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Section A This ONE question is compulsory and MUST be attempted

1 Since becoming independent just over 20 years ago, the country of Mehgam has adopted protectionist measureswhich have made it difficult for multinational companies to trade there. However, recently, after discussions with theWorld Trade Organisation (WTO), it seems likely that Mehgam will reduce its protectionist measures significantly.

Encouraged by these discussions, Chmura Co, a company producing packaged foods, is considering a project to set

up a manufacturing base in Mehgam to sell its goods there and in other regional countries nearby. An initialinvestigation costing $500,000 established that Mehgam had appropriate manufacturing facilities, adequate transportlinks and a reasonably skilled but cheap work force. The investigation concluded that, if the protectionist measureswere reduced, then the demand potential for Chmura Cos products looked promising. It is also felt that an early entryinto Mehgam would give Chmura Co an advantage over its competitors for a period of five years, after which thecurrent project will cease, due to the development of new advanced manufacturing processes.

Mehgams currency, the Peso (MP), is currently trading at MP72 per $1. Setting up the manufacturing base inMehgam will require an initial investment of MP2,500 million immediately, to cover the cost of land and buildings(MP1,250 million) and machinery (MP1,250 million). Tax allowable depreciation is available on the machinery atan annual rate of 10% on cost on a straight-line basis. A balancing adjustment will be required at the end of yearfive, when it is expected that the machinery will be sold for MP500 million (after inflation). The market value of the

land and buildings in five years time is estimated to be 80% of the current value. These amounts are inclusive of anytax impact.

Chmura Co will require MP200 million for working capital immediately. It is not expected that any further injectionsof working capital will be required for the five years. When the project ceases at the end of the fif th year, the workingcapital will be released back to Chmura Co.

Production of the packaged foods will take place in batches of product mixes. These batches will then be sold tosupermarket chains, wholesalers and distributors in Mehgam and its neighbouring countries, who will repackage themto their individual requirements. All sales will be in MP. The estimated average number of batches produced and soldeach year is given below:

Year 1 2 3 4 5

Batches produced and sold 10,000 15,000 30,000 26,000 15,000The current selling price for each batch is estimated to be MP115,200. The costs related to producing and sellingeach batch are currently estimated to be MP46,500. In addition to these costs, a number of products will need aspecial packaging material which Chmura Co will send to Mehgam. Currently the cost of the special packagingmaterial is $200 per batch. Training and development costs, related to the production of the batches, are estimatedto be 80% of the production and selling costs (excluding the cost of the special packaging) in the first year, beforefalling to 20% of these costs (excluding the cost of the special packaging) in the second year, and then nil for theremaining years. It is expected that the costs relating to the production and sale of each batch will increase annuallyby 10% but the selling price and the special packaging costs will only increase by 5% every year.

The current annual corporation tax rate in Mehgam is 25% and Chmura Co pays annual corporation tax at a rate of 20% in the country where it is based. Both countries taxes are payable in the year that the tax liability arises. Abi-lateral tax treaty exists between the two countries which permits offset of overseas tax against any tax liabilitiesChmura Co incurs on overseas earnings.

The risk-adjusted cost of capital applicable to the project on $-based cash flows is 12%, which is considerably higherthan the return on short-dated $ treasury bills of 4%. The current rate of inflation in Mehgam is 8%, and in thecountry where Chmura Co is based, it is 2%. It can be assumed that these inflation rates will not change for theforeseeable future. All net cash flows from the project will be remitted back to Chmura Co at the end of each year.

Chmura Cos finance director is of the opinion that there are many uncertainties surrounding the project and hasassessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties.

Recently Bulud Co offered Chmura Co the option to sell the entire project to Bulud Co for $28 million at the start of year three. Chmura Co will make the decision of whether or not to sell the project at the end of year two.

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3 Makonis Co, a listed company producing motor cars, wants to acquire Nuvola Co, an engineering company involvedin producing innovative devices for cars. Makonis Co is keen to incorporate some of Nuvola Cos innovative devicesinto its cars and thereby boosting sales revenue.

The following financial information is provided for the two companies:

Makonis Co Nuvola Co

Current share price $580 $240Number of issued shares 210 million 200 millionEquity beta 12 12Asset beta 09 12

It is thought that combining the two companies will result in several benefits. Free cash flows to firm of the combinedcompany will be $216 million in current value terms, but these will increase by an annual growth rate of 5% for thenext four years, before reverting to an annual growth rate of 225% in perpetuity. In addition to this, combining thecompanies will result in cash synergy benefits of $20 million per year, for the next four years. These synergy benefitsare not subject to any inflationary increase and no synergy benefits will occur after the fourth year. The debt-to-equityratio of the combined company will be 40:60 in market value terms and it is expected that the combined companyscost of debt will be 455%.

The corporation tax rate is 20%, the current risk free rate of return is 2% and the market risk premium is 7%. It canbe assumed that the combined companys asset beta is the weighted average of Makonis Cos and Nuvola Cos assetbetas, weighted by their current market values.

Makonis Co has offered to acquire Nuvola Co through a mixed offer of one of its shares for two Nuvola Co shares plusa cash payment, such that a 30% premium is paid for the acquisition. Nuvola Cos equity holders feel that a 50%premium would be more acceptable. Makonis Co has sufficient cash reserves if the premium is 30%, but not if it is50%.

Required:

(a) Estimate the additional equity value created by combining Nuvola Co and Makonis Co, based on the freecash flows to firm method. Comment on the results obtained and briefly discuss the assumptions made.

(13 marks)

(b) Estimate the impact on Makonis Cos equity holders if the premium paid is increased to 50% from 30%.(5 marks)

(c) Estimate the additional funds required if a premium of 50% is paid instead of 30% and discuss how thispremium could be financed. (7 marks)

(25 marks)

5 [P.T.O.

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7 [P.T.O.

Formulae

Modigliani and Miller Proposition 2 (with tax)

The Capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordons growth approximation

The weighted average cost of capital

The Fisher formula

Purchasing power parity and interest rate parity

k k T)(k kV

Ve ei

ei

dd

e

= + ( )1

E(r R E(r Ri f i m f ) ( ) )= +

ae

e de

d

e d

V

V V T))

V T

V V=

+ +

+( (

( )

( (1

1

1 T)) d

PD g)

(r g)oo

e

= +(

1

g bre=

WACCV

V Vk

V

V Vke

e de

d

e dd

=+

++

( 1 TT)

( ) (1 1+ = +i r)(1+h)

S S x(1+h

(1+hF S x

(1+i

(11 0c

b0 0

c= =)

)

)

++i b )

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Modified Internal Rate of Return

The Black-Scholes option pricing model

The Put Call Parity relationship

c P N(d P N(d e

Where:

dP P r+

a 1 e 2rt

1a e

=

= +

) )

ln( / ) ( 00.5s t

s t

d d s t

2

2 1

)

=

MIRRPV

PV r R

I

n

e= +( )

1

1 1

p c P P ea ert= +

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9 [P.T.O.

Present Value Table

Present value of 1 i.e. (1 + r )n

Where r = discount rate n = number of periods until payment

Discount rate (r)Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1 2 0980 0961 0943 0925 0907 0890 0873 0857 0842 0826 2 3 0971 0942 0915 0889 0864 0840 0816 0794 0772 0751 3 4 0961 0924 0888 0855 0823 0792 0763 0735 0708 0683 4 5 0951 0906 0863 0822 0784 0747 0713 0681 0650 0621 5

6 0942 0888 0837 0790 0746 0705 0666 0630 0596 0564 6

7 0933 0871 0813 0760 0711 0665 0623 0583 0547 0513 7 8 0923 0853 0789 0731 0677 0627 0582 0540 0502 0467 8 9 0914 0837 0766 0703 0645 0592 0544 0500 0460 0424 9 10 0905 0820 0744 0676 0614 0558 0508 0463 0422 0386 10

11 0896 0804 0722 0650 0585 0527 0475 0429 0388 0350 11 12 0887 0788 0701 0625 0557 0497 0444 0397 0356 0319 12 13 0879 0773 0681 0601 0530 0469 0415 0368 0326 0290 13 14 0870 0758 0661 0577 0505 0442 0388 0340 0299 0263 14 15 0861 0743 0642 0555 0481 0417 0362 0315 0275 0239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1 2 0812 0797 0783 0769 0756 0743 0731 0718 0706 0694 2 3 0731 0712 0693 0675 0658 0641 0624 0609 0593 0579 3 4 0659 0636 0613 0592 0572 0552 0534 0516 0499 0482 4 5 0593 0567 0543 0519 0497 0476 0456 0437 0419 0402 5

6 0535 0507 0480 0456 0432 0410 0390 0370 0352 0335 6 7 0482 0452 0425 0400 0376 0354 0333 0314 0296 0279 7 8 0434 0404 0376 0351 0327 0305 0285 0266 0249 0233 8

9 0391 0361 0333 0308 0284 0263 0243 0225 0209 0194 9 10 0352 0322 0295 0270 0247 0227 0208 0191 0176 0162 10

11 0317 0287 0261 0237 0215 0195 0178 0162 0148 0135 11 12 0286 0257 0231 0208 0187 0168 0152 0137 0124 0112 12 13 0258 0229 0204 0182 0163 0145 0130 0116 0104 0093 13 14 0232 0205 0181 0160 0141 0125 0111 0099 0088 0078 14 15 0209 0183 0160 0140 0123 0108 0095 0084 0074 0065 15

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Annuity Table

Present value of an annuity of 1 i.e.

Where r = discount rate

n = number of periods

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0990 0980 0971 0962 0952 0943 0935 0926 0917 0909 1 2 1970 1942 1913 1886 1859 1833 1808 1783 1759 1736 2 3 2941 2884 2829 2775 2723 2673 2624 2577 2531 2487 3 4 3902 3808 3717 3630 3546 3465 3387 3312 3240 3170 4 5 4853 4713 4580 4452 4329 4212 4100 3993 3890 3791 5

6 5795 5601 5417 5242 5076 4917 4767 4623 4486 4355 6 7 6728 6472 6230 6002 5786 5582 5389 5206 5033 4868 7 8 7652 7325 7020 6733 6463 6210 5971 5747 5535 5335 8 9 8566 8162 7786 7435 7108 6802 6515 6247 5995 5759 9 10 9471 8983 8530 8111 7722 7360 7024 6710 6418 6145 10

11 10368 9787 9253 8760 8306 7887 7499 7139 6805 6495 11 12 11255 10575 9954 9385 8863 8384 7943 7536 7161 6814 12 13 12134 11348 10635 9986 9394 8853 8358 7904 7487 7103 13 14 13004 12106 11296 10563 9899 9295 8745 8244 7786 7367 14 15 13865 12849 11938 11118 10380 9712 9108 8559 8061 7606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0901 0893 0885 0877 0870 0862 0855 0847 0840 0833 1 2 1713 1690 1668 1647 1626 1605 1585 1566 1547 1528 2 3 2444 2402 2361 2322 2283 2246 2210 2174 2140 2106 3 4 3102 3037 2974 2914 2855 2798 2743 2690 2639 2589 4 5 3696 3605 3517 3433 3352 3274 3199 3127 3058 2991 5

6 4231 4111 3998 3889 3784 3685 3589 3498 3410 3326 6 7 4712 4564 4423 4288 4160 4039 3922 3812 3706 3605 7

8 5146 4968 4799 4639 4487 4344 4207 4078 3954 3837 8 9 5537 5328 5132 4946 4772 4607 4451 4303 4163 4031 9 10 5889 5650 5426 5216 5019 4833 4659 4494 4339 4192 10

11 6207 5938 5687 5453 5234 5029 4836 4656 4486 4327 11 12 6492 6194 5918 5660 5421 5197 4988 4793 4611 4439 12 13 6750 6424 6122 5842 5583 5342 5118 4910 4715 4533 13 14 6982 6628 6302 6002 5724 5468 5229 5008 4802 4611 14 15 7191 6811 6462 6142 5847 5575 5324 5092 4876 4675 15

1 (1 + r )nr

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Standard normal distribution table

000 001 002 003 004 005 006 007 008 00900 00000 00040 00080 00120 00160 00199 00239 00279 00319 0035901 00398 00438 00478 00517 00557 00596 00636 00675 00714 0075302 00793 00832 00871 00910 00948 00987 01026 01064 01103 01141

03 01179 01217 01255 01293 01331 01368 01406 01443 01480 0151704 01554 01591 01628 01664 01700 01736 01772 01808 01844 01879

05 01915 01950 01985 02019 02054 02088 02123 02157 02190 0222406 02257 02291 02324 02357 02389 02422 02454 02486 02517 0254907 02580 02611 02642 02673 02704 02734 02764 02794 02823 0285208 02881 02910 02939 02967 02995 03023 03051 03078 03106 0313309 03159 03186 03212 03238 03264 03289 03315 03340 03365 03389

10 03413 03438 03461 03485 03508 03531 03554 03577 03599 03621

11 03643 03665 03686 03708 03729 03749 03770 03790 03810 0383012 03849 03869 03888 03907 03925 03944 03962 03980 03997 0401513 04032 04049 04066 04082 04099 04115 04131 04147 04162 0417714 04192 04207 04222 04236 04251 04265 04279 04292 04306 04319

15 04332 04345 04357 04370 04382 04394 04406 04418 04429 0444116 04452 04463 04474 04484 04495 04505 04515 04525 04535 0454517 04554 04564 04573 04582 04591 04599 04608 04616 04625 0463318 04641 04649 04656 04664 04671 04678 04686 04693 04699 0470619 04713 04719 04726 04732 04738 04744 04750 04756 04761 04767

20 04772 04778 04783 04788 04793 04798 04803 04808 04812 0481721 04821 04826 04830 04834 04838 04842 04846 04850 04854 0485722 04861 04864 04868 04871 04875 04878 04881 04884 04887 0489023 04893 04896 04898 04901 04904 04906 04909 04911 04913 0491624 04918 04920 04922 04925 04927 04929 04931 04932 04934 04936

25 04938 04940 04941 04943 04945 04946 04948 04949 04951 0495226 04953 04955 04956 04957 04959 04960 04961 04962 04963 0496427 04965 04966 04967 04968 04969 04970 04971 04972 04973 0497428 04974 04975 04976 04977 04977 04978 04979 04979 04980 0498129 04981 04982 04982 04983 04984 04984 04985 04985 04986 04986

30 04987 04987 04987 04988 04988 04989 04989 04989 04990 04990

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

End of Question Paper