Answers
Part 3 Examination – Paper 3.7 (ENG) Strategic Financial Management (English) 1
December 2005 Answers
Report on the proposed theme park investment The decision to invest in a major project must be evaluated using both financial and non-financial information. From a financial perspective the estimated net present value of the investment will provide an indicator of whether or not the project will create wealth. Non-financial considerations will include the strategic fit of the investment with the company and its future plans. Financial evaluation Year Cash receipts: Adult admission Child admission Food (incremental cash flow) Gifts (incremental cash flow)
0
Cash flow forecasts (£ million) 2 3 4
1
Total receipts Expenses: Labour Maintenance Insurance Capital allowances Total expenses Taxable Taxation (30%)
Add back capital allowances Initial cost Realisable value Working capital Net cash flow Discount factors (11%) Present values
(200)
–––––– (200) (200)
5
41·25 34·37 13·75 11·46 –––––– 100·83
42·49 35·40 14·16 11·80 –––––– 103·85
43·76 36·47 14·59 12·16 –––––– 106·98
45·07 37·56 15·02 12·52 –––––– 110·17
42·44 15·00 2·12 62·50 –––––– 122·06 (21·23) 6·37 –––––– (14·86) 62·50
43·70 19·00 2·19 46·88 –––––– 111·77 (7·92) 2·38 –––––– (5·54) 46·88
45·02 23·00 2·25 35·16 –––––– 105·43 1·55 (0·47) –––––– 1·08 35·16
46·37 27·00 2·32 26·37 –––––– 102·06 8·11 (2·43) –––––– 5·68 26·37
(1·55) –––––– 46·09 0·812 37·43
(1·59) –––––– 39·75 0·731 29·06
(1·64) –––––– 34·60 0·659 22·80
250·00 (1·69) –––––– 280·36 0·593 166·25
6
(200) (51·5) –––––– (251·50) 0·901 (226·60)
57·97 –––––– 57·97 0·535 31·01
The estimated net present value is (£140·05) million. Even if the higher realisable value estimate is used, the expected net present value is still significantly negative. Notes: (i) Receipts year 2 Adult admission (6,000) (360) (18) (1·03)2 Child admission (9,000) (360) (10) (1·03)2 Food (15,000) (360) (8) (0·3) (1·03)2 Gifts (15,000) (360) (5) (0·4) (1·03)2 (ii)
= = = =
41·25 34·37 13·75 11·46
million million million million
Capital allowances: It is assumed that allowances are available with a one year lag. Year 0+1 2 3 4
Written down value 250 187·50 140·62 105·47
Capital allowance (25%) 62·50 46·88 35·16 26·37
Year available 2 3 4 5
No balancing allowances or charges have been estimated as the year 5 realisable value of fixed assets has been estimated on an after tax basis. As the hotel business is successful, it is assumed that allowances may be used as soon as they are available against other taxable cash flows of Sleepon plc. (iii) Interest is not a relevant cash flow. All financing costs are included in the discount rate. (iv) The market research is a sunk cost. (v)
Apportioned overhead is not a relevant cash flow.
15
(vi) Although the company will save money by advertising in its existing hotels, this is not a change in cash flow as a result of the project and is not included in cash flows. (In effect the benefit from the savings is present as there is no cash outflow for advertising). (vii) Discount rate The current weighted average cost of capital should not be used. The discount rate should reflect the risk of the investment being undertaken; theme parks are likely to have very different risk to hotels. The cost of capital will be estimated using the risk (beta) of Thrillall plc, as Thrillall operates in the theme park sector. The market weighted capital gearing of Thrillall is: Equity 400 x 3·86 = £1,544 m (78·3%) Debt 460 x 0·93 = £428 m (21·7%) As the gearing of Thrillall is much less than that of Sleepon, the beta used to estimate the relevant cost of equity will need to be adjusted to reflect this difference in gearing. Assuming corporate debt is virtually risk free: Ungearing Thrillall’s equity beta: E 1,544 Beta asset = Beta equity x ––––––––––– or 1·45 x ––––––––––––––––––– = 1·214 E + D (1 – t) 1,544 + 428 (1 – 0·3) Regearing to take into account the gearing of Sleepon: E + D (1 – t) 61·4 + 38·6 (1 – 0·3) Beta equity = Beta asset x ––––––––––– or 1·214 x ––––––––––––––––––– = 1·748 E 61·4 The cost of equity may be estimated using the capital asset pricing model. Ke = Rf + (Rm – Rf) beta equity Ke = 3·5% + (10% – 3·5%) 1·748 = 14·86% Kd is 7·5%, the cost of the new debt used for the project. The weighted average cost of capital relevant to the new investment is estimated to be: 14·86% (0·614) + 7·5% (1 – 0·3) (0·386) = 11·15% 11% will be used as the discount rate for the investment. Other relevant information The financial projections used in the estimated net present value are subject of considerable inaccuracy. It would be useful to know: (i)
The accuracy of estimates of attendance levels and spending in the theme park.
(ii)
The accuracy of price and cost changes.
(iii) Whether or not tax rates are subject to change. (iv) The accuracy of the estimate of realisable value in year four. (v)
The accuracy of the discount rate estimate. The activities of Thrillall are not likely to be of exactly the same risk as the theme park project.
For a major investment it is unwise to rely on a single estimate of expected net present value. Sensitivity analysis or simulation analysis should be used in order to ascertain the impact on the expected NPV of changes in attendance and other key cash flows. It would be better to undertake simulation analysis, based upon different possible attendance levels, costs, risk, tax rates etc. in order to estimate a range of possible net present values, rather than use a single point value. A crucial question is what happens to cash flows beyond the company’s four year planning horizon. The year five realisable values are asset values, not the value of the theme park as a going concern. The value as a going concern could be very different from the asset values, and have a major influence on the investment decision. Will the theme park investment lead to future opportunities/investments (real options), for example in other theme parks or leisure activities? If so the value of such options should be estimated, and should form part of the investment decision. Strategic and other issues The strategic importance of the venture to Sleepon must also be investigated, as this may heavily influence the final decision. Sleepon currently runs a successful hotel chain. It might be better to keep to its core competence in hotels rather than diversify into another sector. If new investments are sought are there better opportunities within the hotel sector? Any final decision must encompass all relevant non-financial factors of which little detail has been provided. Sleepon must be satisfied that it can recruit an appropriately skilled labour force for the theme park, and should thoroughly investigate the competition in the theme park sector, and the likely reaction of competitors if it enters this new market.
16
2
(a)
Revised estimates of the current cost of capital and value The cost of equity has been correctly estimated using the capital asset pricing model to be 11·8%. The cost of debt should be the current cost of debt, not the historic cost of debt of 8% when the debenture was issued. It should also be estimated on an after tax basis as interest on debt is a tax allowable expense. The current cost of debt may be estimated from the redemption yield of the existing debenture. The debenture matures in five years time. The redemption yield may be estimated by solving the following equation for kd. 8 (1 – 0·3) 8 (1 – 0·3) 8 (1 – 0·3) 100 112 = ––––––––– + ––––––––– ....... + ––––––––– + –––––––– . 1 + kd (1 + kd)2 (1 + kd)5 (1 + kd)5 By trial and error: At 5% interest: PV annuity 5·6 x 4·329 PV 100 x 0·784
At 3% interest: PV annuity 5·6 x 4·580 PV 100 x 0·863
= 24·24 = 78·40 –––––– 102·64 = 25·65 = 86·30 –––––– 111·95
The after tax cost of debt is approximately 3% The weighted average cost of capital (WACC) should be estimated using the market values of equity and debt, not book values. The market value of equity is 160 million x 410 pence = £656m The market value of debt is £119m + (£50m x 1·12) = £175m 656 175 WACC = 11·8% x ––– + 3% x ––– = 9·95% 831 831 As free cash flow is expected to grow by 3% per year, the present value of the company’s free cash flows may be estimated by using the equation for a growth perpetuity: FCF (1 + g) 60 (1·03) PV = –––––––––– or –––––––––––– = £889 million WACC – g 0·0995 – 0·03 (b)
Estimated new cost of capital: If equity is repurchased such that the gearing becomes 50% equity, 50% debt, the new estimated weighted average cost of capital is: 415·5 415·5 11·8% x ––––– + 3% x ––––– = 7·40% 831 831 Impact on the value of the company: The free cash flow to the company will not change when equity is replaced by debt. 60 (1·03) Expected new value –––––––––––– = £1,405·5 million 0·074 – 0·03 This is a very large potential increase in value.
17
(c)
Report on the proposed adjustment of gearing through the repurchase of ordinary shares The effect of capital structure on the value of a company is not fully understood. Increasing the proportion of debt in the capital structure may reduce the overall cost of capital due to the interest on debt being a tax allowable expense. Even if a company is in a non-tax paying position, mixing additional low cost debt with relatively expensive equity might reduce the weighted average cost of capital. In such circumstances the proposed strategy to increase gearing would have some validity. However, increasing gearing can also bring problems. Risk to investors, and therefore the required returns on equity and debt, will increase as gearing increases. Very high levels of gearing might lead to direct and indirect bankruptcy costs, with a detrimental effect on cash flow and corporate value. Any benefits from increasing the proportion of debt in the capital structure will be to some extent offset as a result of increased risk with high gearing. The revised estimates of the effect on the cost of capital and value of Semer are not likely to be accurate. Reasons for this include: (i)
The company will not be able to repurchase the necessary shares at their current market value. Approximately £240 million value of equity would need to be repurchased, or more than one third of the existing market value of equity. As repurchases take place it is likely that the share price will significantly increase.
(ii)
The cost of debt is unlikely to remain constant. As more debt is issued lenders will demand a higher interest rate to compensate for the extra risk resulting from higher gearing levels. The cost of equity will also increase with higher gearing. These effects will increase the weighted average cost of capital to a higher level than that estimated.
(iii) The precise market values of debt and equity after the repurchase are unknown, and again will reflect the market attitude to the new risk of the higher gearing. The value of the company is likely to be much lower than that estimated, as the weighted average cost of capital is likely to be underestimated.
3
(a)
The investment bank is offering to sell to Daylon plc an option to sell Mondglobe ordinary shares at a price no worse than 5% below the current market price of 360 pence. This is a put option on Mondglobe shares at a price of 342 pence. The Black-Scholes option pricing model may be used to estimate whether or not the option price is a fair price. The value of a put option may be found by first estimating the value of a call option and then using the put-call parity theorem. Basic data: Share price 360 pence Exercise price 342 pence Risk free rate 4% (0·04) Volatility is measured by the standard deviation. The variance is 169% therefore the standard deviation, σ is 13% (0·13) The relevant period is six months (0·5) Using call price = PsN(d1) – Xe –rT N(d2 ) ln (360/342) + ·04 (0·5) d1 = ––––––––––––––––––––––– + 0·5 (0·13) (0·5)·5 ·13 (0·5)·5 = 0·8218 d2 = d1 – σ (T)0·5 = 0·8218 – 0·0919 = 0·7299 From normal distribution tables: N(d1 ) = 0·5 + 0·2944 = 0·7944 N(d2 ) = 0·5 + 0·2673 = 0·7673 Inputting data into call price = Ps N(d1) – Xe –rT N(d2 ) 342 (0·7673) Call price = 360 (0·7944) – –––––––––––– e (0·04)(0·5) = 285·98 – 257·22 = 28·76 pence The value of a put option on a share may be estimated using the put-call parity theorem, P P = P C – P S + Xe –rT The option exercise price is 342 pence, and the call option price has been estimated to be 28·76 pence. Therefore P P = 28·76 – 360 + 342e–(0·04)(0·5) Solving, P P = 3·99 pence Daylon’s holding of 5,550,000 shares multiplied by the put option price gives a fair option price according to the BlackScholes model of £221,445. If the data is correct then the investment bank is charging £28,555 more than the theoretical fair value for the put option.
18
(b)
Relevant factors that might influence the decision include: (i) The Black-Scholes model is not a perfect estimator of option prices. For example it relies upon the assumption that the price volatility will continue for the relevant future period. In reality price volatility might be quite different. (ii)
The option is for only a six month period. If Daylon wishes to protect against a price fall after that date then further options will be necessary at additional cost.
(iii) There may be tax implications if any gains are made from the option. (iv) There might be cheaper alternatives than the over the counter option. For example using stock index futures with the hedge size adjusted for Mondglobe’s beta, or the use of a collar option which would reduce the premium costs, but would limit any gains if Mondglobe’s share price was to increase. (v)
4
(a)
The company might consider hedging the whole portfolio, not just the part represented by Mondglobe’s shares.
The advantages of a buy-out may be viewed from the perspectives of each of the parties involved. The selling company may regard a buy-out as preferable to the liquidation of a loss making division. A buy-out might result in a higher disposal price, and has the social effect of protecting jobs. Selling part of the organisation might allow the company to focus on its core competence. The current managers, with their existing expertise of the markets, relationships with clients etc may have a better chance of successfully operating the company. They are also likely to be highly motivated through their significant equity holdings, and by the potential for large capital gains if the company succeeds. A venture capitalist or other type of investor normally takes a high risk, in the hope of high returns mainly through capital gains. Most investors would seek some form of exit route for their investment after several years, possible through a listing on the AIM or other relevant market. In some countries investing in buy-outs may offer tax advantages.
(b)
The increase in the value of equity may be estimated from the expected retained earnings over the four year period. The maximum 15% dividend payment is assumed. Year Earnings before interest and tax Interest 8·5% Interest 9% loan1
0
1 320,000 170,000 27,000 –––––––– 123,000 36,900 –––––––– 86,100 12,915 –––––––– 73,185 873,185
Earnings before tax Taxation (30%) Earnings after tax Dividend (15%) Retained earnings Book value of equity
800,000
2 410,000 170,000 23,411 –––––––– 216,589 64,977 –––––––– 151,612 22,742 –––––––– 128,870 1,002,055
3 500,000 170,000 19,499 –––––––– 310,501 93,150 –––––––– 217,351 32,603 –––––––– 184,748 1,186,803
4 540,000 170,000 15,236 –––––––– 354,764 106,429 –––––––– 248,335 37,250 –––––––– 211,085 1,397,888
Growth in the book value of equity from 800,000 to 1,397,888 over four years is a compound growth rate of 14·97%. This is considerably less than the 20% growth rate claimed by the managers. It should be noted that this is a book value of equity. The market value of equity is much more relevant to a potential investor, and is likely to be very different from this book value. Note 1Interest
on the 9% loan
The equal annual payment comprising interest and capital that is necessary to pay off a £300,000 loan over six years is: 300,000 –––––––– = £66,875 (4·486 is the PV annuity factor for six years at 9%) 4·486 Year 1 2 3 4 (c)
Remaining value 300,000 260,125 216,661 169,285
Interest 27,000 23,411 19,499 15,236
Repayment of capital 39,875 43,464 47,376 51,639
At the start of the buy-out, the equity holding would be 1,000,000 shares by the managers, and 600,000 by the venture capital organisation. The initial warrant proposal would allow the venture capital organisation to purchase 300,000 new shares after four years, a total of 900,000. The revised suggestion would allow 450,000 new shares to be purchased which would give majority ownership and control of the company to the venture capital organisation. This is likely to be unacceptable to the managers, unless they also will have further opportunities to increase their share ownership, for example through other forms of option.
19
5
From a group perspective a sensible hedging strategy would be to net off as many offsetting currency receipts and payments as possible, and to only hedge the relevant net amounts. As MJY is a UK based multinational, the payments and receipts in pounds are not exposed to currency risk and should be ignored. All $ and € receipts and payments within the group and with third party companies are relevant when estimating the group currency exposure. In the case of intragroup trade, a receipt for one company is a payment for another. From a group view, relevant $ receipts are: 90 + 50 + 40 + 20 + 30 = 230 $ payments are: 170 + 120 + 50 = 340 $110,000 net payments need to be hedged € receipts are: 75 + 85 + 72 + 20 + 52 + 35 = 339 € payments are: 72 + 35+ 50 + 20 + 65 = 242 €97,000 net receipts need to be hedged Forward market hedges: $110,000 Buy $ 3 months forward: ––––––––– = £61,676 1·7835 €97,000 Sell € 3 months forward: ––––––––– = £67,408 1·4390 Currency options: It is now 31 December. The time of the transactions is 31 March. As the February options will have expired, May options should be used. Pounds need to be sold to purchase dollars, therefore MJY will need to purchase put options. The dollar payment is $110,000, which is the equivalent of approximately one £62,500 option contract. Option hedge Strike price
$ if exercised
Premium ($)
1·80 1·78
112,500 111,250
3,338 2,625
Premium £ (at spot 1·7982) 1,856 1,460
Overhedge ($) 2,500 1,250
Overhedge (£) (at forward 1·7861) 1,400 1,700
Worse case outcomes using currency options: 1·80:62,500 + 1,856 – 1,400 = £62,956 1·78:62,500 + 1,460 – 700 = £63,260 These are both much worse than the forward hedge, but if the dollar was to weaken to more than the relevant strike price, the option could be lapsed, and the necessary $110,000 purchased in the spot market at a more favourable exchange rate. For a relatively small hedge of this nature a multinational company would probably use a forward contract as it involves less administrative time and costs, and fixes the payment of £61,676.
6
(a)
Historically, the most important protectionist measures were tariffs, a levy or effectively a tax on imports, and quotas, which restricted either the volume or value of imports. In most recent years import barriers have tended to become more subtle, largely in response to the actions of GATT (General Agreement on Tariffs and Trade) and the WTO, which sought to promote free trade. Such barriers include explicit or ‘hidden’ subsidies favouring local companies, and regulations/red tape that made access to markets by importers difficult. These might include onerous environmental or health regulations, very lengthy bureaucratic process before permission to import is given, and very slow customs procedures which delay the entry of goods into a market. All of these measures are intended to deter overseas companies from exporting to the country.
(b)
The World Trade Organisation (WTO) in 1995 succeeded GATT (General Agreement on Tariffs and Trade) as the major world forum for international negotiations and agreement in trade. It now encompasses almost 150 countries, which represent the vast majority of world trade. In contrast to GATT, which focussed on the trade in goods, the WTO also covers trade in services including banks, insurance companies, telecommunications and hotels, intellectual property and agriculture. The WTO’s overriding objectives are to promote freer trade and thereby to help trade flow smoothly, and to reduce or eliminate protectionist barriers. It administers trade agreements, acts as a forum for negotiations and settles trade disputes. Its activities involve: (i)
Extending trade concessions equally to all members of the WTO.
(ii)
Encouraging lower tariffs and fairer trade around the world, including anti-dumping measures and subsidies.
(iii) Introducing rules that make trade more predictable. (iv) Stimulating competition through cutting subsidies.
20
(c)
A developing country that had recently joined the WTO would be expected to gradually reduce any barriers to trade of its goods and services. However, because it is a developing country it would be permitted a much longer time to undertake such measures. The effect on multinational companies could vary. If the multinational currently takes advantage of protectionist barriers that exist in the country, such barriers would be gradually removed exposing the multinational to more competition. However, freer trade might facilitate the expansion of the multinational’s exports into more markets and stimulate demand for its products. In either case the multinational company would normally have a considerable period of time in which to modify its operations in response to the reduction in barriers to trade.
21
Part 3 Examination – Paper 3.7 (ENG) Strategic Financial Management (English) 1
December 2005 Marking Scheme
This question requires the detailed analysis of a potential capital investment in a new industry, including the identification of relevant cash flows, and the risk of the investment. It also involves discussion of strategic and non-financial factors that might affect the investment decision. Marks 1
Criterion (a) for the decision Financial evaluation Cash admission receipts Food Gifts Expenses Labour Maintenance Insurance Capital allowance. For full marks capital allowance must be added back Allow also tax savings estimated directly. (Different timing is allowable) Tax Ignoring interest in the analysis Ignoring advertising Ignoring market research and apportioned overhead Initial cost and realisable value Working capital (WC could be recovered in year 5 or year 6) Discount rate estimates. Maximum 3 marks if no ungearing/regearing Correct use of discount factors Estimated NPV with comment
Other relevant information 1–2 marks for each relevant point. Look for accuracy of data, strategic considerations, suggested improvements in the analysis, what happens after four years, going concern value etc.
2
3 1 1 1 1 1 4 1 1 1 1 1 2 7 1 1 ––– max 28
max 12 ––––––– Total 40 ––––––
This question requires understanding of how the cost of capital and value of a company might be estimated, and of the possible affect on a company’s market value when capital gearing is increased. (a)
Existing cost of capital For full marks brief reasons for adjustments must be given Cost of equity correct Revised after tax cost of debt Market value of equity (1 for an attempt at MV that ignores reserves) Market value of debt Revised weighted average cost of capital Free cash flow value including growth
(b)
New weighted average cost of capital New value
(c)
Discussion of the effect of increasing gearing Reasons why the estimates might not be accurate
1 6–7 2 2 2 2 ––– max 15 2 3 ––– 5 5–6 5–6 max 10 ––––––– Total 30 –––––––
23
Marks 3
(a)
Estimate of the put option price Call option price Put option price Conclusion Reward technique, and reasonable attempts to estimate the call option first and then use put-call parity
(b)
6 3 1 ––– 10
1–2 marks for each point. Look especially for problems of Black-Scholes, alternative hedges, comments about the total portfolio and the limited time horizon. max 5 ––––––– Total 15 –––––––
4
(a)
1 mark for each valid point. Look for advantages to the various parties involved in the buy-out
(b)
Interest payments Other elements in retained earnings estimate Book value of equity and growth rate estimate
max 5 3–4 2 2 ––––––– max 7
Bonus mark if comment is made about book value estimates not being very useful (subject to 15 max for the question) (c)
5
6
Calculations and discussion of the effect on ownership
3 ––––––– Total 15 –––––––
Principle of netting off relevant transactions Ignoring £ cash flows
1 1
$ net € net Forward market hedges Options hedge Use of May put option Option calculations including over hedge Comment on possible benefit of not exercising the option, small hedge size
2 2 2 1 5 1–2 ––––––– Total 15 –––––––
(a)
Protectionist measures. Max 3 if only tariffs and quotas are discussed
5
(b)
Role of WTO and effect on potectionist measures
6
(c)
Effects on multinational. Look for reasoned discussion. Answers could vary
24
4 ––––––– Total 15 –––––––
