PART 3 WEDNESDAY 15 JUNE 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
Paxis plc will soon announce a takeover bid for Wragger plc, a company in the same industry. The initial bid will be an all share bid of four Paxis shares for every five Wragger shares. The most recent annual data relating to the two companies are shown below: £000 Sales revenue Operating costs Tax allowable depreciation Earnings before interest and tax Net interest Taxable income Taxation (30%) After tax income Dividend Retained earnings Other information: Annual replacement capital expenditure (£000) Expected annual growth rate in sales, operating costs (including depreciation), replacement investment and dividends for the next four years Expected annual growth rate in sales, operating costs (including depreciation), replacement investment and dividends after four years Gearing (long term debt/long term debt plus equity by market value) Market price per share (pence) Number of issued shares (million) Current market cost of fixed interest debt Equity beta Risk free rate Market return
Paxis 13,333 (8,683) (1,450) –––––– 3,200 (715) –––––– 2,485 (746) –––––– 1,739 (870) –––––– 869
Wragger 9,400 (5,450) (1,100) –––––– 2,850 (1,660) –––––– 1,190 (357) –––––– 833 (458) –––––– 375
Paxis 1,600
Wragger 1,240
5%
6·5%
4% 30% 298 7 6% 1·18
5% 55% 192 8 7·5% 1·38 14% 11%
The takeover is expected to result in cost savings in advertising and distribution, reducing the operating costs (including depreciation) of Paxis from 76% of sales to 70% of sales. The growth rate of the combined company is expected to be 6% per year for four years, and 5% per year thereafter. Wragger’s debt obligations will be taken over by Paxis. The corporate tax rate is expected to remain at 30%. Sales and costs relevant to the decision may be assumed to be in cash terms.
2
Required: (a) Using free cash flow analysis for each individual company and the potential combined company, estimate how much synergy is expected to be created from the takeover. State clearly any assumptions that you make. Note: The weighted average cost of capital of the combined company may be assumed to be the market weighted average of the current costs of capital of the individual companies, weighted by the current market value of debt and equity of the combined company, with the equity of Wragger adjusted for the effect of the bid price. (20 marks) (b) Discuss the limitations of the above estimates.
(6 marks)
(c) Discuss the factors that might influence whether the initial bid is likely to be accepted by the shareholders of Wragger plc. (4 marks) (d) Estimate by how much the bid might be increased without the shareholders of Paxis suffering a fall in their expected wealth, and discuss whether or not the directors of Paxis should proceed with the bid. (5 marks) (e) Once the bid is announced, discuss what defences Wragger plc might use against the bid by Paxis plc. (5 marks) (40 marks)
3
[P.T.O.
2
McTee plc is a Scottish manufacturer of golf clubs. The company has decided to purchase an existing golf club manufacturer in the State of Florida, USA. The purchase will cost an agreed $72 million for fixed assets and equipment, and in addition $8 million of working capital will be needed. No additional external funding for the proposed US subsidiary is expected to be needed for at least five years, and sales from the subsidiary would be exclusively to the US market. McTee has no other foreign subsidiaries, and the company’s managers are considering how to finance the US investment. McTee’s bank has advised that, taking into account McTee’s credit rating, the following alternatives might be possible, with finance available up to the amount shown: (i)
A one for four rights issue, at a price of 280 pence per share. Underwriting and other costs are expected to be 5% of the gross amount raised.
(ii) Five year Sterling 7% fixed rate secured bank term loan of up to £50 million, initial arrangement fee 1%. (iii) $15 million one year commercial paper, issued at $US LIBOR plus 1·5%. This could be renewed on an annual basis. An additional 0·5% per year would be payable to a US bank for a back-up line of credit. (iv) 80 million Swiss Franc five year fixed rate secured bank loan at 2·5%. This may be swapped into fixed rate $ at an additional annual interest rate of 2·3%. An upfront fee of 3·0% is also payable. (v) £42 million 10-year Sterling Eurobond issue at 6·85%. This may be swapped into $ at an annual interest rate of 4·95%. Eurobond issue costs of 2%, and upfront swap costs of 1·7% would also be payable. (vi) $40 million floating rate six year secured term loan from a US bank, at $US LIBOR plus 3%. No currency swaps are available other than those shown. Currency swaps would involve swapping the principal at the current spot exchange rate, with the reversal of the swap at the same rate at the swap maturity date. $US LIBOR is currently 3%. Exchange rates: $/£ SF/£
Spot 1·7985 – 1·8008 2·256 – 2·298
One year forward 1·7726 – 1·7746 2·189 – 2·205
McTee’s current balance sheet is summarised below. £m 117·8 8·1 98·1
Fixed assets Investments Current assets Creditors: amounts falling due within one year Loans and other borrowings Other creditors
(38·0) (48·6) ––––– 137·4 –––––
Creditors: amounts falling due after more than one year Medium and long-term bank loans 8% Bond 2009 (par value £100)
Capital and reserves Ordinary shares (25 pence par value) Reserves
30·0 18·0 ––––– 48·0 20·0 69·4 ––––– 137·4 –––––
A covenant exists that prevents the book value of McTee’s debt finance from exceeding 50% of total assets. McTee’s current dividend per share is 22·2 pence and dividend growth is approximately 4% per year. The company’s current share price is 302 pence. Interest payments on debt financing may be assumed to be made annually at the end of the year. Corporate tax in the UK, USA and Switzerland is at a rate of 30%. Issue costs and fees such as swap fees are not tax allowable.
4
Required: (a) Discuss the factors that McTee should consider before deciding how to finance the proposed US subsidiary. (10 marks) (b) Prepare a report discussing and evaluating each of the six possible sources of finance, and provide a reasoned recommendation of which source, or combination of sources, McTee should use. Supporting calculations, including costs, should be provided wherever relevant. (20 marks) (30 marks)
5
[P.T.O.
Section B – TWO questions ONLY to be attempted 3
Assume that it is now 1 June. Your company expects to receive £7·1 million from a large order in five months’ time. This will then be invested in high quality commercial paper for a period of four months, after which it will be used to pay part of the company’s dividend. The company’s treasurer wishes to protect the short-term investment from adverse movements in interest rates, by using futures or forward rate agreements (FRAs). The current yield on high quality commercial paper is LIBOR + 0·60%. LIFFE £500,000 3 month Sterling futures. £12·50 tick size. September 96·25 December 96·60 Futures contracts mature at the month end. LIBOR is currently 4%. FRA prices (%) 4 v 5 3·85 – 3·80 4 v 9 3·58 – 3·53 5 v 9 3·50 – 3·45 Required: (a) Devise a futures hedge to protect the interest yield of the short-term investment, and estimate the expected lock-in interest rate as a result of the hedge. (4 marks) (b) Ignoring transactions costs, explain whether the futures or FRA hedge would provide the higher expected interest rate from the short-term investment. (2 marks) (c) If LIBOR fell by 0·5% during the next five months show the expected outcomes of each hedge in the cash market, futures market and FRA market as appropriate. (6 marks) (d) Explain why the futures market outcome might differ from the outcome in (c) above.
(3 marks) (15 marks)
6
4
The managers of a pension fund follow an active portfolio management strategy. They try to purchase shares and bonds that show a positive abnormal return (positive alpha factor in the case of shares). The pension fund is required by law to hold at least 40% of its investments in bonds. £100 million is currently available for investment. Three shares and three bonds are being considered for purchase. The required return on bonds may be measured using a model similar to the capital asset pricing model, where beta is replaced by the relative duration of the individual bond (Di) and the bond market portfolio (Dm). This is shown as Di ––– Dm Shares: Equity market Flitter plc Polgin plc Scruntor plc Bonds: Bond market UK Government Supragow plc Teffon plc
Expected return (%) 10·5 11·0 19·5 13·5
Standard deviation of returns 15 25 18 35
Correlation coefficient of returns with the market 1 0·76 0·54 0·63
Duration (years) 17·5 11·5 18·6 14·2
Coupon (%) – 8 6 9
Redemption yield (%) 5·8 4·5 5·3 7·2
The risk free rate is 4%. Required: (a) Evaluate whether or not any of the shares or bonds are expected to offer a positive abnormal return. (7 marks) (b) The pension fund currently has the maximum permitted investment in shares and wishes to continue this strategy. It has a market value of £1,000 million and a beta of 0·62. Calculate the required return from the pension fund if any shares and bonds with positive abnormal returns are purchased. State clearly any assumptions that you make
(3 marks)
(c) Discuss possible problems with the pension fund’s investment strategy.
(5 marks) (15 marks)
7
[P.T.O.
5
Boster plc is a multinational company that has investments in several developing countries. It is considering investments in three more developing countries, Ammobia, Flassia and Hracland. All three countries have a history of political instability, but Boster believes that the potential returns from the investments might justify the political risk. A consultancy report has produced the following assessments of the countries. Ammobia Flassia Hracland
Expected investment return (%) 21 18 28
Political Risk (%) 33 29 42
Political risk was measured by investigating key variables in the relevant countries. These were: corruption, changes in government, social conditions, cultural issues, unfair trade and asset security. Boster will invest in a maximum of two of the countries, with an equal amount invested in each country. The countries are in diverse parts of the world, and the returns from the investments in the three countries are believed to be independent. Required: (a) Calculate the risk, return and coefficient of variation of the possible investment combinations.
(6 marks)
(b) Discuss how useful the information calculated in (a) above might be to Boster in making its investment decisions. (5 marks) (c) Briefly discuss other ways by which Boster might attempt to measure the potential political risk of the investments. (4 marks) (15 marks)
6
Discuss the possible foreign exchange risk and economic implications of each of the following types of exchange rate system for multinational companies with subsidiaries located in countries with these systems: (a) a managed floating exchange rate; (b) a fixed exchange rate linked to a basket of currencies; and (c) a fixed exchange rate backed by a currency board system. (15 marks)
8
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
9
[P.T.O.
7
3UHVHQW 9DOXH 7DEOH 3UHVHQW YDOXH RI LH U ²Q :KHUH
U Q
GLVFRXQW UDWH QXPEHU RI SHULRGV XQWLO SD\PHQW 'LVFRXQW UDWH U
3HULRGV Q
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
Q
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
10
77
$QQXLW\ 7DEOH
3UHVHQW YDOXH RI DQ DQQXLW\ RI LH :KHUH
U Q
² U ²Q ³³³³²² U
GLVFRXQW UDWH QXPEHU RI SHULRGV 'LVFRXQW UDWH U
3HULRGV Q
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
Q
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
ă ă ă ă ă
11
[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
12
