Professional Level – Options Module

Advanced Financial

Paper P4
Management

Time allowed: 3 hours 15 minutes

This question 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

Do NOT open this question paper until instructed by the supervisor.

This question paper must not be removed from the examination hall.
Section A – This One Question are compulsory and MUST be attempted

Question 1
Gambit Inc will soon announce a takeover bid for Larnc Inc, a company in the same industry. The initial
bid will be an all share bid of four Gambit shares for every five Larnc shares.
The most recent annual data relating to the two companies are shown below:

Gambit Larnc
$000 $000
Sales revenue 13333 9400
Operating costs (8683) (5450)
Tax allowable depreciation (1450) (1100)
Earnings before interest and tax 3200 2850
Net interest (715) (1660)
Taxable income 2485 1190
Taxation(30%) (746) (357)
After tax income 1739 833
Dividend (870) (458)
Retained earnings 869 375

Other information:

Gambit Larnc
Annual replacement capital expenditure ($'000) 1600 1240
Expected annual growth rate in sales, operating costs (including depreciation), 5% 6.5%
replacement investment and dividends for the next four years
Expected annual growth rate in sales, operating costs (including depreciation), 4% 5%
replacement investment and dividends after four years 4
Gearing (long term debt/long term debt plus equity by market value) 30% 55%
Market price per share (cents) 298 192
Number of issued shares (million) 7 8
Default Risk Premium 2% 3.5%
Equity Beta 1.18 1.38

Risk free rate 4%

Market return 11%

The takeover is expected to result in cost savings in advertising and distribution, reducing the operating
costs (including depreciation) of Gambit(group) from 76% of sales to 70% of sales. The growth rate of
the combined company is expected to be 6% per year for four years, and 5% per year thereafter. Larnc's
debt obligations will be taken over by Gambit. Combine cost of debt after taking into account the revised
default risk premium is 8 %.Combine beta after acquisition is the weighted average of individual beta
assets weighted with the proportion of individual calculated market values of business. The corporate tax
rate is expected to remain at 30%.Group gearing will be same as Gambit company gearing.

Sales and costs relevant to the decision may be assumed to be in cash terms.
Required:
(a) Using free cash flow analysis for each individual company and the potential combined company,
estimate how much synergy is expected to be created from the takeover. State clearly any
assumptions that you make.

Note. Group will achieve same gearing of Gambit after acquisition .

(23marks)

(b) Discuss the limitations of the above estimates.

(8 marks)

(c) Estimate the percentage gain earned by Gambit and wrrager company shareholders in share for
share exchange method.
(5 marks)
(d) Discuss the factors that might influence whether the initial bid is likely to be accepted by the
shareholders of Larnc Inc.
(4 marks)

(e) Estimate by how much the bid might be increased without the shareholders of Gambit suffering a fall
in their expected wealth, and discuss whether or not the directors of Gambit should proceed with the
bid.
(5 marks)

(f) Once the bid is announced, discuss what defences Larnc Inc might use against the bid by Gambit
Inc.
(5 marks)

(Total = 50 marks)
Question 2
(a) Tesalon plc is a medium sized UK company that trades with companies inseveral European countries.
Trade dealsover the next three months are shown below. Assume that it is now 20th April.
(Switzerland is a Euro zone country).

2 months’ time 3 months’ time

Receipts Payments Receipts Payments

Nil €393,265 €491,011 €60,505
Switzerland Nil Nil €890,271 €1,997,651
Denmark Nil Nil Kr8,600,000 Nil

Foreign Exchange rates

DK roner/ £1 Euro(CHF)/ £1
10.68–10.71 1.439–1.465
Two months forward 10.74–10.77 1.433–1.459

Three months forward 10.78–10.83 1.431–1.456

Annual interest rates

Borrowing Investing
% %
United Kingdom 7.50 5.50
Eurozone 5.75 3.50
Denmark 8.00 6.00

Futures market rates:

Three month Euro contracts (125,000 Euro contract size)
Contracts are for buying or selling Euros. Futures prices are in £ per Euro.
June 0.6964
September 0.6983
December 0.7013

Required:
(i) Using the forward market, money market and currency futures market as appropriate
methods or tools for hedging devise a foreign exchange hedging strategy that is
expected to maximise the cash flows of Tesalon plc at the end of the three month
time period.

N ot e: Denmark is not a member of the Euro block.

 Transaction costs and margin requirements can be ignored for this part of the
question. Basis risk may be assumed to be zero at the time the contracts are closed
out. Futures contracts may be assumed to mature at the month end.
(15marks)

(ii) Successive daily prices on the futures market for a June contract which you have SOLD are:

Sellingprice 0.691
Day1 6
0.693
Day2 0.694
Day3 0.694

Initial margins are £1,000 per contract. Variation margin is 100% of the initial margin.

Spot exchange rates may be assumed to not change significantly during these three days.

Required:

For each of the three days, show the effect on your cash flow of the price changes of the
contract.
(5marks)

(b) Discuss the advantages and disadvantages of forward contracts and currency
futures for hedging against foreign exchange risk.
(5marks)

(Total:25marks)
Question 3
Megatron plc is a multinational company with a current annual cost of capital of 15%. Its capital
structure consists of 100 percent equity. The directors are concerned about the establishment of a
subsidiary company in Flit on, a European country whose currency is the Nelett (symbol N). Megatron plc
has previously exported its products to Flit on, but these exports have become less competitive in price
because of rising UK costs and the increased strength of Sterling relative to the Nelett.

The government of Flit on wants to encourage foreign investment for a period of five years and thus
allows overseas investors to send home an annual cash dividend equal to that year’s after-tax accounting
profit. The cash amount equal to the depreciation charged in arriving at the after-tax accounting profit
can be invested in Flit on government bonds at an annual gross interest rate of 15%. These funds can
then be repatriated at the end of the five years, when the operating assets of the Flit on subsidiary must
be sold to local investors at a price equal to their net book value. Depreciation is to be calculated on a
straight-line basis assuming a zero scrap value and a five-year life. Company accounting profits (after
depreciation and the interest on government bonds) are taxed at the rate of 35%, and the tax is payable
immediately after the accounting year-end. There is a full double-taxation treaty between Flit on and the
UK. Megatron plc pays corporation tax in the UK at 30%.

Details relating to the project are as follows:

(a) Plant and equipment will cost N20 million to be paid immediately.
(b) Sales revenue and exchange rates are fore casted to be:
Exchange
Revenue rate
Year (Nmillion) N/£
0 – 2.5
1 18 2.6
2 20 2.7
3 24 2.8
4 30 2.9
5 36 3.0

(c) Variable costs are expected to be 35% of sales revenue. Fixed costs (excluding depreciation) are
expected to be N4.0 million in the first year of operations and then rise by the general rate of
inflation in Flit on of 8% per annum.
(d) Working capital effects can be ignored for the purpose of the investment appraisal.
(e) Within Flit on, projects of this type would be expected to achieve a minimum internal rate of return
of 25%.

Required:
(a) Calculate the net present value of:
(i) the project in local currency (to the nearest N0.1 million) for its first five years of
operations; and
(ii) the proposed investment to Megatron plc (to the nearest £0.1million);
(13marks)
(b) Comment on the results of your analysis in (a)above and discuss whether Megatron plc
should proceed with the proposed investment;
(5marks)

(c) Compare the advantages and disadvantages of manufacturing goods in the UK for export
to an overseas country with setting up an overseas subsidiary company to manufacture
and sell the same products.
(7marks)

(Total: 25marks)
Question 4
US Government research laboratories have developed a new technique for manufacturing a weapons-
grade platinum compound. Regice Inc has been offered a licence to produce the compound for permitted
non-military uses on condition that it commences manufacture within the next twelve months.

Preliminary research, presented by the Marketing Director at the last board meeting, suggests that the
project would have a Net Present Value of -£10 million with the Present Value of future cash flows
estimated at + £180 million. She thus argued that the proposal should be rejected.

However ,the Finance Director argued that conventional NPV analysis under values projects with high
uncertainty as the value of embedded real options is often ignored. He suggested that he possibility of
delaying the project for up to twelve months effectively gives Regice a call option on development and
that if market forecasts improve over the next year, then the company can benefit. To get the‘ right
answer’, he concluded, option values must be incorporated.

The Chief Executive would like to know what the NPV of the investment would be, assuming the
company delays twelve months to see if predicted demand is realised.

The current long-term government bond yield is marked at 5%.The expected volatility (standard
deviation) of future cash flows is estimated to be 35%.

Required:
(a) Comment on the views of the Finance Director and the Marketing Director.
(7marks)

(b) Using the Black- Scholes option pricing model for a European call option, estimate the
value of the option to commercially develop and market the platinum compound.
Provide are commendation as to whether or not Regice should develop the compound.
(12marks)

(c) Comment on in corporating the possibility of delay as a European call option.

(6marks)

(Total: 25marks)