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Answers

Part 3 Examination Paper 3.7


Strategic Financial Management
1

(a)

June 2004 Answers

Pro forma accounts


Pro forma profit and loss account for the years ended March 20058

Turnover
Operating costs before deprecation
EBITDA
Tax allowable depreciation
EBIT
Net interest payable
Profit on ordinary activities before tax
Tax on ordinary activities
Dividends
Amount transferred to reserves

2005
1,787
(1,215)

572
(165)

407
(63)

344
(103)
(135)

106

million
2006
2007
1,929
2,064
(1,312)
(1,404)

617
660
(179)
(191)

438
469
(65)
(66)

373
403
(112)
(121)
(146)
(158)

115
124

2008
2,188
(1,488)

700
(203)

497
(70)

427
(128)
(167)

132

Pro forma balance sheets 20058

Fixed assets
Land and buildings
Plant and machinery (net)
Investments

Current assets
Stocks
Debtors
Cash in hand and short term deposits

Creditors: amounts falling due within one year:


Short term loans and overdrafts
Other creditors

Creditors: amounts falling due after one year:


Borrowings1

Capital and reserves


Called up share capital (10 pence par)
Reserves

1Refinanced

2005

2006

million
2007

2008

310
1,103
32

1,445

310
1,191
32

1,533

350
1,275
32

1,657

350
1,351
32

1,733

488
615
22

1,125

527
664
24

1,215

564
710
25

1,299

598
753
27

1,378

266
514

(780)

287
556

(843)

332
595

(927)

320
630

(950)

(580)

1,210

(580)

1,325

(580)

1,449

(580)

1,581

240
970

1,210

240
1,085

1,325

240
1,209

1,449

240
1,341

1,581

with a similar type of loan in 2006

15

(b)

The pro forma accounts are based primarily upon the percentage of sales method of forecasting. This provides a simple
approach to forecasting, but is based upon assumptions of existing or planned relationships between variables remaining
constant, which are highly unlikely. It also does not allow for improvements in efficiency over time.
(i)

Accurate forecasts of sales growth are very difficult. Sensitivity or simulation analysis is recommended to investigate the
implications of sales differing from the forecast levels. A constant growth rate of 6% forever after four years is most
unlikely.

(ii)

Cash operating costs are unlikely to increase in direct proportion with sales. The variable elements (wages, materials,
distribution costs etc.) could all move at a higher or lower rate than sales, whilst the fixed elements will not change with
the value of sales at all in the short run. If the company becomes more efficient then costs as a proportion of sales should
reduce.

(iii) Unless tax allowable depreciation from new asset purchases exactly offsets the diminishing allowances on older assets,
and effect of the increase in assets with sales growth, this relationship is unlikely to be precise. The government might
also change the rates of tax allowable deprecation.
(iv) Assuming a direct relationship between stocks, debtors, cash and other creditors to sales could promote inefficiency.
Although a strong correlation between such variables exists, there should be no need to increase stock, debtors and
creditors in direct proportion to sales.
(ix) Paying dividends as a constant percentage of earnings could lead to quite volatile dividend payouts. Most investors are
believed to prefer reasonably constant dividends (allowing for inflation) and might not value a company with volatile
dividends as highly as one with relatively stable dividends.
(c)

Free cash flow will be estimated by EBIT(1-t) plus depreciation less adjustments for changes in working capital and
expenditure on fixed assets. (N.B. other definitions of free cash flow exist)

Change in land and buildings


Change in plant and machinery
Change in working capital
Change in assets

EBIT (1-t)
Depreciation
Change in assets
Free cash flow

million
2007
40
84

124

2005

91
15

106

2006

88
27

115

2005
285
165
(106)

344

million
2006
2007
307
328
179
191
(115)
(124)

371
395

2008

76
56

132
2008
348
203
(132)

419

The present value of free cash flow for the company after 2008 may be estimated by:
FCF2008 (1 + g)

WACC g

or

419 (106)
=
011 006

8,883

The estimated value of the company at the end of 2008 is 8,883 million. From this must be deducted the value of any
loans in order to find the value accruing to shareholders. From the pro forma accounts, loans are expected to total 900
million, leaving a net value of 7,983 million. If the number of issued shares has not changed, the estimated market value
7,983
per share is = 333 pence per share, an increase of 58% on the current share price.
2,400
Based upon this data the managing directors claim that the share price will double in four years is not likely to occur.
However, the impact of the performance of the economy, and unforeseen significant changes affecting Wurrall plc mean that
such estimates are subject to a considerable margin of error.
(d)

Ratios
2005
411
144
082
227
100
228
126

Gearing (%)
Current ratio
Quick ratio
Return on capital employed1 (%)
Asset turnover
EBIT/Sales (%)
Debtor collection period (days)
1EBIT/(shareholders

equity plus long term debt). Other definitions are possible

16

2006
396
144
082
230
101
227
126

2007
386
140
079
231
102
227
126

2008
363
145
082
230
101
227
126

It is difficult to comment upon ratios without comparative data for companies in the same industry. The current gearing level,
at 423%, breaches the covenant limit of 40%, and it is expected to continue to do so in 2005. Whether or not this breaches
the one-year covenant is not clear, but would need to be investigated by the company and action taken to reduce gearing if
the covenant was to be breached for too long a period. The debtor collection period appears high at 126 days. It is unlikely
that credit would be given for such a long period, and the company might consider improving its credit control procedures to
reduce the collection period. If this is successful it could also reduce the overdraft and help reduce the gearing level.
Another ratio that would need investigating is the asset turnover. At around one this is relatively low. Unless the industry is
very capital intensive, management should consider if assets could be utilised more efficiently to improve this ratio, and with
it the return on capital employed.
As previously mentioned, managers might also review the companys dividend policy. Paying a constant level of earnings
could lead to volatile dividend payments which might not be popular with investors, including financial institutions, that rely
upon dividends for part of their annual cash flow.
Wurrall proposes to finance any new capital needs with increases in the overdraft. Overdraft finance is not normally
considered to be appropriate for long term financing, and the company should consider longer term borrowing or equity issues
for its long-term financing requirements.

(a)

Possible currency hedges are a forward market hedge, currency futures hedge or currency options hedge.
Forward market hedge
The forward market hedge locks into a known exchange rate at the time the payment by the customer is made. It is a legally
binding obligation.
A forward rate is required for four months time. This may be estimated by interpolating between the three month and one
year forward rates.
15362 15140 = 00222 x 1/9 = 00025
The four month rate is 15362 00025 = 15337
15398 15178 = 0220 x 1/9 = 00024
The four month rate is 15398 00024 = 15374
60% of the receipts will be in $US, i.e. the equivalent to 405m pesos.
P405m
At the official rate = $4,124,236
9820
$4,124,236
Selling $ forward, = 2,682,605
15374
The balance of 270m pesos will be converted at 115% of the official rate
270
= 1,502,128
179745
Total expected receipts are 4,184,733.
Futures hedge
A futures hedge locks the transaction into an expected exchange rate. In this case December futures will need to be bought
as the September contract will have expired by the date of the payment, 1 November.
Basis on the December contract is 15510 15275, or 235 cents. The expected basis on 1 November is 2/6 (the remaining
period of the futures contract) x 235 cents, or 078 cents. The expected lock-in futures price, no matter what happens to
actual spot rates, is 15275 + 00078 = $15353.
This is slightly better than the forward market rate.
However, basis on 1 November when the futures contract would be closed out (by buying an identical contract) might not be
078 cents, due to the existence of basis risk. A better or worse outcome than the expected lock-in rate is possible. The hedge
is for $4,124,236
4,124,236
This will require = 2,686,274 or 4298 62,500 contracts.
15353
43 contracts would be needed, a slight overhedge.
Futures contracts also require the payment of margin, a security deposit. Profit on futures contracts through favourable
currency movement may be taken daily, but any losses will result in daily variation margin calls in order to keep the hedge
open. The futures contract looks to offer a slightly better rate than the forward contract, but will involve more risks. The
company must choose whether or not the expected extra return would compensate for these risks.

17

Currency options hedge


Currency options offer an advantage over both forwards and futures in that they not only protect against downside risk, they
also allow the buyer of the option to take advantage of favourable currency movements by allowing the option to lapse. The
price of this extra benefit is the option premium.
Given that the dollar is strengthening against the pound in the forward market, the currency option rates do not look very
favourable. As Polytot wishes to exchange dollars for pounds, it will need to purchase December call options. Probably only
the 15250 and 1550 strike prices would be considered, as the other rates are far less favourable than the forward market.
Strike price
15250
15500

$ receipts
4,124,236
4,124,236

equivalent
2,704,417
2,660,797

Number of contracts
8654
8515

Number used
86 (or 87)
85 (or 87)

86 contracts is $4,098,438 at 15250, leaving $25,798 over which could be sold forward at $15374/ to yield 16,780.
85 contracts is $4,117,188 at 15500, leaving $7,048 over which could be sold forward to yield 4,584.
Strike price

Premium ($)

15250
15500

90,031
59,766

Premium
( at spot)
(58,179)
(38,621)

receipts

over

Worst case outcome

2,687,500
2,656,250

16,780
14,584

2,646,101
2,622,213

These outcomes are much worse than the forward or futures hedges, but if the dollar was to strengthen further, the options
could be lapsed and the pounds purchased in November in the spot market. For example, in order for the 15250 option to
become better than the forward market hedge the dollar would have to strengthen at least to approximately 15250
(15250 15374 + 00335) or 15039/.
The recommended hedge is either the forward market, (unless Polytot is happy with the extra risks of futures) or currency
options at a probable strike price of 15250.
(b)

The proposed countertrade needs to be compared with the 40% of expected receipts that are at 15% less than the official
rate. Three million kilos at 5060 pence per kilo gives receipts of between 15 and 18 million. This compares with
1,502,128 from the foreign exchange transaction. The price for the strawberries would need to be in excess of 50 pence
per kilo. Other factors that would need to be considered in any countertrade include:
(i)

How reliable is the supplier of the strawberries? Are they of suitable quality and could such a large quantity be supplied?

(ii)

Strawberries are perishable and require specialised transportation. Who is responsible for the costs of transportation,
insurance etc?

(iii) What additional administrative/organisational expense will the countertrade involve?


(iv) What are the tax implications of a countertrade in strawberries?
(c)

Advantages of the Euromarkets include:


(i)

They are more flexible than many domestic markets and not subject to the same degree of control.

(ii)

The cost of borrowing in the Euromarkets is often slightly less than for the same currency in relevant domestic capital
markets.

(iii) Interest is normally payable gross, which is attractive to some investors.


(iv) Very large sums can be quickly raised, without the queuing process that exists in many domestic capital markets.
(v)

Issue costs are relatively low.

(vi) There is an active secondary market in many types of Euromarket security.


(vii) Eurobonds, in particular, offer the opportunity to swap interest payments into a more convenient form (e.g. fixed to
floating rate), often at lower costs than borrowing directly.
Potential problems include:
(i)

The Grobbian company would either need to be rated highly by one of the international rating agencies in order to be
able to access the markets, or it would probably be necessary for the company to offer a guarantee from its government
in association with any issue.

(ii)

Any Euromarket borrowing is likely to be in dollars or another hard currency. The company will need to convince the
market that it has access to sufficient hard currency to fully service the interest and principal payments.

18

(a)

(i)

As the investment is an expansion of existing activities, the risk of the investment will be estimated using the companys
current equity beta. The cost of equity may be estimated using either CAPM or the dividend growth model. Using CAPM:
Ke = Rf + (Rm Rf) beta, or 35% + (11% 35%) 115 = 1213%

Using the dividend growth model:


D1
364(104)
Ke = + g = + 004 = 01192 or 1192%
P
478
Both methods give a cost of equity of approximately 12%
The current pre tax cost of debt is 75%, although this cost will vary as the proposed loan is at a floating rate. The
weighted average cost of capital should be estimated using market values of equity and debt. The current market
weighted gearing of Zendeck is:
Equity 30 million shares at 478 pence = 1434 million
Debt 34m + (56m x 1078) = 9437 million
This is 603% equity, 397% debt by market values.
E
D
WACC = Ke x + Kd (1t) x
E +D
E+D
Maintaining the current capital structure the estimated weighted average cost of capital is:
12% (0603) + 75% (1 03) (0397) = 932%
(ii)

There is no easy method of adjusting the CAPM cost of equity for issue costs, instead cash flows would be adjusted
when undertaking the investment appraisal.
Using the dividend growth model the revised equation including issue costs is:
D1
Ke = + g where I is issue costs
PI
364 (104)
Ke = + 004 = 0851 + 004 = 01251 or 1251%
478 33
(33 is 478/0935 478)
Assuming the new debentures carry the same risk as the existing ones, and that there are three years until the
redemption of the existing debentures, the current gross redemption yield (cost) of debentures may be estimated from:
11
11
11
100
1078m = + + +
1 + Kd
(1 + Kd)2
(1 + Kd)3
(1 + Kd)3
By trial and error
At 9%
111 x 2531 = 2784
100 x 0772 = 7720

10504
At 8%
111 x 2577 = 2835
100 x 0794 = 7940

10775
The gross redemption yield of existing debentures is approximately 8%.
Assuming the new debentures have a similar risk to existing debentures they will be issued at par of 100 with a coupon
of 8%. They are also assumed to be issued for the expected maturity of the investment, five years. The effective cost of
the debentures may be estimated by solving:
8
8
8
108
(100 35) = + +
+ . . . . . .
1 + Kd
(1 + Kd)2
(1 + Kd)3
(1 + Kd)5
At 9%
118 x 3890 = 3112
100 x 0065 = 6500

9612
At 8% the value is 100 by definition
35
Interpolating: 8% + x 1% = 890%
35 + 038
The weighted average cost of capital is:
1251% (0603) + 890 (1 03) (0397) = 1002%
The issue costs and use of a different type of debt increase the WACC by about 070%.

19

(b)

As the companies are unlisted, there is no share price with which to estimate CAPM or to use the dividend growth model. It
might be possible to use the beta of similar risk quoted companies (with adjustment for differences in gearing), but such
companies are often difficult to identify, and the degree of accuracy of the estimate of WACC is likely to be reduced. There is
also the problem that no measure of the market value of equity exists with which to estimate gearing, although a target gearing
might be used, probably benchmarked against other companies in the same sector.
Unlisted companies sometimes use a cost of capital estimate of a similar listed company, and add a further risk premium to
reflect the fact the they are unlisted. Inevitably this involves subjectivity.

(a)

Rational investors would normally require increased return when taking increased risk. The expected returns and risks of the
two divisions managers are:
Division 1
Expected NPV
1,000,000 with certainty
80% chance of 13m, 20%
60% chance of 18m, 40%
40% chance of 25m, 60%
20% chance of 30m, 80%
10% chance of 40m, 90%

chance
chance
chance
chance
chance

of
of
of
of
of

Risk ()
0
024
074
108
124
126

700,000
300,000
100,000
(100,000)
(200,000)

Expected return (m)


100
118
120
106
052
022

Division 2
The missing risk for the two probability combinations may be estimated as follows:
Probability
035
065

Return(m)
30
(01)

Expected return
1051
(0065)

0985

(Return deviation)2 x probability


1421
0765

variance = 2186
= 148

Probability
020
080

Return(m)
40
(02)

Expected return
080
(016)

064

(Return deviation)2 x probability


2258
0564

variance = 2822
= 168

Expected NPV
1,000,000 with certainty
85% chance of 13m, 15%
75% chance of 18m, 25%
50% chance of 25m, 50%
35% chance of 30m, 65%
20% chance of 40m, 80%

chance
chance
chance
chance
chance

of
of
of
of
of

Risk ()
0
021
065
120
148
168

700,000
300,000
100,000
(100,000)
(200,000)

Expected return (m)


100
121
143
130
099
064

If these data correctly reflect risk/return combinations of equal satisfaction (utility) they show unusual attitudes towards high
risk. Initially there is the expected relationship between increased risks and increased returns. However, it appears that the
divisions managers would be willing to take unusually high risks in order to gain the possible opportunity of earning very
high returns, even if the chance of achieving such returns is relatively low. There is in fact an inverse relationship between
risk and return where possible best case returns are at or above 2,500,000.
If this attitude towards risk and return is reflected in the managers investment decisions for the company, it could lead to
them selecting relatively risky projects in order to try to achieve a very high return. Such projects would not provide the best
possible expected NPV for the company.
(b)

Possible actions are:


(i)

Provide additional training for the managers in capital investment decision-making.

(ii)

Take more decisions centrally. Reduce the local autonomy of managers.

(iii) Replace the managers


(iv) Do nothing, as the board may not consider the analysis to be relevant.
(c)

The analysis focuses upon the standard deviation as the measure of risk. This is a measure of total risk, whereas it is often
argued that the relevant risk in decision-making is the systematic risk of the investment. The analysis might have been
improved by trying to measure managers attitudes to return and systematic risk.
Analyses such as this might be criticised for presenting only hypothetical opportunities and for being removed from the actual
pressures of decision-making. Managers might react differently when there is real money at stake.

20

(a)

Folter can protect against possible falls in the share price either by buying put options or selling call options in Magterdoors
shares. Ideally a put option would be purchased at the money i.e. at the current market price of the shares. This opportunity
is not available. If an in the money price of 550 pence is selected, the outcome with a market price at the end of October of
485 pence would be:
550 (exercise price) 51 (option premium) = 499 pence x 2 million shares = 998m.
If the exercise price of 500 pence is used the outcome would be:
500 245 = 4755 x 2m = 951m
If no hedge were undertaken the shares would be worth 970m.
The success of the hedge would depend upon the exercise price selected.
However, if the price at the end of October was not 485, but was in excess of the relevant exercise price of the option, then
the option would be allowed to lapse.

(b)

The purpose of a delta neutral hedge is to set up a riskless portfolio. Any adverse movement in a share price would be offset
by a similar favourable movement in the option price. A delta of 047 means that for every share held 1/047call options
would need to be sold to establish the delta neutral hedge.
12,000,000
= 4,255 call options would need to be sold
1,000 x 047
Delta hedges are only valid for small movements in the share price. As the share price changes, so will the relevant delta,
and the hedge would need to be frequently rebalanced in order to maintain the delta neutral position.

(c)

The intrinsic value of the January 550 call option is zero, as the exercise price exceeds the current market price. The option
premium of 34 pence is the time value of the option. The time value depends upon the remaining time to the expiration of
the option, the volatility of the option and the level of interest rates. As these variables increase, so will the time value of the
option.

(d)

Apart from the obvious cost and risk associated with increasing the holding, an increase to six percent means that Folter would
have to publicly declare its holding in Magterdoor, which might reveal that a take-over is being considered. Under the City
Code on Take-overs and Mergers any holding over 3% must be disclosed to the target company.
The main advantage of increasing the percentage holding is that it makes achieving the ownership of more than 50% of the
shares easier. It might be argued that if Folter has to reveal its holding to Magterdoor, a larger holding than 6% should be
considered.

(a)

The global debt problem has existed for some countries for nearly thirty years. It developed partly as a result of a massive
increase in petrol and other commodity prices during the 1970s and 1980s. This together with widespread economic
recession, reductions in the imports of many advanced countries from developing countries, and relatively high levels of
international interest rates, meant that many countries were forced to borrow internationally in order to meet their import
requirements of essential goods such as fuel and foodstuffs. Such countries often experienced large current account deficits,
and could not get access to the necessary hard currency to pay for imports other than by borrowing. Many also suffered from
capital flight, with funds leaving the country to find what was perceived to be a safer international home. Major international
banks were very willing to lend to sovereign nations, as historically country default risk had been low. Arguably banks risk
assessment took too optimistic a view and vast amounts of sovereign loans were agreed, with countries such as Mexico and
Brazil borrowing in excess of 100 billion dollars. Debt servicing payments in some countries exceeded 50% of total export
earnings, and domestic savings were insufficient to provide the necessary funds to repay international debts. Continuing
current account deficits made the situation even worse in many countries. Many countries had insufficient hard currency to
meet the debt servicing conditions of their loans.
Financial contagion refers to the spread of economic and financial problems from one country to another. As barriers to trade,
investment and capital flows are reduced or eliminated the resultant more global economy is more susceptible to contagion.
As can be seen from the problems of the Thai baht in 1997, the problems of even a relatively small economy can easily have
severe economic impacts on neighbouring countries and even upon larger countries such as Brazil and Russia. Financial
contagion potentially worsens the impact of the international debt problem. If financial problems in one country directly lead
to similar problems in several others it accentuates the debt servicing difficulties.

21

(b)

Attempts to resolve the international debt problem have included:


(i)

Lending additional funds to the countries, sometimes to meet current interest payments and prevent default. Most
lending has been accompanied by suggested or imposed economic reforms to try and address the fundamental causes
of the problem. Such reforms are often based upon stringent conditions set by the IMF.

(ii)

Rescheduling the repayment of debt to extend the repayment period and reduce current cash outflows.

(iii) Writing off some or all of the debt. Where lenders are institutions such as international banks this naturally requires their
agreement, and has substantial cost for them.
(iv) Sale of debt for less than face value.
(v)

Swapping debt into some other form of commitment. This includes swaps from debt into the equity of local companies,
or even promises to reduce pollution, provided enhanced education etc.

Financial problems are most often experienced in those countries that have fixed exchange rates and an overvalued currency;
suffer from large short-term capital outflows; or have overheated parts of the economy (especially the property sector). Fixed
exchange rate systems are also much more likely to be the subject of speculative attacks. Financial crises are also associated
with weak economic fundamentals such as high unemployment, low growth in GDP, high short-term debt to currency
reserves, balance of payments deficits and high real interest rates.
Governments might reduce the risk of financial problems and the potential associated contagion by altering the exchange rate
system and trying to address these economic issues. For example, the government might adopt a floating rate regime
(although this will impact upon other aspects of the economy), or possibly a currency board system. Governments should
closely monitor important sectors of the economy to assess the risks within those sectors, and consider the use of taxation,
monetary policy and/or exchange controls to prevent a crisis occurring.

22

Part 3 Examination Paper 3.7


Strategic Financial Management
1

June 2004 Marking Scheme

This question requires the production of, and critical analysis of, medium term financial forecasts, and discussion of their possible
implications for profits, share price and the general financial performance of a company.
Marks
(a)

Pro forma accounts


Profit and loss accounts
Balance sheets
Max

56
67

12

Max

Reward technique but calculations must be quite accurate for very


high marks. If only one or two years are attempted max 7 marks.
(b)

12 marks for each good point

(c)

Free cash flow estimate


Present value of the company and shares
Comment/conclusion re the managing director

5
4
1

10

(d)

Ratios or other calculations


Problems and suggested actions

56
56

10
40

Max
Total

This question requires analysis and understanding of techniques that might be used to hedge foreign exchange risk. It also requires
knowledge of the implications of using countertade, and of financing in the Euromarkets.
(a)

Forward market
Comment
Calculations
Futures market
Comment
Calculations
Options market
Comment
Calculations
Conclusion

12
3
2
34

Max
(b)

(c)

Value of strawberries calculation


Factors to be considered 12 each. Look for common sense answers

Max

Advantages of Euromarkets
Potential problems for the Grobbian company
Max
Total

23

2
45
1

17
1
5

6
34
34

7
30

Marks
3

(a)

(i)

(ii)

(b)

Internal sources of funds


Market values of equity and debt
Cost of equity
Cost of debt
WACC

1
2
1
1

Cost of equity
Cost of debt
WACC
Max

2
4
1

11

Total

15

Reward in particular comments about lack of market price,


CAPM, and how an estimate might be made

(a)

Expected returns
Missing risk data
Discussion

(b)

Possible actions 1 mark for each sensible suggestion.

(c)

Reward especially discussion of relevant risk, and real world effects

(a)

Traded option hedge with comment on exercise price

(b)

Number and type of contracts


Practical problems

2
3
3

8
Max

Total

4
15

Max

(c)

Reward understanding, especially intrinsic value and the causes of time value

(d)

Comments about the City Code implications


Other comments

(a)

(b)

Max
Total

12
12

3
15

Max

45
3

Max
Total

45
34

8
15

Reasons for the global debt problem


Financial contagion and its links to global debt

Attempts to resolve the debt problem


How financial contagion might be limited

24

23
12