PART 3 WEDNESDAY 14 DECEMBER 2005
QUESTION PAPER Time allowed 3 hours This paper is divided into two sections Section A
BOTH questions are compulsory and MUST be answered
Section B
TWO questions ONLY to be answered
Formulae sheet, present value, annuity and standard normal distribution 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 examination hall
The Association of Chartered Certified Accountants
Paper 3.7
Strategic Financial Management
Section A – BOTH questions are compulsory and MUST be attempted 1
Sleepon Hotels plc owns a successful chain of hotels. The company is considering diversifying its activities through the construction of a theme park near London. The theme park would have a mixture of family activities and adventure rides. Sleepon has just spent £230,000 on market research into the theme park, and is encouraged by the findings. The theme park is expected to attract an average of 15,000 visitors per day for at least four years, after which major new investment would be required in order to maintain demand. The price of admission to the theme park is expected to be £18 per adult and £10 per child. 60% of visitors are forecast to be children. In addition to admission revenues, it is expected that the average visitor will spend £8 on food and drinks, (of which 30% is profit), and £5 on gifts and souvenirs, (of which 40% is profit). The park would open for 360 days per year. All costs and receipts (excluding maintenance and construction costs and the realisable value) are shown at current prices; the company expects all costs and receipts to rise by 3% per year from current values. The theme park would cost a total of £400 million and could be constructed and working in one year’s time. Half of the £400 million would be payable immediately, and half in one year’s time. In addition working capital of £50 million will be required from the end of year one. The after tax realisable value of fixed assets is expected to be between £250 million and £300 million after four years of operation. Maintenance costs (excluding labour) are expected to be £15 million in the first year of operation, increasing by £4 million per year thereafter. Annual insurance costs are £2 million, and the company would apportion £2·5 million per year to the theme park from existing overheads. The theme park would require 1,500 staff costing a total of £40 million per annum (at current prices). Sleepon will use the existing advertising campaigns for its hotels to also advertise the theme park. This will save approximately £2 million per year in advertising expenses. As Sleepon has no previous experience of theme park management, it has investigated the current risk and financial structure of the closest UK theme park competitor, Thrillall plc. Details are summarised below. Thrillall plc, summarised balance sheet £ million Fixed assets (net) 1,440 Current assets 570 Less current liabilities (620) ––––– 1,390 ––––– ––––– Financed by: £1 ordinary shares 400 Reserves 530 ––––– 930 Medium and long term debt 460 ––––– 1,390 ––––– –––––
2
Other information: (i)
Sleepon has access to a £450 million Eurosterling loan at 7·5% fixed rate to provide the necessary finance for the theme park.
(ii) £250 million of the investment will attract 25% per year capital allowances on a reducing balance basis. (iii) Corporate tax is at a rate of 30%. (iv) The average stock market return is 10% and the risk free rate 3·5%. (v) Sleepon’s current weighted average cost of capital is 9%. (vi) Sleepon’s market weighted gearing if the theme park project is undertaken is estimated to be 61·4% equity, 38·6% debt. (vii) Sleepon’s equity beta is 0·70. (viii) The current share price of Sleepon is 148 pence, and of Thrillall 386 pence. (ix) Thrillall’s medium and long term debt comprises long term bonds with a par value of £100 and current market price of £93. (x) Thrillall’s equity beta is 1·45. Required: Prepare a report analysing whether or not Sleepon should undertake the investment in the theme park. Your report should include a discussion of what other information would be useful to Sleepon in making the investment decision. All relevant calculations must be included in the report or as an appendix to it. State clearly any assumptions that you make. (Approximately 28 marks are available for calculations and 12 for discussion) (40 marks)
3
[P.T.O.
2
A proposal has been put to the board of directors of Semer plc that the company should increase its capital gearing to at least 50%, in order to reduce the company’s cost of capital and increase its market value. The managing director of Semer is not convinced by the logic of the proposal, or the accuracy of the calculations, but is unable to explain the reasons for his reservations. A summary of the proposal and its implications is shown below. Proposal to increase the capital gearing of Semer plc The company’s current weighted average cost of capital is estimated to be 10·6%. If the proportion of debt is increased to 50% of total capital, by the repurchase of ordinary shares at their current market value, the cost of capital may be reduced to 9·9%. A reduced cost of capital means that the value of the company will increase which will be welcomed by our shareholders. Calculations supporting the above proposal are shown below: Existing cost of capital Cost of equity using the capital asset pricing model: 4% + (10·5% – 4%) 1·2 = 11·8% Cost of debt: 8% Weighted average cost of capital: £350m £169m 11·8% x –––––– + 8% x –––––– = 10·56% £519m £519m Estimated new cost of capital: £259·5m £259·5m 11·8% x –––––––– + 8% x –––––––– = 9·90% £519m £519m Impact on the value of the company: £60m Current value ––––––– = £568 million 0·1056 £60m Expected new value –––––– = £606 million 0·099 Other information: (i) Most recent summarised balance sheet Semer plc Fixed assets (net) Current assets Less current liabilities
Issued ordinary shares (50 pence par) Reserves Liabilities falling due after one year: Bank loans 8% debenture 2010 (£100 par value)
£ million 442 345 (268) –––– 519 –––– –––– 180 270
119 150 –––– 519 –––– –––– (ii) The current price of Semer’s ordinary shares is 410 pence. (iii) The market price of one 8% debenture 2010 is £112. (iv) The market return is 10·5% and the risk free rate 4·0%. (v) Semer’s equity beta is 1·2. (vi) Semer currently pays £15 million in dividends. (vii) The corporate tax rate is 30%. (viii) The company currently generates a free cash flow of £60 million per year, which is expected to increase by approximately 3% per year. 4
Required: (a) What, if any, are the mistakes in the proposal? Correcting for any mistakes produce revised estimates of the company’s current cost of capital and current value. Brief explanation of the reasons for any revisions should be included. (15 marks) (b) Assuming that the cost of equity and cost of debt do not alter, estimate the effect of the share repurchase on the company’s cost of capital and value. (5 marks) (c) Acting as an external consultant to Semer, discuss the validity of the proposed strategy to increase gearing, and explain whether or not the estimates produced in (b) above are likely to be accurate. (10 marks) (30 marks)
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[P.T.O.
Section B – TWO questions ONLY to be attempted 3
The managers of Daylon plc are reviewing the company’s investment portfolio. About 15% of the portfolio is represented by a holding of 5,550,000 ordinary shares of Mondglobe plc. The managers are concerned about the effect on portfolio value if the price of Mondglobe’s shares should fall, and are considering selling the shares. Daylon’s investment bank has suggested that the risk of Mondglobe’s shares falling by more than 5% from their current value could be protected against by buying an over the counter option. The investment bank is prepared to sell an appropriate six month option to Daylon for £250,000. Other information: (i)
The current market price of Mondglobe’s ordinary shares is 360 pence.
(ii) The annual volatility (variance) of Mondglobe’s shares for the last year was 169%. (iii) The risk free rate is 4% per year. (iv) No dividend is expected to be paid by Mondglobe during the next six months. Required: (a) Evaluate whether or not the price at which the investment bank is willing to sell the option is a fair price. (10 marks) (b) Discuss what factors Daylon should consider before deciding whether or not to purchase the option. (5 marks) (15 marks)
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4
A division of Reflator plc has recently experienced severe financial difficulties. The management of the division is keen to undertake a buy-out, but in order for the buyout to succeed it needs to attract substantial finance from a venture capital organisation. Reflator plc is willing to sell the division for £2·1 million, and the managers believe that an additional £1 million of capital would need to be invested in the division to create a viable going concern. Possible financing sources: Equity from management £500,000, in 50 pence ordinary shares. Funds from the venture capital organisation: Equity £300,000, in 50 pence ordinary shares Debt: 8·5% fixed rate loan £2,000,000 9% subordinated loan with warrants attached £300,000. The warrants are exercisable any time after four years from now at the rate of 100 ordinary shares at the price of 150 pence per share for every £100 of subordinated loan. The principal on the 8·5% fixed rate loan is repayable as a bullet payment at the end of eight years. The subordinated loan is repayable by equal annual payments, comprising both interest and principal, over a period of six years. The division’s managers propose to keep dividends to no more than 15% of profits for the first four years. Independently produced forecasts of earnings before tax and interest after the buy-out are shown below: £000 Year EBIT
1 320
2 410
3 500
4 540
Corporate tax is at the rate of 30% per year. The managers involved in the buy-out have stated that the book value of equity is likely to increase by about 20% per year during the first four years, making the investment very attractive to the venture capital organisation. The venture capital organisation has stated that it is interested in investing, but has doubts about the forecast growth rate of equity value, and would require warrants for 150 shares per £100 of subordinated loan stock rather than 100 shares. Required: (a) Briefly discuss the potential advantages of management buy-outs.
(5 marks)
(b) On the basis of the above data, estimate whether or not the book value of equity is likely to grow by 20% per year. (7 marks) (c) Evaluate the possible implication of the managers agreeing to offer warrants for 150 ordinary shares per £100 of loan stock. (3 marks) (15 marks)
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[P.T.O.
5
Assume that it is now 31 December. MJY plc is a UK based multinational company that has subsidiaries in two foreign countries. Both subsidiaries trade with other group members and with four third party companies (company 1 – company 4). Projected trade transactions for three months’ time are shown below. All currency amounts are in thousands. Receipts (read across) ‘000’ MJY Subsidiary 1 Subsidiary 2 Company 1 Company 2 Company 3 Company 4 Foreign exchange rates Spot 3 months forward
Co 1 $90 £50 £15 – – – –
Payments (read down) ‘000’ Co 2 Co 3 Co 4 MJY Subsidiary 1 £60 €75 – – £40 €85 $40 $20 €72 – – €52 $30 £55 €35 – – – – – – – – $170 – – – – $120 €50 – – – – –
Subsidiary 2 $50 €20 – – – – €65
€/£ 1·4492 – 1·4523 1·4365 – 1·4390
$/£ 1·7982 – 1·8010 1·7835 – 1·7861
Currency options. £62,500 contract size. Premium in cents per £ Calls Strike price February May 1·80 1·96 3·00 1·78 2·91 3·84
Puts February 3·17 2·12
May 5·34 4·20
Required: Working from the perspective of a group treasurer, devise a hedging strategy for the MJY group, and calculate the expected outcomes of the hedges using forward markets, and, for the dollar exposure only, currency options. (15 marks)
6
(a) Provide examples of how countries might impose protectionist measures to control the volume of imports. (5 marks) (b) Discuss the role and main objectives of the World Trade Organisation (WTO), and its potential effect on protectionist measures. (6 marks) (c) Briefly discuss the possible effects of the activities of the WTO for a multinational company with foreign direct investment in a developing country that has recently joined the WTO. (4 marks) (15 marks)
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Formulae Sheet
[
]
E( r j ) = r f + E( rm ) – r f β j
Ke (i)
D1 +g (ii) P0 WACC Keg
E D + Kd (1 – t ) E+D E+D
Dt or Keu 1 – E + D 2 asset portfolio
σ p = σ a2 x 2 + σ b2 (1 – x ) 2 + 2 x (1 – x ) p abσ a σ b Purchasing power parity
βa = βe
i f – i uk 1 + i uk
D(1 – t ) E + βd E + D(1 – t ) E + D(1 – t )
Call price for a European option = Ps N( d1) – Xe – rT N( d 2 ) d1 =
1n ( Ps / X ) + rT
σ T
+ 0.5σ T
d 2 = d1 – σ T Put call parity PP = PC – PS +Xe–rT
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[P.T.O.
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[P.T.O.
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 0·1 0·2 0·3 0·4
0·0000 0·0398 0·0793 0·1179 0·1554
0·0040 0·0438 0·0832 0·1217 0·1591
0·0080 0·0478 0·0871 0·1255 0·1628
0·0120 0·0517 0·0910 0·1293 0·1664
0·0160 0·0557 0·0948 0·1331 0·1700
0·0199 0·0596 0·0987 0·1368 0·1736
0·0239 0·0636 0·1026 0·1406 0·1772
0·0279 0·0675 0·1064 0·1443 0·1808
0·0319 0·0714 0·1103 0·1480 0·1844
0·0359 0·0753 0·1141 0·1517 0·1879
0·5 0·6 0·7 0·8 0·9
0·1915 0·2257 0·2580 0·2881 0·3159
0·1950 0·2291 0·2611 0·2910 0·3186
0·1985 0·2324 0·2642 0·2939 0·3212
0·2019 0·2357 0·2673 0·2967 0·3238
0·2054 0·2389 0·2703 0·2995 0·3264
0·2088 0·2422 0·2734 0·3023 0·3289
0·2123 0·2454 0·2764 0·3051 0·3315
0·2157 0·2486 0·2794 0·3078 0·3340
0·2190 0·2517 0·2823 0·3106 0·3365
0·2224 0·2549 0·2852 0·3133 0·3389
1·0 1·1 1·2 1·3 1·4
0·3413 0·3643 0·3849 0·4032 0·4192
0·3438 0·3665 0·3869 0·4049 0·4207
0·3461 0·3686 0·3888 0·4066 0·4222
0·3485 0·3708 0·3907 0·4082 0·4236
0·3508 0·3729 0·3925 0·4099 0·4251
0·3531 0·3749 0·3944 0·4115 0·4265
0·3554 0·3770 0·3962 0·4131 0·4279
0·3577 0·3790 0·3980 0·4147 0·4292
0·3599 0·3810 0·3997 0·4162 0·4306
0·3621 0·3830 0·4015 0·4177 0·4319
1·5 1·6 1·7 1·8 1·9
0·4332 0·4452 0·4554 0·4641 0·4713
0·4345 0·4463 0·4564 0·4649 0·4719
0·4357 0·4474 0·4573 0·4656 0·4726
0·4370 0·4484 0·4582 0·4664 0·4732
0·4382 0·4495 0·4591 0·4671 0·4738
0·4394 0·4505 0·4599 0·4678 0·4744
0·4406 0·4515 0·4608 0·4686 0·4750
0·4418 0·4525 0·4616 0·4693 0·4756
0·4429 0·4535 0·4625 0·4699 0·4761
0·4441 0·4545 0·4633 0·4706 0·4767
2·0 2·1 2·2 2·3 2·4
0·4772 0·4821 0·4861 0·4893 0·4918
0·4778 0·4826 0·4864 0·4896 0·4920
0·4783 0·4830 0·4868 0·4898 0·4922
0·4788 0·4834 0·4871 0·4901 0·4925
0·4793 0·4838 0·4875 0·4904 0·4927
0·4798 0·4842 0·4878 0·4906 0·4929
0·4803 0·4846 0·4881 0·4909 0·4931
0·4808 0·4850 0·4884 0·4911 0·4932
0·4812 0·4854 0·4887 0·4913 0·4934
0·4817 0·4857 0·4890 0·4916 0·4936
2·5 2·6 2·7 2·8 2·9
0·4938 0·4953 0·4965 0·4974 0·4981
0·4940 0·4955 0·4966 0·4975 0·4982
0·4941 0·4956 0·4967 0·4976 0·4982
0·4943 0·4957 0·4968 0·4977 0·4983
0·4945 0·4959 0·4969 0·4977 0·4984
0·4946 0·4960 0·4970 0·4978 0·4984
0·4948 0·4961 0·4971 0·4979 0·4985
0·4949 0·4962 0·4972 0·4979 0·4985
0·4951 0·4963 0·4973 0·4980 0·4986
0·4952 0·4964 0·4974 0·4981 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-Scholes model of option pricing. If di > 0, add 0·5 to the relevant number above. If di < 0, subtract the relevant number above from 0·5.
End of Question Paper
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