-
Professional Level
–
Options Module
Advanced Financial
Management
Tuesday 2
December 2014
Time allowed
Reading and planning: 15 minutes
Writing:
3 hours
This paper is divided into two
sections:
Section A
–
This ONE question is
compulsory and MUST be attempted
Section B
–
TWO
questions ONLY to be attempted
Formulae and tables are on pages
8
–
12.
Do NOT open
this paper until instructed by the supervisor.
During reading and planning time only
the question paper may
be annotated.
You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed
from the examination hall.
The
Association of Chartered Certified Accountants
Section A
–
This
ONE question is compulsory and MUST be attempted
1
Nahara Co and Fugae Co
Nahara Co is a private holding company
owned by the government of a wealthy oil-rich
country to invest its sovereign
funds.
Nahara Co has followed a strategy of risk
diversification for a number of years by acquiring
companies from
around the world in many
different sectors.
One of Nahara Co’s
acquisition strategies is to identify and purchase
undervalued companies in the airline
industry
in Europe. A recent
acquisition was Fugae Co, a company based in a
country which is part of the European Union
(EU). Fugae Co repairs and maintains
aircraft engines.
A few weeks ago,
Nahara Co stated its intention to pursue the
acquisition of an airline company based in the
same
country as Fugae Co. The EU,
concerned about this, asked Nahara Co to sell
Fugae Co before pursuing any further
acquisitions in the airline industry.
Avem Co’s acquisition interest in Fugae
Co
Avem Co, a UK-based
company specialising in producing and servicing
business jets, has approached Nahara Co
with a proposal to acquire Fugae Co for
$$1,200 million. Nahara Co expects to receive a
premium of at least 30% on
the
estimated equity value of Fugae Co, if it is sold.
Given below are extracts from the most
recent statements of financial position of both
Avem Co and Fugae Co.
Avem Co
$$ million
800
3,550
2,200
130
––––––
6,680
––––––
Fugae Co
$$ million
100
160
380
30
––––
670
––––
Share
capital (50c/share)
Reserves
Non-current liabilities
Current liabilities
Total
capital and liabilities
Each Avem Co
share is currently trading at $$7·
50,
which is a multiple of 7·
2 of its free
cash flow to equity. Avem Co
expects
that the total free cash flows to equity of the
combined company will increase by $$40 million due
to synergy
benefits. After adding the
synergy benefits of $$40 million, Avem Co then
expects the multiple of the total free cash
flow of the combined company to
increase to 7·
5.
Fugae Co’s
free cash flow to equity is currently estimated at
$$76·5 million and it is expected to generate a
return on
equity of 11%.
Over the past few years, Fugae Co has returned
77·
3% of its annual free cash flow to
equity back to
Nahara Co, while
retaining the balance for new investments.
Fugae Co’s non
-current
liabilities consist entirely of $$100 nominal value
bonds which are redeemable in four years at
the nominal value, on which the company
pays a coupon of 5·
4%. The debt is
rated at B+ and the credit spread on
B+
rated debt is 80 basis points above the risk-free
rate of return.
Proposed luxury
transport investment project by Fugae Co
In recent years, the country in which
Fugae Co is based has been expanding its tourism
industry and hopes that this
industry
will grow significantly in the near future. At
present tourists normally travel using public
transport and taxis,
but there is a
growing market for luxury travel. If the tourist
industry does expand, then the demand for luxury
travel
is expected to grow rapidly.
Fugae Co is considering entering this market
through a four-year project. The project will
cease after four years because of
increasing competition.
The initial
cost of the project is expected to be $$42,000,000
and it is expected to generate the following
after-tax cash
flows over its four-year
life:
Year
Cash flows
($$000s)
1
3,277.6
2
16,134.3
3
36,504.7
4
35,683.6
The above figures
are based on the tourism industry expanding as
expected. However, it is estimated that there is a
25% probability that the tourism
industry will not grow as expected in the first
year. If this happens, then the present
value of the project’s cash
f
lows will be 50% of the original
estimates over its four-year life.
2
It is also estimated that if the
tourism industry grows as expected in the first
year, there is still a 20% probability that
the expected growth will slow down in
the second and
subsequent years, and
the present value of the project’s cash
flows would then be 40% of the original
estimates in each of these years.
Lumi
Co, a leisure travel company, has offered $$50
million to buy the project from Fugae Co at the
start of the second
year. Fugae Co is
considering whether having this choice would add
to the value of the project.
If Fugae
Co is bought by Avem Co after the project has
begun, it is thought that the project will not
result in any
additional synergy
benefits and will not generate any additional
value for the combined company, above any value
the
project has already generated for
Fugae Co.
Although there is no beta for
companies offering luxury forms of travel in
the tourist industry, Reka Co, a listed
company, offers passenger
transportation services on coaches, trains and
luxury vehicles. About 15% of its business
is in the luxury transport market and
Reka Co’s equity beta is 1·6. It is estimated that
the asset beta of the non
-luxury
transport industry is 0·
80.
Reka C
o’s shares are currently trading
at $$4·50 per share and its debt is currently
trading
at $$105 per $$100. It
has 80 million shares in issue and the book value
of its debt is $$340 million. The debt beta is
estimated to be zero.
General information
The
corporation tax rate applicable to all companies
is 20%. The risk-free rate is estimated to be 4%
and the market
risk premium is
estimated to be 6%.
Required:
(a) Discuss whether or not Nahara
Co’s acquisition strategies, of pursuing risk
diversification
and of purchasing
undervalued companies, can be valid.
(7 marks)
(b) Discuss why
the European Union (EU) may be concerned about
Nahara Co’s stated intention and how
selling
Fugae Co could
reduce this concern.
(4 marks)
(c) Prepare a report for the Board of
Directors of Avem Co, which:
(i)
Estimates the additional value
created for Avem Co, if it acquires Fugae Co
without considering the
luxury
transport project;
(10 marks)
(ii) Estimates the
additional value of the luxury transport project
to Fugae Co, both with and without the
offer from Lumi Co;
(18 marks)
(iii) Evaluates the benefit
attributable to Avem Co and Fugae Co from
combining the two companies with
and
without the project, and concludes whether or
not the acquisition is beneficial. The
evaluation
should include any
assumptions made.
(7 marks)
Professional marks will be awarded in
part (c) for the format, structure and
presentation of the report.
(4 marks)
(50 marks)
3
[P
.T.O.
Section B
–
TWO questions ONLY to be
attempted
2
Keshi Co is a
large multinational company with a number of
international subsidiary companies. A centralised
treasury
department manages Keshi Co
and its subsidiaries’ borrowing
requirements, cash surplus investment
and financial
risk management.
Financial risk is normally managed using
conventional derivative products such as
forwards,
futures, options and swaps.
Assume it is 1 December 2014 today and
Keshi Co is expecting to borrow $$18,000,000 on 1
February 2015 for a
period of seven
months. It can either borrow the funds at a
variable rate of LIBOR plus 40 basis points or a
fixed rate
of 5·
5%. LIBOR is
currently 3·
8% but Keshi Co feels that
this could increase or decrease by 0·
5%
over the coming
months due to
increasing uncertainty in the markets.
The treasury department is considering
whether or not to hedge the $$18,000,000, using
either exchange-traded
March options or
over-the-counter swaps offered by Rozu Bank.
The following information and quotes
for $$ March options are provided from an
appropriate exchange. The options
are
based on three-month $$ futures, $$1,000,000
contract size and option premiums are in annual %.
March calls
0·
882
0·
648
Strike
price
95·
50
96·
00
March puts
0·
662
0·
902
Option
prices are quoted in basis points at 100 minus the
annual % yield and settlement of the options
contracts is
at the end of March 2015.
The current basis on the March futures price is 44
points; and it is expected to be
33
points on 1 January 2015, 22 points on 1 February
2015 and 11 points on 1 March 2015.
Rozu Bank has offered Keshi Co a swap
on a counterparty variable rate of LIBOR plus 30
basis points or a fixed rate
of
4·
6%, where Keshi Co receives 70% of
any benefits accruing from undertaking the
swap, prior to any bank
charges. Rozu
Bank will charge Keshi Co 10 basis points for the
swap.
Keshi Co’s chief executive
officer believes that a centralised treasury
department is necessary in order to
increase
shareholder value,
but Keshi Co’s new chief financial officer
(CFO) thinks that having decentralised
treasury
departments
operating across the subsidiary companies
could be more beneficial. The CFO thinks
that this is
particularly relevant to
the situation which Suisen Co, a company owned by
Keshi Co, is facing.
Suisen Co
operates in a country where most companies
conduct business activities based on Islamic
finance
principles. It produces
confectionery products including chocolates.
It wants to use Salam contracts instead of
commodity futures contracts to hedge
its exposure to price fluctuations of cocoa. Salam
contracts involve a commodity
which is
sold based on currently agreed prices,
quantity and quality. Full payment is
received by the seller
immediately,
for an agreed delivery to be made in the future.
Required:
(a) Based on
the two hedging choices Keshi Co is
considering, recommend a hedging strategy for
the
$$18,000,000 borrowing. Support your
answer with appropriate calculations and
discussion.
(15 marks)
(b)
Discuss how a centralised treasury department may
increase value for Keshi Co and the possible
reasons for
decentralising the treasury
department.
(6 marks)
(c) Discuss the key
differences between a Salam contract, under
Islamic finance principles, and futures
(4 marks)
contracts.
(25 marks)
4
3
Riviere Co is a small company based in
the European Union (EU). It produces high quality
frozen food which it exports
to a small
number of supermarket chains located within the EU
as well. The EU is a free trade area for trade
between
its member countries.
Riviere Co finds it difficult to obtain
bank finance and relies on a long-term strategy of
using internally generated funds
for
new investment projects. This constraint means
that it cannot accept every profitable project and
often has to
choose between them.
Riviere Co is currently considering
investment in one of two mutually exclusive food
production projects: Privi and
Drugi.
Privi will produce and sell a new range of frozen
desserts exclusively within the EU. Drugi will
produce and
sell a new range of frozen
desserts and savoury foods to supermarket chains
based in countries outside the EU. Each
project will last for five years and
the following financial information refers to both
projects.
Project Drugi, annual after-
tax cash flows expected at the end of each year
(
?
000s)
Year
Cash flows
(
?
000s)
Current
(11,840)
1
1,230
2
1,680
Privi
?
2,054,000
17·
6%
13·
4%
?
1,103,500
?
860,000
3
4,350
4
10,240
Drugi
?
2,293,000
Not provided
Not provided
Not provided
Not provided
5
2,200
Net
present value
Internal rate of return
Modified internal rate of return
Value at risk (over the
project’s life
)
95% confidence level
90%
confidence level
Both projects’ net
present value has been calculated based on Riviere
Co’s nominal cost of
capital of 10%. It
can be
assumed that both projects’ cash
flow returns are normally distributed and the
annual standard deviation of project
Drugi’s present value of
after
-tax cash flows is estimated to be
?
400,000. It can also be
assumed that all sales are
made in
?
(Euro) and therefore the
company is not exposed to any foreign exchange
exposure.
Notwithstanding how
profitable project Drugi may appear to be, Riviere
Co’s board of directors is concerned about
the
possible legal risks if
it invests in the project because they have never
dealt with companies outside the EU before.
Required:
(a) Discuss the
aims of a free trade area, such as the
European Union (EU), and the possible benefits
to
(5 marks)
Riviere Co of
operating within the EU.
(b)
Calculate the figures which have not been
provided for project Drugi and recommend which
project should
be accepted. Provide a
justification for the recommendation and explain
what the value at risk measures.
(13
marks)
(c) Discuss the possible legal
risks of investing in project Drugi which Riviere
Co may be concerned about and
(7
marks)
how these may be mitigated.
(25 marks)
5
[P
.T.O.
4
Kamala Co, a listed company,
manufactures parts and machinery for the
construction industry. About five years ago,
Kamala Co started to manufacture parts
and machinery for hospitals and companies engaged
in biomedical research
using largely
the same manufacturing and processing systems
it already had in place. In 2011, a young
and
ambitious chief executive officer
(CEO) took over the running of the company.
With the publication of the latest
financial statements for the year to 30 November
2014, the CEO made a brief
statement
and it includes the following two points:
–
The CEO was
very pleased with growth in the financial ratios
provided and sales revenue from 2012 to 2014.
More pleasing was growth in the share
price, which increased even faster than the growth
in the market index,
suggesting that
Kamala Co has been a successful company.
The CEO expressed a desire to make
Kamala Co the leading manufacturer of parts
and machinery for the
construction
industry by acquiring a major rival manufacturer
in 2015, and financing the acquisition through an
issue of a new bond and a small rights
issue.
–
An
analyst, after examining the recent financial
statements and the two points above, was
less positive about
Kamala Co’s
future prospects.
Given
below are extracts from the recent financial
statements, some ratios, and other financial
information for
Kamala Co.
Kamala Co
Year ending 30
November (all amounts in $$m)
Sales
revenue
Operating profit
Finance costs
Profit before
tax
Taxation
Profit for the
year
Dividends
2012
3,760
––––––
714
97
––––––
617
154
––––––
463
––––––
139
2013
4,054
––––––
819
168
––––––
651
163
––––––
488
––––––
137
2014
5,230
––––––
1,098
269
––––––
829
207
––––––
622
––––––
152
Kamala Co
Year ending 30
November (all amounts in $$m)
Total
non-current assets
Total current assets
Total non-current and current assets
Equity
Ordinary shares
($$0·
25)
Reserves
Total equity
Non-current
liabilities
Bank loans
Bonds
Total non-current liabilities
Current liabilities
Trade
and other payables
Bank overdraft
Total current liabilities
2012
3,962
980
––––––
4,942
––––––
750
1,476
––––––
2,226
––––––
476
1,008
––––––
1,484
––––––
1,232
–––––––
2013
5,507
1,410
––––––
6,917
––––––
750
1,827
––––––
2,577
––––––
1,176
1,008
––––––
2,184
––––––
1,540
616
––––––
2,156
––––––
4,340
––––––
6
2014
7,669
1,880
––––––
9,549
––––––
750
2,297
––––––
3,047
––––––
1,316
2,218
––––––
3,534
––––––
2,016
952
––––––
2,968
––––––
6,502
––––––
1,232
––––––
Total non-
current and current liabilities
2,716
––––––
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