Professional Level Options Module

Advanced Financial Management

Tuesday 3 December 2013

Time allowed Reading and planning: Writing:

15 minutes 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 711. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper P4

Section A This ONE question is compulsory and MUST be attempted 1 Since becoming independent just over 20 years ago, the country of Mehgam has adopted protectionist measures which have made it difficult for multinational companies to trade there. However, recently, after discussions with the World Trade Organisation (WTO), it seems likely that Mehgam will reduce its protectionist measures significantly. Encouraged by these discussions, Chmura Co, a company producing packaged foods, is considering a project to set up a manufacturing base in Mehgam to sell its goods there and in other regional countries nearby. An initial investigation costing $500,000 established that Mehgam had appropriate manufacturing facilities, adequate transport links and a reasonably skilled but cheap work force. The investigation concluded that, if the protectionist measures were reduced, then the demand potential for Chmura Cos products looked promising. It is also felt that an early entry into Mehgam would give Chmura Co an advantage over its competitors for a period of five years, after which the current project will cease, due to the development of new advanced manufacturing processes. Mehgams currency, the Peso (MP), is currently trading at MP72 per $1. Setting up the manufacturing base in Mehgam will require an initial investment of MP2,500 million immediately, to cover the cost of land and buildings (MP1,250 million) and machinery (MP1,250 million). Tax allowable depreciation is available on the machinery at an annual rate of 10% on cost on a straight-line basis. A balancing adjustment will be required at the end of year five, when it is expected that the machinery will be sold for MP500 million (after inflation). The market value of the land and buildings in five years time is estimated to be 80% of the current value. These amounts are inclusive of any tax impact. Chmura Co will require MP200 million for working capital immediately. It is not expected that any further injections of working capital will be required for the five years. When the project ceases at the end of the fifth year, the working capital will be released back to Chmura Co. Production of the packaged foods will take place in batches of product mixes. These batches will then be sold to supermarket chains, wholesalers and distributors in Mehgam and its neighbouring countries, who will repackage them to their individual requirements. All sales will be in MP. The estimated average number of batches produced and sold each year is given below: Year Batches produced and sold 1 10,000 2 15,000 3 30,000 4 26,000 5 15,000

The current selling price for each batch is estimated to be MP115,200. The costs related to producing and selling each batch are currently estimated to be MP46,500. In addition to these costs, a number of products will need a special packaging material which Chmura Co will send to Mehgam. Currently the cost of the special packaging material is $200 per batch. Training and development costs, related to the production of the batches, are estimated to be 80% of the production and selling costs (excluding the cost of the special packaging) in the first year, before falling to 20% of these costs (excluding the cost of the special packaging) in the second year, and then nil for the remaining years. It is expected that the costs relating to the production and sale of each batch will increase annually by 10% but the selling price and the special packaging costs will only increase by 5% every year. The current annual corporation tax rate in Mehgam is 25% and Chmura Co pays annual corporation tax at a rate of 20% in the country where it is based. Both countries taxes are payable in the year that the tax liability arises. A bi-lateral tax treaty exists between the two countries which permits offset of overseas tax against any tax liabilities Chmura Co incurs on overseas earnings. The risk-adjusted cost of capital applicable to the project on $-based cash flows is 12%, which is considerably higher than the return on short-dated $ treasury bills of 4%. The current rate of inflation in Mehgam is 8%, and in the country where Chmura Co is based, it is 2%. It can be assumed that these inflation rates will not change for the foreseeable future. All net cash flows from the project will be remitted back to Chmura Co at the end of each year. Chmura Cos finance director is of the opinion that there are many uncertainties surrounding the project and has assessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties. Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.

Required: (a) Discuss the role of the World Trade Organisation (WTO) and the possible benefits and drawbacks to Mehgam (9 marks) of reducing protectionist measures. (b) Prepare an evaluative report for the Board of Directors of Chmura Co which addresses the following parts and recommends an appropriate course of action: (i) An estimate of the value of the project before considering Bulud Cos offer. Show all relevant calculations; (14 marks)

(ii) An estimate of the value of the project taking into account Bulud Cos offer. Show all relevant calculations; (9 marks) (iii) A discussion of the assumptions made in parts (i) and (ii) above and the additional business risks which Chmura Co should consider before it makes the final decision whether or not to undertake the project. (14 marks) Professional marks will be awarded in part (b) for the format, structure and presentation of the report. (4 marks) (50 marks)

[P.T.O.

Section B TWO questions ONLY to be attempted 2 Awan Co is expecting to receive $48,000,000 on 1 February 2014, which will be invested until it is required for a large project on 1 June 2014. 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 Cos 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 409%. However, Awan Co is of the opinion that interest rates could increase or decrease by as much as 09% 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 2013: 9480 March 2014: 9476 June 2014: 9469 Options on three-month $ futures, $2,000,000 contract size, option premiums are in annual % December 0342 0097 Calls March 0432 0121 Strike June 0523 0289 9450 9500 December 0090 0312 Puts March 0119 0417 June 0271 0520

Voblaka Bank has offered the following FRA rates to Awan Co: 17: 34: 37: 47: 437% 478% 482% 487%

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 2013 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 09%. Support your answer with appropriate calculations and discussion. (19 marks) (b) A member of Awan Cos 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) (25 marks)

Makonis Co, a listed company producing motor cars, wants to acquire Nuvola Co, an engineering company involved in producing innovative devices for cars. Makonis Co is keen to incorporate some of Nuvola Cos innovative devices into its cars and thereby boosting sales revenue. The following financial information is provided for the two companies: Current share price Number of issued shares Equity beta Asset beta Makonis Co $580 210 million 12 09 Nuvola Co $240 200 million 12 12

It is thought that combining the two companies will result in several benefits. Free cash flows to firm of the combined company will be $216 million in current value terms, but these will increase by an annual growth rate of 5% for the next four years, before reverting to an annual growth rate of 225% in perpetuity. In addition to this, combining the companies will result in cash synergy benefits of $20 million per year, for the next four years. These synergy benefits are not subject to any inflationary increase and no synergy benefits will occur after the fourth year. The debt-to-equity ratio of the combined company will be 40:60 in market value terms and it is expected that the combined companys cost of debt will be 455%. The corporation tax rate is 20%, the current risk free rate of return is 2% and the market risk premium is 7%. It can be assumed that the combined companys asset beta is the weighted average of Makonis Cos and Nuvola Cos asset betas, weighted by their current market values. Makonis Co has offered to acquire Nuvola Co through a mixed offer of one of its shares for two Nuvola Co shares plus a cash payment, such that a 30% premium is paid for the acquisition. Nuvola Cos equity holders feel that a 50% premium would be more acceptable. Makonis Co has sufficient cash reserves if the premium is 30%, but not if it is 50%. Required: (a) Estimate the additional equity value created by combining Nuvola Co and Makonis Co, based on the free cash flows to firm method. Comment on the results obtained and briefly discuss the assumptions made. (13 marks) (b) Estimate the impact on Makonis Cos equity holders if the premium paid is increased to 50% from 30%. (5 marks) (c) Estimate the additional funds required if a premium of 50% is paid instead of 30% and discuss how this premium could be financed. (7 marks) (25 marks)

[P.T.O.

Nubo Co has divisions operating in two diverse sectors: production of aircraft parts and supermarkets. Whereas the aircraft parts production division has been growing rapidly, the supermarkets divisions growth has been slower. The company is considering selling the supermarkets division and focusing solely on the aircraft parts production division. Extracts from the Nubo Cos most recent financial statements are as follows: Year ended 30 November Profit after tax Non-current assets Current assets Non-current liabilities Current liabilities 2013 $m 166 550 122 387 95

About 70% of Nubo Cos non-current assets and current assets are attributable to the supermarkets division and the remainder to the aircraft parts production division. Each of the two divisions generates roughly half of the total profit after tax. The market value of the two divisions is thought to be equivalent to the price-to-earnings (PE) ratios of the two divisions industries. The supermarket industrys PE ratio is 7 and the aircraft parts production industrys PE ratio is 12. Nubo Co can either sell the supermarkets division as a going concern or sell the assets of the supermarkets division separately. If the assets are sold separately, Nubo Co believes that it can sell the non-current assets for 115% of the book value and the current assets for 80% of the book value. The funds raised from the sale of the supermarkets division will be used to pay for all the companys current and non-current liabilities. Following the sale of the supermarkets division and paying off the liabilities, Nubo Co will raise additional finance for new projects in the form of debt. It will be able to borrow up to a maximum of 100% of the total asset value of the new downsized company. One of the new projects which Nubo Co is considering is a joint venture with Pilvi Co to produce an innovative type of machinery which will be used in the production of light aircraft and private jets. Both companies will provide the expertise and funding required for the project equally. Representatives from both companies will make up the senior management team and decisions will be made jointly. Legal contracts will be drawn up once profit-sharing and other areas have been discussed by the companies and agreed on. Pilvi Co has approached Ulap Bank for the finance it requires for the venture, based on Islamic finance principles. Ulap Bank has agreed to consider the request from Pilvi Co, but because the financing requirement will be for a long period of time and because of uncertainties surrounding the project, Ulap Bank wants to provide the finance based on the principles of a Musharaka contract, with Ulap Bank requiring representation on the ventures senior management team. Normally Ulap Bank provides funds based on the principles of a Mudaraba contract, which the bank provides for short-term, low-risk projects, where the responsibility for running a project rests solely with the borrower. Required: (a) Advise Nubo Co whether it should sell the supermarkets division as a going concern or sell the assets separately and estimate the additional cash and debt funds which could be available to the new, downsized company. Show all relevant calculations. (7 marks) (b) An alternative to selling the supermarkets division would be to demerge both the divisions. In this case, all of Nubo Cos liabilities would be taken over by the demerged supermarkets division. Also, either of the demerged companies can borrow up to 100% of their respective total asset values. Required: Discuss whether a demerger of the supermarkets division may be more appropriate than a sale. (6 marks) (c) Discuss why Ulap Bank may want to consider providing the finance based on a Musharaka contract instead of a Mudaraba contract, and the key concerns Nubo Co may have from the arrangement between Pilvi Co and Ulap Bank. (12 marks) (25 marks) 6

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

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

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

Gordons growth approximation g = bre

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

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

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

[P.T.O.

Modified Internal Rate of Return

1

PV n MIRR = R 1 + re 1 PVI

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

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

Present Value Table Present value of 1 i.e. (1 + r)n Where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0914 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0350 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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

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

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

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

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

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

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

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

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

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

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

[P.T.O.

Annuity Table

(1 + r)n Present value of an annuity of 1 i.e. 1 r Where r = discount rate n = number of periods Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 10368 11255 12134 13004 13865 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191 2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 10575 11348 12106 12849 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811 3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 10635 11296 11938 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462 4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 10563 11118 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142 5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 10380 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847 6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575 7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324 8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092 9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876 10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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

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

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

End of Question Paper

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