Strategic FinancialManagement

PART 3

WEDNESDAY 13 JUNE 2007

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A BOTH questions are compulsory and MUST beanswered

Section B TWO questions ONLY to be answered

Formulae sheet, present value, annuity and standard normaldistribution tables are on pages 9, 10, 11 and 12

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examinationhall

The Association of Chartered Certified Accountants

Pape

r 3.7

Section A – BOTH questions are compulsory and MUST be attempted

1 Partsea plc, a UK company, currently exports to a developing country, Hotternia. Hotternia has recently enjoyed aperiod of sustained economic growth, and inflation has reduced from 60% per year to 10% per year during the lastthree years. Partsea wishes to expand its sales in Hotternia and is considering either foreign direct investment or alicensing deal with KBD, a large Hotternian company.

Foreign Direct InvestmentForeign direct investment would involve the purchase of an existing competitor in Hotternia, expansion of its facilitiesand the introduction of new technologically advanced machinery. A purchase price of 120 million Hotternian dollars($H) has been agreed for the Hotternian company, in addition to which $H70 million will be needed for expansionof buildings, and $H35 million for working capital. The purchase of the Hotternian company and the working capitaloutlay would take place immediately, the other cash outflows would occur at the end of year 1. The new machinerywill be supplied from the UK parent company at a cost of £4 million, has an expected working life of four years, andwill increase the parent company’s pre-tax net cash flow in year 1 by £1 million. Tax allowable depreciation isavailable in Hotternia on the new machinery on a straight line basis at 25% per year from the beginning of year two.The existing Hotternian company has fully depreciated its machinery.

Production and sales is expected to be 1 million units at a price of $H150 per unit in the first year as existingoperations continue in the Hotternian company, and 2·5 million units per year for the remainder of Partsea’s five-yearplanning horizon. Sales prices are expected to increase after year 1 in line with Hotternian inflation.

At the end of five years the investment, including working capital, is expected to have a total after tax realisable valueof $H150 million.

Variable costs per unit ($H) are expected to be:

Year 1 Year 2Labour 35·0 28·6Materials 33·0 32·0Distribution 8·0 9·0

Variable costs after year 2 are expected to increase in line with inflation in Hotternia for the relevant year.

Fixed costs in year 1 are expected to be $H23 million, increasing to H$40 million in each of years 2-5.

Semi-finished components for the product will be imported from another of Partsea’s subsidiaries in Bottoniland fromyear two onwards at a fixed price of 5 Bottoniland tala (Bt) per unit. 25% of this price represents a profit element tothe Bottoniland company.

LicensingUnder a licensing agreement Partsea would permit KBD to manufacture and market its product for an initial periodof four years commencing in year 2. Partsea would sell the £4 million new machinery to KBD in year 1, and wouldalso insist on a maintenance contract for the machinery for which it would charge a fixed rate of £500,000 per year.This is double the expected annual cost of maintenance. Partsea would also supply two members of staff to Hotterniato monitor quality control. The cost of these staff (salaries and other expenses) is expected to be £200,000 per yearin total at current prices.

KBD would pay Partsea a fee of $H20 per unit for the license, increasing after year 2 by the rate of inflation inHotternia. KBD expects to sell 2 million units per year. Partsea would not have a legal presence in Hotternia and wouldnot be liable for Hotternian tax.

Other information:

Exchange rates $H/£ Bt/£Spot 15·80 4·2

2

Forecast inflation rates

Year UK Hotternia Bottoniland1 2% 10% 5% 2 3% 8% 5%3 3% 8% 5% 4 3% 8% 5% 5 3% 8% 5%

Corporate taxation is at the rate of 20% per year in Hotternia, and 30% per year in both the UK and Bottoniland.Bilateral tax treaties exist between each pair of countries. Tax is payable in the year that the tax liability arises.

The relevant risk-free rate is 5% and market return 12%. The beta of the proposed foreign direct investment isestimated to be 1·3.

Partsea expects its current exports to Hotternia from the UK to fall by 500,000 units per year, which currently yieldsa pre-tax net cash flow of £700,000. This would occur with both FDI and licensing.

It is Partsea’s policy to remit all available annual cash flows from overseas subsidiaries to the UK.

Required:

Evaluate whether Partsea should expand its sales in Hotternia by using foreign direct investment or licensing.Relevant calculations, and discussion of other information that would assist the investment decision, must beincluded as part of your evaluation.

State clearly any assumptions that you make. Approximately 31 marks are available for calculations and 9 marksfor discussion.

(40 marks)

3 [P.T.O.

2 Greffer plc is reviewing its plans for the next three years.

Sales are forecast to increase by 5% per year from their current level of £55 million for three years and then to remainconstant. Variable operating costs have recently been steady at 65% of sales, and fixed costs at £9.8 million.

Capital allowances, for the last financial year ending March 31 were £6·2 million, estimated on a reducing balancebasis at 25% per year. No tax allowable capital investment is planned for the next three years.

Summarised balance sheet as at 31 March:£ million

Fixed assets 38·60Current assets 26·20Current liabilities1 (20·20)

———Net assets 44·60

———

Capital and reservesMedium and long term borrowing 10·50Ordinary shares (25 pence par value) 10·00Reserves 24·10

———44·60———

1Includes an overdraft of £9·5 million

The company’s financial targets for the next three years are:

(i) Growth in pre-tax profits of 20% per year from year 1.

(ii) To repay the overdraft within three years using profit.

(iii) To satisfy a loan covenant that restricts the maximum book value of gearing (measured by total borrowed fundsto shareholders’ equity) to a maximum of 35% in three years’ time.

Other information:

(i) The company has a policy of paying out a constant 40% of its after tax earnings as dividends.

(ii) The company pays an average interest rate of 7% per annum on each of its loans and overdraft.

(iii) The company’s cost of capital is 12%.

(iv) The corporate tax rate is 30%.

Required:

(a) State the meaning of, and briefly discuss the importance of, gap analysis in financial planning. (3 marks)

(b) Produce financial planning estimates for Greffer plc that show whether or not Greffer is likely to achieve itsfinancial targets. State clearly any assumptions that you make. (Full pro forma balance sheets are notrequired.) (12 marks)

(c) Acting as an external consultant to Greffer plc

(i) Suggest actions that Greffer might take if the objective of repaying the overdraft in three years is notachieved. (2 marks)

(ii) Prepare a brief memo for the managers of Greffer discussing how appropriate each of the company’sfinancial targets is. (5 marks)

4

(d) Greffer’s current share price is 150 pence. Assume that after year 3 annual replacement investment necessaryfor the company to continue its existing level of operations is £4 million, capital allowances are £3·5 million peryear, and working capital remains constant.

Required:

Evaluate whether or not the share price is higher or lower than might be expected by using free cash flowanalysis. Comment upon your findings. (8 marks)

(30 marks)

5 [P.T.O.

Section B – TWO questions ONLY to be attempted

3 Assume that it is now 1 June.

Trenter plc has invested in the ordinary shares of each of five companies which it has identified as potential futuretake-over targets.

Trenter’s managers are concerned that the recent rise in the share price index might not last, and share prices couldfall during the next three or four months.

Trenter does not want to sell any of the shares, but wishes to gain some protection against possible falls in share price.The company’s financial advisers have suggested three alternatives:

(i) Stock index futures

(ii) Options on stock index futures

(iii) A synthetic short position in the index, using both call and put options at the same exercise price.

Market data:

Investment Shares held (000) Share price (pence) Equity betaFangle 250 740 1·35 Knoten 400 510 1·26 Dupple 120 1,140 1·15Wraiter 310 365 0·82 Plesenn 1,435 98 1·65

The FTSE 100 index is currently 5930, and the face value of an index contract is £10 per point.

FTSE 100 Stock Index FuturesJune 5936September 5950

Options on FTSE 100 Stock Index FuturesExercise price September

Call Put (pence)5625 331·0 35·55925 140·0 108·0

Required:

(a) Illustrate how each alternative might be used to hedge against falling share prices. The type of hedge,number of contracts and hedge cost should be shown wherever relevant. (9 marks)

(b) If, in September, the actual market prices had moved as shown below, calculate and comment upon theoutcomes of each of the hedges.

Investment Share price (pence)Fangle 680Knoten 479Dupple 1,026Wraiter 370Plesenn 78

FTSE 100 stock index futures price: 5585 (6 marks)

(15 marks)

6

4 Doubler plc is considering a takeover bid for Fader plc.

Doubler’s board of directors has issued the following statement:

‘Our superior PE ratio and synergistic effects of the acquisition will lead to a post-acquisition increase in earnings pershare and in the combined market value of the companies’.

Summarised financial data for the companies:£ million

Doubler FaderSales 48·00 35·30Profit before tax 6·30 4·10Tax (1·89) (1·23)

——— ———Profit after tax 4·41 2·87Dividends (2·00) (1·10)

——— ———Retained earnings 2·41 1·77

——— ———

Fixed assets (net) 28·40 26·50Current assets 22·64 17·30Less current liabilities (17·32) (10·20)

——— ———33·72 33·60

——— ———Financed by:Medium and long term borrowing 8·60 11·40Ordinary shares (10 pence par value) 4·00 3·00Reserves 21·12 19·20

——— ———33·72 33·60

——— ———

Notes:

(i) After tax saving in cash operating costs of £750,000 per year indefinitely are expected as a result of theacquisition.

(ii) Initial redundancy costs will be £1million before tax.

(iii) Doubler’s cost of capital is 12%.

(iv) Current shares prices are: Doubler 290 pence, Fader 180 pence.

(v) The proposed terms of the takeover are payment of 2 Doubler shares for every 3 Fader shares.

Required:

(a) Calculate the current PE ratios of Doubler and Fader (2 marks)

(b) Estimate the expected post acquisition earnings per share and comment upon the importance of increasingthe earnings per share. (4 marks)

(c) Estimate the effect on the combined market value as a result of the takeover using:

(i) PE based valuation;(ii) Cash flow based valuation.

State clearly any assumptions that you make. (5 marks)

(d) Discuss the limitations of your estimates in (c) above. (4 marks)

(15 marks)

7 [P.T.O.

5 Tertial plc has recently commenced exports to Blundonia, a developing country. A payment of 100 million pesos isdue from a customer in Blundonia in three months’ time. The Blundonian government sometimes restricts themovement of funds from the country, but has indicated that payment to Tertial has a good chance of receivingapproval. No forward market or derivatives markets exist for the Blundonian peso.

The Blundonian peso is currently linked to the US dollar.

Exchange rates: B peso/£ $/£Spot rate 126·4 – 128·2 1·775 – 1·7823 month forward rate Not available 1·781 – 1·789

Tertial can borrow at 6% per annum or invest at 4% per annum in the UK, can borrow at 7% and invest at 4·5% inthe USA, and at 14% and 10% respectively in Blundonia.

Tertial currently has a £800,000 overdraft in the UK.

Inflation rates:UK 3%USA 4%Blundonia 14%

Tertial’s Blundonian customer has indicated that it might be willing to make a lead payment in return for a 1·5%discount on the sale price.

Required:

(a) Discuss the advantages and disadvantages of the alternative currency hedges (including relevant cross-hedges) that are available to Tertial. Calculate the expected outcome of each hedge, and recommend whichhedge should be selected. (9 marks)

(b) Evaluate whether or not Tertial should agree to its Blundonian customer receiving the 1·5% discount.(3 marks)

(c) Suggest possible action that Tertial might take if the government decides not to allow the transfer of moneyout of Blundonia. (3 marks)

(15 marks)

6 Provide examples of ethical issues that might affect capital investment decisions, and discuss the importance ofsuch issues for strategic financial management.

(15 marks)

8

9 [P.T.O.

Formulae Sheet

Ke (i)

(ii)

WACC

or Keu

2 assetportfolio

Purchasingpower parity

E r r E r r

DP

g

KegE

E DKd t D

E D

DtE D

x x x x p

i i

i

EE

j f m f j

p a b ab a b

f uk

uk

a e

( ) ( ) –

( – )

–

( – ) ( – )

–

= + [ ]+

++

+

+⎛⎝⎜

⎞⎠⎟

= + +

+

=

β

σ σ σ σ σ

β β

1

0

2 2 2 2

1

1

1 2 1

1

+++

+

=

= + +

=

D tD t

E D t

Ps N d Xe N d

dPs X rT

TT

d d T

d

rT

( – )( – )

( – )

( ) – ( )

/.

–

–

11

1

10 5

1 2

1

2 1

β

σσ

σ

Call price for a European option

n ( )

Put call parity PP = PC – PS +Xe–rT

10

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11 [P.T.O.

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[P.T.O.

12

Standard normal distribution table

0·00 0·01 0·02 0·03 0·04 0·05 0·06 0·07 0·08 0·09

0·0 0·0000 0·0040 0·0080 0·0120 0·0160 0·0199 0·0239 0·0279 0·0319 0·0359 0·1 0·0398 0·0438 0·0478 0·0517 0·0557 0·0596 0·0636 0·0675 0·0714 0·0753 0·2 0·0793 0·0832 0·0871 0·0910 0·0948 0·0987 0·1026 0·1064 0·1103 0·1141 0·3 0·1179 0·1217 0·1255 0·1293 0·1331 0·1368 0·1406 0·1443 0·1480 0·1517 0·4 0·1554 0·1591 0·1628 0·1664 0·1700 0·1736 0·1772 0·1808 0·1844 0·1879

0·5 0·1915 0·1950 0·1985 0·2019 0·2054 0·2088 0·2123 0·2157 0·2190 0·2224 0·6 0·2257 0·2291 0·2324 0·2357 0·2389 0·2422 0·2454 0·2486 0·2517 0·2549 0·7 0·2580 0·2611 0·2642 0·2673 0·2703 0·2734 0·2764 0·2794 0·2823 0·2852 0·8 0·2881 0·2910 0·2939 0·2967 0·2995 0·3023 0·3051 0·3078 0·3106 0·3133 0·9 0·3159 0·3186 0·3212 0·3238 0·3264 0·3289 0·3315 0·3340 0·3365 0·3389

1·0 0·3413 0·3438 0·3461 0·3485 0·3508 0·3531 0·3554 0·3577 0·3599 0·36211·1 0·3643 0·3665 0·3686 0·3708 0·3729 0·3749 0·3770 0·3790 0·3810 0·38301·2 0·3849 0·3869 0·3888 0·3907 0·3925 0·3944 0·3962 0·3980 0·3997 0·40151·3 0·4032 0·4049 0·4066 0·4082 0·4099 0·4115 0·4131 0·4147 0·4162 0·41771·4 0·4192 0·4207 0·4222 0·4236 0·4251 0·4265 0·4279 0·4292 0·4306 0·4319

1·5 0·4332 0·4345 0·4357 0·4370 0·4382 0·4394 0·4406 0·4418 0·4429 0·44411·6 0·4452 0·4463 0·4474 0·4484 0·4495 0·4505 0·4515 0·4525 0·4535 0·45451·7 0·4554 0·4564 0·4573 0·4582 0·4591 0·4599 0·4608 0·4616 0·4625 0·46331·8 0·4641 0·4649 0·4656 0·4664 0·4671 0·4678 0·4686 0·4693 0·4699 0·47061·9 0·4713 0·4719 0·4726 0·4732 0·4738 0·4744 0·4750 0·4756 0·4761 0·4767

2·0 0·4772 0·4778 0·4783 0·4788 0·4793 0·4798 0·4803 0·4808 0·4812 0·48172·1 0·4821 0·4826 0·4830 0·4834 0·4838 0·4842 0·4846 0·4850 0·4854 0·48572·2 0·4861 0·4864 0·4868 0·4871 0·4875 0·4878 0·4881 0·4884 0·4887 0·48902·3 0·4893 0·4896 0·4898 0·4901 0·4904 0·4906 0·4909 0·4911 0·4913 0·49162·4 0·4918 0·4920 0·4922 0·4925 0·4927 0·4929 0·4931 0·4932 0·4934 0·4936

2·5 0·4938 0·4940 0·4941 0·4943 0·4945 0·4946 0·4948 0·4949 0·4951 0·49522·6 0·4953 0·4955 0·4956 0·4957 0·4959 0·4960 0·4961 0·4962 0·4963 0·49642·7 0·4965 0·4966 0·4967 0·4968 0·4969 0·4970 0·4971 0·4972 0·4973 0·49742·8 0·4974 0·4975 0·4976 0·4977 0·4977 0·4978 0·4979 0·4979 0·4980 0·49812·9 0·4981 0·4982 0·4982 0·4983 0·4984 0·4984 0·4985 0·4985 0·4986 0·4986

3·0 0·4987 0·4987 0·4987 0·4988 0·4988 0·4989 0·4989 0·4989 0·4990 0·4990

This table can be used to calculate N(di), the cumulative normal distribution functions needed for the Black-Scholesmodel of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number abovefrom 0·5.

End of Question Paper