from China and, more importantly, Eastern European countries that have favourable access to the Russian petrochemical industry. However, the company has managed to sustain a 5% growth rate in earnings through aggressive management of its cost base, the management of its risk and careful attention to its value base. As part of its strategic development, Burcolene is considering a leveraged (debt-financed) acquisition of PetroFrancais, a large petrochemical business that has engaged in a number of high quality alliances with oil drilling and extraction companies in the newly opened Russian Arctic fields. However, the growth of the company has not been particularly strong in recent years, although Burcolene believes that an expected long term growth of 4% per annum is realistic under its current management. Preliminary discussions with its banks have led Burcolene to the conclusion that an acquisition of 100% of the equity of PetroFrancais, financed via a bond issue, would not have a significant impact upon the companys existing credit rating. The key issues, according to the companys advisors, are the terms of the deal and the likely effect of the acquisition on the companys value and its financial leverage. Both companies are quoted on an international stock exchange and below are relevant data relating to each company: Financial data as at 30 November 2007 Market value of debt in issue ($bn) Market value of equity in issue ($bn) Number of shares in issue (million) Share options outstanding (million) Exercise price of options ($ per share) Company tax rate (%) Equity beta Default risk premium Net operating profit after tax and net reinvestment ($ million) Current EPS ($ per share) Burcolene 330 990 34000 2540 2200 3000 185 16% 45000 119 PetroFrancais 580 670 44000 2500 095 30% 20500 044

The global equity risk premium is 40% and the most appropriate risk free rate derived from the returns on government stock is 30%. Burcolene has a share option scheme as part of its executive remuneration package. In accordance with the accounting standards, the company has expensed its share options at fair value. The share options held by the employees of Burcolene were granted on 1 January 2004. The vesting date is 30 November 2009 and the exercise date is 30 November 2010. Currently, the company has a 5% attrition rate as members leave the company and, of those remaining at the vesting date, 20% are expected not to have achieved the standard of performance required. Your estimate is that the options have a time value of $731. PetroFrancais operates a defined benefits pension scheme which, at its current actuarial valuation, shows a deficit of $430 million. You have been appointed to advise the senior management team of Burcolene on the validity of the free cash flow to equity model as a basis for valuing both firms and on the financial implications of this acquisition for Burcolene. Following your initial discussions with management, you decide that the following points are relevant: 1. 2. 3. The free cash flow to all classes of capital invested can be reliably approximated as net operating profit after tax (NOPAT) less net reinvestment. Given the rumours in the market concerning a potential acquisition, the existing market valuations may not fully reflect each companys value. The acquisition would be financed by a new debt issue by Burcolene.

Required: (a) Estimate the weighted average cost of capital and the current entity value for each business, taking into account the impact of the share option scheme and the pension fund deficit on the value of each company. (16 marks) (b) Write a briefing paper for management, advising them on: (i) The validity of the free cash flow model, given the growth rate assumptions made by management for both firms; (ii) The most appropriate method of deriving a bid price; and (iii) The implications of an acquisition such as this for Burcolenes gearing and cost of capital. Note: requirement (b) includes 2 professional marks. (14 marks) (30 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted 3 Digunder, a property development company, has gained planning permission for the development of a housing complex at Newtown which will be developed over a three year period. The resulting property sales less building costs have an expected net present value of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire the land in Newtown, at an agreed price of $24 million, which must be exercised within the next two years. Immediate building of the housing complex would be risky as the project has a volatility attaching to its net present value of 25%. One source of risk is the potential for development of Newtown as a regional commercial centre for the large number of professional firms leaving the capital, Bigcity, because of high rents and local business taxes. Within the next two years, an announcement by the government will be made about the development of transport links into Newtown from outlying districts including the area where Digunder hold the land option concerned. The risk free rate of interest is 5% per annum. Required: (a) Estimate the value of the option to delay the start of the project for two years using the Black and Scholes option pricing model and comment upon your findings. Assume that the government will make its announcement about the potential transport link at the end of the two-year period. (12 marks) (b) On the basis of your valuation of the option to delay, estimate the overall value of the project, giving a concise rationale for the valuation method you have used. (4 marks) (c) Describe the limitations of the valuation method you used in (a) above and describe how you would value the option if the government were to make the announcement at ANY time over the next two years. (4 marks) (20 marks)

The chairman of your company has become concerned about the accumulation of cash in hand and in the deposit accounts shown in the companys balance sheet. The company is in the manufacturing sector, supplying aerospace components to the civil aviation markets in the UK and Europe. For the last 20 years the company has grown predominantly by acquisition and has not invested significantly in research and development on its own account. The acquisitions have given the company the technology that it has required and have all tended to be small, relative to the companys total market capitalisation. The company has a healthy current asset ratio of 13, although its working capital cycle has an average of 24 unfunded days. The company has not systematically embraced new manufacturing technologies nor has it sought to reduce costs as a way of rebuilding profitability. Managerial and structural problems within divisions have led to a number of substantial projects overrunning and losses being incurred as a result. It has also proven difficult to ensure the accountability of managers promoting projects many of which have not subsequently earned the cash flows originally promised. At the corporate level, much of the companys accounting is on a contracts basis and over the years it has tended to be cautious in its revenue recognition practices. This has meant that earnings growth has lagged behind cash flow. Over the last 12 months the company has come under strong competitive pressure on the dominant defence side of its business which, coupled with the slow-down in spending in this area across the major western economies, has slowed the rate of growth of its earnings. The companys gearing ratio is very low at 12% of total market capitalisation and borrowing has invariably been obtained in the European fixed interest market and used to support capital investment in its European production facility. In the current year, investment plans are at the lowest they have been in real terms since the company was founded in the 1930s. In discussion, the chairman comments upon the poor nature of the companys buildings and its poor levels of pay which could, in his view, be improved to reflect standards across the industry. Directors pay, he reminds you, is some 15% below industry benchmarks and there is very little equity participation by the board of directors. He also points out that the companys environmental performance has not been good. Last year the company was fined for an untreated discharge into a local river. There are, he says, many useful things the company could do with the money to help improve the long-term health of the business. However, he does admit some pessimism that business opportunities will ever again be the same as in previous years and he would like a free and frank discussion at the next board meeting about the options for the company. The company has a very open culture where ideas are encouraged and freely debated. The chairman asks if you, as the newly appointed chief financial officer, would lead the discussion at the next board. Required: (a) In preparation for a board paper entitled Agenda for Change, write brief notes which identify the strategic financial issues the company faces and the alternatives it might pursue. (10 marks) (b) Identify and discuss any ethical issues you believe are in the above case and how the various alternatives you have identified in (a) may lead to their resolution. (10 marks) (20 marks)

[P.T.O.

Your company, which is in the airline business, is considering raising new capital of $400 million in the bond market for the acquisition of new aircraft. The debt would have a term to maturity of four years. The market capitalisation of the companys equity is $12 billion and it has a 25% market gearing ratio (market value of debt to total market value of the company). This new issue would be ranked for payment, in the event of default, equally with the companys other long-term debt and the latest credit risk assessment places the company at AA. Interest would be paid to holders annually. The companys current debt carries an average coupon of 4% and has three years to maturity. The companys effective rate of tax is 30%. The current yield curve suggests that, at three years, government treasuries yield 35% and at four years they yield 51%. The current credit risk spread is estimated to be 50 basis points at AA. If the issue proceeds, the companys investment bankers suggest that a 90 basis point spread will need to be offered to guarantee take up by its institutional clients. Required: (a) Advise on the coupon rate that should be applied to the new debt issue to ensure that it is fully subscribed. (4 marks) (b) Estimate the current and revised market valuation of the companys debt and the increase in the companys effective cost of debt capital. (8 marks) (c) Discuss the relative advantages and disadvantages of this mode of capital financing in the context of the companys financial objectives. (8 marks) (20 marks)

Formulae Modigliani and Miller Proposition 2 (with tax) k e = kie + (1 T)(kie k d ) Vd Ve

Two asset portfolio sp = w2s2 + w2s2 + 2wawbrab sasb a a b b

The Capital Asset Pricing Model E(ri ) = Rf + i (E(rm ) Rf ) The Asset beta formula asset V (1 T) Ve d a = e + d (Ve + Vd (1 T)) (Ve + Vd (1 T))

The Growth Model Po = Do (1 + g) (re g)

Gordons growth approximation g = bre

The weighted average cost of capital V V e d ke + k (1 T) WACC = Ve + Vd Ve + Vd d

The Fisher formula (1 + i) = (1 + r)(1+h)

Purchasing power parity and interest rate parity S1 = S0 x (1+hc ) (1+hb ) F0 = S0 x (1+ic ) (1+ib )

[P.T.O.

The Put Call Parity relationship p = c Pa + Pee rt

Modified Internal Rate of Return PV n MIRR = R 1 + re 1 PVI


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The Black-Scholes option pricing model c = PaN(d1) PeN(d2 )e rt Where: d1 = ln(Pa / Pe ) + (r+0.5s2 )t s t

The FOREX modified Black-Scholes option pricing model c = e rt F0N(d1) XN(d2 ) Or p = e rt XN(d2 ) F0N(d1) Where: d1 = and d2 = d1 s T 1n(F0 / X) + s2T/2 s T

d2 = d1 s t

[P.T.O.

Present Value Table Present value of 1 i.e. (1 + r)n Where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0941 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0305 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

(n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

11% 0901 0812 0731 0659 0593 0535 0482 0434 0391 0352 0317 0286 0258 0232 0209

12% 0893 0797 0712 0636 0567 0507 0452 0404 0361 0322 0287 0257 0229 0205 0183

13% 0885 0783 0693 0613 0543 0480 0425 0376 0333 0295 0261 0231 0204 0181 0160

14% 0877 0769 0675 0592 0519 0456 0400 0351 0308 0270 0237 0208 0182 0160 0140

15% 0870 0756 0658 0572 0497 0432 0376 0327 0284 0247 0215 0187 0163 0141 0123

16% 0862 0743 0641 0552 0476 0410 0354 0305 0263 0227 0195 0168 0145 0125 0108

17% 0855 0731 0624 0534 0456 0390 0333 0285 0243 0208 0178 0152 0130 0111 0095

18% 0847 0718 0609 0516 0437 0370 0314 0266 0225 0191 0162 0137 0116 0099 0084

19% 0840 0706 0593 0499 0419 0352 0296 0249 0209 0176 0148 0124 0104 0088 0074

20% 0833 0694 0579 0482 0402 0335 0279 0233 0194 0162 0135 0112 0093 0078 0065 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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[P.T.O.

Annuity Table
n Present value of an annuity of 1 i.e. 1 (1 + r) r

Where

r = discount rate n = number of periods Discount rate (r)

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 1037 1126 1213 1300 1387 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191

2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 1058 1135 1211 1285 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811

3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 1063 1130 1194 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462

4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 1056 1112 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142

5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 1038 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847

6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575

7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324

8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092

9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876

10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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Standard normal distribution table 000 00000 00398 00793 01179 01554 01915 02257 02580 02881 03159 03413 03643 03849 04032 04192 04332 04452 04554 04641 04713 04772 04821 04861 04893 04918 04938 04953 04965 04974 04981 04987 001 00040 00438 00832 01217 01591 01950 02291 02611 02910 03186 03438 03665 03869 04049 04207 04345 04463 04564 04649 04719 04778 04826 04864 04896 04920 04940 04955 04966 04975 04982 049987 002 00080 00478 00871 01255 01628 01985 02324 02642 02939 03212 03461 03686 03888 04066 04222 04357 04474 04573 04656 04726 04783 04830 04868 04898 04922 04941 04956 04967 04976 04982 04987 003 00120 00517 00910 01293 01664 02019 02357 02673 02967 03238 03485 03708 03907 04082 04236 04370 04484 04582 04664 04732 04788 04834 04871 04901 04925 04943 04957 04968 04977 04983 04988 004 00160 00557 00948 01331 01700 02054 02389 02704 02995 03264 03508 03729 03925 04099 04251 04382 04495 04591 04671 04738 04793 04838 04875 04904 04927 04945 04959 04969 04977 04984 04988 005 00199 00596 00987 01368 01736 02088 02422 02734 03023 03289 03531 03749 03944 04115 04265 04394 04505 04599 04678 04744 04798 04842 04878 04906 04929 04946 04960 04970 04978 04984 04989 006 00239 00636 01026 01406 01772 02123 02454 02764 03051 03315 03554 03770 03962 04131 04279 04406 04515 04608 04686 04750 04803 04846 04881 04909 04931 04948 04961 04971 04979 04985 04989 007 00279 00675 01064 01443 01808 02157 02486 02794 03078 03340 03577 03790 03980 04147 04292 04418 04525 04616 04693 04756 04808 04850 04884 04911 04932 04949 04962 04972 04979 04985 04989 008 00319 00714 01103 01480 01844 02190 02517 02823 03106 03365 03599 03810 03997 04162 04306 04429 04535 04625 04699 04761 04812 04854 04887 04913 04934 04951 04963 04973 04980 04986 04990 009 00359 00753 01141 01517 01879 02224 02549 02852 03133 03389 03621 03830 04015 04177 04319 04441 04545 04633 04706 04767 04817 04857 04890 04916 04936 04952 04964 04974 04981 04986 04990

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above from 05.

End of Question Paper

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