ACCA PAPER AFM Advanced Financial Management Lecture Notes ACCA SILVER APPROVED LEARNING PARTNER KOFI ANNAN PROFESSIONAL INSTITUTE Contents The Financial Management Function...................................................................12 INVESTMENT APPRAISAL .........................................................................................13 Question 1 ............................................................................................................... 18 Question 2 Fernhurst Co. (assignment) ............................................................... 18 Question 3 (assignment) ....................................................................................... 22 Question 4 ............................................................................................................... 23 Question 5 GNT Co[ASSIGNMENT]. ...................................................................... 24 Question Bank for Investment Appraisal ............................................................ 24 Capital Rationing ...................................................................................................25 Question 6 ............................................................................................................... 27 Question 7 (assignment) ....................................................................................... 29 Question 8 Abore Co. ........................................................................................... 29 Cost of Capital .......................................................................................................31 Question 9 ............................................................................................................... 33 Question 10 ............................................................................................................. 33 Question 11 ............................................................................................................. 34 Question 12 ............................................................................................................. 35 Question 13 ............................................................................................................. 35 Question 14 ............................................................................................................. 37 Question 15 ............................................................................................................. 38 Question 16 ............................................................................................................. 38 Question 17 ............................................................................................................. 39 Question 18 ............................................................................................................. 39 Question 19 ............................................................................................................. 40 Question 20 ............................................................................................................. 40 Question 21 Batch Co. .......................................................................................... 41 Question 22 ............................................................................................................. 41 Question 23 AMH Co. ............................................................................................ 42 Risk-adjusted WACC (De-gear & Re-gear) ........................................................ 43 Question 24 ............................................................................................................. 45 Question 25 Moorland Co. ................................................................................... 45 Question 26 Moon dog Co. .................................................................................. 52 Question 27 Mlima Co. .......................................................................................... 53 Question 28 Tisa Co. (assignment) ...................................................................... 53 Question Bank for Risk Adjusted WACC ............................................................. 55 Adjusted Present Value (APV) ..............................................................................55 Question 29 Blades Co. ......................................................................................... 57 Question 30 Strayer assignment ........................................................................... 58 Question bank for APV .......................................................................................... 58 International Investment Appraisal ......................................................................59 Question Bank for International Appraisal ......................................................... 59 Question 31 ............................................................................................................. 61 Question 32 ............................................................................................................. 62 Question 33 ............................................................................................................. 62 Question 34 ............................................................................................................. 63 Question 35 Parrott Co. ......................................................................................... 63 Question 36 Puxty Plc. ........................................................................................... 64 BOND VALUATION ..................................................................................................65 Question bank for Bonds....................................................................................... 65 Question 37 ............................................................................................................. 72 Question 38 Landline Co. ..................................................................................... 72 Question 39 ............................................................................................................. 72 Question 40 assignment ........................................................................................ 73 Question 41 Kenand Co. ...................................................................................... 74 Question 42 Levante Co. ...................................................................................... 74 BUSINESS VALUATION .............................................................................................77 Question 43 ............................................................................................................. 79 Question 44 ............................................................................................................. 79 Question 45 ............................................................................................................. 80 Question 46 ............................................................................................................. 80 Question 47 ............................................................................................................. 82 Question 48 ............................................................................................................. 82 Question 49(ASSIGNMENT) ................................................................................... 83 Question 50 ............................................................................................................. 83 Question 51 ............................................................................................................. 86 Question 52 ............................................................................................................. 86 Question 53 assignment ........................................................................................ 86 Question 54 Stanzial Inc. ....................................................................................... 87 Mergers and Acquisitions ..................................................................................... 89 Question Bank for Mergers and Acquisitions ..................................................... 89 Question 55 Pursuit Co. (Jun 11 Adapted) ......................................................... 92 Question 56 SIGRA CO (Dec 12 Adapted) ........................................................ 98 Question 57 Anderson Co.(ASSIGNMENT) .......................................................... 99 Question 58 Detox Plc.(ASSIGNMENT) ............................................................... 100 Detox plc ............................................................................................................... 100 Question Bank for Dividend Capacity .............................................................. 101 Question Bank for Restructuring ......................................................................... 101 Currency Risk Management ............................................................................... 102 Question 59 ........................................................................................................... 105 Question 60 Casasophia Co. ............................................................................. 107 QUESTION 61 Lammer Plc. ..................................................................................... 1 Question 62 Lirio Co. ................................................................................................ 2 Question 63 Kenduri Co. ......................................................................................... 3 Question 64 The Armstrong Group ........................................................................ 8 Interest Rate Hedges .............................................................................................11 Question Bank for Interest Rate Risk .................................................................... 11 Question 65 ............................................................................................................. 14 Question 66 ............................................................................................................. 14 Question 67 ............................................................................................................. 15 Question 68 ............................................................................................................. 20 Question 69 ............................................................................................................. 20 Question 70 Warne Co. ......................................................................................... 21 Question 71 Wa Inc. .............................................................................................. 21 Question 72 Alecto Co. ......................................................................................... 22 Question 73 Pault Co............................................................................................. 23 Question 74 Sembilan Co. .................................................................................... 24 Question 75 Buryecs .............................................................................................. 26 Question 76 Awan Co. .......................................................................................... 28 Option Pricing ........................................................................................................30 Question 77 Uniglow .............................................................................................. 37 Question 78 Mesmer Magic Co. .......................................................................... 38 Mergers & Acquisitions ..........................................................................................39 Business Reorganization ........................................................................................48 Question Bank (Complete)................................................................................... 55 MATHEMATICAL TABLES AND FORMULAE SHEET Present Value Table Present value of 1 i.e. (𝟏 + 𝐫)−𝐧 Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 2 3 4 5 0.990 0.980 0.971 0.961 0.951 0.980 0.961 0.942 0.924 0.906 0.971 0.943 0.915 0.888 0.863 0.962 0.925 0.889 0.855 0.822 0.952 0.907 0.864 0.823 0.784 0.943 0.890 0.840 0.792 0.747 0.935 0.873 0.816 0.763 0.713 0.926 0.857 0.794 0.735 0.681 0.917 0.842 0.772 0.708 0.650 0.909 0.826 0.751 0.683 0.621 1 2 3 4 5 6 7 8 9 10 0.942 0.933 0.923 0.914 0.905 0.888 0.871 0.853 0.837 0.820 0.837 0.813 0.789 0.766 0.744 0.790 0.760 0.731 0.703 0.676 0.746 0.711 0.677 0.645 0.614 0.705 0.665 0.627 0.592 0.558 0.666 0.623 0.582 0.544 0.508 0.630 0.583 0.540 0.500 0.463 0.596 0.547 0.502 0.460 0.422 0.564 0.513 0.467 0.424 0.386 6 7 8 9 10 11 12 13 14 15 0.896 0.887 0.879 0.870 0.861 0.804 0.788 0.773 0.758 0.743 0.722 0.701 0.681 0.661 0.642 0.650 0.625 0.601 0.577 0.555 0.585 0.557 0.530 0.505 0.481 0.527 0.497 0.469 0.442 0.417 0.475 0.444 0.415 0.388 0.362 0.429 0.397 0.368 0.340 0.315 0.388 0.356 0.326 0.299 0.275 0.350 0.319 0.290 0.263 0.239 11 12 13 14 15 (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 2 3 4 0.901 0.812 0.731 0.659 0.893 0.797 0.712 0.636 0.885 0.783 0.693 0.613 0.877 0.769 0.675 0.592 0.870 0.756 0.658 0.572 0.862 0.743 0.641 0.552 0.855 0.731 0.624 0.534 0.847 0.718 0.609 0.516 0.840 0.706 0.593 0.499 0.833 0.694 0.579 0.482 1 2 3 4 5 6 7 8 9 10 0.593 0.535 0.482 0.434 0.391 0.352 0.567 0.507 0.452 0.404 0.361 0.322 0.543 0.480 0.425 0.376 0.333 0.295 0.519 0.456 0.400 0.351 0.308 0.270 0.497 0.432 0.376 0.327 0.284 0.247 0.476 0.410 0.354 0.305 0.263 0.227 0.456 0.390 0.333 0.285 0.243 0.208 0.437 0.370 0.314 0.266 0.225 0.191 0.419 0.352 0.296 0.249 0.209 0.176 0.402 0.335 0.279 0.233 0.194 0.162 5 6 7 8 9 10 11 12 13 14 15 0.317 0.286 0.258 0.232 0.209 0.287 0.257 0.229 0.205 0.183 0.261 0.231 0.204 0.181 0.160 0.237 0.208 0.182 0.160 0.140 0.215 0.187 0.163 0.141 0.123 0.195 0.168 0.145 0.125 0.108 0.178 0.152 0.130 0.111 0.095 0.162 0.137 0.116 0.099 0.084 0.148 0.124 0.104 0.088 0.074 0.135 0.112 0.093 0.078 0.065 11 12 13 14 15 Annuity table Present value of an annuity of 1 i.e. 𝟏 − (𝟏 + 𝒓)−𝒏 𝒓 where r = interest rate n = number of periods Discount rate (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 2 3 4 5 0.990 1.970 2.941 3.902 4.853 0.980 1.942 2.884 3.808 4.713 0.971 1.913 2.829 3.717 4.580 0.962 1.886 2.775 3.630 4.452 0.952 1.859 2.723 3.546 4.329 0.943 1.833 2.673 3.465 4.212 0.935 1.808 2.624 3.387 4.100 0.926 0.178 2.577 3.312 3.993 0.917 1.759 2.531 3.240 3.890 0.909 1.736 2.487 3.170 3.791 1 2 3 4 5 6 7 8 9 10 5.795 6.728 7.652 8.566 9.471 5.601 6.472 7.325 8.162 8.893 5.417 6.230 7.020 7.786 8.530 5.242 6.002 6.733 7.435 8.111 5.076 5.786 6.463 7.108 7.722 4.917 5.582 6.210 6.802 7.360 4.767 5.389 5.971 6.515 7.024 4.623 5.206 5.747 6.247 6.710 4.486 5.033 5.535 5.995 6.418 4.355 4.868 5.335 5.759 6.145 6 7 8 9 10 11 12 13 14 15 10.370 11.260 12.130 13.000 13.870 9.787 10.580 11.350 12.110 12.850 9.253 9.954 10.630 11.300 11.940 8.760 9.385 9.986 10.560 11.120 8.306 8.863 9.394 9.899 10.380 7.887 8.384 8.853 9.295 9.712 7.499 7.943 8.358 8.745 9.108 7.139 7.536 7.904 8.244 8.559 6.805 7.161 7.487 7.786 8.061 6.495 6.814 7.103 7.367 7.606 11 12 13 14 15 Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 2 3 4 5 0.901 1.713 2.444 3.102 3.696 0.893 1.690 2.402 3.037 3.605 0.885 1.668 2.361 2.974 3.517 0.877 1.647 2.322 2.914 3.433 0.870 1.626 2.283 2.855 3.352 0.862 1.605 2.246 2.798 3.274 0.855 1.585 2.210 2.743 3.199 0.847 1.566 2.174 2.690 3.127 0.840 1.547 2.140 2.639 3.058 0.833 1.528 2.106 2.589 2.991 1 2 3 4 5 6 7 8 9 10 4.231 4.712 5.146 5.537 5.889 4.111 4.564 4.968 5.328 5.650 3.998 4.423 4.799 5.132 5.426 3.889 4.288 4.639 4.946 5.216 3.784 4.160 4.487 4.772 5.019 3.685 4.039 4.344 4.607 4.833 3.589 3.922 4.207 4.451 4.659 3.496 3.812 4.078 4.303 4.494 3.410 3.706 3.954 4.163 4.339 3.326 3.605 3.837 4.031 4.192 6 7 8 9 10 11 12 13 14 15 6.207 6.492 6.750 6.982 7.191 5.938 6.194 6.424 6.628 6.811 5.687 5.918 6.122 6.302 6.462 5.453 5.660 5.842 6.002 6.142 5.234 5.421 5.583 5.724 5.847 5.029 5.197 5.342 5.468 5.575 4.836 4.988 5.118 5.229 5.324 4.656 4.793 4.910 5.008 5.092 4.586 4.611 4.715 4.802 4.876 4.327 4.439 4.533 4.611 4.675 11 12 13 14 15 Standard normal distribution table 0 0.01 0.02 0.0000 0.0040 0.0080 0.1 0.0398 0.0438 0.0478 0.2 0.0793 0.0832 0.0871 0.3 0.1179 0.1217 0.1255 0.4 0.1554 0.1591 0.1628 0.0 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.0120 0.0159 0.0199 0.0239 0.0279 0.0319 0.0359 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224 0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2518 0.2549 0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852 0.5 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133 0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389 0.8 0.3413 0.3643 0.3849 0.4032 0.4192 0.3438 0.3665 0.3869 0.4049 0.4207 0.3461 0.3686 0.3888 0.4066 0.4222 0.3485 0.3708 0.3907 0.4082 0.4236 0.3508 0.3729 0.3925 0.4099 0.4251 0.3531 0.3749 0.3944 0.4115 0.4265 0.3554 0.3770 0.3962 0.4131 0.4279 0.3577 0.3790 0.3980 0.4147 0.4292 0.3599 0.3810 0.3997 0.4162 0.4306 0.3621 0.3830 0.4015 0.4177 0.4319 0.4332 1.6 0.4452 1.7 0.4554 1.8 0.4641 0.4345 0.4463 0.4564 0.4649 0.4357 0.4474 0.4573 0.4656 0.4370 0.4485 0.4582 0.4664 0.4382 0.4495 0.4591 0.4671 0.4394 0.4505 0.4599 0.4678 0.4406 0.4515 0.4608 0.4686 0.4418 0.4525 0.4616 0.4693 0.4430 0.4535 0.4625 0.4699 0.4441 0.4545 0.4633 0.4706 1.0 1.1 1.2 1.3 1.4 1.5 1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4762 0.4767 2.0 0.4772 0.4821 0.4861 0.4893 0.4918 2.1 2.2 2.3 2.4 0.4778 0.4826 0.4865 0.4896 0.4920 0.4783 0.4830 0.4868 0.4898 0.4922 0.4938 0.4940 0.4941 2.6 0.4953 0.4955 0.4956 2.7 0.4965 0.4966 0.4967 2.8 0.4974 0.4975 0.4976 2.9 0.4981 0.4982 0.4983 2.5 3.0 0.4788 0.4834 0.4871 0.4901 0.4925 0.4793 0.4838 0.4875 0.4904 0.4927 0.4798 0.4842 0.4878 0.4906 0.4929 0.4803 0.4846 0.4881 0.4909 0.4931 0.4808 0.4850 0.4884 0.4911 0.4932 0.4812 0.4854 0.4887 0.4913 0.4934 0.4817 0.4857 0.4890 0.4916 0.4936 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974 0.4977 0.4977 0.4978 0.4979 0.4980 0.4980 0.4981 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 This table can be used to calculate N (d1), the cumulative normal distribution function needed for the Black-Scholes model of option pricing. If d1 > 0, add 0.5 to the relevant number above. If d1 < 0, subtract the relevant number above from 0.5. HOW TO PASS AFM 1. TIME MANAGEMENT 2. PRACTISE 3. THEORIES 4. COMPONENT (SYLLABUS) AFM Structure Investment Appraisal Local Appraisal International Appraisal APV WACC Risk Adjusted WACC Real Options Business Valuation Methods of Valuation Risk Management Currency Interest Rates Mergers & Acquisitions Forward F.R.A. Reconstruction Futures I.R.G. Ratios Options Futures Bond Valuation Swaps Option Option Pricing Money Markets Collar Netting The Financial Management Function Financial management is unlearned with the efficient acquisition and deployment of both short and long-term financial resources to ensure the objectives of the enterprise are achieved. Decisions must be taken in three key areas: Investment Decision Both long-term investment in non-current assets and short-term investment in working capital. Financing Decision From what sources should funds be raised? Dividend Decision How should cash funds be allocated to shareholders and how will the value of the business be affected by this. ROLES OF A FINANCIAL MANAGER • • • • • • • Investment selection and capital resource allocation. Raising finance and minimizing the cost of capital. Distribution and retentions. Communication with stakeholders. Financial planning and control Risk management Efficient and effective use of resources. Investment Appraisal Local Appraisal - Mar/Jun 2019 Q1 bi, Ferhust Sep/Dec 2016 Investmnt Appraisal Local Appraisal International Appraisal APV WACC Risk Adjusted WACC Real Options The main of objective appraisal investment is to access the financial viability of a project before undertaken. A project is financially viable when it maximizes shareholders wealth. Shareholders wealth is maximize through capital gain (when share prices increases) and dividend payment. Methods of Investment Appraisal Basic Methods Advanced Methods 1. ROCE: Return on Capital Employed or ARR: Accounting Rate of return - None 2. Payback - Duration 3. IRR: Internal Rate of Return - MIRR: Modified Internal Rate of Return 4. NPV: Net Present Value - APV: Adjusted Present Value Other Specialized Areas: a. Capital Rationing b. Sensitivity Analysis c. Equivalent Annual Cost or Benefit Return on Capital Employed (ROCE) Return on Capital Employed is also known as the Accounting Rate of Return. ROCE = Average Annual PBIT & After depreciation Initial Capital Cost/Average Capital Investment Average Capital Investment = Initial Investment + Scrap Value 2 The Accounting Rate of Return (ARR) is a measure of relative project profitability, which expresses: 1. The expected annual profit (after allowing for depreciation but before taxation) as a percentage of 2. The investment involved. Normally the average investment over the life of the project is used, but initial investment is sometimes employed. Advantages of ROCE It is relatively easy to understand The required figures are readily available from accounting data. The ROI technique is frequently used as an assessment of management’s actual performance. It gives an indication as to whether projects are meeting target returns on capital employed. Disadvantages of ROCE Based on accounting profit not cash flows-the success of an enterprise depends on its ability to generate cash. The ability to invest depends on availability of cash. Ignores the time value of money No set of rules for determining the cut-off rate of return. It may ignore working capital It is based on profit which can easily be manipulated. Payback Period The payback period demonstrates the average time needed to generate after-after cash flows from the project to recoup the intial investment. Thus it gives an investor an idea of “how long their money will be at risk”; a short payback period is taken to reveal low risk, and a long payback – high risk. Advantages of Payback Period Easy to calculate and understand. It uses cash flows rather than profits. Rapid payback maximizes liquidity, minimizes risk and leads to rapid company growth. Disadvantages of Payback Period Does not measure profitability nor increases wealth. It ignores cash flows after the payback period. It ignores the time value of money. No set of rules for determining the minimum acceptable payback period. Net Present Value To appraise the overall impact of a project using the Discounted Cash flow (DCF) techniques involves discounting all the relevant cash flows associated with the project back to their present value. If we treat outflows of the project as negative and inflows as positive, the NPV of the project is the sum of the PVs of all flows that arise as a result of doing the project. The NPV represent the surplus funds (after funding the investment) earned on the project, therefore: If the NPV is positive – the project is financially viable. If the NPV is zero – the project breaks even (IRR). If the NPV is negative – the project is not financially viable. If the company has two or more mutually exclusive projects under consideration, it should choose the one with the highest NPV. The NPV gives the impact of the project on shareholders wealth. Assumptions used in discounting (NPV) Unless the examiner tells you otherwise, the following assumptions are made about cash flows when calculating the net present value: All cash flows accrue at the year end. NPV considers relevant cash flows. A relevant cash flow is a future incremental cash flow Non-cash items are excluded In appraisal we assume that all units produced are sold In appraisal we assume the project life is constant We assume a constant tax rate. We assume a constant discount rate. Cash flow at the start of a particular year, should be treated in previous prior to when they occur. Also note, you should never include interest payments within NPV calculations as these are taken account of by the cost of capital. We assume a constant inflation throughout the whole year. Advantages of using NPV Considers the time value of money. It’s an absolute measure of return. It’s based on cash flows not profits. Considers the whole life of the project. Should lead to the maximization of shareholders wealth. Disadvantages of using NPV It is difficult to explain to managers. It requires the knowledge of the cost of capital. It is relatively complex Impact of Inflation and Discounted Cash flows Real Cash flows: Real cash flows are cash flows whereby inflation has not been considered. They are also referred to as current or todays cash flows. They are discounted with real discount rate. Nominal Cash flows Nominal cash flows are cash flows whereby inflation have been considered. They are also referred to as money cash flows. They are discounted with nominal or money discount rate. The formula which relates real and money interest rates is as follows: (1+m) = (1+r) × (1+f) Where: m = money rate r = real rate f = inflation rate Question 1 A company is considering investing $4.5m in a project to achieve an annual increase in revenues over the next five years of $2m. The project will lead to an increase in wage cost of $0.4m pa and will also require expenditure of $0.3m pa to maintain the level of existing assets to be used on the project. Additionally investment in working capital equivalent to 10% of the increase in revenue will need to be in place at the start of each year. The following forecasts are made of the rates of inflation each year for the next five years: Revenues 10% Wages 5% Assets 7% General prices 6.5% The real cost of capital of the company is 8%. All cash flows are in real terms. Assume corporate tax rate is 20% payable in the same year. Tax allowable depreciation is 25% on the reducing balance basis and the balancing charge or allowance is claimed at the end of the project. Assumed there is a scraped value 0f $500,000 after tax at the end of the project. Required: Using all the methods of Investment Appraisal, determine whether the project is worthwhile. Question 2 Fernhurst Co. (assignment) Fernhurst Co is a manufacturer of mobile communications technology. It is about to launch a new communications device, the Milland, which its directors believe is both more technologically advanced and easier to use than devices currently offered by its rivals. Investment in the Milland The Milland will require a major investment in facilities. Fernhurst Co’s directors believe that this can take place very quickly and production be started almost immediately. Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be the same in Year 4 as Year 3, as the product reaches the end of its useful life. The initial selling price in Year 1 is expected to be $100 per unit, before increasing with the rate of inflation annually. The variable cost of each unit is expected to be $43·68 in year 1, rising by the rate of inflation in subsequent years annually. Fixed costs are expected to be $900,000 in Year 1, rising by the rate of inflation in subsequent years annually. The initial investment in non-current assets is expected to be $16,000,000. Fernhurst Co will also need to make an immediate investment of $1,025,000 in working capital. The working capital will be increased annually at the start of each of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the project’s life. Fernhurst Co will also incur one-off marketing expenditure of $1,500,000 post inflation after the launch of the Milland. The marketing expenditure can be assumed to be made at the end of Year 1 and be a tax allowable expense. Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is payable in the year that the tax liability arises. Tax allowable depreciation is available at 20% on the investment in non-current assets on a reducing balance basis. A balancing adjustment will be available in Year 4. The realisable value of the investment at the end of Year 4 is expected to be zero. The expected annual rate of inflation in the country in which Fernhurst Co is located is 4% in Year 1 and 5% in Years 2 to 4. The applicable cost of capital for this investment appraisal is 11%. Other calculations Fernhurst Co’s finance director has indicated that besides needing a net present value calculation based on this data for the next board meeting, he also needs to know the figure for the project’s duration, to indicate to the board how returns from the project will be spread over time. Failure of launch of the Milland The finance director would also like some simple analysis based on the possibility that the marketing expenditure is not effective and the launch fails, as he feels that the product’s price may be too high. He has suggested that there is a 15% chance that the Milland will have negative net cash flows for Year 1 of $1,000,000 or more. He would like to know by what percentage the selling price could be reduced or increased to result in the investment having a zero net present value, assuming demand remained the same. Required: (a) Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the investment’s duration. (b) Calculate the % change in the selling price required for the investment to have a zero net present value, and discuss the significance of your results. The Internal Rate of Return (IRR) The IRR is the discount rate that will give a zero NPV 1. Compare the IRR with the company’s cost of Borrowing Decision Rule: If the project IRR ˃ Cost of Capital → Accept the Project If the project IRR ˂ Cost of Capital → Reject the Project Advantages of IRR It considers the time value of money. Uses cash flows not profits. Considers the whole life of the project. Selecting projects where the IRR exceed the cost of capital, means an increase in shareholders wealth. Disadvantages of IRR It is not a measure of absolute profitability. It is fairly complicated to calculate. Non-conventional cash flows may give rise to multiple IRRs. IRR assumes that the cash-flows can be reinvested at the same IRR rate. The Modified IRR (MIRR) To assist in remedying some of the deficiencies of IRR, a technique called Modified Internal Rate of Return (MIRR) has been developed. MIRR has certain advantages in that it: Advantages of MIRR Considers re-investment of cash flows @least at the company’s cost of capital Eliminates the possibility of multiple rates of return. It considers the time value of money. Uses cash flows not profits. Considers the whole life of the project. Drawbacks of MIRR It is not a measure of absolute profitability. It is fairly complicated to calculate. Calculating the MIRR Formular: Return phase 𝟏 𝒏 𝒕𝒆𝒓𝒎𝒊𝒏𝒂𝒍 𝒗𝒂𝒍𝒖𝒆𝒔 𝑴𝑰𝑹𝑹 = ( ) −𝟏 𝑷. 𝑽. 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘𝒔 Investment phase NB: n = project life The MIRR assumes a single inflow at Time Zero and a single inflow at the end of the final year of the project. The procedures are as follows: Convert all investment phase outlays as a single equivalent payment at time zero. Where necessary, any investment phase outlays arising after time zero must be discounted back to time zero using the company’s cost of capital. All net cash flows generated by the project after the initial investment (i.e. the return phase cash flows) are converted to a single net equivalent terminal receipt at the end of the project’s life, assuming a reinvestment rate equal to the company’s cost of capital. Question 3 (assignment) A project requires an initial investment of $20,000 and will generate annual cash flows as follows: Years Cash flows ($) 1 4,000 2 2,000 3 6,000 4 7,600 5 10,000 The firm’s financing rate is 6% . Required: What is the IRR and MIRR? Question 3 (TRAIL WORK) A project requires an initial investment of $20,000 and will generate annual cash flows as follows: Years Cash flows ($) 1 4,000 2 (2,000) 3 6,000 4 7,600 5 10,000 The firm’s financing rate (for negative cash flows) is 9% and its reinvestment rate for the positive cash flows is 6%. Required: What is the MIRR? Duration (Macaulay Duration) Duration is the average time taken to recover the cash flows of an investment. (If cash flows are discounted at the cost of capital). Duration captures both the time value of money and the whole of the cash flows of a project. Projects with higher durations carry more risk than projects with lower durations. Formula for duration: 𝒔𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝒗𝒂𝒍𝒖𝒆𝒔 𝒔𝒖𝒎 𝒐𝒇 𝒕𝒉𝒆 𝑷𝑽𝒔 (𝒊𝒏𝒇𝒍𝒐𝒘𝒔 𝒐𝒏𝒍𝒚) Steps for finding Duration 1. Calculate the value of each future net cash flow, discounted at the chosen hurdle time. 2. Calculate each year’s discounted cash flow as a proportion of the present value of total cash inflows. 3. Take the time from investment to each discounted cash flow and multiply by respective proportion. 4. Finally, sum the weighted year values. 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 none 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 change in the level of interest rates. As interest rates rise, duration will decrease and the value of the bond will be less sensitive to subsequent rate changes. Question 4 A project with the following cash flows is under consideration: Y0 N.C.F (127) Y1 Y2 Y3 Y4 Y5 Y6 (37) 52 76 69 44 29 Cost of Capital 10% Required: Calculate the projects discounted payback period and Macaulay duration. Question 5 GNT Co[ASSIGNMENT]. GNT Co is considering an investment in one of two corporate bonds. Both Bonds have a par value of $1000 and pay coupon interest on an annual basis. The market price of the first bond is $1079.68. Its coupon rate is 6% and it is due to be redeemed at par in five years. The second Bond is about to be issued with a coupon rate of 4% and will also be redeemable at par in five years. Both bonds are expected to have the same gross redemption yields (yield to maturity). GNT Co considers duration of the Bond to be a key factor when making decisions on which bond to invest. Required: a. Estimate the Macaulay duration of the two bonds GNT Co is considering for investment. b. Discuss how useful duration is a measure of the sensitivity of a bond price to changes in interest rates. Question Bank for Investment Appraisal - Local Appraisal – Mar/Jun 2019, Ferhust Sep/Dec 2016 International Appraisal – Chmura Dec 2013, Yilandwe Jun 2015, Tramont (Pilot 2012) SENSITIVITY ANALYSIS A CHANGE IN A VARIABLE AND THE EFFECT ON THE NPV. A CHANGE IN A VARIABLE WHICH WILL CAUSEB THE NPV TO BE ZERO. CHANGES IN MORE THAN ONE VARIABLE AND THE EFFECT ON THE NPV IS CALLED SIMULATION SENSITIVITY ANALYSIS=NPV/PV OF THE AFFECTED VARIABLE NOTE IF AN INFLOW(SALES,CONTRIBUTION,SCRAP) REDUCES IN VALUE IT BECOMES MORE SENSITIVE IF AN OUTFLOW(INITIAL INVESTMENT,FC,VC)INCREASES IN VALUE IT BECOMES MORE SENSITIVE Capital Rationing Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new projects with a positive NPV, the company is said to experience “capital rationing”. CAPITAL RATIONING Soft Hard - Internal factors - External factors • not to exceed budget limits • fear of loss of control • economic issues • fear of dilution of EPS • stringent requirements • fear of interst & loan commitments • project being too risky • desire to grow organic FORMS OF CAPITAL RATIONING Single Period Multi-Period Divisible Indivisible Mutually Project Projects Exclusive No cashflows until the Can't undertake 2 project is completed projects at the same time Can undertake a part of the project to generate cashflows steps: 1. find profitability index = NPV ÷ 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 2. rank the projects 3. allocate the limited Lack of funding for more than 1 year which will give the highest function 2. state the constraints select a combination of projects 1. state the objective select the project with the highest NPV 3. interprete your results NPV with the limited funds [trial & error] funds to the project NB: When a project is making a loss, it is not considered for capital rationing unless they can be undertaken for strategic purposes Question 6 A company has $100,000 available for investment and has identified the following 5 investments in which to invest. All investment be started now (Year Zero.) Project Initial Investment NPV $’000 $’000 C 40 20 D 100 35 E 50 24 F 60 18 G 50 (10) Required: Determine which project should be chosen if projects are: a) Divisible b) Indivisible c) Mutually-exclusive Multi-Period Capital Rationing Lack of funding for more than one year. In this event, linear programming is used to determine the optimal combinations of products Steps: 1. State the objective function: maximize NPV 2. State the constraints: eg. 40C + 100D + 50E + 60F ≤ $100 C, D, E, F, ≥ 0 the non-negativity condition 3. Interpret the results i. total final value = maximum NPV earned with limited funds ii. adjustable final value = fraction or percentage of the project completed with the limited funds iii. constraint utilized = portion of the limited funds used iv. slack = unused funds Importance of Capital Investment Monitoring Systems (CIMs) Every project has 3 features which must be monitored to ensure the success of the project. These are: 1. Scope of the project – quality 2. Time – deadlines and 3. Budget – costs involved Question 7 (assignment) A company has identified the following independent investment projects, all of which are divisible and exhibit constant returns to scale. No project can be delayed or done more than once. Project A Cash Flow Y0 Y1 $000 $000 $000 $000 -10 -20 +10 +20 +20 - - -10 Y2 +30 Y3 Y4 $000 B -10 C -5 +2 +2 +2 +2 D - -15 -15 +20 +20 E -20 +10 -20 F -8 -4 +15 +20 +10 +20 - There is only $20,000 of capital available at year zero and only $5,000 at year one, plus the cash inflows from the projects undertaken at year zero. In each time period thereafter, capital is freely available. The appropriate discount rate is 10%. Required: Formulate the linear programme. Question 8 Abore Co. 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 Co’s 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 department’s 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. Investment required at start of year Project Year one Year two Year three (Immediately) Project net present value PDur01 $4,000,000 $1,100,000 $2,400,000 $464,000 PDur02 $800,000 $2,800,000 $3,200,000 $244,000 PDur03 $3,200,000 $3,562,000 $0 $352,000 PDur04 $3,900,000 $0 $200,000 $320,000 PDur05 $2,500,000 $1,200,000 $1,400,000 Not provided PDur05 project’s 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 department’s 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: 0·958 Project PDur02: 0·407 Project PDur03: 0·732 Project PDur04: 0·000 Project PDur05: 1·000 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. (5 marks) (d) Provide a brief response to the managing director’s opinions by: (i) (ii) Explaining why Arbore Co may want to impose capital rationing on its departments; (2 marks) Explaining the features of a capital investment monitoring system and discussing the benefits of maintaining such a system. (4 marks) Cost of Capital This represents the amount that a company is incurring with respect to its sources of finance. A firm may evaluate a project’s return using the company’s cost of capital to establish the NPV. An entity has two main sources of finance i.e. equity finance and debt finance. IMPORTANCE OF WACC -It is used in appraisal project(discount rate) Higher WACC could lead to rejecting Good Project Lower WACC could lead to accepting Bad Project -It is used in Business Valuation(discount rate) Higher WACC could lead to Lower MV of a company Lower WACC could lead to Higher MV of a company WACC TABLE CAPITAL STRUCTURE EQUITY DEBT COST MV COST*MV XX XX TOTAL XX XX XX XX XX XX WACC=SUM(COST*MV)/SUM(MV) Cost of Equity 3 models D.V.M. C.A.P.M. M&M Prop 2 The cost of equity finance to the company is the return the investors expect to achieve on their shares. The cost of equity can be estimated via: I. The dividend valuation model (DVM) II. The capital asset pricing model (CAPM) III. The Modigliani and Miller Proposition 2 Cost of Equity using DVM (where there is no growth in dividend) 𝐷𝑜 Ke= 𝑃𝑜 Ke= 𝐷𝑜(1+𝑔) 𝑃𝑜 + 𝑔 (where dividend growing) 𝐷1 Ke= 𝑃𝑜 + g (where dividend for the first year is given) Where: Do = Current dividend per share D1=Dividend to be in one year D1=Do (1+g) g=Constant rate of growth in dividend Po=Current share price Assumptions The company will be paying dividends The company will be paying a constant dividend into perpetuity Where dividend is growing, it must grow at a constant fixed rate into perpetuity. Constant share price Ex-div. (share price after the latest dividend payment) Question 9 A company has a current share price of 320c per share. The company pays dividend of 80c per share and this trend is expected to remain for the foreseeable future. Required: I. II. Calculate the cost of equity Calculate the cost of equity assuming dividend will grow at 3% per annum. Ex-Div Share Price The DVM formula assumes a share price after dividend (ex-div). If the share price is before dividend (Cum-Div). Calculate the ex-div share price by reducing the share price with dividend per share. Question 10 D Co is about to pay a dividend of 15c. Shareholders expect dividends to grow at 6% p.a. D Co current share price is $1.25. Required: Calculate the cost of equity of D Co Estimating growth (g) 2 method Past dividend 𝒈= ( Gordon’s growth model 𝒍𝒂𝒕𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝟏/𝒏 𝒐𝒍𝒅𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 ) g = br −𝟏 Past dividend 𝑫𝒐 𝒈 = 𝒏√𝑫−𝒏 − 𝟏 Or ( 𝒍𝒂𝒕𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝟏/𝒏 ) 𝒐𝒍𝒅𝒆𝒔𝒕 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 −𝟏 n= number of years of dividend growth D0 = latest dividend paid D-n=Oldest dividend The Earnings Retention Model (Gordon’s growth model) g = br r = Accounting Rate of Return/return on investment/return on equity b = Earnings Retention Rate Question 11 A company currently pays a dividend of 32c. Five years ago the dividend was 20c. Required: Estimate the annual growth rate in dividends. Question 12 A company has paid the following dividends per share over the last five years: 20Y0 20Y1 20Y2 20Y3 20Y4 10.0C 11.0C 12.5C 13.6C 14.5C Required: Calculate the average annual growth rate Question 13 GROUP CLASS WORK A company is about to pay an ordinary dividend of 16c share. The share price is 200c. The accounting rate of return on equity is 12.5% and 20% of earnings are paid out as dividends. Required: Calculate the cost of equity for the company. Capital Asset Pricing Model (CAPM) Cost of equity (ke) = Rf + βe (Rm-Rf) Rf = Risk free rate of return Be = equity beta Rm = average market rate of return Equity risk premium=Rm-Rf Beta (βe) is a measure of a company’s systematic risk βe > 1 risk is higher βe < 1 risk is lower βe=0 risk free investment [T Bill] Be=1 Average Systematic risk This is risk that affects all business operations eg. inflation, high interest rates, exchange rate fluctuations etc. This risk cannot be diversified. Unsystematic risk This is risk that affects a company based on the nature of its business operations. This risk can be diversified. Types of Betas 2 types Beta assets Beta equity An entity uses the βa when its business is financed entirely with equity An entity uses the βe when it business is financed with equity and debt Such an entiy faces only the business risk Faces both financial risk and business risk The CAPM is Better than DVM for Two Reasons: - CAPM incorporate risk The variables for CAPM are from reliable source and cannot be easily manipulated. Limitations of CAPM - Constant risk free Constant beta Constant return on the market It assumes that all unsystematic risk can be diversified. Question 14 The current average market return being paid on risky investments is 12%. Compared with 5% on Treasury Bills. G. Co has an equity beta of 1.2. Required: What is the cost of equity of G. Co? Question 15 A company has a beta equity of 1.8 and a beta asset of 1.2. The risk free rate of interest is 4% and the return on the market is 7% with an equity risk premium of 3%. Required Calculate the cost of equity, if the company is financed: i. Entirely by equity (business risk) ii. Both equity and debt ( both business risk and financial risk) Cost of Debt In calculating the cost of debt, first identify the type of debt. Types of Debt Formulas Non traded debts (bank loans, loan Interest × (1 – tax) notes, overdrafts) Irredeemable preference shares Div (nominal) MV (or share price) Redeemable preference shares IRR Redeemable bond IRR Convertible bond IRR Irredeemable bond Int × (1- tax) × 100 MV Types of Debts Preference Shares (Irredeemable): Preference shares have usually a constant dividend. 𝐷 Kp= 𝑃𝑜 D= Constant annual preference dividend Po= Ex-div MV of the share Kp= Cost of the preference share. Or Kp= 𝐷(1−𝑇) 𝑀𝑉 × 100 Question 15 A company has 50,000 8% preference shares in issue, nominal value is $1 and the market value is $1.20/share. Required: What is the cost of the preference shares? Question 16 A Company has issued an irredeemable debt quoted at 105.3. It carries a coupon rate of 8%. Assume a corporate tax rate of 20%. Required: Calculate the cost of debt. Cost of Non-Traded Debt These are debts that do not have market value .e.g. bank loan etc. Kd = I (1-T) where; I = interest rate T =corporate tax rate Question 17 A firm has a fixed rate bank loan of $1million. It is charged 11% p.a. the corporate tax rate is 30%. What is the cost of the bank loan? Redeemable Debt This is a debt where interest will be paid over a period and the principal repaid after the end of the period. The cost of a redeemable debt is calculated by estimating the IRR of the debt, assuming the debt as an investment. Year Cash flow Y0 MV (X) Y1-n Interest payment X n Capital repayment X MV OF A DEBT IS THE PRESENT OF INTEREST AND PRINCIPAL USING THE REQUIRED RATE OF RETURN AS THE DISCOUNT FACTOR =IRR(FIRST CELL:LAST CELL) Question 18 A company has in issue 12% redeemable debt with 5years to redemption. Redemption is at par. The current market value of the debt is $107.59 per $100. The corporation rate is 30%. Required: What is the return required by the debt providers (pre-tax cost of debt). Question 19 A Company has in issue 10% loan notes with a current MV of $98 per $100. The loan notes are due to be redeemed at 5% in six years’ time. Required: If corporation tax is 30%, what is the company’s post-tax cost of debt? Convertible Debts This is a debt which will be redeemed either in cash or in shares. The cost of a convertible bond is the bond’s IRR with the principal or redemption being the higher of the cash on redemption or the value of the shares on redemption. Convertible bonds Cash share Redemption value Below par Current at par ˂ 100 100 conversion value above par No. of ordin. shares converted × ˃100 share price × (1 + g)^ n Question 20 A company has issued convertible loan notes which are due to be redeemed at a 5% premium in five year’s time. The coupon rate is 8% and the current MV is $85. Alternatively, the investor can choose to convert each loan note into 20 shares in five year’s time. The company pays tax at 30% per annum. The company’s shares are currently worth $4 and their value is expected to grow at a rate of 7% p.a. Required: Find the post-tax cost of the convertible debt to the company. Weighted Average Cost of Capital WACC Question 21 Batch Co. Batch Co has $1million loan notes in issue, quoted at $50 per $100 of nominal value; $ 625,000 preference shares of $1 each quoted at 40c and 5million ordinary $1 shares quoted at 25c. The cost of capital of these securities is 9%, 12% and 18% respectively. Required: Calculate the weighted average cost of capital. Question 22 ASSIGMENT B Co has 10 million 25c ordinary shares in issue with a current price of 155c cum div. an annual dividend of 9c has just been proposed. The company earns an accounting rate of return to equity (ROE) of 10% and pays out 40% of the return as dividends. The company also has 13% redeemable loan notes with a nominal value of $7 million, trading $105. They are due to be redeemed at par in five years’ time. Required: If the rate of corporation tax is 33%, what is the company’s WACC? Question 40 assignment An entity has the following information in its balance sheet (statement of financial position): $000 Ordinary Share (50c nominal) 2,500 Debt (8% Redeemable in 5yrs) 1,000 The entity’s equity beta is 1.25 and its credit rating according to standard and Poor’s is A. The share price is $1.22 and the debenture price is $110 per $100 nominal. Extract from standard and Poor’s credit spread tables: Rating 1yr 2yrs 3yrs 5yrs 7yrs 10yrs 30yrs AAA 5 10 15 22 27 30 55 AA 15 25 30 37 44 50 65 A 40 50 57 65 71 75 90 The risk free rate of interest is 6% and the equity risk premium is 8%. Tax is payable at 30%. Required: Calculate the entity WACC. Question 40 assignment An entity has the following information in its balance sheet (statement of financial position): $000 Ordinary Share (25c nominal) 2,500 Debt (8% Redeemable in 10yrs) 1,000 The entity’s equity beta is 1.5 and its credit rating according to standard and Poor’s is AAA. The share price is $1.75 and the debenture price is $105 per $100 nominal. Extract from standard and Poor’s credit spread tables: Rating 1yr 2yrs 3yrs 5yrs 7yrs 10yrs 30yrs AAA 5 10 15 22 27 30 55 AA 15 25 30 37 44 50 65 A 40 50 57 65 71 75 90 The risk free rate of interest is 8% and the equity risk premium is 10%. Tax is payable at 20%. Required: Calculate the entity WACC. Question 23 AMH Co. ASSIGNMENT AMH Co wishes to calculate its current cost of capital for use as a discount rate in investment appraisal. The following financial information relates to AMH Co: Financial position statement extracts as at 31 December 2012 $000 Equity Ordinary shares (nominal value 50 cents) 4,000 Reserves 18,000 ––––––– Long‐term liabilities 4% Preference shares (nominal value $1) 3,000 7% Loan notes redeemable after six years 3,000 Long‐term bank loan 1,000 ––––––– $000 22,000 7,000 ––––––– 29,000 ––––––– The ordinary shares of AMH Co have an ex div market value of $4.70 per share and an ordinary dividend of 36.3 cents per share has just been paid. Historic dividend payments have been as follows: Year Dividends per share (cents) 2008 2009 2010 2011 30.9 2.2 33.6 35.0 The preference shares of AMH Co are not redeemable and have an ex div market value of 40 cents per share. The 7% loan notes are redeemable at a 5% premium to their nominal value of $100 per loan note and have an ex interest market value of $104.50 per loan note. The bank loan has a variable interest rate that has averaged 4% per year in recent years. AMH Co pays corporation tax at an annual rate of 30% per year. Required: (a) Calculate the market value weighted average cost of capital of AMH Co. (12 marks) (b) Discuss why the cost of equity is greater than the cost of debt. (3 marks) (Total: 15 marks) Risk-adjusted WACC (Degear & Re-gear) Existing WACC can be used as a discount rate in project appraisal when: 1. The business risk of the new project is the same as the existing company risk 2. The capital structure (financial risk) of the existing business is expected to be the same as the financial risk of the new project. If the business risk of the new project differs from the entity’s existing business risk a Risk Adjusted WACC must be calculated. This is done by recalculating the cost of equity to reflect the business risk of the new project. If the capital structure is expected to change significantly, the Adjusted Present Value method of project appraisal could be used. Business Risk Same Different Same WACC Risk Adjusted WACC Different A.P.V. A.P.V. Financial Risk Steps for Calculating a Risk-adjusted WACC 1. Find the equity beta (βe) from a suitable quoted company. 2. De-gear: convert the βe to βa using the proxy company’s capital structure (this takes off the financial risk) formula: 𝛽𝑎 = 𝛽𝑒 × 𝐸 𝐸+𝐷(1−𝑡) 3. Re-gear: convert βa to βe using the existing entity’s capital structure. 4. Use this new beta (βe) in the CAPM equation to find Ke. 5. Use this Ke to find the WACC. 6. Evaluate the project. Question 24 B plc is a hot air balloon manufacturer whose equity: debt ratio is 5:2 The company is considering a waterbed-manufacturing Project. B plc will finance the project to maintain its existing capital structure. S plc is a waterbed-manufacturing company, it has an equity beta of 1.59 and Ve:Vd ratio of 2:1. The yield on B plc debt, which is assumed to be risk free, is 11%. B plc’s equity beta is 1.10. The average return on the stock market is 16%. The corporation tax rate is 30%. Required: Calculate a suitable cost of capital to apply to the project. Question 25a Moorland Co. The directors of Moorland Co, a company which has 75% of its operations in the retail sector and 25% in manufacturing, are trying to derive the firm’s cost of equity. However, since the company is not listed, it has been difficult to determine an appropriate beta factor. Instead, the following information has been researched: Retail Industry- quoted retailers have an average equity beta of 1.20 and an average gearing ratio of 20:80 (debt: equity). Manufacturing Industry – quoted manufacturing have an average equity beta of 1.45 and an average gearing ratio of 45:55 (debt: equity). The risk free rate is 3% and the equity risk premium is 6%. Tax on corporate profits is 30%. Moorland Co has gearing of 50% debt and 50% equity by market values. Assume that the risk on corporate debt is negligible. Required: Calculate the cost of capital of M Co using the CAPM Model. Q25b The directors of Moorland Co, a company which has 60% of its operations in the retail sector and 40% in manufacturing, are trying to derive the firm’s cost of equity. However, since the company is not listed, it has been difficult to determine an appropriate beta factor. Instead, the following information has been researched: Retail Industry- quoted retailers have an average equity beta of 1.20 and an average gearing ratio of 25:75 (debt: equity). Manufacturing Industry – quoted manufacturing have an average equity beta of 1.45 and an average gearing ratio of 35:65 (debt: equity). The risk free rate is 5% and the equity risk premium is 6%. Tax on corporate profits is 30%. Moorland Co has gearing of 30% debt and 70% equity by market values. Assume that the risk on corporate debt is negligible. Required: Calculate the cost of capital of M Co using the CAPM Model. COEDEN CO (EXTRACT) Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s 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 capital structure of Coeden is 50:50 EQUITY TO DEBT and remain the same after the proposal. Coeden Co’s current equity beta is 1.1 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 0.4. 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 Co’s corporation tax rate is 20%. The company spread on A+ rated bonds is 60 basis points . After proposal Co will be rated A+. Required: Calculate Coeden Co’s cost of capital after implementing the proposal. MORADA CO (GROUP ASSIGNMENT) Morada Co is involved in offering bespoke travel services and maintenance services. The besoke travel services account for 70% and maintenance services 30%.The first director is of the opinion that Morada Co should reduce its debt in order to mitigate its risk and therefore reduce its cost of capital. He proposes that the company should sell its repair and maintenance services business unit and focus just on offering bespoke travel services and hotel accommodation Morada Co’s current share price is $2.88 per share and has number of share 125m and debt 120m quoted at 104.5 per $100. The capital structure of MORADA remain the same after the proposal. Morada Co’s equity beta is estimated at 1.2, while the asset beta of the repairs and maintenance services business unit is estimated to be 0.65. A tax rate of 20% is applicable to all companies. The current risk free rate of return is estimated to be 3.8% and the market risk premium is estimated to be 7% .ASSUME CORPORATE DEBT IS RISK FREE. Required: Calculate Morada Co’s cost of capital after implementing the proposal. CAPITAL STRUCTURE THEORIES BUSINESS RISK AND FINANCIAL RISK Business risk affects a company due to the nature of the business operations PESTEL Political(political instability ,E-levy ,taxation policies) Economic(dumsor ,interest rate, exchange rate,inflation,fuel prices) Socio-cultural (occupation, population, education, taste and preferences) Technology (IT) Environmental (Polution, emission, recycling) Legal(company law, employment, health and safety) Business risk affects going concern, cash flows, reputation, profit margins TARA FRAMEWORK(RISK MANAGEMENT TOOLS) LOW LIKELIHOLD HIGH LIKELIHOLD LOW IMPACT ACCEPT REDUCE HIGH IMPACT TRANSFER AVOID Financial risk is the measure of proportion of debt in the company’s capital structure . Liquidity risk –not being able to pay debt as and when they arise Credit risk-not able to take monies from debtors Gearing-financing higher proportion of business with debt Direct relationship between business and financial risk. An increase in the business risk can cause an increase in financial risk and vice versa Gearing Gearing means financing your business with a proportion of debt More gearing leading to high financial risk because in event on liquidation ,debt holders will be paid before equity holders Advantages of gearing Tax benefits / savings (reduce WACC) Debt is always available Debt is cheaper Less riskier to investors Disadvantage Agency problems (directors vs. shareholders) Bankruptcy where all assets are secured on loans Financial distress Default risk/legal issue FACTORS TO CONSIDER IN CHOOSING BETWEEN EQUITY OR DEBT Availability Cost Control Gearing EPS Tax savings Economic situation Security Capital Structures Theories 1. 2. 3. 4. Traditional theory on capital structure Pecking order theory M&M propositions on capital structure with no tax M&M with tax 1. Traditional theory on capital structure Debt is cheaper than equity Tax savings Debt has lower issue cost Debt is less riskier(In event of liquidation debt holder are paid first, returns on debt is paid before return on equity) If company should finance it business more debt ,WACC may reduce 2.Pecking order theory Internal fund/retained earnings Redeemable debt Irredeemable debt Convertible debt Preference shares Ordinary shares 3. M&M propositions on capital structure with no tax Assumptions Assumes a perfect market ie (information symmetry or perfect market information ) Assumes no transaction cost No agency cost Investors are rational No individual dominates the market The debt is risk free and readily available Business risk is constant Looks at financial the business with debt With no tax effect financing business with more will not have serious effect WACC 4. M&M with tax As the company gears more it’s WACC will reduce with increasing tax savings AS the gears up to exceed debt capacity ,equity holder becomes at high risk and begins demand more return to compensate the risk.Therefore KE increases WACC may begin to rise Modigliani & Miller’s Proposition 2 With Tax As part of their theory, they derived a formula which can be used to derive a firm’s cost of equity when the capital structure is changing: USAGE No betas Company’s capital structure is changing formula: Keg = Keu + (1-T) (Keu-Rd) (E/D) E and D are the market values of equity and debt respectively. Rd is the (pre tax) return required by the debt holders. T is the corporation tax rate Keu is the cost of equity in an equivalent ungeared firm(Ba). Keg is the cost of equity in the geared firm(Be). 1.DE-GEAR –TURN KEG INTO KEU (PROXY CAPITAL STRUCTURE /OLD CAPITAL STRUCTURE ) Keu = E*Keg+ D(1-T)(Rd) E+D(1-T) 2.RE-GAER-TURN KEU INTO KEG(EXISTING CAPITAL STRUCTURE/NEW CAPITAL STRUCTURE) Keg = Keu + (1-T) (Keu-Rd) (D/E) 3. KIND KD & WACC Question 26 Moon dog Co. Moon dog Co is a company with a 20:80 debt: equity ratio. Using CAPM, its cost of equity has been calculated as 12%. It is considering raising some debt finance to change its gearing ratio to 25:75 debt to equity. The expected return to debt holders is 4% per annum and the rate of corporate tax is 30%. Required: Calculate the theoretical cost of equity in Moon dog Co after the refinancing. Question 27 Mlima Co. Mlima Co’s closest competitor is Ziwa Co, a listed company which mines metals worldwide. Mlima Co’s directors are of the opinion that after listing Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity. Ziwa Co’s cost of capital is estimated at 9·4%, its geared cost of equity is estimated at 16·83% and its pre-tax cost of debt is estimated at 4·76%. These costs are based on a capital structure comprising of 200 million shares, trading at $7 each, and $1,700 million 5% irredeemable bonds, trading at $105 per $100. Both Ziwa Co and Mlima Co pay tax at an annual rate of 25% on their taxable profits. Required: Explain why Mlima Co’s directors are of the opinion that Mlima Co’s cost of capital should be based on Ziwa Co’s ungeared cost of equity and, showing relevant calculations, estimate an appropriate cost of capital for Mlima Co; TIP TIPPLETINE(MJ 2018) Humabuz Co is a large manufacturer of office equipment in Valliland. Humabuz Co’s geared cost of equity is estimated to be 10.5% and its pretax cost of debt to be 5.4%. These estimates are based on a capital structure comprising $225 million 6% irredeemable bonds, trading at $107 per $100, and 125 million $1 equity shares, trading at $3.20 per share. Humabuz Co also pays tax at an annual rate of 30% on its taxable profits. Question 28 Tisa Co. (assignment) Tisa Co is considering an opportunity to produce an innovative component which, when fitted into motor vehicle engines, will enable them to utilise fuel more efficiently. The component can be manufactured using either process Omega or process Zeta. Although this is an entirely new line of business for Tisa Co, it is of the opinion that developing either process over a period of four years and then selling the productions rights at the end of four years to another company may prove lucrative. The annual after-tax cash flows for each process are as follows: Process Omega Year 0 After-tax cash flows (3,800) 1 1,220 Process Zeta Year 0 After-tax cash flows (3,800) 1 643 2 1,153 3 1,386 2 546 3 1,055 4 3,829 4 5,990 Tisa Co has 10 million 50c shares trading at 180c each. Its loans have a current value of $3.6 million and an average after-tax cost of debt of 4.50%. Tisa Co’s capital structure is unlikely to change significantly following the investment in either process. Elfu Co manufactures electronic parts for cars including the production of a component similar to the one being considered by Tisa Co. Elfu Co’s equity beta is 1.40, and it is estimated that the equivalent equity beta for its other activities, excluding the component production, is 1.25. Elfu Co has 400 million 25c shares in issue trading at 120c each. Its debt finance consists of variable rate loans redeemable in seven years. The loans paying interest at base rate plus 120 basis points have a current value of $96 million. It can be assumed that 80% of Elfu Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other activities excluding the component production. Both companies pay annual corporation tax at a rate of 25%. The current base rate is 3.5% and the market risk premium is estimated at 5.8%. Required: (a) Provide a reasoned estimate of the cost of capital that Tisa Co should use to calculate the net present value of the two processes. Include all relevant calculations. (8 marks) (b) Calculate the net present value (NPV), the internal rate of return (IRR) and the modified internal rate of return (MIRR) for Process Omega. Given that the NPV, IRR and MIRR of Process Zeta are $1.64 million, 26.6% and 23.3% respectively, recommend which process, if any, Tisa Co should proceed with and explain your recommendation. (12 marks) (c) Elfu Co has estimated an annual standard deviation of $800,000 on one of its other projects, based on a normal distribution of returns. The average annual return on this project is $2,200,000. Required: Estimate the project’s Value at Risk (VAR) at a 99% confidence level for one year and over the project’s life of five years. Explain what is meant by the answers obtained. Question Bank for Risk Adjusted WACC Morada Sep/Dec 2016 Coeden Dec 2012 Tisa Jun 2012 Makonis Dec 2013 Rivere Dec 2014 Adjusted Present Value (APV) The APV method evaluates the project and the impact of financing separating. Hence, it can be used if a new project has a different financial risk (debt-equity ratio) from the company. i.e. the overall capital structure of the company changes. APV consists of two different elements. APV = Base case NPV Value of an all equity financed project Value a of geared project + Financing Impact present value of financing side effects. If the company’s capital structure will change then the APV must be used instead of NPV The Financing Side-effects 1. Isssue costs Assume the money needed is the net amount eg. if the issue cost is 3%, to find the issue cost is: 3 97 × 𝑙𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 Issue cost may be tax allowable, meaning tax savings can be enjoyed. The more the issue cost the more tax savings. 2. PV of TAX SAVINGS on INTEREST on DEBT 3. PV of Post tax Interest saved on Cheap loan Situations where APV is better than NPV The APV method may be better than NPV because: 1. There is a significant change in capital structure of the company as a result of the investment. 2. There are subsidized loans or other benefits (grants) associated explicitly with an individual project and which requires discounting at different rate rather than applied to the mainstream cash flows. 3. The investment involves complex tax payment and tax allowances, and or has periods when taxation is not paid. 4. The operation risk of the company changes as a result of the investment. Practical Problems of the APV Approach 1. Determine a suitable cost of equity for the initial DCF computation as if the project was all equity financed, and also establishing the all equity beta are still based M&M assumptions. 2. Difficulties in identifying all the cost associated with the method of financing. 3. 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 or the normal borrowing rate can be assumed. 4. In complex investment decisions the calculations can be extremely long and hence more difficult. Question 29 Blades Co. Blades Co is considering diversifying its operations away from its main area of business (food manufacturing) into plastics business. It wishes to evaluate an investment project, which involves the purchase of a moulding machine that costs $450,000. The project is expected to produce net annual operating cash flows of $220,000 for each of the three years of its life. At the end if this time its scrap value will be zero. The assets of the project can support debt finance of 40% of its initial cost (including issue costs). Blades is considering borrowing this amount from two different sources. First, a local government organization has offered to lend $90,000, with no issue costs, at a subsidized interest rate of 3% per annum. The full $90,000 would be repayable after 3 years. The rest of the debt would be provided by the bank, at Blades’ normal interest rate. This bank loan would repaid in three equal annual installments. The balance of finance will be provided by a placing of new equity. Issue costs will be 5% of funds raised for the equity placing and 2% for the bank loan. Debt issue costs are allowable for corporation tax. The plastics industry has an average equity beta of 1.368 and an average debt: equity ratio of 1.5 at market values. Blades’ current equity beta is 1.8 and 20% of its long-term capital is represented by debt which is generally regarded to be risk-free. The risk-free rate is 10% pa and the expected return on an average market portfolio is 15%. Corporation tax is at a rate of 30%, payable in the same year. The machine will attract a 70% initial tax allowable depreciation allowance and the balance is to be written off evenly over the remainder of the asset life and is allowable against tax. The firm is certain that it will earn sufficient profits against which to offset these allowances. Required: Calculate the adjusted present value and determine whether project worthwhile. Question 30 Strayer assignment The managers of Strayer Inc. are investigating a potential $25 million investment. The investment would be a diversification away from existing mainstream activities and into the printing industry. $6 million of the investment would be financed by internal funds, $10 million by a rights issue and $9 million by long-term loans. The investment is expected to generate pre-tax net cash flows of approximately $5 million per year, for a period of ten years. The residual value at the end of Year 10 is forecast to be $5 million after tax. As the investment is in an area that the government wishes to develop, a subsidized loan of $4 million out of the total $9 million is available. This will cost 2% below the company’s normal cost of long-term debt finance, which is 8%. Strayer’s equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by market value. The average equity beta in the printing industry is 1.2, and average gearing 50% equity, 50% debt by market value. The risk-free rate is 5.5% per annum and the market return 12% per annum. Issue costs are estimated to be 1% for debt financing (excluding the subsidised loan), and 4% for equity financing. These costs are not tax allowable. The corporate tax rate is 30%. Required: (a) Estimate the Adjusted Present Value (APV) of the proposed investment. (12 marks) (b) Explain the difference between APV and NPV as methods of investment appraisal and comment upon the circumstances under which APV might be a better method of evaluating a capital investment than NPV. (5 marks) (c) Explain the major differences between Islamic finance and other conventional forms of finance such as those being considered by Strayer. Identify, and briefly discuss, two Islamic financial instruments that could be of use to Strayer in the above situation. (8 marks) Question bank for APV Burung Jun 2014 Q2 Mar/Jun 2018 Q3 Dec 2018 Strayer Jun 2002 Tramont Pilot 2012 International Investment Appraisal Question Bank for International Appraisal Yilandwe Chmura Tramont Sep 2018 Q1 This is when you appraise a project outside of your home jurisdiction. Reasons why companies consider international investments: Access to cheaper materials Access to cheaper labour There may be government support Increase in demand or sales Cheaper overheads Tax benefits or savings It is a way for risk diversification Barriers to Overseas International Investments Currency risk Political risks Language barriers Competition Culture Trade barriers (tariffs, quotas etc) The World Trade Organisation (WTO) The main aim of the WTO is to remove or reduce barriers to international trade among member states to encourage free trade among member states. Benefits of the WTO Increase in sales Encourage competitions Lead to specialization Reduce retaliation from govt Encourage govt support Access to cheap material & labour Drawbacks of removing protectionist measures Dumping of inferior goods at cheap prices It could kill local businesses Create unemployment Benefits of having a direct investment instead of licensing The company can easily control the quality of its products The company can maintain the confidentiality of its products It offers an opportunity for risk diversification It also offers an opportunity for follow-on projects Govt support Drawbacks of having a direct investment instead of licensing Cost of recruitment and training No Learning curve effects. Higher upfront costs Political risk Culture risk Difficult to exit Issues to be considered when doing an International Appraisal 1. Additional Taxation i.e. if the foreign tax rate is less than the home tax rate The additional tax should always be based on the same taxable cash flows from the foreign business. 2. Predicting exchange rates 3. Management charges or royalties 4. Remittance block Predicting Exchange Rates: 2 methods PPPT IRPT - Purchasing Power Parity Theory - Interest Rate Parity theory The 2 methods both use the same formula: 𝑺𝒊 = 𝑺𝒐 × ( 𝟏 + 𝒊𝒇 ) 𝟏 + 𝒊𝒉 where: Si = future exchange rate So = current or spot rate if = inflation or interest rate in foreign country ih = inflation or interest rate in home country The formula works with the indirect quoting where the home currency is one. Quoting Exchange Rates Direct Quoting - as used in Ghana The foreign currency is 1 & home is more or less than 1 Indirect Quoting The home currency is 1 & foreign is more or less than 1 Question 31 The current dollar sterling Exchange rate is given as $/£ 1.7025-1.7075 Expected Inflation rates are: Year U.S.A U.K 1 5% 2% 2 3% 4% 3 4% 4% Required: Use the relationships above to work out the Expected spot rate for the next three years. Question 32 The Spot Exchange rate is €1.5325 to £1. Expected inflation rates are: Year Europe U.K 1 3% 1% 2 1% 4% 3 2% 3% Required: Use the relations above to work out the expected spot rate for the next three years. Cross Rates You may not be given the Exchange rate you need for a particular currency, but instead be given the relationship it has with a different currency. You will then need to calculate a cross a cross rate. For example, if you have a rate in $/£ and a rate in €/£, you can derive a cross rate for $/£ dividing the $/£ rate by the €/£ rate. Question 33 A UK company has a Greek subsidiary which is to purchase materials costing $100,000. The NPV of the overseas cash flows is being calculated in euros, but you have not been provided with euro/dollar exchange rate. Instead you have the following information: $/£ 1.90 €/£ 1.45 Required: Calculate the value of the purchase in euros? Question 34 The current rate of inflation in Costovia is 65%. Government is helping to reduce this rate each by 10% of the previous rate. The Costovian peso/dollar rate is currently142-146 and the inflation rate in the US over the next three years is expected to be 4%, 3.5% and 3% respectively. Required: Calculate the Exchange rate for the Costovian peso against the dollar for the next three years. Question 35 Parrott Co. Parrott Co is a UK based company. It is considering a 3 year project in Farland. The project will require an initial investment of 81m Farland Florins (FFI) and will have a residual value of 10m FFI. The project’s pretax net FFI inflows are expected to be: Year 1 35m Year 2 80m Year 3 50m The UK parent company will charge the overseas project with £2m of management charges each year. The current spot rate is 5FFI - £1. UK inflation is expected to be 4% per annum, and Farland inflation is expected to be 7% per annum. Farland tax is 20% and is paid immediately. Any losses are carried forward and netted off the first available profits for tax purposes. Tax allowable depreciation will be granted on a straight line basis, and any residual value will be taxable at 20%. UK tax is 30% and is payable 1 year in arrears. Parrott Co recently undertook a similar risk project in the UK and used 11% as a suitable discount rate. Required: Calculate the NPV of the project in £. Question 36 Puxty Plc. Puxty Plc. is a specialist manufacturer of window frames. Its main UK manufacturing operation is based in the south of England, from where it distributes its products throughout the UK. The directors are now considering whether they should open up an additional manufacturing operation in France - which they believe there will be a good market for their products. A suitable factory has been located just outside Paris that could be rented on a 5-year lease at an annual charge of €3.8m, payable each year in advance. The manufacturing equipment would cost €75m, of which €60m would have to be paid at the start of the project, with the balance payable 12 months later. At the start of each year the French factory would require working capital equal to 40% of that year's sales revenues. It is expected that the factory will be able to produce and sell 80,000 window units per year although, in the first year, because of the need to 'run in' the machinery and its workforce, output is only expected to be 50,000 window units. Each window is likely to be sold for €750, a price that represents a 150% mark-up on cash production costs. The French factory would be set up as a wholly-owned subsidiary of Puxty Pic. In France, 25% straight-line depreciation on cost is an allowable expense against company tax. Corporation tax is payable at 40% at each year-end without delay and any unused losses can be brought forward for set off against the following year's profits. No UK tax would be payable on the after-tax French profits. All amounts in € are given in current terms. Annual inflation in French is expected to run at 6% per year in the foreseeable future. All FF cash flows involved are expected to increase in line with this inflation rate, with the exception of the factory rental and the cost of the manufacturing equipment, both of which would remain unchanged. The French factory would be producing windows to a special design patented by Puxty. To protect its patent rights, Puxty Pic will charge its French subsidiary a fixed royalty of £20 per window. This cost would be allowable against the subsidiary's French tax liability. The current €/£ spot rate is 1.5. Inflation in the UK is expected to be 4% per year over the period. There are no cash flow remittance restrictions between France and the UK. Puxty Pic is an all-equity financed company that is quoted on the London Stock Exchange. Its shares have a beta value of 1.25. The current annual return on UK Government Treasury Bills is 10% and the expected return on the market is 18%. In the UK Corporation Tax is payable at 35%, one year in arrears. Puxty operates on a 5-year planning horizon. At the end of five years, assume that working capital would be fully recovered and the production equipment would have a scrap value, at that time, of €70m before tax. Proceeds on asset sales are taxed at 40%. Assume all cash flows arise at the end of the year to which they relate, unless otherwise stated. Required: Evaluate the proposed investment in France and recommend what investment decision should be made by Puxty pic. State clearly any assumptions you make and work all calculations rounded to nearest 1 0,000 (either € or £) - i.e. €O.01 m or £0.01 m. BOND VALUATION Question bank for Bonds Toltuck Mar/Jun 2017 GNT Pilot 2012 Kenand Levante Dec 2011 Conejo Sep/Dec 2017 A bond is a long term traded debt Areas to take note of: MV or Market Value of bonds Coupon Rate Yield or return to maturity (IRR or spread table) Duration of bonds Modified duration of bonds Bond theories BONDS Yield Curve Factors that affect the yield curve Normal - Market Segmentation - Liquidity Preference Inverse Criteria for credit rating - Expectation theory 1. Industry Risk 2. Earnings Protection Risk 3. Financial Flexibility 4. Mgt. Performance Flat The Theories 1. Yield Curve This is an analyses of the relationship between the return or yield of the bond and the time, period or duration of a debt or bond. Types of Yield Curves Normal Yield Curve As the time increases, the return on the debt also increases. return time Inverse Curve As the time increases, the returns decrease. return time Flat The same return is charged regardless of the period or time return time 2. Factors that affect the Yield Curve i. Market Segmentation Theory The interest rate depends on demand and supply for debt or loans. The more the demand for debts, the higher the interest rates will be and vice versa. ii. Liquidity Preference Theory If the investor has a natural preference for liquid capital to meet its day-to-day activities, then the interest rate will increase. If the investor has more capital available for investment, then lower rates will be charged. iii. Expectation Theory If the investor expects that interest rates will rise in the future, then loans will be given at higher rates. If the investor expects the interest rates to fall in the future, then loans will be given today at a lower rate. 3. Criteria for Credit Rating Industry Risk This considers how the industry is performing in terms of changes in the environment. -Seasonal variations can affect the rating. -Changes in consumer preference can affect the rating. -Economic downturn Earnings Protection Risk This considers how the business is able to maintain its earnings in times of changing environment or in the event of an economic downturn. It considers: - the customer base; the more customers the better Sources of income Profitability i.e. ROCE, Net Profit margin, etc, f the margins are increasing in times of changing environment, then the rating will be higher. Financial Flexibility This considers how the company is able to assess its loans. It considers: - The company’s relationship with its bankers. - Sources of obtaining funds - Restrictive covenants, the more restrictions, the lower the rating Management Performance How managers manage the operations of the business. - Management level of qualification and experience Succession planning Future plans & policies The Market Value (MV) of Bonds The market value of a bond is the present value of the interest and the principal using the required rate of return or the yield to maturity (IRR) as the discount factor. The MV is an estimation or is theoretical valuation The lower the yield on the market, the higher the MV and vice versa As the investor charges a coupon rate that is higher than the MV then the investor gain and vice versa. The Coupon Rate – actual interest to be paid. Yield or Return to maturity (Required rate of return) – effective market rate Duration of Bonds The duration is the average time needed to generate the cash flows in present value terms to repay the bond. Advantages - It considers the time value of money It considers all cash flows. 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒𝑠 𝑠𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑉𝑠 (𝑓𝑜𝑟 𝑏𝑜𝑛𝑑𝑠 𝑡ℎ𝑖𝑠 𝑖𝑠 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑎𝑠 𝑀𝑉) Modified Duration This measures the changes in the interest rate/yield and the effects on the MV of the bond. It also measures the interest rate sensitivity on the bond. An increase in the yield on the market will lead to a decrease in the MV of the bond and vice versa. Modified Duration = 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 1+𝑟 where r is the original yield to maturity Change in the MV = Change in yield x Modified Duration x original MV Question 1 -Coupon rate 5% -Yield 6% -Redeemable @ par ($100) in 3yrs time. Required: What is MV of the bond? Question 2 -Coupon rate 5% -Yield 4% -Redeemable @ par ($100) in 3yrs time. Required: What is MV of the bond? Question 3 -Coupon rate ?% -Yield 6% -Redeemable @ par ($100) in 3yrs time. -MV of the bond is $97.33 Required: What is the coupon rate? Question 4 -Coupon rate ?% -Yield 4% -Redeemable @ par ($100) in 3yrs time. -MV of the bond is $102.77 Required: What is the coupon rate? Question 5a -Coupon rate 5% -Yield ?% -Redeemable @ par ($100) in 3yrs time. -MV of the bond is $97.33 Required: What is the yield to maturity? Question 5b -Coupon rate 5% -Yield ?% -Redeemable @ 10% premium in 7yrs time. -MV of the bond is $107.33 Required: What is the yield to maturity? Question 6 -Coupon rate 5% -Yield 6% -Redeemable @ par ($100) in 3yrs time. Required: What is the duration of the bond? Question -Coupon rate 5% -Yield 6% -Redeemable @ par ($100) in 3yrs time. Required: What is the modified duration of the bond & explain your answer? Question GNT Co is considering an investment in one of two corporate bonds. Both Bonds have a par value of $1000 and pay coupon interest on an annual basis. The market price of the first bond is $1079.68. Its coupon rate is 6% and it is due to be redeemed at par in five years. The second Bond is about to be issued with a coupon rate of 4% and will also be redeemable at par in five years. Both bonds are expected to have the same gross redemption yields (yield to maturity). GNT Co considers duration of the Bond to be a key factor when making decisions on which bond to invest. Required: a. Estimate the Macaulay duration of the two bonds GNT Co is considering for investment. b. Discuss how useful duration is a measure of the sensitivity of a bond price to changes in interest rates. Credit Spread An alternative technique used in paper P4 for deriving cost of debt is based on an awareness of credit spread (sometimes referred to as the “default risk premium” and the formula: Kd (1-T) = (Risk free rate + credit spread) (1-t) The credit spreads are generally calculated by a credit rating agency and presented in a table like the one below. Credit or default risk is the uncertainty surrounding a firm’s ability to service its debts and obligations. It can be defined as the risk borne by a lender that the borrower will default either on interest payments, the repayment of the borrowing at the due date or both. Rating Risk of default AAA AA A BBB BB B CCC CC C Highest quality – zero risk High quality – very little risk Strong – minimal risk Medium grade – low but clear risk Speculative – marginal Significant risk exposure Considerable risk exposure Highly speculative – very high risk of failure In default – very high likelihood Table of credit spreads for industrial company bonds: Rating 1yr 2yrs 3yrs 5yrs 7yrs 10yrs 30yrs AAA 5 10 15 22 27 30 55 AA 15 25 30 37 44 50 65 A 40 50 57 65 71 BBB 65 80 88 95 BB 210 235 240 250 75 90 126 149 175 265 275 290 B 375 402 415 425 440 440 450 Question 37a The current 4-year risk free return is 26%. F plc has 4-year bonds in issue but has an AA rating. Required: a. Calculate the expected yield on ‘F’ bonds. b. Find F’s post tax cost of debt associated with these bonds if the rate of corporation tax is 30%. Question 37b The current 9-year risk free return is 26%. F plc has 9-year bonds in issue but has an AAA rating. Required: a. Calculate the expected yield on ‘F’ bonds. b. Find F’s post tax cost of debt associated with these bonds if the rate of corporation tax is 30%. Question 38 Landline Co. Landline Co has an A credit rating. It has $30m of 2years bond in issue, which are trading at $90%and $50m of 10year bond which are trading at $108%. The risk free rate is 2.5% and the corporation tax rate is 30%. Required: Calculate the company’s post tax cost of debt capital? Question 39 The spot yield curve for government bond is: Year % 1 3.5 2 3.65 3 3.80 The following table of credit spreads (in basis points) is presented by standard and poor’s: Rating 1year 2years 3years AAA 14 25 38 AA 29 41 55 A 46 60 76 Required: a. Estimate the individual yield curve for Stone Co, an A rated company. b. Estimate the market value of a 6% bond redeemable at a premium of 10% in 3years time. c. Duration of the bond as in requirement b: i) Based on interest payable annually and principal at maturity date. ii) Based on fixed equal annual installments (both interest and principal) Question 40 assignment An entity has the following information in its balance sheet (statement of financial position): $000 Ordinary Share (50c nominal) 2,500 Debt (8% Redeemable in 5yrs) 1,000 The entity’s equity beta is 1.25 and its credit rating according to standard and Poor’s is A. The share price is $1.22 and the debenture price is $110 per $100 nominal. Extract from standard and Poor’s credit spread tables: Rating 1yr 2yrs 3yrs 5yrs 7yrs 10yrs 30yrs AAA 5 10 15 22 27 30 55 AA 15 25 30 37 44 50 65 A 40 50 57 65 71 75 90 The risk free rate of interest is 6% and the equity risk premium is 8%. Tax is payable at 30%. Required: Calculate the entity WACC. Question 41 Kenand Co. Kenand Co has a cash surplus of $1m, which the financial manager is keen to invest in corporate bonds. He has identified two potential investment opportunities, in two different companies which are both rated A by the major credit rating agencies: Option 1: AB Co has $100m of bonds already in issue. The bonds carry a coupon rate of 5% per annum, and the financial press is reporting that the bonds have a bid yield of 6.2% per annum. The bonds are redeemable at a 10% premium to nominal value in 4 years. Option 2: XY Co is about to issue $50m of 3 year bonds with a coupon rate of 4% per annum. The bonds will be redeemable at par in 3 years. The annual spot yield curve for government bonds is: 1 year 3.54% 2 year 4.01% 3 year 4.70% 4 year 5.60% Extract from a major credit rating agency’s website: Table of spreads (in basis points) Rating 1 year 2 year AAA 5 18 AA 16 30 A 26 39 3 year 29 42 50 4 year 40 50 60 Required: i. Calculate the theoretical market value of a $100 bond in AB Co, and the theoretical issue price of a $100 bond in XY Co. Calculate how many bonds Kenand Co will be able to buy with its $1m. (6 marks) ii. Estimate the Macaulay duration of the AB Co bonds and the XY Co bonds, and interpret your results. (8 marks) Question 42 Levante Co. Levante Co. has identified a new project for which it will need to increase its long-term borrowings from $250 million to $400 million. This amount will cover a significant proportion of the total cost of the project and the rest of the funds will come from cash held by the company. The current $250 million borrowing is in the form of a 4% bond which is trading at $98.71 per $100 and is due to be redeemed at par in three years. The issued bond has a credit rating of AA. The new borrowing will also be raised in the form of a traded bond with a par value of $100 per unit. It is anticipated that the new project will generate sufficient cash flows to be able to redeem the new bond at $100 par value per unit in five years. It can be assumed that coupons on both bonds are paid annually. Both bonds would be ranked equally for payment in the event of default and the directors expect that as a result of the new issue, the credit rating for both bonds will fall to A. The directors are considering the following two alternative options when issuing the new bond: i. Issue the new bond at a fixed coupon of 5% but at a premium or discount, whichever is appropriate to ensure full take up of the bond; or ii. Issue the new bond at a coupon rate where the issue price of the new bond will be $100 per unit and equal to its par value. The following extracts are provided on the current government bond yield curve and yield spreads for the sector in which Levante Co. operates: Current Government Bond Yield Curve Years 1 2 3 2% 3.7% 4.2% 4 4.8% 5 5.0% Yield spreads (in basis points) Bond Rating 1 year 2 years AAA 5 9 AA 16 22 A 65 76 BBB 102 121 4 years 19 40 100 167 5 years 25 47 112 193 3 years 14 30 87 142 Required: a) Calculate the expected percentage fall in the market value of the existing bond if Levante Co’s bond credit rating falls from AA to A. (3 marks) b) Advise the directors on the financial implications of choosing each of the two options when issuing the new bond. Support the advice with appropriate calculations. (7 marks) c) Among the criteria used by credit agencies for establishing a company’s credit rating are the following: industry risk, earnings protection, financial flexibility and evaluation of the company’s management. Briefly explain each criterion and suggest factors that could be used to assess it. (8 marks) d) Discuss the importance to a company of recognising all of its stakeholders when making a new project investment decision. (7 marks). Question bank for Bonds Toltuck Mar/Jun 2017 GNT Pilot 2012 Kenand Levante Dec 2011 Conejo Sep/Dec 2017 BUSINESS VALUATION This means placing a value on a business Value of a business is also called Market Capitalization 𝑴𝒂𝒓𝒌𝒆𝒕 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒔𝒂𝒕𝒊𝒐𝒏 = 𝒏𝒐. 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 × 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒔𝒉𝒂𝒓𝒆 𝒑𝒓𝒊𝒄𝒆 Methods of finding the Share Price 1. DVM Dividend Valuation Method (based on dividends) 2. P/E ratio method (based on profits) or Earnings Yield Method 3. Net Asset Based Valuation (based on assets) 4. Free cash flow method (cash) Reasons for Business Valuation 1. To establish the terms to take over bids or mergers. 2. To fix a share price for an initial public offering (IPO) 3. For investors to make buy, hold or sell decisions 4. For capital gains tax or inheritance tax purposes. 5. Where a major shareholder or director wishes to dispose of a large block of shares. 6. When the company needs to raise additional finance. 7. Upon restructuring 8. Upon management Buy-in or management Buy-out Management Buy In It is when managers from outside the business team up together to buy a company. Management Buy Out It is when the current managers of an existing company decide to buy the company from existing shareholders. Advantages of management Buy Out / Disadvantages of management Buy In 1. The existing company’s culture is retained. 2. The managers possess in-depth or cumulative knowledge about the company so they can run the company without facing problems compared to outside managers. 3. Employee and managers mostly retain their jobs i.e. job security. 4. Doesn’t disrupt business operations. Advantages of management Buy In / Disadvantages of management Buy Out 1. Intention to sell business thus they mismanage the business to reduce value of company. 2. No new or fresh idea are brought into the company. 3. Any conflicts or disagreements still remain in the company. 4. Leads to leverage capital i.e. raise debt finance to acquire a company. Reverse Takeover It is the process by which a smaller listed company acquires a larger unlisted company through a share for share exchange. After the acquisition the larger unlisted company would have majority shares in the smaller listed company thereby obtaining control over the smaller listed company. Advantages 1. Quicker way to obtain listing 2. Relatively cheaper 3. In event of economic crisis it’s better to obtain listing through a reverse takeover. 4. Less stringent requirement Disadvantages 1. Leads to acquiring a company which has hidden contingent liabilities. 2. Leads to culture problems. 3. Lack of skills & Expertise to run listed company 4. There can be compliance risk 5. Share price of the company might go down 6. Challenges in raising funds in the future. Methods of Business Valuation Dividend Valuation Method DVM where there is growth in dividend 𝑃𝑜 = 𝐷𝑜(1 + 𝑔) 𝑘𝑒 − 𝑔 where there is no growth in dividend 𝑃𝑜 = 𝐷𝑜 𝑘𝑒 where next year’s dividend is given 𝑃𝑜 = 𝐷1 𝑘𝑒 − 𝑔 Po= Value of company g= Annual growth rate ke shareholders required return or cost of equity. NB: Market capitalization = Po x no. of ordinary shares. Assumptions of the DVM - The company should be paying dividends - There must be constant dividend to perpetuity - When dividend is growing it must grow at a constant rate to perpetuity - The cost of equity ke must be greater than the dividend growth. - Issue cost or transaction cost is ignored Question 43 A company has the following financial information available: Share capital in issue. 4million ordinary shares at par value of 50c Current dividend per share (just paid) 24c dividend four years ago 15.25c Current equity beta 0.8. You also have the following market information Current market returns 15% risk-free rate 8%. Required: Find the market capitalization of the company. Question 44 A company has the following financial information available. Share capital in issue 2million ordinary shares at a par value of $1. Current dividend per share (just paid) 18c Current EPS 25c Current return earned on assets 20% Current equity beta 1.1 You also have the following market information: Current market returns 12% Risk-free rate 5% Required: Find the market capitalization of the company. Question 45 C plc has just paid a dividend of 25₵ per share. The return on equities in this risk class is 20%. Required: Calculate the value of the shares assuming: (i) no growth in dividends (ii) constant growth of 5% pa (iii) constant dividends for 5 years and then growth of 5% pa to perpertuity. Question 46 C plc has just paid a dividend of 32₵ per share. The return on equities in this risk class is 16%. Required: Calculate the value of the shares, assuming constant dividends for 3 years and then growth of 4% pa to perpetuity. The P/E ratio method for price of a single share Price = P/E ratio x EPS 𝐄𝐏𝐒 = 𝑷𝑨𝑻 − 𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒏𝒐. 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 Total equity value = P/E ratio x earnings The earnings yield is the reciprocal of the P/E ratio For the price of a single share 𝐏𝐫𝐢𝐜𝐞 = 𝑬𝑷𝑺 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒀𝒊𝒆𝒍𝒅 𝐓𝐨𝐭𝐚𝐥 𝐞𝐪𝐮𝐢𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐛𝐮𝐬𝐢𝐧𝐞𝐬𝐬 = 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒚𝒊𝒆𝒍𝒅 If there is constant growth into perpetuity 𝐏𝐫𝐢𝐜𝐞 = 𝐭𝐨𝐭𝐚𝐥 𝐯𝐚𝐥𝐮𝐞 = 𝑬𝑷𝑺(𝟏 + 𝒈) 𝑬𝒀 − 𝒈 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔 (𝟏 + 𝒈) 𝑬𝒀 − 𝒈 Drawbacks of the earnings method - Earnings is profit and therefore can be easily manipulated to get a favorable business value The earnings is based on the company’s policy and therefore varies from company to company The earnings is based on historical information which may not be reliable for future valuation. The method doesn’t work if the company is making loses If the P/E ratio is from a similar company or the industry, it could lead to over or under valuation. Question 47 You are given the following information regarding A10, an unquoted company: a) Issued ordinary share capital is 400,000 25c shares b) Extract from the income statement for the year ended 31st July 20x4. $ Profit before taxation 260,000 Less: corporation tax 120,000 Profit after taxation Less: preference dividend Ordinary dividend $ 140,000 20,000 36,000 Retained profit for the year (56,000) 84,000 c) The PE ratio applicable to a similar type of business is 12.5 Required Value 200,000 shares in A Co. on a PE ratio basis. Question 48 a) Company A has earnings of $300,000. A similar listed company has an earnings yield of 12.5%. b) Company B has earnings of $420,000. A similar listed company has a PE ratio of 7. Required: Estimate the value of each company. Question 49(ASSIGNMENT) ABC Co is considering making a bid for the entire equity capital of XYZ Co, a firm which has a PE ratio of 9 and annual earnings of $390m. ABC Co has a PE of 13 and annual earnings of $693m, and it is thought that $125m of annual synergistic savings will be made as a consequence of the takeover. The PE of the combined company is expected to be 12. Required: Calculate the minimum value acceptable to XYZ’s shareholders, and the maximum amount which ABC should consider paying. Net Assets Method Net assets = total assets (mv)– total liabilities It is also the equity value of the business. The total assets and liabilities must be at their fair values or market value. Limitations of the Net Assets method - It gives the minimum value to shareholders, they get nothing more than equity. - The method is only useful if the is about to be liquidated. - It ignores certain intangible assets like goodwill, customer database etc. - There could be difficulty in getting the correct market values of the assets. - It uses historical information. Question 50 The following is an abridged version of the statement of financial position of Grasmere Contractors Co, an unquoted company as at 30th April, x6 $ Non-current assets (CV) 450,000 Net current assets 100,000 550,000 Represented by: $1 ordinary shares 200,000 Reserves 250,000 6% loan notes ZS 100,000 550,000 You ascertain that: Loan notes are redeemable at a premium of 2% Current market value of freehold property exceeds book value by $30,000 All assets other than property are estimated to be realizable at their book value. Required: Calculate the value of an 80% holding of ordinary shares on an assets basis. The Free Cash flows Method This method combines the DVM and the NPV There are 2 values: 1. Free cash flows to equity (equity only) 2. Free cash flows to the firm(equity + debt) 𝐄𝐪𝐮𝐢𝐭𝐲 𝐕𝐚𝐥𝐮𝐞 = 𝐭𝐨𝐭𝐚𝐥 𝐯𝐚𝐥𝐮𝐞 = 𝑭𝑪𝑭 𝒕𝒐 𝒆𝒒𝒖𝒊𝒕𝒚 (𝟏 + 𝒈) 𝒌𝒆 − 𝒈 𝑭𝑪𝑭 𝒕𝒐 𝒕𝒉𝒆 𝒇𝒊𝒓𝒎 (𝟏 + 𝒈) 𝑾𝑨𝑪𝑪 − 𝒈 Equity Value = Total Value – MV of debt FCF to equity is the same as dividend capacity The cash flow to equity holders is the company’s ability to pay dividend. Free Cash flow to Equity Sales Operating Cost (VC, FC, others) XXX (XXX) Operating Profit before depreciation or CA Less: CA/tax allowable dep. Less: interest or finance cost (ignore when finding FCF to the firm as WACC includes it) XXX (XXX) Taxable cash flows less: Tax add back CA(ignore if the same as asset replac. Working Capital investment Less Capital Investment add proceeds from sales of assets (cash proceeds) Less profit on disposal Add loss on disposal XXX (XXX) XXX (XXX) (XXX) FCF to equity or dividend capacity XXX Assumptions of the Free Cash flow method - Constant free cash flows Constant cost of capital/ke Constant growth rate Cost of capital is greater than growth rate (XXX) XXX (XXX) XXX Question 51 The following information has been taken from the income statement and balance sheet of B Co. Revenue Production expenses Administration expenses Tax allowable dep. Capital investment in year Corporation tax is $350 $210 $24 $31 $48 30% Corporation debt $14 trading at 130%. The WACC is 16.6%. Inflation is 6%. These cash flow are expected to continue every for the foreseeable future. Required: Calculate the value of equity. Question 52 A company’s current revenues and costs are as follows: Sales Cost of sales $200 million $110 million Dist. & Admin. Expenses are Tax allowable depreciation Annual capital spending Corporation tax is The current value of debt The WACC is Inflation is $20 million $40 million $50 million 30% $17 million 14.40% 4% These cash flows are expected to continue every year for the foreseeable future. Required: Calculate the value of equity. Question 53 assignment A company is preparing a free cash flow forecast in order to calculate the value of equity. The following information is available: Sales: Current sales are $500m. Growth is expected to be 8% in year 1, failing by 2% pa (e.g. to 6% in year 2) until sales level out in year 5 where they are expected to remain constant in perpetuity. The operating profit margin will be 10% for the first two years and 12% thereafter. Depreciation in year 1 will be $7m increasing by $1m pa over the planning horizon before leveling off and replacement asset investment is assumed to equal depreciation. Incremental investment in assets is expected to be 8% of the increase in sales in year 1.6% of the increase in sales in each of the following two years, and 4% of the increase in year 4. Tax will be charged at 30% pa. the WACC is 15%. The market value of short-term investments is $4m and the market value of debt is $48m. Required: Calculate the value of equity. Question 54 Stanzial Inc. Stanzial Inc is a listed telecommunications company. The company is considering the purchase of Besserlot Co, an unlisted company that has developed, patented and marketed a secure, medium-range, wireless link to broadband. The wireless link is expected to increase Besserlot’s revenue by 25% per year for three years, and by 10% per year thereafter. Besserlot is currently owned 35% by its senior managers, 30% by a venture capital company, 25% by a single shareholder on the board of directors, and 10% by about 100 other private investors. Summarised accounts for Besserlot for the last two years are shown below: Statements of profit or loss for the years ended 31 March ($000) 20X6 20X5 Sales revenue 22,480 20,218 –––––– –––––– Operating profit before exceptional items 1,302 820 Exceptional items (2,005) – Interest paid (net) (280) (228) –––––– –––––– Profit before taxation Taxation Profit after taxation Note: Dividend (983) (210) –––––– (1,193) –––––– 200 592 (178) –––––– 414 –––––– 100 Statements of financial position as at 31 March ($000) 20X6 20X5 Non-current assets (net) Tangible assets 5,430 5,048 Goodwill 170 200 Current assets Inventory 3,400 2,780 Receivables falling due within one year 2,658 2,462 Receivables falling due after one year 100 50 Cash at bank and in hand 48 48 –––––– –––––– Total assets 11,806 10,588 –––––– –––––– Equity and liabilities Called-up share capital (25 cents par) 2,000 1,000 Retained profits 3,037 4,430 Other reserves 1,249 335 –––––– –––––– Total equity 6,286 5,765 Current liabilities – payables 5,520 4,823 –––––– –––––– 11,806 10,588 –––––– –––––– Other information relating to Besserlot: (i) Non-cash expenses, including depreciation, were $820,000 in 20X5–6. (ii) Corporate taxation is at the rate of 30% per year. (iii) Capital investment was $1 million in 20X5–6, and is expected to grow at approximately the same rate as revenue. (iv) Working capital, interest payments and non-cash expenses are expected to increase at the same rate as revenue. (v) The estimated value of the patent if sold now is $10 million. This has not been included in non-current assets. (vi) Operating profit is expected to be approximately 8% of revenue in 20X6–7, and to remain at the same percentage in future years. (vii) Dividends are expected to grow at the same rate as revenue. (viii) The realisable value of existing inventory is expected to be 70% of its book value. (ix) The estimated cost of equity of Besserlot is 14%. Information regarding the industry sector of Besserlot: (i) The average PE ratio of listed companies of similar size to Besserlot is 30:1. (ii) Average earnings growth in the industry is 6% per year. Required: (a) Prepare a report that: (i) Estimates the value of Besserlot Co using: Asset based valuation PE ratios Dividend based valuation The present value of expected future cash flows. State clearly any assumptions that you make. (16 marks) (ii) Discusses the potential accuracy of each of the methods used and recommends, with reasons, a value, or range of values that Stanzial might bid for Besserlot. (11 marks) Professional marks will be awarded in part (a) for the format, structure and presentation of the report. (4 marks) (b) Discuss how the shareholder mix of Besserlot and type of payment used might influence the success or failure of the bid. (8 marks) (c) Assuming that the bid was successful, discuss other factors that might influence the medium-term financial success of the acquisition. (5 marks) (d) The directors of Stanzial Inc are also considering whether to dispose of one of the company’s business units. Required: Explain the potential advantages for Stanzial of undertaking the divestment by means of (i) a sell-off and (ii) a demerger (6 marks) Mergers and Acquisitions Question Bank for Mergers and Acquisitions Pursuit Jun 2011 Cigno Sep/Dec 2015 Chikepe Mar/Jun 2018 Nente Jun 2012 Opao Dec 2018 Nahara and Fugae Dec 2014 Vogel Jun 2014 Exam focus areas: - Synergy Takeover regulations Net benefit to a company or maximum premium Mode of payment, gains or losses and advantages - Defense strategies Definitions Acquisitions Taking over ownership of another company. Organic Growth Growing with your own resources or capabilities. Mergers When two or more companies come together to form one company. Synergy The main reason for acquisition is synergy. This is the fact that the combined value after an acquisition or a merger is greater than their separate values. Types of Synergy I. Revenue Synergy II. Cost Synergy III. Occurs from competitive advantage by reducing competition increase the market share. Helps to enjoy economies of scale Reduce cost duplication Financial Synergy Access to asset base which can be used to secure cheaper loans. Improve rating or reputation Takeover Regulations 1. Mandatory Bid rule This is when after acquiring a company the remaining shareholders can exit the company at a fair price. The main purpose is to ensure that the acquirer does not exploit their postion of power at the expense of minority shareholders. 2. Principle of equal treatment This is where all the shareholders are offered the same terms of conditions after acquiring the company. The main purpose is to that all shareholders are offered the same level of benefit. 3. Squeeze out rights condition This is where after attaining a certain share of holding percentage the acquirer will force minority shareholders to sell their shares. The main purpose is to ensure that the acquirer gain 100% control of the target company and prevent problems arising from minority shareholder at a later date. Types of Acquisitions Type I Acquisitions This is where after acquisition there is no effect on the business and financial risk. There is no change in the capital structure. Type II Acquisitions This is where after acquisition there is no effect on the business risk but there is an effect on the financial risk. (APV) Type III Acquisitions This is where after acquisition there is an effect on both the business risk and financial risk of the combined company. Steps to dealing with a Type III Acquisition 1. 2. 3. 4. 5. Estimate the value of the target company Estimate the value of the acquirer company Estimate the Ba of the acquirer company. Estimate the Ba of the target company Find the combined Ba of both the acquirer and the target using appropriate weight. 6. Find the combined value and discount them with the combined WACC or the ke 7. Determine the synergy (i.e. the combined value less the separate values of the acquirer and the target). 8. Determine the net benefit or maximum premium (i.e. synergy less any premium payments) Question 55 Pursuit Co. (Jun 11 Adapted) Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products. The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed. Pursuit Co wishes to acquire Fodder Co using a combination of debt finance (borrowed from either the domestic banking system or from the Euromarkets) and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level. Information on Pursuit Co and Fodder Co Pursuit Co Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1.18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million. Fodder Co, Statement of profit or loss extracts Year Ended All amounts are in $000 Sales revenue Operating profit (after operating costs and tax allowable depreciation) Net interest costs Profit before tax Taxation (28%) After tax profit Dividends Retained earnings 31 May 20Y1 31 May 20Y0 31 May 20X9 31 May 20X8 16,146 15,229 14,491 13,559 5,169 489 4,680 1,310 3,370 123 3,247 5,074 473 4,601 1,288 3,313 115 3,198 4,243 462 3,781 1,059 2,722 108 2,614 4,530 458 4,072 1,140 2,932 101 2,831 Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1.53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels. However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings. For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future. Information about the combined company Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future. After the first year the growth rate in sales revenue will be 5.8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6.4% on future borrowings. The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate. It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value. Other information The current annual government base rate is 4.5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%. SGF Co’s interest in Pursuit Co There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company. The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid. The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend. Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co. Required: a) Discuss the advantages and disadvantages of organic growth and growth by acquisition. (8 marks) b) Discuss the advantages and disadvantages of borrowing funds from the domestic banking system compared to the Euromarkets. (6 marks) c) Prepare a report to the Board of Directors of Pursuit Co that I. Evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Fodder Co and the combined company assuming that the combined company’s capital structure stays the same as that of Pursuit Co’s current capital structure. Include all relevant calculations. II. (16 marks) Discusses the limitations of the estimated valuations in part (i) above. (4 marks) III. Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co and concludes whether Pursuit Co’s current capital structure can be maintained. IV. (3 marks) Explains the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved. V. (4 marks) Assesses whether the Chief Financial Officer’s recommendation would provide a suitable defence against a bid from SGF Co and would be a viable option for Pursuit Co. (5 marks) Professional marks will be awarded in this question for the format, structure and presentation of the report in part (c). (4 marks) (Total: 50 marks) Advantage of borrowing funds domestic compared to Euromarkets -Easy access -No currency risk -Can borrow any amount @ any giving time Disadvantage of borrowing funds domestic compared to Euromarkets -cannot borrow large amount -cost of borrowing is more expensive -more regulations & stringent requirement -require security 1. Strategic Defenses Post bid A target company can use the following to defend itself against a possible takeover: Try to convince the shareholders that the terms of the offer are unacceptable. This can be done using the following: o Attempt to show that the current share price of the company is unrealistically low relative to the future potential. Assets revaluation, new profit forecasts, dividends and promises of rationalization are commonly employed here. o If it is for share for share exchange, the target company can attempt to convince the shareholders that the offer’s equity is currently overvalued. The suitability of the bidding company to run the merged business can also be questioned. Launching an advertising campaign against the takeover bid. One technique is to attack the account of the predator company. A reverse takeover (Pac Mac), that is make a counter offer for the predator company. This can be done if the companies are of reasonably similar size. Finding a ‘white knight’, a company which will make a welcome takeover bid. This involves finding a more suitable acquirer and promoting it to compete with the predator company. Pre-bid Selling crowning jewels- 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. Golden parachutes- this is a policy of introducing attractive termination packages for the senior executives of the victim company. This makes it more expensive for the predator company. Shark repellent- super-majority. The articles of association are changed to require a very high percentage of shares to approve an acquisition or merger, say 80%. Poison pill The most commonly used and seeming most effective takeover defence is the so called poison pill. An example is the Flip-in pill. This involves the granting of rights to shareholders, other than the potential acquirer, to purchase the shares of the target company at a deep discount. This dilutes the ownership interest of the potential acquirer. Mode of Payment - Cash Share exchange Bonds Advantages of Cash payment to the Acquirer - There is no loss of control There is no dilution of EPS Can be achieved quickly It is cheaper to arrange Amount paid is certain Subsidiary is not involved in operations Disadvantages of Cash payment to the Acquirer - It results in cash drain Leads to high gearing if a loan is used. Advantages of Cash payment to the Target - Amount received is certain Improves liquidity for other business operations There is no risk of default Can be achieved quickly Disadvantages of Cash payment to the Target - Leads to capital gains tax due to the cash received. Loss of control. Cannot participate in management activities. Advantages of Share Exchange to the Acquirer -No cash drain -No increase in gearing Disadvantages of Share Exchange to the Acquirer - loss of control dilution of EPS Cannot be achieved quickly Amount paid is uncertain Subsidiary will be involved in operations Advantages of Share Exchange to the Target - No capital gains tax. No Loss of control. Can participate in management activities. Disadvantages of Share Exchange to the Target - Amount received is uncertain It does not improves liquidity for other business operations Cannot be achieved quickly. Advantages of BOND payment to the Acquirer - There is no loss of control There is no dilution of EPS Amount paid is certain Subsidiary is not involved in operations. Have tax savings(reduce WACC). Disadvantages of BOND payment to the Acquirer - Default risk can arise. Leads to high gearing if a loan is used . Advantages of BOND payment to the Target - Amount received is certain Guaranteed returns. No capital gain tax Disadvantages of BOND payment to the Target - Loss of control. Does not partake management activities. Cash Payment (Target) - Find the value of the target using any method available Compare cash payment with value of target company to see if there is a gain or a loss. Cash payment(Acquirer) -find the combined value(value of acquirer + target + synergy) -deduct cash payment from the combine value -find the value per share -compare the value per share to the acquirer share price to determine gain or loss Share Exchange (Target/Acquirer) - Find the combined value of the company (i.e. acquirer + target + synergy) Find the combined no. of shares Find the acquirer company’s share price after acquisition Find the gain or loss Bonds (Target) - Find the MV of bonds exchanged for per share Compare value per share to the subsidiary’s value using any method applicable. Bonds(Acquirer) -Find combined value -deduct the bond value -value per share after the bond payment -compare the share to share price before to gain or loss Question 56 SIGRA CO (Dec 12 Adapted) 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 $5.00 per Dentro Co share; or Method 2 An offer of three of its shares for two of Dentro Co’s shares; or Method 3 An offer of a 2% coupon bond in exchange for 16 Dentro Co’s 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: Sales revenue Profit before tax Taxation Sigra Co. Dentro Co. $000 $000 44,210 4,680 6,190 -1,240 780 -155 Profit after tax Dividends 4,950 -2,700 625 -275 2,250 350 22,450 3,350 Current assets Non-current liabilities 3,450 9,700 247 873 Current liabilities Share capital (40c per share) 3,600 4,400 436 500 Reserves 8,200 1,788 Retained earnings for the year Non-current assets Sigra Co’s current share price is $3.60 per share and it has estimated that Dentro Co’s price to earnings ratio is 12.5% higher than Sigra Co’s current price to earnings ratio. Sigra Co’s 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 Co’s 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) Explain briefly, in general terms, why many acquisitions in the real world are not successful. (5 marks) (b) Estimate the percentage gain on a Dentro Co share under each of the above three payment methods. Comment on the answers obtained. (16 marks) (c) 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. 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) (Total: 25 marks) Question 57 Anderson Co.(ASSIGNMENT) Anderson Co is planning to take over Webb Co, a company in a different business sector, with a different level of risk. Anderson Co’s free cash flows are forecast to be $50m per annum in perpetuity, Webb Co’s free cash flows are forecast to be $10m per annum into perpetuity and there are expected to be annual post-tax cash synergies of $5m if the acquisition goes ahead. The combined company will pay tax at 30% and will have a pre-tax cost of debt of 5%. The risk free is 3% and the equity risk premium is 5.8%. Currently, Anderson Co has an asset beta of 1.25 and Webb Co has an asset beta of 1.60. assume that the beta of debt is zero. The current financing of the two companies is: $million Debt Equity Anderson Co 50 450 Webb Co 20 80 Anderson Co is planning to make a cash offer of $80m to buy 100% of the share of Webb Co. the cash offer will be funded by additional borrowing. Required: Calculate the gain in wealth for Anderson Co’s shareholders if the acquisition goes ahead. Question 58 Detox Plc.(ASSIGNMENT) Detox plc a drug manufacturer is considering a bid for Nexta plc a company in the plastics industry. The directors of Detox have decided to make a cash offer of $200 million for the purchase of 100% of Nexta plc’s shares. The cash offer is expected to be funded by additional borrowing. The following information is available: Detox plc Nexta plc Value of equity $2,240 million $126 million Value of debt $560 million $54 million Asset beta 1.2 0.8 The following post-tax cash flows: EBIT (1-t) are expected post-acquisition Year EBIT (1-t) $m 1 2 3 300 500 600 4 onwards 800 per year Corporation tax is at the rate of 30%. Risk-free rate and average market returns are expected to be 6% and 14% respectively. Corporate debt can be assumed to be risk-free. Required: Calculate the gain in wealth for Anderson Co’s shareholders if the acquisition goes ahead. Question Bank for Mergers and Acquisitions Pursuit Jun 2011 Cigno Sep/Dec 2015 Chikepe Mar/Jun 2018 Nente Jun 2012 Opao Dec 2018 Nahara and Fugae Dec 2014 Vogel Jun 2014 Question Bank for Dividend Capacity Arthuro Mar/Jun 2018 Lirio Mar/Jun 2016 Cigno Sep/Dec 2015 Bento Jun 2015 Chrysos Mar/Jun 2017 Fluffort Sep/Dec 2015 Currency Risk Management Currency Risk Question Bank Cassasophia Jun 2011 Kenduri Jun 2013 Nutourne Dec 2018 Lammer Jun 2006 Lirio Mar/Jun 2016 Adverene Mar/Jun 2018 Washi Sep 2018 Lignum Dec 2012 CMC Pilot Question Risk Management Currency Risk Forward contracts Futures Options Money market Swaps Swaptions Interest Rate Risk Forward rate agreement FRA Interest Rate Guarantee IRG Interest Rate futures Options on futures Collar Interest rate swaps Netting Types of Currency Risk Transaction Risk The risk of exchange gains or losses that arise due to the difference between the date of transaction and the date of payment. Economic Risk It is the long term effect of the transaction risk whereby the exchange gains or losses affects the company’s future cash flow and hence its market value. Translation Risk This is the risk of exchange gains or losses that arise when the foreign investments assets and liabilities are converted to the home currency on the day of consolidation. Managing Currency Risk Natural or Traditional Methods - Dealing in the home currency. Accept payments & receipts in home currency. Leading: making early payments or receipts for goods or services. Lagging: delaying receipts or payments for goods or services Matching: we match receipts and payments in the same currency at the same time or period. Do nothing: if it is a gain and loss affair then do nothing, as the gains will cancel out the losses. NOTE: PAY EARLY WHEN YOUR LOCAL CURRENCY IS WEAK DELAY PAYMENT WHEN LOCAL CURRENCY IS STRONG RECEIVE EARLY WHEN THE LOCAL CURRENCY IS STRONG DELAY RECEIPT WHEN THE LOCAL CURRENCY IS WEAK Using artificial methods (Derivatives) 1. Forward contracts. This is an agreement between two parties to buy or sell an underlying asset (currency) at a fixed price and future date. Advantages of forward contracts - Amount to receive or pay is fixed -Can hedge any amount at any time - No premium payment is required - No initial margin required as compared to futures Disadvantages of using Forward Contracts - It’s a legally binding contract and hence could have legal implications upon default - Cannot enjoy favorable market movements since it’s fixed - It is usually for short term purposes only. Variables needed for hedging forward contracts 1.the exposure i.e. receipt or payment in the foreign currency and 2.the forward or lock up rate. Direct (Receipt) = exposure x lower forward rate Direct (Payment) = exposure x higher forward rate Indirect (Receipt) = exposure ÷ higher forward rate Indirect (Payment = exposure ÷ lower forward rate NOTE: Direct=discount=less Direct=premium=add Indirect=discount=add Indirect=premium=less Question 59 An Australian firm has just bought some machinery from a US supplier for $250,000 & $400,000 with payment due in 3 months’ time & 4 months’ time respectively. Exchange rates are quoted as follows: Spot (US$/A$) 0.7785 – 0.7891 Three months forward 0.21 – 0.18 cents premium Six months forward 0.15 – 0.12 cents premium Required: Calculate the amount payables if forward contracts are used. 2. Futures This is an agreement between two parties to buy or sell a standardized contract at a future date and price. Futures require an initial margin or deposit. Gains made on futures is added to the initial margin. Losses reduce the initial margin If the intial margin reduces below the maintenance margin, an additional margin will be required. Futures are settled on a quarterly basis i.e. end of March, June, September and December. Advantages of futures - Amount to be received or paid is fixed thus aids in planning (budgeting & forecasting) - It is highly regulated and therefore transparent in nature - No premium is required Disadvantages of futures - It is not flexible, you can’t enjoy favorable market movements. - It is a legally binding contract and may have legal implications. - It is standardized contract , you can’t hedge any amount at any time. -The hedge is only used on short term basis. -They are in certain international currencies. Future hedge = exposure x future rate (for direct quoting) Future hedge = exposure ÷ future rate (for indirect quoting) No. of contracts = exposure or converted exposure ÷ contract size SIMILARITIES BTN FORWARD & FUTURES Legal binding contract Amount to receive or pay is fixed. There it aid planning and forecasting Cannot enjoy the favourable market movement Short term DIFFERENCES FUTURES INITIAL DEPOSIT/MARGIN COMPLEX SETTLED ON QUARTERLY HIGHLY REGULATED TRADEABLE STANDARDISED CERTAIN CURRENCY FORWARD NO INITIAL DEPOSIT MARGIN SIMPLE SETTLED ANY TIME NOT REGULATED OVER THE COUNTER CUSTOMIZE ALL CURRENCY OR Question 60 Casasophia Co. Casasophia Co, based in a European country that uses the Euro (€), constructs and maintains advanced energy efficient commercial properties around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months. Exchange Rates available to Casasophia Per €1 Spot US$1.3585–US$1.3618 4-month forward US$1.3588–US$1.3623 Per €1 MShs116–MShs128 Not available Currency Futures (Contract size €125,000, Quotation: US$ per €1) 2-month expiry 1.3633 5-month expiry 1.3698 Currency Options (Contract size €125,000, Exercise price quotation: US$ per €1, cents er Euro) Calls Puts Exerc price 2-month expiry 1.36 2.35 1.38 1.88 5-month expiry 2-month expiry 2.80 2.47 2.23 4.23 5-month expiry 2.98 4.64 Required: Advise Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. Include all relevant calculations. (15 marks) CMC CO (SPECIMEN PAPER 2018) Cocoa-Mocha-Chai (CMC) Co is a large listed company based in Switzerland and uses Swiss Francs as its currency. It imports tea, coffee and cocoa from countries around the world, and sells its blended products to supermarkets and large retailers worldwide. The company has production facilities located in two European ports where raw materials are brought for processing, and from where finished products are shipped out. All raw material purchases are paid for in US dollars (US$), while all sales are invoiced in Swiss Francs (CHF). a payment of US$5,060,000 which is due in four months’ time; and Exchange-traded currency futures Contract size CHF125,000 price quotation: US$ per CHF1 3-month expiry 1.0647 6-month expiry 1.0659 Exchange-traded currency options Contract size CHF125,000, exercise price quotation: US$ per CHF1, premium: cents per CHF1 Call Options Put Options Exercise price 3-month expiry 6-month expiry 3-month expiry 6-month expiry 1.06 1.87 2.75 1.41 2.16 1.07 1.34 2.22 1.88 2.63 It can be assumed that futures and option contracts expire at the end of the month and transaction costs related to these can be ignored. Over-the-counter products A forward rate between the US$ and the CHF of US$ 1.0677 per CHF1. Required: Advise CMC Co on an appropriate hedging strategy to manage the foreign exchange exposure of the US$ payment in four months’ time. Show all relevant calculations, including the number of contracts bought or sold in the exchange-traded derivative markets. (1 5 marks) QUESTION 61 Lammer Plc. Lammer plc is a UK-based company that regularly trades with companies in the USA. Several large transactions are due in five months’ time. These are shown below. The transactions are in ‘000’ units of the currencies shown. Assume that it is now 1 June and that futures and options contracts mature at the relevant month end. Exports to: Imports from: Company 1 $490 £150 Company 2 – $890 Company 3 £110 $750 Exchange rates: Spot 3 months forward 1 year forward $US/£ 1.9156–1.9210 1.9066–1.9120 1.8901–1.8945 Annual interest rates available to Lammer plc Borrowing Sterling up to 6 months 5.5% Dollar up to 6 months 4.0% Investing 4.2% 2.0% CME $/£ Currency futures (£62,500) 30 September 1.9045 31 December 1.8986 CME currency options prices, $/£ options £31,250 (cents per pound) CALLS PUTS Sept Dec Sept Dec 1.8800 4.76 5.95 1.60 2.96 1.9000 3.53 4.70 2.36 4.34 1.9200 2.28 3.56 3.40 6.55 Required: Prepare a report for the managers of Lammer plc on how the five-month currency risk should be hedged. Include in your report all relevant calculations relating to the alternative types of hedge. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 1 Question 62 Lirio Co. Lirio Co is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. . It can be assumed that the date today is 1 March 20X6. Sale of equity investment in the European country It is expected that Lirio Co will receive Euro (€) 20 million in three months’ time from the sale of its investment. The following exchange contracts and rates are available to Lirio Co. Per €1 Spot rates $1.1585 – $1.1618 Three-month forward rates $1.1559 – $1.1601 Currency futures (contract size $125,000, quotation: € per $1) March futures €0.8638 June futures €0.8656 Currency options (contract size $125,000, exercise price quotatio € per $1, premium € per $1) Calls Puts Exercise price March June March June 0.8600 0.0255 0.0290 0.0267 0.0319 It can be assumed that futures and options contracts expire at the end of their respective months. Required: Prepare a discussion paper, including all relevant calculations, for the board of directors (BoD) of Lirio Co which: Advises Lirio Co on, and recommends, an appropriate hedging strategy for the Euro (€) receipt it is due to receive in three months’ time from the sale of the equity investment (14 marks) KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 2 Money market hedges The Money market is a market for investments and deposits on short term basis. Hedging Receipts 1. Borrow in the foreign currency 2. Convert to the home currency using the spot rate 3. Deposit or invest in the home currency or bank Hedging Payments 1. Deposit in the foreign currency 2. Convert to the home currency using the spot rate 3. Borrow from the home bank or home currency Advantages of Money Markets - There is no premium payment requirement - There is no initial margin requirement - There is no foreign exchange exposure - There could be an early receipt on goods or services and this can improve liquidity - Amount to be received or paid is certain & this can aid planning. Disadvantages of using Money markets - You cannot enjoy favorable market movements - It is not suitable in the event of an economic crisis - The hedge will not be effective when the interest rate is changing in the market - The hedge is only used on short term basis Question 63 Kenduri Co. Kenduri Co is a large multinational company based in the UK with a number of subsidiary companies around the world. Currently, foreign exchange exposure as a result of transactions between Kenduri Co and its subsidiary companies is managed by each company individually. Kenduri Co is considering whether or not to manage the foreign exchange exposure using multilateral netting from the UK, with the Sterling Pound (£) as the base currency. If multilateral netting is undertaken, spot mid-rates would be used. The following cash flows are due in three months between Kenduri Co and three of its subsidiary companies. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 3 The subsidiary companies are Lakama Co, based in the United States (currency US$), Jaia Co, based in Canada (currency CAD) and Gochiso Co, based in Japan (currency JPY). Owed by Owed to Amount Kenduri Co Lakama Co US$ 4.5 million Kenduri Co Jaia Co CAD 1.1 million Gochiso Co Jaia Co CAD 3.2 million Gochiso Co Lakama Co US$ 1.4 million Jaia Co Lakama Co US$ 1.5 million Jaia Co Kenduri Co CAD 3.4 million Lakama Co Gochiso Co JPY 320 million Lakama Co Kenduri Co US$ 2.1 million Exchange rates available to Kenduri Co US$/£1 CAD/£1 Spot 1.5938–1.5962 1.5690–1.5710 3-month forward 1.5996–1.6037 1.5652–1.5678 JPY/£1 131.91–133.59 129.15–131.05 Currency options available to Kenduri Co Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents per £1 Call Options Put Options Exercise price 3-month 6-month 3-month 6-month expiry expiry expiry expiry 1.60 1.55 2.25 2.08 2.23 1.62 0.98 1.58 3.42 3.73 It can be assumed that option contracts expire at the end of the relevant month Annual interest rates available to Kenduri Co and subsidiaries UK United States Canada Japan Borrowing rate 4.0% 4.8% 3.4% 2.2% Investing rate 2.8% 3.1% 2.1% 0.5% Required: (a) Advise Kenduri Co on, and recommend, an appropriate hedging strategy for the US$ cash flows it is due to receive or pay in three months, from Lakama Co. Show all relevant calculations to support the advice given. (12 marks) KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 4 (b) Calculate, using a tabular format (transactions matrix), the impact of undertaking multilateral netting by Kenduri Co and its three subsidiary companies for the cash flows due in three months. Briefly discuss why some governments allow companies to undertake multilateral netting, while others do not. (10 marks) Options An option is the right but there is no obligation to buy or sell an underlying asset (or currency) at a future price and date (i.e. exercise price and date) The cost of undertaking an option is called the premium. It is payable upfront and it is not refundable. An option to sell = PUT option An option to buy = CALL option An option which can be exercised only at the maturity date is called a European option. An option which can be exercised on or before the maturity date is called an American option. Types of Options Over the counter options (OTC) It is a customized option or tailored to a particular customer or individual. Exchanged traded options These are standardized in nature and are traded or marketed on the financial markets. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 5 Advantages of exchange traded options - They are readily available on the market - It could be bought and sold on the market - It is highly regulated and transparent in nature - There is no counter party risk Drawbacks of exchange traded options - There is a limited range of products - There is a fixed date, you cannot hedge at any time - They are in contract sizes, you cannot hedge any amount - They are for short term period -They are in certain international currencies Similiarities for futures and options Traded Short term Certain international currency Complex Contract size Fixed date regulated OPTIONS FUTURES Premium payment flexible Can enjoy favourable mkt condition Initial margin Legal binding Cannot enjoy favourable market condition Amount certain DIFFERENCES Amount not certain KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 6 Steps for Hedging Options 1. Determine the exposure. 2. Determine whether it is a call or put option The golden rule If the option or contract size is in the home currency then Payment will PUT (HPP) & Receipt will be CALL (HRC) If the option or contract size is in the foreign currency then Payment will CALL (FPC) & Receipt will be PUT (FRP) 3. If the exposure is in different currency from contract size currency, convert the exposure to the contract size currency using an exercise price. 4. Determine the number of contracts (exposure/converted exposure ÷ contract size) 5. Calculate the basic hedge (no. of contracts x contract size) The basic hedge must always be in the local currency, if not convert it into the local currency using the exercise price. 6. Calculate the premium. 7. Determine the amount not hedged or over hedge when there is an imperfect hedge ((total exposure – (basic hedge x exercise prices). 8. Hedge the amount not hedged using the forward rate. 9. Determine the overall outcome=Basic - premium +/- forward contract Netting This occurs when mutual indebtedness between group members and other group members is reduced. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 7 Advantages of Netting - Reduces the amount of transaction costs - Reduces counter party risk - Overcome exchange control restrictions - It helps to encourage foreign investments Disadvantages of Netting - Cost involved in arranging the netting - Some governments disallow netting arrangements by banks - There could be currency exposure to some other group members - There could be a difficulty in controlling netting exercise. Steps to Netting 1. Convert all currencies to the home currency(Parent) 2. Set up the netting table with each company horizontally and vertically 3. Input the converted amounts into their respective columns or matrix 4. Find the net receipts or payments to each party concerned. Question 64 The Armstrong Group The Armstrong Group is a multinational group of companies. Today is 1st September. The treasury manager at Massie Co, one of Armstrong Group’s subsidiaries based in Europe, has just received notification from the group’s head office that it intends to introduce a system of netting to settle balances owed within the group every six months. Previously intergroup indebtedness was settled between the two companies concerned. The predicted balances owing to, and owed by, the group companies at the end of February are as follows: Owed by Owed to Local currency million (m) Armstrong (USA) Horan (South Africa) US $12.17 Horan (South Africa) Massie (Europe) SA R42.65 Giffen (Denmark) Armstrong (USA) D Kr21.29 Massie (Europe) Armstrong (USA) US $19.78 Armstrong (USA) Massie (Europe) €1.57 Horan (South Africa) Giffen (Denmark) D Kr16.35 Giffen (Denmark) Massie (Europe) €1.55 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 8 The predicted exchange rates, used in the calculations of the balances to be settled, are as follows: D Kr US$ SAR € 1 D Kr = 1.0000 0.1823 1.9554 0.1341 1 US $ = 5.4855 1.0000 10.7296 0.7358 1 SA R = 0.5114 0.0932 1.0000 0.0686 1€= 7.4571 1.3591 14.5773 1.0000 Settlement will be made in dollars, the currency of Armstrong Group, the parent company. Settlement will be made in the order that the company owing the largest net amount in dollars will first settle with the company owed the smallest net amount in dollars. Note: D Kr is Danish Krone, SA R is South African Rand, US $ is United States dollar and € is Euro. Required: (a) (i) Calculate the inter-group transfers which are forecast to occur for the next period. (8 marks) (ii) Discuss the problems which may arise with the new arrangement. (3 marks) The most significant transaction which Massie Co is due to undertake with a company outside the Armstrong Group in the next six months is that it is due to receive €25 million from Bardsley Co on 30 November. Massie Co’s treasury manager intends to invest this money for the six months until 31 May, when it will be used to fund some major capital expenditure. However, the treasury manager is concerned about changes in interest rates. Predictions in the media range from a 0.5% rise in interest rates to a 0.5% fall. Because of the uncertainty, the treasury manager has decided to protect Massie Co by using derivatives. The treasury manager wishes to take advantage of favourable interest rate movements. Therefore she is considering options on interest rate futures or interest rate collars as possible methods of hedging, but not interest rate futures. Massie Co can invest at LIBOR minus 40 basis points and LIBOR is currently 3.6% The treasury manager has obtained the following information on Euro futures and options. She is ignoring margin requirements. Three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. September 95.94 December 95.76 March 95.44 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 9 Options on three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. Option premiums are in annual %. Calls September December 0.113 0.182 0.017 0.032 Strike March 0.245 0.141 96.50 97.00 Puts September December March 0.002 0.123 0.198 0.139 0.347 0.481 It can be assumed that settlement for the contracts is at the end of the month. It can also be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted in months. Required: Based on the choice of options on futures or collars which Massie Co is considering and assuming the company does not face any basis risk, recommend a hedging strategy for the €25 million receipt. Support your recommendations with appropriate comments and relevant calculations. (14 marks) Currency Risk Question Bank Cassasophia Jun 2011 Kenduri Jun 2013 Nutourne Dec 2018 Lammer Jun 2006 Lirio Mar/Jun 2016 Adverene Mar/Jun 2018 Washi Sep 2018 Lignum Dec 2012 CMC Pilot Question KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 10 Interest Rate Hedges Question Bank for Interest Rate Risk Mar/Jun 2019 Q3 Awan Co. Dec 2013 Alecto Pilot 2012 Keshi Dec 2014 Daikon Jun 2015 Armstrong Sep/Dec 2015 Wardegal Sep/Dec 2017 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 11 Risk Management Interest Rate Risk Forward rate agreement FRA Interest Rate Guarantee IRG Interest Rate futures Options on futures Collar Interest rate swaps Forward Rate Agreements FRA This is an agreement between two parties to borrow or invest at a fixed rate and time. For borrowing If the individual is borrowing more at the open market than the fixed rate, the hedge institution or bank pays the difference. The difference is known as compensation received from the bank If the individual is borrowing less than the agreed fixed rate the individual pays the difference to the bank. The difference is compensation paid to the bank. For investing KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 12 If the individual is receiving more on the open market than the fixed rate, the individual pays the difference to the bank hedge institution. If the individual is receiving less on the open market than the fixed rate, the bank or hedge institution pays the difference to the individual. Advantages of FRA - No margin requirement - No premium payment - Amount is certain - You can hedge any amount at any time Disadvantages for FRA - You can’t enjoy favorable market movement in interest rates - It is for short term periods - Legally binding contract How to Read FRAs 1-7 or 1 v 7 An investor or borrower who intends to invest or borrow in a months’ time but will pay or withdraw in 7 months’ time from now. Thus investing or borrowing for 6 months period. If there are 2 rates then: Investing = lower rate Borrowing = higher rate • 2v5 → 5.75 – 6.00 Means forward rate agreement that start in 2 months and last for 3 months at a borrowing rate of 6% and lending rate of 5.75% • 3v5 → 5.78 – 6.13 Means forward rate agreement that start in 3 months and last for 2 months at borrowing rate of 6.13% and lending rate of 5.78%. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 13 Question 65 A bank has quoted the following FRA rates: 2v6 → 5.75 – 6.00 3v5 → 5.78 – 6.13 4v7 → 5.95 – 6.45 Assume that now is 1st November, 2008. Required: Determine the FRA interest applicable to the following situations: 1. A company wants to borrow on 1st February 2009 and repay the loan on 1st of April, 2009. 2. A company wants to deposit money on 1st January, 2009 and expect to withdraw the amounts for an investment on 1st of May, 2009. 3. A company wants to borrow on 1st March, 2009 and repay the loan on 1st of June, 2009. Question 66 A company will have to borrow an amount of £100 million in three months’ time for a period of six months. The company borrows at LIBOR plus 50 basis points. LIBOR is currently 3.5%. The treasure wishes to protect the short-term investment from adverse movements in interest rates by using forward rate agreement (FRAs). FRA prices (%) 3v9 3.85 – 3.80 4v9 3.58 – 3.53 5v9 3.55 - 3.45 Required: Show the expected outcome of FRA a. If LIBOR increases by 0.5% b. If LIBOR decreases by 0.5% KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 14 Question 67 Assume that it is now 1st June. Your company expects to receive £7.1m from a large order in five months’ time. This will then be invested in highquality commercial paper for a period of four months, after that it will be used to pay part of the company’s dividend. The treasurer wishes to protect the short-term investment from adverse movements in interest rates, by using forward rate agreement (FRA). FRA prices (%) 4v5 → 3.85 – 3.80 4v9 → 3.58 - 3.53 5v9 → 3.50 – 3.45 The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR is currently 3%. Required: If LIBOR falls or increases by 0.5% during the next five months, show the expected outcome of FRA. Options on FRAs/ Interest rate guranteed This is where there is a right but no obligation to borrow or invest at a fixed rate and time. For Investment If the market rate is higher than fixed rate (FRA), the individual will go the market and will not exercise its right and vice versa. For Borrowing If the market rate is lower than fixed rate (FRA), the individual will go the market but will not exercise its right and vice versa Advantages of Options on FRAs - Flexible: enjoy favorable market movements - You can hedge any amount at any time KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 15 - No margin requirement Drawbacks of Options on FRAs - Premium payment required and is not refundable - Doesn’t aid forecasting and budgeting because the amount to be received or paid is not certain - It is for short term purposes. Question 68 A company will have to borrow an amount of £100 million in three months’ time for a period of six months. The company borrows at LIBOR plus 50 basis points. LIBOR is currently 3.5%. The treasure wishes to protect the short-term investment from adverse movements in interest rates by using INTEREST RATE GURANTEE(IRG). FRA prices (%) 3v9 3.85 – 3.80 4v9 3.58 – 3.53 5v9 3.55 - 3.45 Required: Show the expected outcome of FRA a. If LIBOR increases by 0.5% b. If LIBOR decreases by 0.5% Question 67 Assume that it is now 1st June. Your company expects to receive £7.1m from a large order in five months’ time. This will then be invested in highquality commercial paper for a period of four months, after that it will be used to pay part of the company’s dividend. The treasurer wishes to protect the short-term investment from adverse movements in interest rates, by using INTEREST RATE GURANTEE(IRG). FRA prices (%) 4v5 → 3.85 – 3.80 4v9 → 3.58 - 3.53 5v9 → 3.50 – 3.45 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 16 The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR is currently 3%. Required: If LIBOR falls or increases by 0.5% during the next five months, show the expected outcome of FRA. Futures Steps to hedging Interest rate Futures 1. Determine the number of contracts = Amt borrow/invest × Period of Borrow or Invest Contract size 3 2. 3. 4. 5. 6. 7. Find the basis(currency Libor less closing futures chosen) Find the unexpired basis Calculate the return on the market or cost of borrowing Determine the gain or loss on futures market Determine the net interest cost or return Find the effective rate Ticks A tick is the minimum price movement permitted by the exchange on which the future contract is traded. Ticks are used to determine the profit or loss on the future contract. The significance of the ticks is that everyone tick movement in price has the same money value. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 17 Interest Rate Options Steps to hedge Options 1. Determine whether it’s a call or put option. Golden Rule Investment=CALL Borrowing=PUT 2. Compare the strike price to the expected closing future and determine if option should be exercised 3. Calculate the gain made if the option is exercised 4. Find the premium to be paid 5. Return on investments or cost of borrowing 6. Find the net interest receipt or cost 7. Find the effective rate Collar Hedges This is the simultaneous purchase and sale of put and call options at different exercise prices. Floor This is the minimum return expected on investments Cap This is the maximum amount of interest expected on borrowings Advantage It helps to minimize the amount of premium paid or the cost of transaction. Disadvantage If the counter party exercises the right, the gain made by the counter party will be a loss to the option holder. How to hedge Collar If it is an investment, buy CALL at the exercise price with the least premium, sell PUT at a different exercise price with the highest premium. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 18 If it is a borrowing, buy PUT at the exercise price with the least premium, sell CALL at a different exercise price with the highest premium. Investment Borrowing BUY SELL BUY SELL CALL PUT PUT CALL Interest Rate Swaps This is agreement between two parties to exchange a fixed interest rate for a floating interest rate and vice versa over a period of time. Fixed rate – not affected by LIBOR increase or decrease Floating rate - affected by LIBOR increase or decrease Advantages of Swaps - It can be hedged for a longer period of time There is no premium requirement There is no margin requirement You can have access to money in a market which is impossible to borrow Finance costs could be cheaper with swaps than borrowing directly on the market. Drawbacks of Swaps - There could be counter party risk The bank charges a fee for arranging the swaps You cannot easily enjoy favorable market movements unless it’s a swaption. Steps for Swaps 1. 2. 3. 4. Set up a table for fixed and floating rates for the parties involved. Find out where more savings can be achieved Whoever will bring more savings should borrow at their rate. Find the net saving(share based on proportion given) KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 19 5. Effective rate(Amount of interest paying less share of gain) Question 68 Company A wishes to raise $6m and to pay interest at a floating rate, as it would like to be able to take advantage of any tall in interest rates. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above LIBOR. Company B also wishes to raise $6m. They would prefer to issue fixed rate debt because they want certainly about their future interest payments but can only borrow for one year at 13% fixed or LIBOR + 2% floating as it has a lower credit rating than Company A. Required: Calculate the effective swap rate for each company – assume savings are split equally. Question 69 Company X wishes to raise $50m. They would prefer to issue fixed rate debt and can borrow for one year at 6% fixed or LIBOR + 80 points. Company Y also wishes to raise $50m and to pay interest at a floating rate. It can borrow for one year at a fixed rate of 5% or at LIBOR + 50 points. Required: Calculate the effective swap rate for each company. Assume savings are split equally. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 20 Question 70 Warne Co. Warne Co is an Australian firm looking to expand in Germany and is looking to raise €24m. it can borrow at the following fixed rates: At $ 7% € 5.6% Euro parts Inc is a French company looking to acquire an Australian firm and is looking to borrow A $40m. It can borrow at the following rates. A $7.2% £ 5.5% The current spot rate is A$1 = €0.6 Required: Show how a “fixed for fixed” currency swaps would work in the circumstances described. Question 71 Wa Inc. Wa Inc is a Japanese firm looking to expand in the U.S.A and is looking to raise $20m at a variable interest rate. It has been quoted the following rates: $ LIBOR + 60 points ¥ 1.2% Mcgregor Inc is an American company looking to refinance a ¥2,400m loan at a fixed rate. It can borrow at the following rates: $ LIBOR + 50 points ¥ 1.5% The current spot rate is $1 = ¥120. Required: Show how the “fixed for variable” currency swaps would work in the circumstances described. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 21 Question 72 Alecto Co. Alecto Co, a large listed company based in Europe, is expecting to borrow €22,000,000 in four months’ time on 1 May 20X2. It expects to make a full repayment of the borrowed amount nine months from now. Currently there is some uncertainty in the markets, with higher than normal rates of inflation, but an expectation that the inflation level may soon come down. This has led some economists to predict a rise in interest rates and others suggesting an unchanged outlook or maybe even a small fall in interest rates over the next six months. Although Alecto Co is of the opinion that it is equally likely that interest rates could increase or fall by 0.5% in four months, it wishes to protect itself from interest rate fluctuations by using derivatives. The company can borrow at LIBOR plus 80 basis points and LIBOR is currently 3.3%. The company is considering using interest rate futures, options on interest rate futures or interest rate collars as possible hedging choices. The following information and quotes from an appropriate exchange are provided on Euro futures and options. Margin requirements may be ignored. Three month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25 March 96.27 June 96.16 September 95.90 Options on three month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. Option premiums are in annual %. March 0.279 0.012 Calls Strike June September 0.391 0.446 96.00 0.090 0.263 96.50 Puts March June September 0.006 0.163 0.276 0.196 0.581 0.754 It can be assumed that settlement for both the futures and options contracts is at the end of the month. It can also be assumed that basis diminishes to zero at contract maturity at a constant rate and that time intervals can be counted in months. Required: (a) Briefly discuss the main advantage and disadvantage of hedging interest rate risk using an interest rate collar instead of options. (4 marks) (b) Based on the three hedging choices Alecto Co is considering and assuming that the company does not face any basis risk, recommend a KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 22 hedging strategy for the €22,000,000 loan. Support your recommendation with appropriate comments and relevant calculations in €. (17 marks) (c) Explain what is meant by basis risk and how it would affect the recommendation made in part (b) above. (4 marks) Question 73 Pault Co. Pault Co is currently undertaking a major programme of product development. Pault Co has made a significant investment in plant and machinery for this programme. Over the next couple of years, Pault Co has also budgeted for significant development and launch costs for a number of new products, although its finance director believes there is some uncertainty with these budgeted figures, as they will depend upon competitor activity amongst other matters. Pault Co issued floating rate loan notes, with a face value of $400 million, to fund the investment in plant and machinery. The loan notes are redeemable in ten years’ time. The interest on the loan notes is payable annually and is based on the spot yield curve, plus 50 basis points. Pault Co’s finance director has recently completed a review of the company’s overall financing strategy. His review has highlighted expectations that interest rates will increase over the next few years, although the predictions of financial experts in the media differ significantly. The finance director is concerned about the exposure Pault Co has to increases in interest rates through the loan notes. He has therefore discussed with Millbridge Bank the possibility of taking out a four-year interest rate swap. The proposed terms are that Pault Co would pay Millbridge Bank interest based on an equivalent fixed annual rate of 4.847%. In return, Pault Co would receive from Millbridge Bank a variable amount based on the forward rates calculated from the annual spot yield curve rate at the time of payment minus 20 basis points. Payments and receipts would be made annually, with the first one in a year’s time. Millbridge Bank would charge an annual fee of 25 basis points if Pault Co enters the swap. The current annual spot yield curve rates are as follows: KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 23 Year Rate One 3.70% Two 4.25% Three 4.70% Four 5.10% A number of concerns were raised at the recent board meeting when the swap arrangement was discussed. Pault Co’s chairman wondered what the value of the swap arrangement to Pault Co was, and whether the value would change over time. One of Pault Co’s non-executive directors objected to the arrangement, saying that in his opinion the interest rate which Pault Co would pay and the bank charges were too high. Pault Co ought to stick with its floating rate commitment. Investors would be critical if, at the end of four years, Pault Co had paid higher costs under the swap than it would have done had it left the loan unhedged. Required: (a) (i) Using the current annual spot yield curve rates as the basis for estimating forward rates, calculate the amounts Pault Co expects to pay or receive each year under the swap (excluding the fee of 25 basis points). (6 marks) (ii) Calculate Pault Co’s interest payment liability for Year 1 if the yield curve rate is 4.5% or 2.9%, and comment on your results. (6 marks) (b) Advise the chairman on the current value of the swap to Pault Co and the factors which would change the value of the swap. (4 marks) (c) Discuss the disadvantages and advantages to Pault Co of not undertaking a swap and being liable to pay interest at floating rates. (9 marks) Question 74 Sembilan Co. Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 24 Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders. Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3.76¼% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed. The current annual spot yield curve rates are as follows: Year One Two Three Four Rate 2.5% 3.1% 3.5% 3.8% The current annual forward rates for years two, three and four are as follows: Year Two Three Four Rate 3.7% 4.3% 4.7% Required: (a) Based on the above information, calculate the amounts Sembilan Co expects to pay or receive every year on the swap (excluding the fee of 20 basis points). Explain why the fixed annual rate of interest of 3.76¼% is less than the four-year yield curve rate of 3.8%. (6 marks) (b) Demonstrate that Sembilan Co’s interest payment liability does not change, after it has undertaken the swap, whether the interest rates increase or decrease. (5 marks) (c) Discuss the advantages of hedging with interest rate caps and collars. (6 marks) (d) Discuss the factors that Sembilan Co should consider when deciding whether it should raise equity capital to pay off the floating rate debt. (8 marks) Currency Swaps This is an agreement between two parties to exchange one currency for another over an agreed period of time. Advantages - Helps to overcome the currency risk KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 25 - Helps to overcome exchange control restrictions You can restructure your capital without redeeming it It can be hedged for a longer period of time There is no premium requirement There is no margin requirement You can have access to money in a market which is impossible to borrow Finance costs could be cheaper with swaps than borrowing directly on the market. Disadvantages - There can be political risk. There could be counter party risk The bank charges a fee for arranging the swaps You cannot easily enjoy favorable market movements unless it’s a swaption. Question 75 Buryecs Buryecs Co is an international transport operator based in the Eurozone which has been invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise. Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in each of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to take over the franchise. Today’s spot exchange rate between the Euro and Wirtonia $ is €0·1430 = $1. The predicted inflation rates are as follows: Year 1 2 3 Eurozone 6% 4% 3% Wirtonia 3% 8% 11% KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 26 Buryecs Co’s finance director (FD) has contacted its bankers with a view to arranging a currency swap, since he believes that this will be the best way to manage financial risks associated with the franchise. The swap would be for the initial fee paid for the franchise, with a swap of principal immediately and in three years’ time, both these swaps being at today’s spot rate. Buryecs Co’s bank would charge an annual fee of 0·5% in € for arranging the swap. Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% of the bank fees. Relevant borrowing rates are: Eurozone Wirtonia Buryecs Co Counterparty 4·0% Wirtonia bank rate 5·8% Wirtonia bank rate + 0·6% + 0·4% In order to provide Buryecs Co’s board with an alternative hedging method to consider, the FD has obtained the following information about over-the-counter options in Wirtonia $ from the company’s bank. The exercise price quotation is in Wirtonia $ per €1, premium is % of amount hedged, translated at oday’s spot rate. Exercise price 7·75 7·25 Call options 2·8% 1·8% Put options 1·6% 2·7% Assume a discount rate of 14%. Required: (a) Discuss the advantages and drawbacks of using the currency swap to manage financial risks associated with the franchise in Wirtonia. (6 marks) (b) (i) Calculate the annual percentage interest saving which Buryecs Co could make from using a currency swap, compared with borrowing directly in Wirtonia, demonstrating how the currency swap will work. (4 marks) (ii) Evaluate, using net present value, the financial acceptability of Buryecs Co operating the rail franchise under the terms suggested by the government of KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 27 Wirtonia and calculate the gain or loss in € from using the swap arrangement. (8 marks) (c) Calculate the results of hedging the receipt of $7,500 million using the currency options and discuss whether currency options would be a better method of hedging this receipt than a currency swap. (7 marks) Question 76 Awan Co. Awan Co is expecting to receive $48,000,000 on 1 February 20X4, which will be invested until it is required for a large project on 1 June 20X4. Due to uncertainty in the markets, the company is of the opinion that it is likely that interest rates will fluctuate significantly over the coming months, although it is difficult to predict whether they will increase or decrease. Awan Co’s treasury team want to hedge the company against adverse movements in interest rates using one of the following derivative products: Forward rate agreements (FRAs); Interest rate futures; or Options on interest rate futures. Awan Co can invest funds at the relevant inter-bank rate less 20 basis points. The current inter-bank rate is 4.09%. However, Awan Co is of the opinion that interest rates could increase or decrease by as much as 0.9% over the coming months. The following information and quotes are provided from an appropriate exchange on $ futures and options. Margin requirements can be ignored. Three-month $ futures, $2,000,000 contract size Prices are quoted in basis points at 100 – annual % yield December 20X3: 94.80 March 20X4: 94.76 June 20X4: 94.69 Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual % Calls December March June 0.342 0.432 0.523 0.097 0.121 0.289 Strike 94.50 95.00 December 0.090 0.312 Puts March 0.119 0.417 June 0.271 0.520 Voblaka Bank has offered the following FRA rates to Awan Co: 1–7: 4.37% 3–4: 4.78% KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 28 3–7: 4–7: 4.82% 4.87% It can be assumed that settlement for the futures and options contracts is at the end of the month and that basis diminishes to zero at contract maturity at a constant rate, based on monthly time intervals. Assume that it is 1 November 20X3 now and that there is no basis risk. Required: (a) Based on the three hedging choices Awan Co is considering, recommend a hedging strategy for the $48,000,000 investment, if interest rates increase or decrease by 0.9%. Support your answer with appropriate calculations and discussion. (19 marks) (b) A member of Awan Co’s treasury team has suggested that if option contracts are purchased to hedge against the interest rate movements, then the number of contracts purchased should be determined by a hedge ratio based on the delta value of the option. Required: Discuss how the delta value of an option could be used in determining the number of contracts purchased. (6 marks) Question Bank for Interest Rate Risk Mar/Jun 2019 Q3 Awan Co. Dec 2013 Alecto Pilot 2012 Keshi Dec 2014 Daikon Jun 2015 Armstrong Sep/Dec 2015 Wardegal Sep/Dec 2017 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 29 Option Pricing Option Terminology An Option: the right but not an obligation, to buy or sell a particular good at an exercise price, at or before a specified date. Call Option: the right but not an obligation to buy a particular good at an exercise price. Put Option: the right but not an obligation to sell a particular good at an exercise price. Exercise/Strike price: the fixed price at which the good may be bought or sold. American Option: an option that can be exercised on any day up until its expiry date. European Option: an option that can only exercise on the last day of the option. Premium: the cost of an option. Traded Option: standardized option contracts sold on a future exchange (normally American options). Over the counter (OTC) option: tailor-made option usually sold by a bank (normally European options). At, In And Out Of The Money If the exercise price is more than the market price of the underlying item, a call option will be out of money and a put option will be in the money. If the exercise price is less than the market price of the underlying item, a call option will be in the money and a put option will be out of the money. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 30 If the exercise price is equal to the market price of the underlying item both call and put options will be at the money. Intrinsic Value Intrinsic value is the difference between the strike price for the option and the current market price of the underlying item. However, an in-themoney option has an intrinsic value; but because intrinsic value cannot be negative, an out of the money option has an intrinsic value of zero. Advantages of Traded Options – Over-the-Counter Options 1. It offers greater liquidity, with easy sale or purchase of options of a known standard quality. 2. Lower counter party risk contracts are marked to the market on a daily basis, and a central clearing house monitors the ability of all counter parties to meet the obligations. 3. Better regulations. Most options exchanges are subject to stringent regulation by government authorities. 4. Market traded options are normally American style options may be exercised at any time. OTC are options which are often European style, and can only be exercised at their maturity date. 5. There is greater price transparency, with current price on the market immediately available. Advantages of OTC options 1. OTC options offer a much larger choice of contract size and maturity which allow the purchaser of the option to tailor the option much more specifically to individual needs. 2. Option sizes are typically much larger on the OTC market. 3. Options may be arranged for longer periods than is possible with traded options. Pricing of Options Writers of options need to establish a way of pricing them. This is important because there has to be a method of deciding what premium to charge to the buyers. The pricing model for call options are based on the Black-Scholes model. Factors Determining the Value (Price) Of the Option 1. The price of the underlying item 2. The exercise price 3. Time to expiry of the option KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 31 4. Interest rate 5. Volatility of underlying item. The Price of the Underlying Item For a call option, the greater the price for the underlying item the greater the value of the option to the holder. The price of the underlying item is the market prices for buying and selling the underlying item. However, mid-price is usually used for option pricing, for example, if price is quoted as 200-202, then a mid-price of 201 should be used. The Exercise Price For a call option the lower the exercise price the greater the value of the option. For a put option the greater the exercise price, the greater the value of the option. The exercise price will be stated in terms of the option contract. Time to Expiry of The Option The larger the remaining to expiry, the greater the probability that the underlying item will rise in value. Call options are worth more the longer the time to expiry (time value) because there is more time for the price of the underlying item to rise. Put options are worth more if the price of the underlying item falls over time. The term to expiry will also be stated in the terms of the option contract. Interest Rate or Risk Free Rates The seller of a call option will receive initially a premium and if the option is exercised, the exercise price at the exercised date. If interest rate rises the present value of the exercise price will diminish and he will therefore ask for a higher premium to compensate for his risk. The risk free rate such as treasury bills is usually used as the interest rate. Volatility of Underlying Item The greater the volatility of the price of the underlying item the greater the probability of the option yielding profits. The volatility represents the standard deviation of day-to-day price changes in the underlying item, expressed as an annualized percentage. Summary of the determinants of call and put option prices Increase in Call Share price Increase Exercise price Decrease KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 Put Decrease Increase 32 Time to expiry Increase Increase Volatility Increase Increase Interest rate Increase Decrease THE GREEKS In principle, an option writer could sell options without hedging his position. If the premiums received accurately reflect the expected payouts at expiry, there is theoretically no profit or loss on average. This is analogous to an insurance company not reinsuring it business. In practice, however, the risk that any one option may move sharply inthe-money makes this too dangerous. In order to manage a portfolio of options, the dealer must know how the value of the options he has sold and bought will vary with changes in the various factors affecting their price. Such assessments of sensitivity are measured by the ‘Greeks’ which can be used by options traders in evaluating their hedge positions. DELTA For each option held, the delta value can be established i.e: Delta = change in option price Change in price underlying security Delta is a measure of how much an option premium changes in response to a change in the security price. 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. Accordingly a writer can hedge a holding of 300,000 shares using options with a delta value estimated by N(d1) of 0.6, by holding the following number of LIFFE contracts (each on 1,000 shares). Number of shares = 300,000 Delta value × contract size 0.6 × 1,000 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 = 500 contracts. 33 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. GAMMA Gamma measures the amount by which the delta value changes as underlying security prices change. This is calculated as the: Change in the delta value Change in the price of the underlying security VEGA Vega measures the sensitivity of the option premium to a change in volatility. As indicated above high volatility increases the price of an option. Therefore any change in volatility can affect the option premium. Thus: Vega = change in the option price Change in volatility Note: vega is the name of a star, not a letter of the Greek alphabet. THETA Theta measures how much the option premium changes with the passage of time. The passage of time affects the price of any derivative instrument because derivatives eventually expire. An option will have a lower value as it approaches maturity. Thus: Thata = change in the option price (due to changes in value) Change in time to expiry RHO Rho measures how much the option premium responds to changes in interest rates. Interest rates affect the price of an option because today’s price will be a discounted value of future cash flows with KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 34 interest rates determining the rate at which this discounting takes place. Thus: Rho = change in the option price Change in the rate of interest Summary of The Greeks Change in In response to change in Delta Option premium Value of underlying security Gamma Delta value Value of underlying security Vega Option premium volatility Theta Time value in option premium Time to expiry Rho Option premium Risk free rate of interest Real Options Flexibility increases the value of an investment and financial options theory provides a guide as to how this flexibility can be incorporated into project appraisal. Conventional project appraisal techniques do not adequately recognize the value of flexibility. However, real options theory attempts to apply the principles used in the evaluation of financial options and develop them for use in capital investment appraisal. In some project evaluation situations, a company may have one or more options to make strategic changes to the project during its life e.g. the: KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 35 Option to delay (i.e. defer investment without loss of the opportunity for further investment, effectively creating a call option) Option to expand (i.e. to increase the scale of investment if market conditions change). Thus the right to expand is effectively a call option; Option to abandon (i.e. where a project consists of clearly identifiable stages, an abandonment option can be considered at the end of each stage, if this is preferable to continuation). The right to generate some salvage value if abandonment occurs is effectively a put option: Option to redeploy (i.e. switch to another use). This could result in the creation of a put option if there is salvage value from the work already performed, together with a call option arising on the right to commence the new investment at a later stage. There may even be options to downsize, option is to change inputs or options, options to shut down and then subsequently restart or, perhaps, option to invest in stages (as opposed to one single major investment). The building of the East Stand at West Bromwich Albion FC is cited as an example or real options in investment appraisal. This stand, which contains extensive corporate facilities, was built between 1999 and 2001 as a single tier stand. However, due to the stronger foundations which were laid and the design of exits and walkways etc., it would be relatively straightforward to add a second tier at some future stage without having to demolish the existing first tier. Obviously, this single tier stand was more expensive to build than a conventional one tier stand, but the additional expenditure was the premium that was paid as a call option to expand, if or when attendances grow to justify the additional ground capacity. The black- scholes option pricing model can be applied to real options (sometimes referred to as ‘embedded option), where there is a single source of uncertainty and a single expiry date (i.e. a European style option). Obviously this model employs the usual five features i.e. Pa: the value of the underlying asset is no longer a share price, but the PV of the future cash flows arising from the project: Pe: the exercise price is the volatility expenditure (or receipts) arising from the option; KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 36 S: this will represent the volatility (in the form of thetα) of the operating cash flows related to projects of the type under consideration. r: this is the risk free rate of interest, however some writers believe that additional project risk should be reflected with the use of a higher interest rate: t: this is, as usual, the time to expiry for exercising a European style option: Question 77 Uniglow (a) Discuss how an increase in the value of each of the determinants of the option price in the Black-Scholes option-pricing model for European options is likely to change the price of a call option. (8 marks) (b) Briefly discuss the meaning and importance of the terms ‘delta’, ‘theta’, and ‘vega’ (also known as kappa or lambda) in option pricing. (6 marks) (c) Assume that your company has invested in 100,000 shares of Uniglow plc, a manufacturer of light bulbs. You are concerned about the recent volatility in Uniglow’s share price due to the unpredictable weather in the United Kingdom. You wish to protect your company’s investment from a possible fall in Uniglow’s share price until winter in three months’ time, but do not wish to sell the shares at present. No dividends are due to be paid by Uniglow during the next three months. Market data: Uniglow’s current share price: 200 pence Call option exercise price: 220 pence Time to expiry: 3 months Interest rate (annual): 6% Volatility of Uniglow’s shares 50% (standard deviation per year) Assume that option contracts are for the purchase or sale of units of 1,000 shares. Required: KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 37 (i) Devise a delta hedge that is expected to protect the investment against changes in the share price until winter. Delta may be estimated using N (d1). (9 marks) (iii) Comment upon whether or not such a hedge is likely to be totally successful. Question 78 Mesmer Magic Co. Mesmer Magic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the film has been released and the game is available for sale. MMC has forecast the following end of year cash flows for the fouryear sales period of the game. Year Cash flows ($ million) 1 25 2 18 3 10 4 5 MMC will spend $12 million immediately to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four year sales period of the game. It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 5%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 50%. Required: (a) Estimate the financial impact of the directors’ decision to delay the production and marketing of the game. The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be shown. (13 marks) (b) Briefly discuss the implications of the answer obtained in part (a) above. (6 marks) KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 38 (c) MMC is funded partly by equity and partly by debt. The yield on its five year debt is 5.2% and the yield on its ten year debt is 5.4% i.e. MMC faces an upward sloping yield curve. Required: Explain the possible reasons for an upward sloping yield curve. (6 marks) Mergers & Acquisitions Synergy An expansion policy based on merger or takeover can be justified on the basis of synergy. (sometimes stated as 2+2=5) ie Value of A plc ˃ Value of A plc + Value of B plc And B plc combined operating independently operating independently Acquisitions and mergers are ultimately justified as leading to an increase in shareholders wealth. The potential for synergy is often classified as follows: Revenue synergy: sources of which include: o Economies of vertical integration; o Market power and the elimination of competition ie the desire to earn monopoly profits (which is good for shareholders but not in the public interest); o Complementary resources e.g. a company with marketing strengths could usefully combine with the company owning excellent research and development facilities. Cost synergy: sources of which include: o Economies of scale (arising from eg larger production volumes and bulk buying); o Economies of scope (which may arise from reduced advertising and distribution costs where combing companies have duplicated activities); o Elimination of inefficiency; o More effective use of existing managerial talent. Financial synergy: sources of which include: KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 39 o Elimination of inefficient management practices; o Use of the accumulated tax losses of one company that may be made available to the other party in the business combination; o Use of surplus cash to achieve rapid expansion o Diversification reduces the variance of operating cash flows giving less bankruptcy risk and therefore cheaper borrowing; o Diversification reduces risk (however this is a suspect argument, since it only reduces total risk not systematic risk for well diversified shareholders); o High PE ratio companies can impose their multiples on low PE ratio companies (however this argument, known as ˋˋbootstrappingˊˊ, is rather suspect). Conclusions on synergy o Synergy is not automic o When bid premiums are considered, the consistent winners in mergers and takeovers are victim company shareholders. 2. High failure rate of acquisitions in enhancing shareholder value In practice the shareholders of predator companies seldom enjoy synergistic gains whereas the shareholders of victim companies benefit from a takeover. The acquiring company often pays a significant premium over and above the market value of the target company prior to acquisition; this problem is particularly acute for the successful predator following a contested takeover bid. The reason advanced for the high failure rate of business combinations from the perspective of the predator shareholders are as follows: Agency theory suggests that takeovers bids are primarily motivated by the self-interest of the managers of bidding companies. Often free cash flow mat be used to increase the size of their company in order to enhance the status of directors who wish to be seen as heading a large listed plc. Diversification of the activities of the predator may provide job security for the directors of such companies; Over-optimistic assessment of the economies of scale or economies of scope that may be achieved as a result of the business combination; Inadequate investigation of the victim company prior to the bid being made, or insufficient appreciation of the problems that may arise after the acquisition takes place (e.g. the difficulties experienced by Wm. Morrison Supermarkets following the takeover of Safeway); Following a successful bid, the directors and managers of the predator become too keen to identify their next victim, instead of KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 40 devoting time to ensuring that the company that they have already taken over provides the expected synergies; Directors of the predator company become so obsessed with the success of their bid that they fail to seek alternative target companies. Furthermore, their valuations of the victim and their justifications for the acquisition become exaggerated. 3. Mode of Offer Cash Consideration The offer is made to purchase the shares of the target company for cash. This method is very appropriate for relatively small acquisitions unless the acquirer has accumulation of cash from operations or divestments. The advantages of cash offer to the target entity’s shareholders are that: The price that they will receive is obvious. It is not like share exchange where the movements in the market price may change their wealth. The cash purchase increases the liquidity of the target shareholders who are in position to alter their investments portfolio to meet any changing opportunities. A disadvantage to target shareholders’ for receiving cash is that if the price that they receive is on sale is more than the price paid when purchasing the shares, they may be liable to capital gains tax. The advantages to the predator company are that: The value of the bid is known and target company shareholders’ are encouraged to sell their shares. It represents a quick and easily understood approach when resistance is expected. The shareholders of the target company are bought out and have no further participation in the control and profits of the combined entity. The main disadvantages to the predator company are that it may deplete the company’s liquidity position and may increase gearing. Method of Raising Cash The predator company can raise cash from many sources to finance the acquisition, some of the sources are: Borrowing To Obtain Cash The predator company may not have enough cash immediately available to finance the acquisition and may have to raise the necessary cash through ban loans and issuing of debt instruments. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 41 Mezzanine Finance 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 borrowing 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. It is therefore of higher risk than normal forms of borrowing. Mezzanine finance is often unsecured. 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. Retained Earnings This method is used when the predator company has accumulated profits over time and is appropriate when the acquisition involves a small company and the consideration is reasonably low. This method may be the cheapest option of finance. Vendor Placing In a vendor placing the predator company issues its shares by placing the shares with institutional investors to raise the cash required to pay the target shareholders. Share Exchange The predator company issues its own shares in exchange for the shares of the target company and the shareholders of the target company become shareholders of the predator company. The advantages of a 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 where the movements in the market price may change their 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 earnings ratio is higher than that of the target company. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 42 The main disadvantages of a share exchange are that: It causes dilution in control It may cause dilution in earning per share. As equity shares are issued this comparatively more expensive than debt capital. The company may not have enough authorized share capital to issue the additional shares required. Debentures, Loan Stock & Preference Shares Very few companies use debentures, loan stock and preference shares as a means of paying a purchase consideration on acquisitions. The main problems of using debentures and loan stock to the predator company are that: It affects gearing and financial risk. Difficulty in determining appropriate interest rate to attract the shareholders of the target company. Availability of collateral security against repayment. The main advantages of using debentures and loan stock are that: Interest payments are a tax allowable expense. Cost of debt is cheaper than equity. Does not dilute control. The main problems of using preference share are that: Dividends on preference shares are fixed and not tax allowable. May not be attractive to target shareholders as preference shares carry no voting power. Preference shares are less marketable. Earn-Out Arrangements An earn-out arrangement is where the purchase considerations is structured such that an initial payment is made at the date of acquisition and the balance is paid depending upon the financial performance of the target company of the target company over a specified period of time. The main advantages of earn-out arrangements are that: Initial payment is reduced. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 43 The risk to the predator company is reduced as it is less likely to pay more than the target is worth. The price is limited to future performance. It encourages the management of the target company to work hard as the overall consideration depends on future performance. 4. Strategic Defenses Post bid A target company can use the following to defend itself against a possible takeover: Try to convince the shareholders that the terms of the offer are unacceptable. This can be done using the following: o Attempt to show that the current share price of the company is unrealistically low relative to the future potential. Assets revaluation, new profit forecasts, dividends and promises of rationalization are commonly employed here. o If it is for share for share exchange, the target company can attempt to convince the shareholders that the offer’s equity is currently overvalued. The suitability of the bidding company to run the merged business can also be questioned. Lobbying the office of fair trading and or the department of trade and industry to have the offer referred to the competition commission. This will at least delay the takeover and may prevent it completely. Launching an advertising campaign against the takeover bid. One technique is to attack the account of the predator company. A reverse takeover (Pac Mac), that is make a counter offer for the predator company. This can be done if the companies are of reasonably similar size. Finding a ‘white knight’, a company which will make a welcome takeover bid. This involves finding a more suitable acquirer and promoting it to compete with the predator company. Crown jewels (or scorched earth) policy, with the approval of shareholders in general meeting. Pre-bid Selling crowning jewels- 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. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 44 Golden parachutes- this is a policy of introducing attractive termination packages for the senior executives of the victim company. This makes it more expensive for the predator company. Shark repellent- super-majority. The articles of association are changed to require a very high percentage of shares to approve an acquisition or merger, say 80%. Poison pill The most commonly used and seeming most effective takeover defence is the so called poison pill. An example is the Flip-in pill. This involves the granting of rights to shareholders, other than the potential acquirer, to purchase the shares of the target company at a deep discount. This dilutes the ownership interest of the potential acquirer. 5. Regulation of takeovers 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. Typically, the rules will require the target company to: Notify its shareholders of the identity of the bidder and the terms and conditions of the bid; Seek independent advice; Not issue new shares or purchase or dispose of major assets of the company, unless agreed prior to the bid, without the agreement of a general meeting; Not influence or support the market price of its shares by providing finance or financial guarantees for the purchase of its own shares; The company may not provide information to some shareholders which is not made available to all shareholders; Shareholders must be given sufficient information and time to reach a decision. No relevant information should be withheld; The directors of the company should not prevent a bid succeeding without giving shareholders the opportunity to decide on the merits of the bid themselves. Directors and mangers should disregard their own personal interest when advising shareholders. 6. Competition commission in United Kingdom Under the terms of this commission, the office of fair trading (OFT) is entitled to scrutinize all major mergers and takeovers. If the OFT thinks KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 45 that a merger or takeover might be against the public interest, it can refer it to competition commission. If no referral is made to the commission within normally 20 days, the merger can proceed without fear of a referral. The function of the competition commission is to advise the government. The commission can make recommendations to the relevant government department or to any other body including the companies involved in the bid. The result of the investigation by the commission might be: Withdrawal of the proposal for the merger or takeover, in anticipation of it rejection by the commission. Acceptance or rejection of the proposal by the commission. Acceptance of the proposal by the commission subject to the new company agreeing to certain conditions laid down by the commission, for example on prices, employment or arrangement for the sale of the group’s products. DARK POOL TRADING The recent financial crisis has been the alleged (see newspaper article below) growth of a practice, which is sometimes referred to as “Dark pool trading”. It is also known as “Dark pool liquidity”, the “Upstairs market”, “Dark liquidity” or simply “Dark pool”. The term “Dark pool” 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 publicized 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 displaced. 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. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 46 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 time scale 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. A report in “The Independent” newsletter on 25th May 2010 stated: “Six big investments banks published trading volumes for their “dark pools” for the first time yesterday, showing them as a tiny fraction of the market and not the major hidden rivals to stock exchanges that some argue. Citi, Credit Suisse, Deutsche Bank, JP Morgan Cazenove, Morgan Stanley and UBS together executed £596 million (£513 million) of equity trades from 15 countries on their automated crossing systems on Friday, according to Markit data. That accounted for about 0.4 per cent of all types of cash equity trades in Europe and 1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT service that day, according to Thomson Reuters data. Dark pools are electronic platforms that allow would-be buyers and sellers of large orders of shares to avoid revealing pre-trade information and signing their intentions to the rest of the market. Bankers argue that for the bulk of OTC trades they act purely as dealers, using their own money or share inventories to take one or another side, or they act in a non-automated way to match buyers and sellers for big blocks of stock.” KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 47 Business Reorganization Unbundling Unbundling is the process of selling off incidental non-core business to release funds, reduce gearing, and allow management to concentrate on their chosen core business. The main forms of Unbundling are: Divestment. Demergers Sell-offs. Spin-offs. Management buy-outs. Divestment Divestment is a proportional or complete reduction in ownership stake in an organization. It is the withdrawal of investment in a business. This can be achieved either by selling the whole business to a third party or by selling the assets piecemeal. Reasons for Divestment The principal motive for divestment will be if they either do not conform to group or business unit strategy. A company may decide to abandon a particular product/activity because it fails yield an adequate return. Allowing management to concentrate on core business. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 48 To raise more cash possibly to fund new acquisitions or to pay debts in order to reduce gearing and financial risk. The management lack the necessary skills for this business sector. Protection from takeover possibly by disposing of the reasons for the takeover or producing sufficient cash to fight it effectively. Sell-offs A sell-off is a form of divestment involving the sale of part of an entity to a third party, usually in return for cash. The most common reasons for a sell-off are: To divest of less profitable and/or non-core business units. To offset cash shortages. The extreme form of sell-off is liquidation, where the owners of the company voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the proceeds amongst themselves. Spin-offs/demergers This is where a new company is created and the shares in the new company are owned by the shareholders of the original company which is making the distribution of assets. There is no change in ownership of assets but the assets are transferred to the new company. The result is to create two or more companies whereas previously there was only one company. Each company now owns some of the assets of the original company and the shareholders own the same proportion of shares in the new company as in the original company. An extreme form of spin-off is where the original company is split up into a number of separate companies and the original company broken up and it ceases to exist. This is commonly called demerger. 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. The main disadvantages of de-merger are: Economies of scale may be lost, where the de-merged parts of the business had operations in common to which economies of scale applied. The ability to raise extra finance, especially debt finance, to support new investments and expansion may be reduced. Vulnerability to takeovers may be increased. There will be lower revenue, profits and status than the group before the de-merger. Management Buy-Out (MBO) KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 49 A management buy-out is the purchase of a business from its owners by its managers. For example, the directors of a company in a subsidiary company in a group might buy the company from the holding company, with the intention of running it as proprietors of a separate business entity. Reasons for MBOs MBOs may exist for several reasons including: A parent company wishes to divest itself of a business that no longer fits in with its corporate objectives and strategy. A company/group may need to improve its liquidity. In such circumstances a buy-out might be particularly attractive as it would normally be for cash. A company may decide to abandon a particular product/activity because it fails to yield an adequate return. In administration a buy-out may be the management’s only best alternative to redundancy. Advantages of MBOs to disposing company To raise 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. Better publicity can be earned by preserving employer’s jobs rather than closing the business down. It is better for the existing management to acquire the company rather than it possibly falling into enemy hands. Advantages of buy-out to acquiring management It preserves their jobs. It offers them the prospects of significant equity participation in their company. It is quicker than starting a similar business from scratch. They can carry out their own strategies, no longer having to seek approval from the head office. Problems with MBOs Management may have little or no experience financial management and financial accounting. Difficulty in determining a fair price to be paid. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 50 Maintaining continuity of relationships with suppliers and customers. Accepting the board representation requirement that many sources of funding may insist on. Inadequate cash flow to finance the maintenance and replacement of assets. Sources of Finance for MBOs Several institutions specialize in providing funds for MBOs. These include: The clearing banks. Pension funds and insurance companies. Venture capital. Government agencies and local authorities, for example Scottish Development Agency. Factors a supplier of finance will consider before lending The purchase consideration. Is the purchase price right or high? The level of financial commitment of the buy-out team. The management experience and expertise of the buyout team. The stability of the business’s cash flows and the prospects for the future growth. The rate of technological change in the industry and the costs associated with the changing technologies. The level of actual and potential competition. The likely time required for the business to achieve a stock market flotation, (s0 as to provide an exit route for the venture capitalist). Availability of security. Conditions attached to provision of finance Board representation for the venture capitalist. Equity options. A right to take a controlling equity stake and so replace the existing management if the company fails to achieve specified performance targets. Management buy-in KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 51 A management buy-ins occurs when a group of outside managers buys a controlling stake in a business. Share Repurchase Any limited company may, if authorized by it articles, purchase its own shares. The Companies Act permits any company to purchase its own shares. Therefore if a company has surplus cash and cannot think of any profitable use of that cash, it can use that cash to purchase its own shares. Share repurchase is an alternative to dividend policy where the company returns cash to its shareholders by buying shares from the shareholders in order to reduce the number of shares in issue. Shares may be purchased either by: Open market purchase – the company buys the shares from the open market at the current market price. Individual arrangement with institutional investors. Tender offer to all shareholders. Reasons for Share Repurchase Shares may be purchased in order to buy out dissident shareholders. To adjust the gearing ratio towards an optimal capital structure. Reduction in the size of the company. Where circumstances indicate a permanent reduction in company size is desirable this can be achieved easily with share repurchase and subsequent cancellation of the shares. Purchase of own shares may be used to take a company out of the public market and back into private ownership. Purchase of own shares provide an efficient means of returning surplus cash to the shareholders. It enables companies to reduce total dividend payments whiles maintaining or increasing the level of dividend to individual shareholders. This may mean more earnings available for capital investment which leads to growth. Purchase of own shares increases earning per share and return on capital employed. To increase the share price by creating artificial demand. Problems of Share Repurchase KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 52 Lack of new ideas. Shares repurchase may be interpreted as a sign that the company has no new ideas for future investments strategy. This may cause the share to fall. Costs. Compared with a one-off dividend payment, share repurchase will require more time and transaction costs to arrange. Resolution. Shareholders have to pass a resolution and it may be difficult to obtain their consent. Gearing. If the equity base is reduced because of share repurchase, gearing may increase and financial risk may increase. Going private A public company may occasionally give up its stock market quotation and return itself to the status of a private company. The reasons for such move are varied, but are generally linked to the disadvantages of being in the stock market and the inability of the company to obtain the supposed benefits of a stock market quotation. Other reasons are: To avoid the possibility of takeover by another company. Savings of annual listing costs. To avoid detailed regulations associated with being a listed company. Where the stock market undervalues the company’s shares. Protection from volatility in share price with its financial problems. CAPITAL RECONSTRUCTION SCHEMES A capital reconstruction scheme is a scheme whereby a company reorganizes its capital structure by changing the rights of its shareholders and possibly the creditors. This can occur in a number of circumstances, the most common being when a company is in financial difficulties, but also when a company is seeking floatation or being acquired. Financial difficulties If a company is in financial difficulties it may have no recourse but to accept liquidation as the final outcome. Typical financial difficulties Large accumulated losses. Large arrears of dividends on cumulative preference shares. Large arrears of debenture interest. No payment of ordinary dividend. Market share price below nominal value. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 53 However, it may be in position to survive, and indeed flourish, by taking up some future contract or opening in the market. The only major problem is the cash needed to finance such operations because the present structure of the company will not be attractive to outside investors. To get cash the company will need to reorganize or reconstruct. Possible reconstruction The changing or reconstruction of the company’s capital could solve these problems. The company can take any or all of the following steps: Write off the accumulated losses. Write of the debenture interest and preference share dividend arrears. Write down the nominal value of the shares. To do this the company must ask all or some of its existing stakeholders to surrender existing rights and amount owing in exchange for new rights under a new or reformed company. The question is why would the stakeholders be willing to do this? The answer to this is that it may be preferable to the alternatives which are: To accept whatever return they could be given in a liquidation; To remain as they are with the prospect of no return from their investment and no growth in their investment. Generally, stakeholders may be willing to give up their existing rights and amounts owing (which are unlikely to be met) for the opportunity to share in the growth in profits which may arise from the extra cash which can be generated as a consequence of their actions. KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 54 Question Bank (Complete) *Investment Appraisals* Local - M/J 2019, Ferhurst (S/D 2016) International- Chmura (Dec 2013), Yilandre (June 2015), Tramont (Pilot 2012) *Restructuring* Cigno (S/D 2015) Bento (June 2015) Chyrsos (M/J 2017) Fluffort (S/D 2015) *Risk Adjusted WACC/ WACC Questions* Morada- Sept/Dec 2016 Coeden- Dec 2012 Tisa - June 2012 Makonis- Dec 2013 Rivere - Dec 2014 *Interest Rate Risk Past Questions* March/June 2019 Q3 Awan Co - December 2013 Alecto- Pilot 2012 Keshi- December 2014 Daikon- June 2015 Armstrong- September/December 2015 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 55 Wardegal- September/December 2017 *Currency Risk Past Questions* Cassasophia - June 2011 Kenduri - June 2013 Nutourne - December 2018 Lammer- June 2006 Lirio - March/June 2016 Adverane- March/June 2018 Washi - September 2018 Lignum- December 2012 CMC - Pilot question *APV Questions* Burong- June 2014 March/June 2018 Q2 December 2018 Q3 Strayer - June 2002 Tramont - Pilot 2012 *Bonds* Toltuck- March/June 2017 GNT- Pilot 2012 Kenand Levante - December 2011 Conejo- September/December 2017 *Mergers and Acquisitions* Pursuit - June 2011 Cigno Sept/Dec 2015 Chikepe- March/June 2018 Nente- June 2012 Opao - Dec 2018 Nahara and Fugae - Dec 2014 Vogel- June 2014 *Dividend Capacity* Arthuro- M/J 2018 Lirio -M/J 2016 KOFI ANNAN PROFESSIONAL INSTITUTE PAPER AFM 2020 56
