Cases

Case Bank for International Financial Management

(0) Objective of International Financial Management Question: Stakeholder objectives using UK as a case (a) 'The objective of financial management is to maximise the value of the firm.' You are required to discuss how the achievement of this objective might be compromised by the conflicts which may arise between the various stakeholders in an organisation. (10 marks)

Answer: Stakeholder objectives (a) If it is agreed to maximise the value of the firm, it is necessary to ask two fundamental questions:
• •

who is the firm? what do we mean by value?

In the United Kingdom the traditional view has been for the interests of a firm to equate with those of the current equity shareholders. But it is now recognised that this is much too narrow. The employees and lenders to a business certainly have a legitimate interest, probably also the government. Japanese influences on UK thinking would add a company's suppliers and customers as part of the stakeholders. Perhaps the general public also belong to the list. Each of the members of the above list has different key objectives. For example employees might want their labour remuneration to be larger, while the shareholders want labour costs to be low so that higher profits can lead to higher dividends. Shareholders might be uninterested whether the company invests in 'unethical' areas of business such as armaments or cigarettes, as long as their investment is profitable, while certain sections of the public will discourage unethical products. The value of an investment in terms of financial management theory is the present value of the cash returns available from the investment. However this varies from investor to investor depending on personal discount rate, tax position, period of investment, etc. For example the value of a share bought today and expected to be sold in five years time will

be the present value of the five years dividends plus the present value of the expected net realisable value at the end of the holding period. So the value of the same share will be different to different shareholders, and the job of the managers to maximise the total value becomes impossible. A further problem arises in the conflict between short-term results and long-term viability. Managers might be on annual service contracts and therefore are motivated to report the highest possible short-term profits. This might involve cutting down on revenue investment such as maintaining fixed assets, advertising, research costs, etc. Such a policy is in the best interests of management, since they will be paid a bonus for reporting good results, but is not in the long-term interests of the company. Financial managers often deal with the above conflicts by adopting a satisficing approach rather than an optimising approach. They hope to please everyone by following moderate policies which are not exclusively in the interests of one of the sectional stakeholders of the business.
Question: Five wealthy individuals Five wealthy individuals have each put £200,000 at your disposal to invest for the next two years. The funds can be invested in one or more of four specified projects and in the money market. The projects are not divisible and cannot be postponed. The investors require a minimum return of 24% over the two years. Details of the possible investments are: Return over Initial cost (£’000) Project 1 Project 2 Project 3 Project 4 Money market minimum 600 400 600 600 100 two years (%) 22 26 28 34 18 Expected standard deviation of returns over two years (%) 7 9 15 13 5

Correlation coefficients of returns (over two years) Between projects and Between projects 1 and 2 0.70 0.40 the market portfolio 1 and market 0.68 Between projects and the money market 1 and money market

1 and 3 1 and 4 2 and 3 2 and 4 3 and 4

0.62 0.45 0.56 0.55 0.65 0.60 0.57 0.76

2 and market 3 and market 4 and market

0.65 0.75 0.88

2 and money market 3 and money market 4 and money market

Between the money market and the market portfolio 0.40 The risk-free rate is estimated to be 16%, the market return 27% and the variance of returns on the market 100% (all for the two year period). You are required: (a) to evaluate how the £1m should be invested using: (i) portfolio theory, (ii) the capital asset pricing model (CAPM).

Portfolio risk may be estimated using the formula:

σ p = x 2σ a + (1 − x) 2 σ b + 2 ( x ) (1 - x) ρ ab σ a σ b

2

2

(15 marks)

(b) to explain why portfolio theory and CAPM might give different solutions as to how the £1m should be invested. (5 marks) (Total: 30 marks) (c) to discuss the main problems of using CAPM in investment appraisal. (10 marks)

Answer: Five wealthy individuals Possible portfolios Projects 1 and 2 Projects 2 and 3 Projects 2 and 4 Project 2 and money market (mm) Project 1 and mm Project 3 and mm Project 4 and mm considered further. (a) (i) = Evaluation of investment using portfolio theory 0. 42 × 92 + 0. 62 × 152 + 2 × 0. 4 × 0. 6 × 0. 65 × 9 × 15 = 12. 96 + 81 + 42.12 =11.7% Return 0.6 × 22 + 0.4 × 26 = 0.4 × 26 + 0.6 × 28 = 0.4 × 26 + 0.6 × 34 = 0.4 × 26 + 0.6 × 18 = 0.6 × 22 + 0.4 × 18 = 0.6 × 28 + 0.4 × 18 = 0.6 × 34 + 0.4 × 18 = 23.6 27.2 30.8 21.2 20.4 24 27.6 X X X

Of the above the three marked X yield returns less than 24% and will therefore not be

Projects 2 and 3

σ

Projects 2 and 4

σ

=

0. 42 × 92 + 0. 62 × 132 + 2 × 0. 4 × 0. 6 × 0. 57 × 9 × 13 =10.3%

=

12. 96 + 60. 84 + 32. 01

Project 3 and mm

σ

=

0. 62 × 152 + 0. 42 × 52 + 2 × 0. 6 × 0. 4 × 0. 55 × 15 × 5 =

81 + 4 + 19. 8

= 10.2%

Project 4 and mm

σ

=

0. 62 × 132 + 0. 42 × 52 + 2 × 0. 6 × 0. 4 × 0. 6 × 13 × 5 =

60. 84 + 4 + 18. 72 = 9.1%

Summary Portfolio 2 and 3 2 and 4 3 and mm 4 and mm Conclusions (1) (2) (3) Projects 2 and 4 are better (more ‘efficient’) than 2 and 3 as they offer a higher return and a lower risk (as measured by standard deviation). Project 4 and the money market is better than Projects 2 and 3 and Project 3 and the money market since returns are higher and risk is lower. Projects 2 and 4 appears better than Project 3 and the money market - much higher return with virtually the same risk. It is not possible to choose between: Return 27.2% 30.8% 24% 27.6% Standard deviation 11.7% 10.3% 10.2% 9.1%

(1) Projects 2 and 3 and Project 3 and money market or (2) Projects 2 and 4 and Project 4 and the money market.

This is because Projects 2 and 3 offer a higher return and a higher risk than Project 3 and the money market. Similarly, Projects 2 and 4 offer a higher return and higher risk than Project 4 and the money market. To make a final choice using portfolio theory, it would be necessary to consider the effect of the investment on the risk and return of the investors’ total portfolio of investments, not just the 2 asset portfolios considered above. Even then it may be necessary to consider the utility preferences of the five individuals in order to ascertain which investments would maximise their utility. (ii) Evaluation of investment using the capital asset pricing model (CAPM) (Tutorial note: to use CAPM it is necessary to do two things: (1) Find the beta (β ) value - the measure of systematic risk - for each project. (2) Find the β for each portfolio ie, each combination of projects. This will simply be a weighted average of the β for each project within the portfolio. This is because β is a measure of systematic or non diversifiable risk and will therefore not be reduced when projects are combined into a portfolio. This contrasts with the portfolio theory approach where it is necessary to identify the standard deviation (total risk) of each portfolio, which will usually be less than the weighted average of the standard deviations of the individual projects - because of the risk reduction effect of diversifying. ps,mσ s

Using capital asset pricing model (CAPM), β Project 0. 68 × 7 100 0. 65 × 9 10 0. 75 × 15 = 10 0. 88 × 13 = 10 0. 4 × 5 10 β

=

σm

1 2 3 4 mm

=

0.476 = 0.585

1.125 1.144 = 0.2

Portfolio 2 and 3 0 2 and 4 0. 3 and mm 4 × 0.585 4 × 0.585 0.6 × 1.125 + + +

β 0.6 × 1.125 0.6 × 1.144 0.4 × 0.2= = = 0.75 0.91 0.92

4 and mm Summary

0.6 × 1.144

+

0.4 × 0.2=

0.77

Portfolio Required return rf + (rm − rf) β 2 and 3 2 and 4 3 and mm 4 and mm Conclusions (1) (2)

Expected return - required return)

Excess return

(Expected return 27.2% 30.8% 24% 27.6% 1.2% 4.7% -0.2% 3.1%

16 + (27 − 16) × 0.91 = 26% 16 + (27 − 16) × 0.92 = 26.1% 16 + (27 − 16) × 0.75 = 24.2% 16 + (27 − 16) × 0.77 = 24.5%

Project 3 and money market is not acceptable. The expected return of 24% is less than the return required of 24.2% given the level of systematic risk. Projects 2 and 3, Projects 2 and 4 and Project 4 and the money market are all acceptable ie, the expected return is greater than the return required for the level of systematic risk taken on.Projects 2 and 4 appear best as they offer the greatest excess return over the return required.

(b) Portfolio theory identifies the return and total risk (as measured by standard deviation) of each possible portfolio of 2 investments. This risk should be reduced further when the 2 investments are combined with the existing investments of the 5 individuals. Hence the risk measure for the 2 asset portfolios includes systematic and unsystematic risk. The capital asset pricing model (CAPM) makes it possible to identify the systematic risk of each of the 2 asset portfolios ie, the total risk reduction effect of using a portfolio is taken into account. β measures the risk that cannot be avoided (other than by investing in risk-free securities) ie, CAPM assumes that investors hold the two assets as part of a well-diversified portfolio, in which case only systematic risk is considered when calculating the required return. In this example, portfolio theory indicates that Projects 2 and 3 are not acceptable relative to Projects 2 and 4 as Projects 2 and 4 offer a higher return and lower risk, whereas CAPM indicates that Projects 2 and 3 are acceptable in that the expected return is greater than the required return. (c) The main problems of using CAPM in investment appraisal are the underlying assumptions: • • CAPM is a one period model. Most investment appraisal concerns projects lasting several years. CAPM assumes the company’s shareholders hold a well-diversified portfolio of investments and therefore only need to consider systematic risk. This may not be the case particularly if it is a smaller company where shareholders may have a substantial proportion of their assets invested in the

company. • Estimation of β . Most approaches involve calculating β on the basis of historic data whereas β for future periods is required. This is particularly problematic if a project involves moving into a new area of operation (when an ‘industry’ beta, adjusted for gearing, would have to be used). Also, β values have been found to change over time. • CAPM is based on a perfect market - information about risk and return on investments freely available, no transaction costs, and investors can borrow and lend freely at the riskfree rate. These assumptions are unrealistic. • • Risk is measured purely by standard deviation - assuming this can be accurately estimated for future returns. It is necessary to accurately estimate the risk-free return and the return on the market; over what period should these returns be estimated and what securities and stock markets should be used? • Smaller companies tend to yield higher returns than predicted by CAPM, suggesting systematic risk, as measured by β , is not necessarily an accurate measure or the only factor which determines the required return.

(2) Hedge . Question: Forun (a) Forun plc, a UK registered company, operates in four foreign countries, with total foreign subsidiary turnover of the equivalent of £60 million. The managing director is conducting a strategic review of the company’s operations, with a view to increasing operations in some markets, and to reducing the scale of operations in others. He has assembled economic and other data on the four countries where subsidiaries are located which he considers to be of particular interest. His major concern is foreign exchange risk of overseas operations. Country UK 1 2 3 4 Inflation rate (%) 4 8 15 9 6 − Real GDP growth (%) 1 2 3 2 2 − − − Balance of payments ($b) 12 3 14 5 2 Base rate (%) 6 10 14 10 8 Unemployment rate (%) 12 8 17 4 9 Population (million) 56 48 120 29 9 Currency reserves ($b) 35 20 18 26 3 − IMF loans ($b) 4 20 5 5 On the basis of this information the managing director proposes that activity is concentrated in countries 1 and 4, and operations are reduced in countries 2 and 3. A non-executive director believes that the meeting should not be focusing on such longterm strategic dimensions, as he has just read the report of the finance director who has forecast a foreign exchange loss on net exposed assets on consolidation of £15 million for the current financial year. The non-executive director is concerned with the detrimental impact he expects this loss to have on the company’s share price. He further suggests a number of possible hedging strategies to be undertaken by Forun’s foreign subsidiaries in order to reduce the exposure and the consolidated loss. These include: (i) early collection of foreign currency receivables; (ii) early repayment of foreign currency loans; (iii) reducing stock levels in foreign countries. Required (i) Discuss whether or not you agree with the managing director’s proposed strategy with respect to countries 1 to 4. (8 marks) Give reasoned advice as to the benefit to Forun plc of the non-executive (ii) director’s suggested hedging strategies. (10 marks)

(b) Forun has a number of intra-group transactions with its four foreign subsidiaries in six months time, and several large international trade deals with third parties. These are

summarised below. Intra-group transactions are denominated in US dollars. All third party international trade is denominated in the currency shown. It is now 1 June. Intra-group transactions Receiving company UK 1 2 3 4 Exports to third parties Receipts due in six months: £2,000,000 from Australia A$3,000,000 from Australia $12 million from the USA £1,800,000 from Germany UK Paying company Sub 1 Sub 2 $US’000 300 450 − 420 − 340 140 300 230 110 Sub 3 Sub 4

− 700 140 300 560

210 − 410 − 510

270 180 700 350 −

Receipts due in some time between three and six months: 32 billion lire from Italy Imports from third parties Payments due in six months: £3,000,000 to the USA A$3,000,000 to Australia 13 million Deutschemarks (DM) to Germany £2,000,000 to France Foreign exchange rates Spot 3 mths forward − 1.4990 1.4960 1.4720 − 1.4770 2.1460 − 2.1500 2.1780 − 2.1840 7.7050 − 7.7090 7.9250 − 7.9490 2.4560 − 2.4590 2.4140 − 2.4180 2,203 − 2,208 2,217 − 2,224

US$/£ Australian$/£ French Francs/£ DM/£ Lire/£

6 mths forward 1.4550 − 1.4600 2.2020 − 2.2090 8.0750 − 8.0990 2.3830 − 2.3870 2,225 − 2,232

September December

Futures market rates Sterling £62,500 contracts $/£ DM/£ 1.4820 2.4510 1.4800 2.4480

Minimum price movements are: $/£ 0.01 cents, DM/£ 0.01 pfennigs Foreign currency option rates Sterling £31,250 contracts (cents per £) Calls Puts September December September December 3.50 5.75 4.80 7.90 1.86 3.42 6.95 9.08 0.82 1.95 9.80 11.53 0.38 0.90 12.16 14.70

Exercise price $1.450/£ $1.475/£ $1.500/£ $1.525/£

Required (i) Explain and demonstrate how multilateral netting might be of benefit to Forun plc. (5 marks) (ii) Recommend, with supporting calculations, alternative hedging strategies that the company might adopt to protect itself against short-term foreign exchange exposure. The company is risk averse with respect to short-term foreign exchange risk. (17 marks) (Total 40 marks) Answer: Forun (a)(i) Candidates are expected to display knowledge of the value of given data to the strategic decision of where to engage in foreign direct investment, drawing attention to the limitations of such data, and other influences on economic exposure. The economic data presented by the managing director gives some indication of the likely future economic strength of the four countries, and could form part of a strategic evaluation. According to the purchasing power parity theory all of the foreign currencies are expected to depreciate in value relative to the pound sterling with the smallest depreciation in countries 1 and 4. Although PPP may hold quite well in the long run, there may be significant deviations from PPP in the short run. The impact of the other variables may be summarised in many ways. The table below is a simple assessment with a + for the two best countries, and a − for the two worst.

Inflation GDP growth Balance of payments (related to population) Base rate Unemployment Population (+ for larger markets) Currency reserves (related to population) IMF loans (related to population)

1 Comment + − + + + + + +

2 − + − − − + − +

3 − + + + + − + −

4 + + − + − − − −

Although country 1 scores highly, except for inflation, economic growth and interest rates country 4 scores poorly, and is heavily indebted to the IMF relative to its small population size. Other data such as per capita GNP and international indebtedness other than to the IMF would be useful to the analysis. The managing director’s major concern is economic exposure, the impact of foreign exchange rate changes on the sterling expected NPV of overseas operations. Strategic decisions should not be made on the basis of the above information alone. The information provides a macro-economic analysis. Even with a relatively weak economy at the micro level a subsidiary within a particular industry may perform well. Examining macro-economic data fails to give a complete picture. Additionally it is possible that a depreciation in the value of a foreign currency might have a beneficial effect rather than a detrimental effect on economic exposure of Forun. If the price elasticity of demand is such that export sales from the foreign subsidiary increase substantially because of the relatively cheaper prices in a depreciated currency, the overall effect in sterling NPV terms might be an increase, not a decrease. If the managing director is concerned about economic exposure one way to reduce such exposure is by diversifying international operations, and financing, among many different countries. Concentrating activities in two foreign countries might lead to greater economic exposure risk, not less. The manager’s strategy to concentrate on countries 1 and 4 is based upon incomplete information and is not recommended.

(ii) This question requires evaluation of suggested hedges against translation exposure, and whether or not such exposure should be hedged. The non-executive director is concerned about the effects of translation exposure, specifically on expected foreign exchange loss of £15 million. If a foreign currency is expected to depreciate relative to sterling, translation exposure may be reduced by reducing net exposed assets. Early collection by foreign subsidiaries of foreign currency receivables will not reduce net exposure (unless the foreign currency is expected to depreciate by more than the currency of the foreign subsidiary). A better tactic would be to delay collection of foreign currency receivables until after significant depreciation of the subsidiary’s currency had occurred, the receivables will then yield a higher amount of the subsidiary’s currency. From a group viewpoint early collection could increase translation exposure rather than reduce it. Early repayment of foreign currency loans could be beneficial, if the loans are in relatively hard currencies, and if the subsidiary has the funds available to make such a repayment without detrimental effects on its operations. Reducing stock levels in foreign countries will reduce net asset exposure. However, before this, or any other balance sheet hedging techniques are used, the effect on the efficient operation of the company must be considered. There is little point in reducing stock levels if this causes production bottlenecks or failure to satisfy customer demand, and potentially a loss of orders. The non-executive director is concerned about a loss on translation of £15 million. Translation losses are not realised economic losses. Part of such a loss may be from translating the historic cost of overseas fixed assets; in reality the sterling economic value of such assets may be little changed if inflation in the foreign country increases the market value of such assets. Hedging against translation losses might result in reducing rather than increasing sterling NPV as such hedges may be opposite in direction to hedges that would be undertaken to protect against transaction exposure. Will the reported £15 million loss have an adverse effect on Forun’s share price? If the stock exchange is efficient the company’s share price will react to relevant changes in the company’s expected cash flows, not reported translation losses. The reported loss could have little or no effect on share price. Hedging is normally undertaken to protect against the risk of transaction exposure, not translation exposure. (b)(i) Candidates are required to show knowledge of the advantages of multilateral netting within a multinational company, and how to estimate the benefits of such netting. Multilateral netting is an effective means of reducing the transactions costs associated with foreign exchange transactions that are payable to banks. The netting of Forun’s intra-company US dollar exposures gives the following net payments and receipts. $’000 3 4

UK 1

2

Total

Net

UK 1 2 3 4 Total

rec. receipts (payments) − 300 450 210 270 1,230 (470) 700 − 420 − 180 1,300 220 140 340 − 410 700 1,590 380 300 140 230 − 350 1,020 (110) 560 300 110 510 − 1,480 (20) _____ 1,700 _____ 1,080 _____ 1,210 _____ 1,130 _____ 1,500 _____ 6,620 ___ ___ −

payments

_____

_____

_____

_____

_____

_____

Some dollar payments will still need to be made from the UK, country 3 and country 4 to countries 1 and 2. However, such payments will total a maximum of $600,000 against the total trade value of $6,620,000, saving transactions and other costs on more than $6,000,000. (ii) Candidates are required to assess what short-term foreign exchange exposures require hedging using given data and to demonstrate how such exposures might be hedged using forward markets, currency futures and currency options. As Forun is risk averse with respect to short-term foreign exchange risk, the company is recommended to hedge against any transaction exposure hedging. In order to reduce foreign exchange transaction hedging should take place after establishing the net exposure position in all currencies. The net group dollar exposure on the intra-company trade is of course zero, as dollar receipts equal dollar payments. Hedging will be undertaken on the net transaction exposure of third party trade. Exposure (Note: Sterling transactions are not exposed!) Australia USA Germany million) Italy Receipts $3 million $12 million − L32 billion Payments $3 million − DM13 million − Net − $12 million (DM13 L32 billion

These net figures are the only ones that require hedging. Hedging may be undertaken on the forward foreign exchange market, currency futures market, or currency option markets. Forward market The relevant outright rates are:

US$/£ DM/£ Lire/£ $US receipts

3 months 1.4720 − 1.4770 2.4140 − 2.4180 2,217 − 2,224

6 months 1.4550 − 1.4600 2.3830 − 2.3870 2,225 − 2,232

$12 m = £8,219,178 1.46 DM13m = £5,455,308 2.383

DM payments

Lire receipts. As the date of the receipt is uncertain, an option forward contract will be used. This will be available at the least favourable exchange rate to Forun between three months and six months forward in this case the six month offer rate. L32 billion = £14,336,918 2,232

(3) Case for Group Study and Presentation Fidden (a) Discuss briefly 4 techniques a company may use to hedge against the foreign exchange risk involved in foreign trade (9 m) (b)Fidden is a medium sized UK company with export and import with USA. The following transactions are due within the next six months. Transactions are in the currency specified. Purchase of components, cash payment due in three months: £116,000, Sale of finished goods, cash receipt due in three months: $197,000 Purchase of finished goods for resale, cash payment due in six months: $447,000 Sale of finished goods, cash receipt due in six months:$154,000 Exchange rate (London market) $/£ Spot 1.7106-1.7140 Three month forward 0.82-0.77 cents premium Six months forward 1.39-1.34 cents premium Interest rates Three months or six months Sterling 2.5% Dollars 9%

Borrowing Lending 9.5% 6%

Foreign currency option prices (New York market) Prices are cents per £,contract size £12,500 Call Put Exercise price ($) March June Sep March June Sep 1.6 15.20 2.75 1.7 5.65 7.75 3.45 6.40 1.8 1.7 3.6 7.9 9.32 15.35 Assume that it is now Dec with three months to expiry of the march contract and that the option is not payable until the end of the option period, or when the option is exercised. You are required to : 1) calculate the net sterling receipts/payments that Fidden might expect for both its three and six month transactions if the company hedges foreign risk on (1) the forward exchange market (2) the money market(8m) 2 ) if the actual spot rate in six months time was with hindsight exactly the present six months forward rate, calculate whether Fidden would have been better to hedge

through foreign currency options rather than the forward market or money market(8m) 3) explain briefly what you consider to be the main advantage of foreign currency options. (5m)

(4) Interest Rate Hedge - Case for Group Study and Presentation Panon Panon plc has a commitment to borrow 6m in 5 months for a period of 4 months. A general election is due in 4 months time and the managers of Panon are concerned that interest rates could significantly increase just after election. Panon can currently borrow at LIBOR+1%. Three month LIBOR is 7.5%. Current LIFFE 500,000 sterling three month futures price are: Sept 92.60 Dec.92.10 Assume it is now the end of June and futures contracts mature at the end of the relevant month. Required: (a) illustrate how Panon plc could use a futures hedge to protect against its potential interest raet risk. The type and number of contract must be included in your illustration (10) (b) Estimate the basis risk for this hedge both now and at the time the contract is likely to be closed out. Comment upon the significance of your estimates for Panon. Illustrate your answer with reference to the impact of a 2% increase in LIBOR.(10)

PZP plc wishes to raise 15million of floating rate finance. The company’s bankers have suggested using a five year swap. PZP has an AAB rating and can issue fixed rate finance at 11.35% or floating rate at LIBOR plus 60 basis points. Foreten plc has only a BBC credit rating and can raise fixed rate finance at 12.8% or floating rate at LIBOR + 13.5% A five year interest rate swap on a 15million loan could be arranged with Gibbank acting as an intermediary for a fee of 10.25% per annum. PZP will only agree to the swap if it can make annual savings of at least 40basis points. LIBOR is currently 10.5%. Required: (a) Evaluate whether or not the swap is likely to be agreed. (3) (b) Estimating the present value of the differences in cask flow that would exit for PZP from using a floating rate swap rather than borrowing fixed rate directly in the market if (1) LIBOR moves to 11.8% after one year and then remains constant (2) LIBOR moves to 8.8% after three years and then remains constant. The market may be assumed to be efficient and the discount rate to be the prevailing effective floating rate swap rate for PZP. Interest may be assumed to be paid annually at the end of the year concerned.(10) Comment upon your findings and discuss whether they would be likely to influence PZP’s decision to undertake a swap. (7) (5) Option pricing

Question Gibb plc (a) Options in Gibbs plc are actively traded on the London traded options market. The chairman of the company does not understand how the option prices quoted are determined and has asked you for a brief report explaining the determinants of option values, Required: Outline the main determinants of the value of an option explaining how and why they affect the price of the option. (6 marks) (b) The chairman’s daughter is currently studying for a master degree at a well known university. She has told him that the best way to value an option is to use the Black Scholes Option valuation model. Required: place a value on a call option in Gibbs plc. The following information is available: The price of the share The exercise price The standard deviation Expiry date Risk free rate £5 £4.5 25% in 6 months 10.25% p.a. (5% per six month)

The value of a call option = Po{N(d1)} –Exe-rt{N(d2)} (5marks) (c) Required : use put-call parity theory to place a value on put option with the same exercise price and expiry date used for the call option in part (b) (5marks))
Answer for Gibbs Plc. (b) Valuing a call option using Black-Scholes Price of a share 5 The exercise price 4.5 The standard deviation 25% Expiry date Risk free rate 6 month 10.25% annually (5% half year)

The value of a call option:

D1=[logn((5/4.5) + (0.1025*0.5)) / (0.25 Sqr0.5)]+(0.25*Sqr/2) D1= 1) D2=0.7975 N(D1)=0.8354 N(D2)=0.7874 2)V=(0.8351*5)-(0.7874*(4.5*e to the power of –0.1025*0.5))=80.92 c).Valuing a put option

Value of put =0.095 (6) FDI Question Axmine (a) The managers of A, a major international copper processor are considering a JV with Traces, a company owing significant copper reserves in a South Amerincan country. If the JV were not to proceed A would still need to import from Traces. A’s CEO is concerned the government of Trace may impose some constraint to free trade which puts A at a competitive disadvantage in importing copper. A further director considers that this is unlikely due to the existence of WTO. You are required to briefly discuss possible forms of Nontarrif barrier that might affect A’s ability to import copper and how the existence of WTO might influence such barriers. (b) The proposed JV will be for an initial period of 4 years. Copper77 will be mined using a new techniques developed by A. A will supply machine at an immediate cost of 800 million pesos and 10 superviors at an annual salary of 40,000 pounds each at current price. Additionally A will pay half of the 1000million pesos per year (at current price ) local labour and other expenses will be increased in line with inflation in UK and South American country. Inflation in the south American country is currenly 100% per year, the government is attempting to control inflation and hopes to reduce it each year by20% of previous year’s rate; and 8%in UK which remains constant. JV will give A 50% shares of Traces’ copper production, with current market price at 1500pounds per 1,000kilogrammes. Trace’s production is expected to be 10million kilo each year and copper price is expected to rise 10% per year in pounds. At the end of 4 year A will be given choice to pull out of the venture or to negotiate another 4 year JV on difference terms. The current exchange rate is 140peso/pound. Future exchange rates may be estimated using the PPPT. A has no foreign operations. The cost of capital of company’s UK mining operations is 16% peryear. As this joint venture involves diversifying into foreign operations the company considers that a 2% reduction in cost of capital would be appropriate for this project. Corporate tax is at the rate of 20% per year in South and 35% per year in UK. A tax treaty exists between two countries and all foreign tax paid is allowable against any UK tax liability. Taxation is payable one year in arrears and a 25% straight line writing down allowance is available on the mahchinery in both countries. CF may be assume to occur at the year end except for the immediate cost of machinery. The machinery is expected to have negligible terminal value at the end of 4 years. You are required to prepare to report discussing whether A should agree with the JV. Relevant calculations shall be shown in the appendix. State clearly your assumptions made. (c) If the south American country is not able to control inflation and inflation were to

increase rapidly during the period of JV discuss the likely effect of very high inflation on the JV.

Research and development (R&D) costs associated with the two proposals are forecast to be as follows: Stoke £'000 780 850 Deal £'000 2,010 2,690 1,800

Year 1 Year 2 Year 3

All the costs stated above are at current price levels. Enterprise Health plc's tax advisor has warned that there is some doubt about the treatment that the Inland Revenue (IR) might apply to the R&D expenditure. IR might accept that the programme is 'scientific research', in which case the expenditure can be set fully against taxable income in the year in which it is incurred. Alternatively, IR might claim that the programme is 'acquisition of know-how', in which case the expenditure will qualify for 25% Writing Down Allowances on a reducing balance basis. The current rate of corporation tax is 35%.

Requirements

(a) Advise Enterprise Health plc which of the two proposals for the contract to develop the foot transplant should be accepted. State whether or not this advice depends on the tax treatment of the R&D expenditure. Support your advice with a full financial analysis. (15 marks) (b) After you have advised Enterprise Health plc as required in (a), you are informed of two developments: • the IR has advised that it will treat the R&D expenditure associated with both the alternative proposals as scientific research; • doubts have been expressed over the reliability of the demand forecast of 28 foot

transplants per year referred to in the scenario: it has been suggested that demand for foot transplants could range from 10 to 50 per year. Draw a diagram (which need not be perfectly to scale) to illustrate the sensitivity of the two alternative proposals to changes in the level of demand and to discuss the conclusions you draw from inspection of this diagram. (10 marks) (c) With regard to your answers to parts (a) and (b), discuss the following statement: 'Discounted cash flow (DCF) analysis appears to give unambiguous answers to most of the questions that arise during investment appraisal; however, DCF analysis usually incorporates a variety of approximations which are not apparent to the casual observer.' (5 marks)

(6)Merge and Acquisition Decison Question: Killisick Killisick plc wishes to acquire Holbeck plc. The directors of Killisick are trying to justify the acquisition to the shareholders of both companies on the grounds that it will increase the wealth of all shareholders. The supporting financial evidence produced by Killisick’s directors is summarised below: £000 Killisick Operating profit Interest payable Profit before tax Tax Holbeck 12,400 5,800 4,431 2,200 7,969 1,260 3,600

2,789

Earnings available to ordinary shareholders 5,l80 2,340 Earnings per share (pre-acquisition) 14.80 pence 29.25 pence Market price per share (pre-acquisition) 222 pence 322 pence Estimated market price (post-acquisition) 240 pence Estimated equivalent value of one old Holbeck share (post-acquisition) 360 pence Payment is to be made with Killisick ordinary shares, at an exchange ratio of 3 Killisick shares for every 2 Holbeck shares. Required:

(a) Show how the directors of Killisick produced their estimates of post-acquisition value and, if you do not agree with these estimates, produce revised estimates of postacquisition values. All calculations must be shown. State clearly any assumptions that you make (10 marks) (b) If the acquisition is contested by Holbeck plc, using Killisick’s estimate of its postacquisition market price calculate the maximum price that Killisick could offer without reducing the wealth of its shareholders. (5 marks) (c) The board of directors of Holbeck plc later informally indicate that they are prepared to recommend to their shareholders a 2 for I share offer. Further information regarding the effect of the acquisition on Killisick is given below: i. The acquisition will result in an increase in the total pre-acquisition after tax operating cash flows of £2.75 million per year indefinitely. ii. Rationalisation will allow machinery with a realisable value of £7.2 million to be disposed of at the end of the next year. iii. Redundancy payments will total £3.5 million immediately and £8.4 million at the end of the next year. iv. Killisick's cost of capital is estimated to be 14% per year. v. All values are after any appropriate taxation. Assume that the pre-acquisition market values of Killisick and Holbeck shares have not changed. Required: Recommend, using your own estimates of post-acquisition values, whether Killisick should be prepared to make a 2 for 1 offer for the shares of Holbeck. (7 marks) (d) Disregarding the information in (c) above and assuming no increase in the total postacquisition earnings, assess whether this acquisition is likely to have any effect on the value of debt of Killisick plc. (8 marks) (30 marks)

Answer: Killisick (a) The answer to this question depends heavily on what assumptions are made. The current price/earnings (P/E) ratios of Killisick and Holbeck are: Killisick 222 = 15:1 Holbeck 322 =11.1 14.80 29.25 Assuming that no synergy occurs, and that the earnings available to ordinary shareholders after the acquisition is the sum of the pre-acquisition earnings for the two companies, post-acquisition earnings total £7.52 million. Killisick has £5. I8m / £0. 148 = 35 million shares Holbeck has £2.34m/ £0.2925 = 8 million shares At an exchange ratio of 3 for 2 Killisick will need to issue 12 million new shares. Killisick's directors have assumed that the post-acquisition P/E ratio will be the same as Killisick's pre-acquisition P/E ratio 15:1. The post-acquisition earnings per share = £7.52 million = 16 pence. 47 million shares The estimated post-acquisition market price of Killisick shares is 16 pence x 15 = 240 pence. One old Holbeck share will be exchanged for 1.5 Killisick shares giving an estimated value per old Holbeck share of 240 pence x 1.5 = 360 pence. Killisick's directors are engaging in what is sometimes referred to as 'bootstrapping' the earnings per share. If no synergy occurs (including synergy through the improved management of Holbeck's assets) and if Holbeck's current share price is not undervalued in an inefficient market, it is very unlikely that the market will hold the P/E ratio of Killisick constant at 15: 1. In the absence of any reasons for shareholders' wealth to increase or decrease in a reasonably efficient market it is likely that the post-acquisition P/E ratio would be the weighted average of the two pre-acquisition P/E ratios. If there is no change in the total market value post-acquisition, the total value will be Killisick 35 million shares at 222 pence = £77,700,000 Holbeck 8 million shares at 322 pence = £25,760,000 £103,460,000 The value will be split 35 to existing Killisick shareholders = £77,044,681 or 220 pence per share 47 (or the total post-acquisition value divided by the total number of shares =£I03.46m / 47m = 220 pence) and 12 to existing Holbeck shareholders = £26,415,319 or 330 pence per share. 47

Holbeck's shareholders experience a slight increase in current wealth because the share exchange ratio of 3 for 2 is more favourable than the ratio of the companies' market prices (322 / 222 = 1.45 for 1 or 2.9 for 2). This gain is at the expense of Killisick's shareholders. As Killisick is paying more than the current market value for Holbeck the current wealth of its shareholders will fall slightly. If any change in expected shareholder wealth occurs because of the acquisition, or if the market is not efficient, different estimated values will result. (7) Case for Group Study and Presentation Question Pricut Question: Pricut
The directors of Pricut plc, a food retailer with 20 superstores, are proposing to make a takeover bid for Verlot plc, a company with six superstores in the north of England. Pricut will offer four of its ordinary shares for every three ordinary shares of Verlot. The bid has not yet been made public. Summarised Accounts Balance sheets as at 31 March 1996 Pricut plc £ million Land and buildings (net) Fixed assets (net) Current assets Stock Debtors Cash 328 12 44 ___ 63.0 Creditors: amounts falling due in less than one year Creditors Dividend Taxation 447 12 22 ___ (50.1) Creditors: amounts falling due after more than one year (481) 46.1 2.0 2.0 ____ 384 51.4 6.3 5.3 ___ 483 150 633 Verlot plc £ million 42.3 17.0 59.3

14% loan stock Floating rate bank term loans (17.5)

(200) (114) 222 54.7

-

Shareholders funds Ordinary shares (25 pence par) 20.0 Reserves 34.7 222 54.7 Profit and loss accounts for the year ending 31 March 1996 Pricut plc £ million Turnover Earnings before interest and tax Net interest Profit before tax Taxation Available to shareholders Dividend Retained earnings 1,130 115 40 75 25 50 24 26 Verlot plc £ million 181 14 2 12 4 8 5 3 147 75 Ordinary shares (50 pence par)

The share price of Pricut plc is currently 232 pence, and of Verlot plc 295 pence. The loan stock price of Pricut plc is £125. Recent annual growth trends: Dividend EPS Pricut plc Verlot plc 7% 7% 8% 10%

Rationalisation following the acquisition will involve the following transactions (all net of tax effects): (i) Sale of surplus warehouse facilities £6.8 million. (ii) Redundancy payments £9.0 million. (iii) Wage savings of £2.7 million per year for at least five years. Pricut's cost of equity is estimated to be 14.5%, and weighted average cost of capital 12%. Verlot's cost of equity is estimated to be 13%. Required (a) Discuss and evaluate whether or not the bid is likely to be viewed favourably by the shareholders of both Pricut plc and Verlot plc. Include discussion of the factors that are likely

to influence the views of the shareholders. All relevant calculations must be shown. (14 marks) (b) Discuss the possible effects on the likely success of the bid if the offer terms were to be amended to a choice of one new Pricut plc 10 year zero coupon debenture redeemable at £100 for every 10 Verlot plc shares, or 325 pence per share cash. Pricut plc could currently issue new 10 year loan stock at an interest rate of 10%. All relevant calculations must be shown. measures: (i) Announce that their company's profits are likely to be doubled next year. Alter the articles of association to require that at least 75% of shareholders need to approve an acquisition. (8 marks) (c) The directors of Verlot plc have decided to fight the bid and have proposed the following

(ii)

(iii) (iv)

Persuade, for a fee, a third party investor to buy large quantities of the company's shares. Introduce an advertising campaign criticising the performance and management ability of Pricut plc.

(v)

Revalue fixed assets to current values so that shareholders are aware of the company's true market values.

Required Acting as a consultant to the company give reasoned advice on whether or not the company should adopt each of these measures. (8 marks) (Total 30 marks)

(8)International Capital Structure Question: Wemere The managing director of Wemere, a medium-sized private company, wishes to improve the company’s investment decision-making process by using discounted cash flow techniques. He is disappointed to learn that estimates of a company’s cost of capital usually require information on share prices which, for a private company, are not available. His deputy suggests that the cost of equity can be estimated by using data for Folten plc, a similar sized company in the same industry whose shares are listed on the AIM, and he has produced two suggested discount rates for use in Wemere’s future investment appraisal. Both of these estimates are in excess of 17% per year which the managing director believes to be very high, especially as the company has just agreed a fixed rate bank loan at 13% per year to finance a small expansion of existing operations. He has checked the calculations, which are numerically correct, but wonders if there are any errors of principle. Estimate 1: capital asset pricing model Data have been purchased from a leading business school: Equity beta of Folten 1.4 Market return 18% Treasury bill yield 12% The cost of capital is 18% + (18% - 12%) 1.4 = 26.4%. This rate must be adjusted to include inflation at the current level of 6%. The recommended discount rate is 32.4%. Estimate 2: dividend valuation model Year Folten plc Average share price Dividend per share (pence) (pence) 19X5 193 9.23 19X6 109 10.06 19X7 96 10.97 19X8 116 11.95 19X9 130 13.03 The cost of capital is

D1 14. 20 = = 11. 01% P - g 138 − 9

where D1 = expected dividend P = market price g = growth rate of dividends (%) When inflation is included the discount rate is 17.01%. Other financial information on the two companies is presented below: Wemere Folten £’000 £’000

Fixed assets Current assets Less: Current liabilities

7,200 7,600 7,600 7,800 3,900 3,700 10,900 11,700

Financed by: Ordinary shares (25 pence) 2,000 1,800 Reserves 6,500 5,500 Term loans 2,400 4,400 10,900 11,700 Notes: (1) The current ex-div share price of Folten plc is 138 pence. (2) Wemere’s board of directors has recently rejected a take-over bid of £10.6 million. (3) Corporate tax is at the rate of 35%. You are required: (a) to explain any errors of principle that have been made in the two estimates of the cost of capital and produce revised estimates using both of the methods. State clearly any assumptions that you make. (b) to discuss which of your revised estimates Wemere should use as the discount rate for capital investment appraisal. (c) to discuss whether discounted cash flow techniques including discounted payback are useful to small unlisted companies.

Answer: Wemere The first error made is to suggest using the cost of equity, whether estimated via the dividend valuation model or the capital asset pricing model (CAPM) as the discount rate. The company should use its overall cost of capital, which would normally be a weighted average of the cost of equity and the cost of debt. Errors specific to CAPM (i) The formula is wrong. It wrongly includes the market return twice. It should be: r = rf + (rm − rf) β (ii) The equity beta of Folten reflects the financial risk resulting from the level of gearing in Folten. It must be adjusted to reflect the level of gearing specific to Wemere. It is also likely that the beta of an unlisted company is higher than the beta of an equivalent listed company. (iii) The return required by equity holders ie, the cost of equity, is inclusive of a return to allow for inflation. Errors specific to the dividend valuation model (i) The formula is wrong. It should be:
D1 +g P

(ii) Treatment of inflation - as for CAPM. (iii) Again the impact of the difference in the level of gearing of Wemere and Folten on the cost of equity has not been taken into account (to do so would require Modligiani and Miller’s theory of capital structure which the examiner would specifically mention if it is to be used). Revised estimates of cost of capital CAPM: required return = rf + (rm − rf) β For Folten β Equity ungeared = β Asset = β Equity geared ×
E D(1- t) + β D× E + D(1- t) E + D(1- t)

Assume β Debt = 0, D = 4,400 E = 1.38 × 1,800 × 4 (= share price × no. of equity shares) = £9,936,000 9 , 936 ∴ β Equity ungeared = 1.4 × = 1.087 9 , 936 + 4 , 400(1 − 0. 35) For Wemere Assume β Debt = 0, D = 2,400, Equity value of £10.6 million, debt costs of 13%. 10, 600 ∴ 1.087 = β Equity geared × 10, 600 + 2 , 400 (1 − 0.35) 1.087 = 0.872 β Equity geared β Equity geared = 1.25 Cost of equity = 12 + (18 -12) × 1.25 =

∴

19.5%

∴

WACC = 19.5% ×

10, 600 2 , 400 + 13(1-0.35) × 10, 600 + 2 , 400 10, 600 + 2 , 400

= 17.5%

Dividend valuation model Folten i=
D1 +g P

We calculate dividend growth rate: 9.23 (1 + g)4 = 13.03 (1 + g)4 = 1.412 1+g = 1.09 g = 9% D1 = = i = 13.03 (1 + 0.09) 14.20p
14. 20 + 0.09 138

∴

=

0.193 ie, 19.3%

∴

WACC

=

19.3 ×

10, 600 2 , 400 + 13(1 − 0.35) × 13, 000 13, 000

=

17.3%

(b) Both methods result in a discount rate of approximately 17.5%. They are both based on estimates from another company which has, for example, a different level of gearing. The cost of equity derived using the dividend valuation model is based on Folten’s dividend policy and share price and not that of Wemere. The dividend policy of Wemere (eg, the dividend growth rate) is likely to be different. CAPM involves estimating the systematic risk of Wemere using Folten. The beta of Folten is likely to be a reasonable estimate, subject to gearing, of the beta of Wemere. CAPM is therefore likely to produce the better estimate of the discount rate to use. However, this will be incorrect if the projects being appraised have a different level of systematic risk to the average systematic risk of Folten’s existing projects or if the finance used for the project significantly changes the capital structure of Wemere. (c) Discounted cash flow techniques allow for the time value of money and should therefore be used for all investment appraisal including that carried out by small unlisted companies. It is important for all managers to recognise that money received now is worth more than money received in the future. Discounting enables future cash flows to be expressed in terms of present value and for net present value to be calculated. A positive net present value indicates that the return provided by the project is greater than the discount rate. One non-discounting method - accounting rate of return - is used because it employs data consistent with financial accounts, but it is not theoretically sound and is not recommended as a final decision arbiter. Nevertheless it registers appreciation of the impact of a new project on the financial statements and thus likely impact on users of these statements.

Discounted payback measures how long it takes to recover the initial investment after taking account of the time value of money. It is a useful initial screening method but should not be used alone since it ignores cash flows outside the payback period. A problem for all companies, not only small unlisted companies, is estimation of the discount rate. This can be partly overcome by calculating the internal rate of return (IRR) ie, the discount rate at which the NPV is zero. This provides a ‘break-even’ cost of capital - ie, a yield which is then acceptable provided the capital cost of the business ‘could not be lower’. (9) Case for Group Study and Presentation
Hotalot Hotalot plc produce domestic electronic heaters. The company is considering diversify into the production of freezers. Data on four listed companies in the freezer industry and for Hotlot are shown as follows: Freeze up Glowcold Shiverall Topice Hotalot (‘000) Fixed assets Workingcapital 24400 Financed by Bank loans Reserve 5300 15100 24400 Turnover Earnings per Share(in pence) Dividend per Share(in pence) Beta equity 11 1.1 20 10:1 1.3 1.25 15 14 9:1 1.05 40 14:1 0.95 8:1 Price/earnings ratio 12:1 25 53.3 38.1 32.2 106 2600 9000 10200 31800 39200 18200 17500 4000 12800 17400 4000 11900 Ordinary shares(1) 4000 3500 22100 5300 33300 45000 14800 9600 31800 24600 7200 28100 12500 20600 11100 9600 12700 33300

39200 22100

35200

42700

46300

28400

(1) the par value per ordinary share is 25p for Freezeup and Shiverall,50p for Topice and £1 for glowcold and hotalot. Corporate debt may be assumed to be almost risk free and is available to Hotlat at 0.5% above the Treasury bill rate which is currently 9% per year. Corporate taxes are payable at a rate of 35%. The market return is estimated to be 16% per year. Hotlat does not expect its financial gearing to change significantly if the company diversifies into the product freezers.

Required: (a) The equity beta of Hotlat is 0.95 and the alpha value is 1.5%. Explain the meaning and significance of these values to the company. (5 marks) (b) Estimate what discount rate Hotalot should use in the appraisal of its proposed diversification into freezer production (12 marks) (c) Corporate debt is often assumed to be risk free. Explain whether this is a realistic assumption and calculate how important this assumption is likely to be to Hotalot’s estimate of a discount rate in (b) (7 marks) (d) Discuss whether systematic risk is the only risk that Hotalot shareholders should be concerned with (6 marks)

(10) International Taxation in MNE Question: Foot Transplants A new medical institution has been established known as The Thaalmer Hospital and Institute of Medicine (the Thaalmer). The purpose of the Thaalmer is both to provide treatment to patients and to undertake research into particular areas of healthcare. The Thaalmer is owned by Enterprise Health plc. It is the intention of the Thaalmer's directors that it should be operated as a commercial venture. Accordingly, Enterprise Health plc is taxed as an ordinary business and does not enjoy any form of charitable status. The Thaalmer employs about 300 domestic, technician and nursing staff on a full-time basis. However, most of its surgical and research work is performed by professional staff engaged on a variety of part-time and temporary contracts. Patients are referred to the Thaalmer by medical insurance companies and the British National Health Service. Most standard treatments are invoiced at prices negotiated with the British Healthcare Federation. Such prices are reviewed annually to take account of inflation and other changing conditions. Research is organised in separate programmes. Each research project forms a programme which must be justified on a commercial basis before it is allowed to proceed. All programmes are expected to result in new or developed treatments which will eventually generate patient referrals and hence income. A research programme is being considered for the development of a new treatment - the foot transplant. Preliminary research has indicated that the successful development of the foot transplant is feasible. The Thaalmer has invited proposals from several leading experts for the contract to carry out the programme.

It is expected that once the treatment has been developed, the Thaalmer will have a demand for 28 foot transplants per year at a price of £100,000 each (at current price levels). Enterprise Health plc evaluates projects on cash flows at future prices over an eight-year time horizon and using a 17% pre-tax cost of capital. Inflation is expected to average 2.8% per year over the next eight years. Two proposals for the contract to develop the foot transplant are received which are judged to be worthy of further consideration. Professor Kane from the University of Stoke advocates a low-technology approach concentrating on the advanced use of traditional surgical technique and drug therapy (the Stoke proposal). By following this route it is believed that the treatment can be developed in two years to the point where it can be used commercially. It is forecast that the variable cost of each foot transplant using the Stoke proposal treatment will be £80,000. Doctor Lea from Deal Hospital advocates a high-technology approach involving the development of new equipment and associated surgical technique (the Deal proposal). By following this route it is believed that the treatment can be developed in three years to the point where it can be used commercially. It is forecast that the variable cost of each foot transplant using the Deal proposal treatment will be £25,000. Research and development (R&D) costs associated with the two proposals are forecast to be as follows: Stoke £'000 780 850 Deal £'000 2,010 2,690 1,800

Year 1 Year 2 Year 3

All the costs stated above are at current price levels. Enterprise Health plc's tax advisor has warned that there is some doubt about the treatment that the Inland Revenue (IR) might apply to the R&D expenditure. IR might accept that the programme is 'scientific research', in which case the expenditure can be set fully against taxable income in the year in which it is incurred. Alternatively, IR might claim that the programme is 'acquisition of know-how', in which case the expenditure will qualify for 25% Writing Down Allowances on a reducing balance basis. The current rate of corporation tax is 35%.

Requirements (a) Advise Enterprise Health plc which of the two proposals for the contract to develop the foot transplant should be accepted. State whether or not this advice depends on the tax treatment of the R&D expenditure. Support your advice with a full financial analysis. (15 marks) (b) After you have advised Enterprise Health plc as required in (a), you are informed of two developments: • the IR has advised that it will treat the R&D expenditure associated with both the alternative proposals as scientific research; • doubts have been expressed over the reliability of the demand forecast of 28 foot transplants per year referred to in the scenario: it has been suggested that demand for foot transplants could range from 10 to 50 per year. Draw a diagram (which need not be perfectly to scale) to illustrate the sensitivity of the two alternative proposals to changes in the level of demand and to discuss the conclusions you draw from inspection of this diagram. (10 marks) (c) With regard to your answers to parts (a) and (b), discuss the following statement: 'Discounted cash flow (DCF) analysis appears to give unambiguous answers to most of the questions that arise during investment appraisal; however, DCF analysis usually incorporates a variety of approximations which are not apparent to the casual observer.' (5 marks) (Total: 30 marks) Answer: Foot transplants (a) Advice to Enterprise Health plc regarding foot transplants The estimated net present values of the two proposals are set out below. Stoke £'000 Value of transplants (Appendix A - real cost) 1,443 Cost of R&D (before tax relief) (Appendix B) (1,452) (11) NPV of tax relief on R&D - fully allowed (Appendix B) 508 - treated as know-how (Appendix C) 401

Deal £'000 4,327 (5,599) (1,272) 1,960 1,554

These figures show that both projects are viable, whichever tax treatment is adopted.

If the R&D is fully allowed, Stoke gives an NPV of £497,000 and Deal an NPV of £688,000, so the latter is preferable. If the R&D is treated as know-how expenditure, Stoke gives an NPV of £390,000 and Deal an NPV of £282,000, so Stoke becomes preferable. Appendix A (a) Stoke proposal - net present value of foot transplants Each transplant gives a contribution of £100,000 - £80,000 = £20,000 at current price levels; this yields £20,000 × 0.65 = £13,000 after tax. The NPV can be calculated in two ways: either discount real cash flows at the real cost of capital; or discount money flows at the money cost of capital. This answer is based on the first method. (i) Real cost of capital
1+ m where r 1+ i

1+r=

=

real cost of capital

m i

= =

money cost of capital inflation rate

Assume that the post-tax money cost of capital is 17% × 0.65 = 11.05%, say 11%.

111 . ≈ 1.08; so e = 0.08 or 8%. 1.028 Assume that the eight-year time horizon includes the two years' development, so that income is received from time 3 to time 8 inclusive. Also assume that tax is paid in the same year as taxable profits arise.
Then 1 + e = NPV of one transplant = £13,000 × AF (t3 − t8) @ 8% = £13,000 × [AF (t1 − t8) − AF (t1 − t2)] = £13,000 × (5.747 − 1.783) = £51,532 × £51,532 = £1,442,896. So 28 annual transplants will have a NPV of 28 (b) Deal proposal - net present value of foot transplants Each transplant gives an after-tax contribution of (£100,000 − £25,000) × 0.65 = £48,350 in current terms. Using the same two approaches as for the Stroke proposal, bearing in mind that income will start one year later. (i) Effective cost of capital NPV of one transplant = £48,750 × AF (t4 − t8) @ 8% = £48,750 × [AF (t1− t8) − AF (t1 − t3)] = £48,750 × [5.747 − 2.577] = £154,538

So 28 annual transplants will have a NPV of 28 × £154,538 = £4,327,064. Appendix B Net present cost of R&D - fully allowed Time Inflated flows* Stoke Deal Deal £'000 £'000 £'000 802 2,066 898 2,843 1,955 DF at 11% Present values Stoke £'000 0.901 0.812 0.731 722.6 729.2 _____ 1,451.8 1,861.5 2,308.5 1,429.1 _____ 5,599.1

1 2 3

* The flows are current costs inflated by 1.028 (time 1), 1.0282 (time 2) or 1.0283 (time 3). Since the expenditure will be fully allowed against tax as it arises, the NPV of the tax relief is 35% × the net present cost. So NPV (Stoke) = 1,451.8 × 0.35 = 508.13 NPV (Deal) = 5,599.1 × 0.35 = 1,959.69 Appendix C Net present cost of R&D - treated as know-how Time Expenditure Allowance at 25% Stoke Deal Stoke Deal £'000 £'000 £'000 £'000 1 802 2,066 200 516 2 602+ 1,550+ 375 1,098 898 2,843 3 1,125 3,295+ 281 1,312 1,955 4 844 3,938 211 984 5 633 2,954 158 738 6 475 2,216 119 554 7 356 1,662 89 416 8 267 1,246 267(BA)1,246(BA) (BA = balancing allowance) It is assumed that the Inland Revenue will permit the balancing allowance to be made in

DF at 11% £'000 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434

Present values Stoke Deal £'000 £'000 180 465 304 892 205 959

139 648 94 438 64 296 43 200 116 541 1,145 4,439

year 8 once the benefit of the R&D has been consumed, since R&D expenditure is put in a separate 'pool'. The writing down allowances will be set against tax each year, so the NPV of each to the company is NPV of allowances multiplied by 35%: NPV (Stoke) = NPV (Deal) = 1,145 × 0.35 = 400.8 4,439 × 0.35 = 1,553.7

(b) Sensitivity

At current estimated levels of demand (28 per annum), Stoke's NPV is £497,000, while Deal's is £688,000 (using the 'fully allowed' figures from part (a)). Using the 'real cost' figures in Appendix A of part (a), the NPV of one transplant is £52,000 for Stoke and £155,000 for Deal. Looking at the two extreme values for possible demand, using 28 as a basis Stoke £'000 Deal £'000

Demand 10 − 18 × 155 = − Change in contribution − 18 × 52 = − 936 2,790 ∴ Expected NPV (497 − 936) = − 439 (688 − 2,790) = − 2,102 Demand 50 Change in contribution + 3,410 ∴ Expected NPV 4,098 (497 + 1,144) = + 1,641 (688 + 3,410) =

+ 22 × 52

= + 1,144

+ 22 × 155

=

NPV £m

4 3 2 1 0 -1 -2 x 10 x x

x

Deal

Stoke Number of transplants per annum

28

50

As is predictable, from Deal's higher contribution per transplant, Deal's NPV is far more sensitive to changes in demand than is Stoke's. Stoke breaks even at a slightly lower level (about 19 transplants, from the graph), but Deal's NPV increases rapidly, overtaking Stoke's at about 26 transplants (reading from the graph). (c) There are two types of approximation used in DCF analysis. The first, and less significant, is mathematical. Discount factors to two or three decimal places are used and calculations are often carried out in round thousands or millions. However, a greater mathematical accuracy would be misleading, as the second type of approximation lies in the use of estimates. Investment appraisal, by its very nature, involves predictions of future cash flows, inflation rates, tax rates, interest rates and so on. Some of these may be easy to predict, for example if a fixed price has been agreed on a contract spanning a number of years; but most of them can be estimated only very roughly. For example, probably the two least accurate estimates given in the scenario are the rate of inflation (which has been applied to all cash flows) and demand. In many instances the effect of changing the estimates can be investigated using sensitivity analysis, as in part (b), but ultimately, any investment decision will be based on approximate data.
(11) Case for Student Group Presentation Question: KYT Inc. Assume that is now 30 June. KYT Inc. is a company located in the USA that has a contract to purchase goods from Japan in two months time on 1 September. The payment is to be made

in yen and will total 140 million yen. The managing director of KYT Inc wishes to protect the contract against adverse movements in foreign exchange rates, and is considering the use of currency futures. The following data are available. Spot foreign exchange rate: Yen/$ 128.15 Yen currency futures contracts on SIMEX (Singapore Monetary Exchange) Contract size 12,500,000 yen, contract prices are in $US per yen. Contract prices: September 0.007985 December 0.008250 Assume that futures contracts mature at the end of the month. Required: (a) Illustrate how KYT might hedge its foreign exchange risk using currency futures. (4 marks) (b) Show what basis risk is involved in the proposed hedge. (3 marks)

(c) Assuming the spot exchange rate is 120 yen/$ on 1 September and that basis risk decreases steadily in a linear manner, calculate what the result of the hedge is expected to be. Briefly discuss why this result might not occur. Margin requirements and taxation may be ignored. (8 marks) (15 marks) (12) Case for Student Group Presentation Question Kulpar The finance director of Kulpar plc is concerned about the impact of capital structure on the firm’s value and wishes to investigate the effect of different capital structures. He is aware that as gearing increases the required return on equity will also increase and the firms’ interest cover is likely to increase. An increase in interest cover can lead to a change in firms’ credit rating by the leading rating agent. He has been informed the following changes are likely: Interest Cover Credit rating Cost of long term debt More than 6.5 AA 4-6.5 1.5-4 A BB 9% 11% 8%

The firm is now A Summarised financial data million pounds Net operating income 110 Depreciation 90 Interest Tax 30% Net Income Capital spending 22 68 47.6 20 20.4 Taxable income 20 Earnings before Interest and tax

Market value of equity is 458 million and of debt 305, Kulpar’s equity beta is1.4. The beta of debt may be assumed zero. The risk free rate is 5.5% and the market return 14%. The firms growth rate of cash flow may be assume to be constant and to be unaffected by any change in capital structure. Required: (a) Determine the likely effect on firms cost of capital and corporate value if the firms capital structure was: 80% equity,20% debt by market value 40% equity , 60% debt by market value recommend which capital structure should be used. Any change in capital structure will be achieved by borrowing to repurchase exiting equity oro by using additional equity to redeem exiting debt as appropriate. The current total firm value is consistent with the growth model CF1/(k-g) applied on a corporate basis,CF1 is next years free cash flow, k is the WACC and g the expected growth rate. Company free cash flow may be estimated using EBIT(1-t) + depreciation – capital spending. State clearly any assumptions you make. (20 marks) (b) Discuss possible reasons for errors in the estimating value in part a above

(13) Kulpar The finance director of Kulpar plc is concerned about the impact of capital structure on the firm’s value and wishes to investigate the effect of different capital structures. He is aware that as gearing increases the required return on equity will also increase and the firms’ interest cover is likely to increase. An increase in interest cover can lead to a change in firms’ credit rating by the leading rating agent. He has been informed the following changes are likely: Interest Cover Credit rating Cost of long term debt More than 6.5 AA 8%

4-6.5 1.5-4

A BB

9% 11%

The firm is now A Summarised financial data million pounds Net operating income 110 Depreciation 90 Interest Tax 30% Net Income Capital spending 22 68 47.6 20 20.4 Taxable income 20 Earnings before Interest and tax

Market value of equity is 458 million and of debt 305, Kulpar’s equity beta is1.4. The beta of debt may be assumed zero. The risk free rate is 5.5% and the market return 14%. The firms growth rate of cash flow may be assume to be constant and to be unaffected by any change in capital structure. Required: (a)Determine the likely effect on firms cost of capital and corporate value if the firms capital structure was: 80% equity,20% debt by market value 40% equity , 60% debt by market value recommend which capital structure should be used. Any change in capital structure will be achieved by borrowing to repurchase exiting equity oro by using additional equity to redeem exiting debt as appropriate. The current total firm value is consistent with the growth model CF1/(k-g) applied on a corporate basis,CF1 is next years free cash flow, k is the WACC and g the expected growth rate. Company free cash flow may be estimated using EBIT(1-t) + depreciation – capital spending. State clearly any assumptions you make. (20 marks) (b) Discuss possible reasons for errors in the estimating value in part a above (10 marks)

Interest Rate Swap (14)Manling plc has 14million of fixed rate loans at an interest rate of 12% per year which are due to mature in one year. The company’s treasurer believes that interest rates are going to fall but dose not wish to redeem the loans because large penalties exist for early redemption. Manling’s bank has offered to arrange an interest rate swap for one year with a company that has obtained floating financed at London Interbank Offered Rate (LIBOR) plus 1.125%. The bank will charge each of the companies an arrangement fee of 20,000 and the proposed

terms of the swap are that Manling will pay LIBOR plus 1/1/2% to the other company and receive from the company 11.625% Corporate tax is at 35% and the arrangement fee is a tax allowable expense. Manling could issue floating rate debt at LOBOR plus 2% and the other company could issue fixed rate debt at 113/4%. Assume that any tax relief is immediately available. Required: (a)Evaluate whether Manling plc would benefit from the interest rate swap (1) If LIBOR remains at 10% for the whole year (2) If LIBOR falls to 9% after six months. (8) (b) If LIBOR remains at 10% evaluate whether both companies could benefit from the interest rate swap if the terms of the swap were altered. Any benefit would be equally shared. (7) (15)Murwarld The corporate treasury team of Murwald plc is debating what strategy to adapt to interest rate risk management. The company’s financial projections show an expected cash deficit in three months time of 12million, which will last for a period of approximately six months. Base rte is currently 6% per year and Murwald can borrow at 1.5% over base or invest at 1% below base. The treasury team believes economic pressure from reunification of Germany will soon force Germany to raise interest rates by 2% per year, which can lead to a similar rise in UK interest rates. The Bundesbank move is not certain as there has recently been significant economic pressure on Germany from other European Union countries not to raise interest rates. In UK the economy is still recovering from a recession and representatives of industry are calling for interest rates to be cut by 1%. Opposing representations are being made by pensions who don’t wish their investment income to fall further due to an interest rate cut. The corporate treasury team believes interest rates are more likely to rise than fall and does not want interest payments during the six month period to increase by more than 10,000 from the amounts that would be paid at current interest rates .It is now December 1st. LIFFE price (1 Dec) Futures LIFE 500,000 three month sterling interest rate (point of %100) Dec 93.75 Mar 93.45 Jun 93.10 Options LIFFE 500,000 short sterling options (points of 100%) Calls Puts Exercise price June June 9200 3.33 9250 2.93 9300 2.55 0.92 9350 2.2 1.25 9400 1.74 1.84 9450 1.32 2.90 9500 0.87 3.46 Required (a) Illustrate results of futures and option hedges if by 1 march (1) interest rate rise by 2% Futures prices move by 1.8% (2) Interest rate fall by 1% Futures prices move by 0.9% Recommend with reasons how Murwald plc should hedge its interest rate exposure all relevant calculations must be shown. Taxation transactions costs and margin requirements may be ignored. State clearly the assumptions you have made (22).

(b) Discuss the advantages and disadvantages of other derivative products that Murwald might have used to hedge the risk (8)