Professional Level Options Module

Advanced Financial Management

Tuesday 4 December 2012

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 and tables are on pages 1115. 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 Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Cos board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities and the remaining funds would be retained for future investments. The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the companys risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal. Coeden Co Financial Information Extract from the most recent Statement of Financial Position Non-current assets (re-valued recently) Current assets Total assets Share capital (25c per share par value) Reserves Non-current liabilities (52% redeemable bonds) Current liabilities Total capital and liabilities $000 42,560 26,840 69,400 3,250 21,780 42,000 2,370 69,400

Coeden Cos latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co. The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that Coeden Cos current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%. Other Information Coeden Cos current equity beta is 11 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4% and the market risk premium is estimated to be 6%. There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 04. It has been estimated that the hotel services business accounts for approximately 60% of the current value of Coeden Co and the property company business accounts for the remaining 40%. Coeden Cos corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest.

Required: (a) Calculate, and comment on, Coeden Cos cost of equity and weighted average cost of capital before and after implementing the proposal. Briefly explain any assumptions made. (20 marks) (b) Discuss the validity of the assumption that the market value of equity will remain unchanged after the implementation of the proposal. (5 marks) (c) As an alternative to selling the hotel properties, the board of directors is considering a demerger of the hotel services and a separate property company which would own the hotel properties. The property company would take over 70% of Coeden Cos long-term debt and pay Coeden Co cash for the balance of the property value. Required: Explain what a demerger is, and the possible benefits and drawbacks of pursuing the demerger option as opposed to selling the hotel properties. (8 marks) (33 marks)

[P.T.O.

Lignum Co, a large listed company, manufactures agricultural machines and equipment for different markets around the world. Although its main manufacturing base is in France and it uses the Euro () as its base currency, it also has a few subsidiary companies around the world. Lignum Cos treasury division is considering how to approach the following three cases of foreign exchange exposure that it faces. Case One Lignum Co regularly trades with companies based in Zuhait, a small country in South America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million, which it is about to deliver to a company based there. It is expecting full payment for the machinery in four months. Although there are no exchange traded derivative products available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-counter derivative products. The first derivative product is an over-the-counter forward rate determined on the basis of the Zuhait base rate of 85% plus 25 basis points and the French base rate of 22% less 30 basis points. Alternatively, with the second derivative product Lignum Co can purchase either Euro call or put options from Medes Bank at an exercise price equivalent to the current spot exchange rate of ZP142 per 1. The option premiums offered are: ZP7 per 1 for the call option or ZP5 per 1 for the put option. The premium cost is payable in full at the commencement of the option contract. Lignum Co can borrow money at the base rate plus 150 basis points and invest money at the base rate minus 100 basis points in France. Case Two Namel Co is Lignum Cos subsidiary company based in Maram, a small country in Asia, whose currency is the Maram Ringit (MR). The current pegged exchange rate between the Maram Ringit and the Euro is MR35 per 1. Due to economic difficulties in Maram over the last couple of years, it is very likely that the Maram Ringit will devalue by 20% imminently. Namel Co is concerned about the impact of the devaluation on its Statement of Financial Position. Given below is an extract from the current Statement of Financial Position of Namel Co. Non-current assets Current assets Total assets Share capital and reserves Non-current liabilities Current liabilities Total capital and liabilities MR 000 179,574 146,622 326,196 102,788 132,237 91,171 326,196

The current assets consist of inventories, receivables and cash. Receivables account for 40% of the current assets. All the receivables relate to sales made to Lignum Co in Euro. About 70% of the current liabilities consist of payables relating to raw material inventory purchased from Lignum Co and payable in Euro. 80% of the non-current liabilities consist of a Euro loan and the balance are borrowings sourced from financial institutions in Maram. Case Three Lignum Co manufactures a range of farming vehicles in France which it sells within the European Union to countries which use the Euro. Over the previous few years, it has found that its sales revenue from these products has been declining and the sales director is of the opinion that this is entirely due to the strength of the Euro. Lignum Cos biggest competitor in these products is based in the USA and US$ rate has changed from almost parity with the Euro three years ago, to the current value of US$147 for 1. The agreed opinion is that the US$ will probably continue to depreciate against the Euro, but possibly at a slower rate, for the foreseeable future.

Required: Prepare a report for Lignum Cos treasury division that: (i) Briefly explains the type of currency exposure Lignum Co faces for each of the above cases; (3 marks)

(ii) Recommends which of the two derivative products Lignum Co should use to manage its exposure in case one and advises on alternative hedging strategies that could be used. Show all relevant calculations; (9 marks) (iii) Computes the gain or loss on Namel Cos Statement of Financial Position, due to the devaluation of the Maram Ringit in case two, and discusses whether and how this exposure should be managed; (8 marks) (iv) Discusses how the exposure in case three can be managed. Professional marks will be awarded in question 2 for the structure and presentation of the report. (3 marks) (4 marks) (27 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted 3 Sigra Co is a listed company producing confectionary products which it sells around the world. It wants to acquire Dentro Co, an unlisted company producing high quality, luxury chocolates. Sigra Co proposes to pay for the acquisition using one of the following three methods: Method 1 A cash offer of $500 per Dentro Co share; or Method 2 An offer of three of its shares for two of Dentro Cos shares; or Method 3 An offer of a 2% coupon bond in exchange for 16 Dentro Cos shares. The bond will be redeemed in three years at its par value of $100. Extracts from the latest financial statements of both companies are as follows: Sigra Co $000 44,210 6,190 (1,240) 4,950 (2,700) 2,250 22,450 3,450 9,700 3,600 4,400 8,200 Dentro Co $000 4,680 780 (155) 625 (275) 350 3,350 247 873 436 500 1,788

Sales revenue Profit before tax Taxation Profit after tax Dividends Retained earnings for the year Non-current assets Current assets Non-current liabilities Current liabilities Share capital (40c per share) Reserves

Sigra Cos current share price is $360 per share and it has estimated that Dentro Cos price to earnings ratio is 125% higher than Sigra Cos current price to earnings ratio. Sigra Cos non-current liabilities include a 6% bond redeemable in three years at par which is currently trading at $104 per $100 par value. Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Cos estimated equity value by eliminating duplicated administrative functions, selling excess non-current assets and through reducing the workforce numbers, if the acquisition were successful. Required: (a) Estimate the percentage gain on a Dentro Co share under each of the above three payment methods. Comment on the answers obtained. (16 marks) (b) In relation to the acquisition, the board of directors of Sigra Co are considering the following two proposals: Proposal 1 Once Sigra Co has obtained agreement from a significant majority of the shareholders, it will enforce the remaining minority shareholders to sell their shares; and Proposal 2 Sigra Co will offer an 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.

Required: With reference to the key aspects of the global regulatory framework for mergers and acquisitions, briefly discuss the above proposals. (4 marks) (20 marks)

[P.T.O.

Arbore Co is a large listed company with many autonomous departments operating as investment centres. It sets investment limits for each department based on a three-year cycle. Projects selected by departments would have to fall within the investment limits set for each of the three years. All departments would be required to maintain a capital investment monitoring system, and report on their findings annually to Arbore Cos board of directors. The Durvo department is considering the following five investment projects with three years of initial investment expenditure, followed by several years of positive cash inflows. The departments initial investment expenditure limits are $9,000,000, $6,000,000 and $5,000,000 for years one, two and three respectively. None of the projects can be deferred and all projects can be scaled down but not scaled up. Project PDur01 PDur02 PDur03 PDur04 PDur05 Investment Year one (Immediately) $4,000,000 $800,000 $3,200,000 $3,900,000 $2,500,000 required at start of year Year two Year three $1,100,000 $2,800,000 $3,562,000 $0 $1,200,000 $2,400,000 $3,200,000 $0 $200,000 $1,400,000 Project net present value $464,000 $244,000 $352,000 $320,000 Not provided

PDur05 projects annual operating cash flows commence at the end of year four and last for a period of 15 years. The project generates annual sales of 300,000 units at a selling price of $14 per unit and incurs total annual relevant costs of $3,230,000. Although the costs and units sold of the project can be predicted with a fair degree of certainty, there is considerable uncertainty about the unit selling price. The department uses a required rate of return of 11% for its projects, and inflation can be ignored. The Durvo departments managing director is of the opinion that all projects which return a positive net present value should be accepted and does not understand the reason(s) why Arbore Co imposes capital rationing on its departments. Furthermore, she is not sure why maintaining a capital investment monitoring system would be beneficial to the company. Required: (a) Calculate the net present value of project PDur05. Calculate and comment on what percentage fall in the selling price would need to occur before the net present value falls to zero. (6 marks) (b) Formulate an appropriate capital rationing model, based on the above investment limits, that maximises the net present value for department Durvo. Finding a solution for the model is not required. (3 marks) (c) Assume the following output is produced when the capital rationing model in part (b) above is solved: Category 1: Total Final Value $1,184,409 Category 2: Adjustable Final Values Project PDur01: 0958 Project PDur02: 0407 Project PDur03: 0732 Project PDur04: 0000 Project PDur05: 1000 Category 3: Constraints Utilised Year one: $9,000,000 Year two: $6,000,000 Year three: $5,000,000 Slack Year one: $0 Year two: $0 Year three: $0

Required: Explain the figures produced in each of the three output categories. (d) Provide a brief response to the managing directors opinions by: (i) Explaining why Arbore Co may want to impose capital rationing on its departments; (2 marks) (5 marks)

(ii) Explaining the features of a capital investment monitoring system and discussing the benefits of maintaining such a system. (4 marks) (20 marks)

[P.T.O.

Strom Co is a clothing retailer, with stores selling mid-price clothes and clothing accessories throughout Europe. It sells its own-brand items, which are produced by small manufacturers located in Africa, who work solely for Strom Co. The recent European sovereign debt crisis has affected a number of countries in the European Union (EU). Consequently, Strom Co has found trading conditions to be extremely difficult, putting pressure on profits and sales revenue. The sovereign debt crisis in Europe resulted in countries finding it increasingly difficult and expensive to issue government bonds to raise funds. Two main reasons have been put forward to explain why the crisis took place: firstly, a number of countries continued to borrow excessive funds, because their expenditure exceeded taxation revenues; and secondly, a number of countries allocated significant sums of money to support their banks following the credit crunch and the banking crisis. In order to prevent countries defaulting on their debt obligations and being downgraded, the countries in the EU and the International Monetary Fund (IMF) established a fund to provide financial support to member states threatened by the risk of default, credit downgrades and excessive borrowing yields. Strict economic conditions known as austerity measures were imposed on these countries in exchange for receiving financial support. The austerity measures have affected Strom Co negatively, and the years 2011 and 2012 have been particularly bad, with sales revenue declining by 15% and profits by 25% in 2011, and remaining at 2011 levels in 2012. On investigation, Strom Co noted that clothing retailers selling clothes at low prices and at high prices were not affected as badly as Strom Co or other mid-price retailers. Indeed, the retailers selling low-priced clothes had increased their profits, and retailers selling luxury, expensive clothes had maintained their profits over the last two to three years. In order to improve profitability, Strom Cos board of directors expects to cut costs where possible. A significant fixed cost relates to quality control, which includes monitoring the working conditions of employees of Strom Cos clothing manufacturers, as part of its ethical commitment. Required: (a) Explain the role and aims of the International Monetary Fund (IMF) and discuss possible reasons why the austerity measures imposed on European Union (EU) countries might have affected Strom Co negatively. (10 marks) (b) Suggest, giving reasons, why the austerity measures might not have affected clothing retailers at the high and low price range, as much as the mid-price range retailers like Strom Co. (4 marks) (c) Discuss the risks to Strom Co of reducing the costs relating to quality control and how the detrimental impact of such reductions in costs could be decreased. (6 marks) (20 marks)

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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 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 )

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[P.T.O.

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

1

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

d2 = d1 s t The Put Call Parity relationship p = c Pa + Pee rt

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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 0914 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 0350 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 10368 11255 12134 13004 13865 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 10575 11348 12106 12849 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 10635 11296 11938 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 10563 11118 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 10380 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 04987 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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