Strategic Financial Management
PART 3 WEDNESDAY 11 JUNE 2003
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 8, 9, 10 and 11
7 . 3 r e p a P
Section A – BOTH questions are compulsory and MUST be attempted 1
Evertalk plc manufactures mobile phones and operates a mobile phone network. In order to offer the latest hand-held videophone technology the company has borrowed extensively on the international bond market. Unfortunately the new technology has proved to be unpopular with consumers, and sales of new handsets and network subscriptions have been less than forecast. As a result the company’s share price has fallen to only 10 pence, from a high two years ago of 180 pence. Capital investment of approximately £100 million per year is required for the company to continue operating at current levels – £20 million for the manufacturing division and £80 million for the network division. Approximately 25% of the sales of the manufacturing division are to the network division. Profit and loss accounts for the years ending 31 March 2002 and 2003 £ million 2002 2003 Inflows: Manufacturing division 280 320 Network division 410 470 —— —— 690 790 Outflows: Manufacturing division 190 230 Network division 490 560 Tax allowable depreciation 50 60 —— —— 730 850 Pre-tax losses (40 ) (60) Balance Sheet as at 31 March 2003 £ million Land and buildings (net) Other fixed assets (net)
120 175 —— 295
Current assets Stock Debtors Cash Creditors: amounts falling due within 1 year Floating rate bank loans 1 Creditors
260 85 5 ——
350
40 209 ——
(249)
Creditors: amounts falling due after more than 1 year 12% unsecured bonds 2010
Shareholders’ funds Ordinary shares (10 pence par) Reserves
1
Currently 8% interest
2
(300) —— 96 50 46 —— 96
Evertalk’s board of directors has arranged a crisis meeting and is considering three proposals: (i)
A corporate corporate restruct restructuring, uring, in which which bonds are are converted to equity equity,, and which gives gives control control of the company company to the current bond holders.
(ii) Sale of the company’s company’s shares shares to Globtalk Globtalk plc, plc, which operates operates a successful successful rival rival mobile phone phone network, network, for the sum of £50 million. This deal would be conditional upon Globtalk not taking over the liability for any of Evertalk’s loans. (iii) Cease trading trading and and close the the company company.. The restructuring has the following proposed conditions: (i)
Existing ordinary Existing ordinary shares shares will be cancelle cancelled d and replaced replaced by 100 100 million million new ordinary ordinary shares shares with a par value value of 50 pence each. 95 million of these will be given to the existing bondholders in exchange for the cancellation of all existing bonds. The bondholders will also make available £100 million of new 10% fixed rate loans.
(ii) Existing Existing shareholde shareholders rs will be offered offered one 5% convertible debenture debenture (£100 (£100 nominal value) value) free of charge charge in exchange for every 1,000 shares they they now own. Conversion into new ordinary shares is available at any time during the next five years at a conversion rate of 50 shares for every £100 convertible debenture held. (iii) 5 million new shares will be given to existing participants in the company’s share option scheme in exchange exchange for cancellation of their existing options to purchase 10 million old shares. Other information: (i)
All existi existing ng creditor creditorss have have equal equal claims claims for for repaym repayment ent against against the compan company’s y’s assets. assets.
(ii)
No dividends have been paid on ordinary shares for the the last three years. years.
(iii) Los Losses ses may may not not be carri carried ed forward forward for for tax tax purposes purposes.. (iv) Surpl Surplus us land and building buildingss could be disposed disposed of for for £40 million million in order to to repay the the bank loan. loan. (v)
The value value of debtors, debtors, cash, fixed fixed assets assets and creditors creditors represented represented by the the two divisions divisions is approxima approximately tely equal. equal. 90% of the stock is represented by the manufacturing division.
(vi) The £300 millio million n bond has been been borrowed borrowed by the network network divisio division, n, and the the £40 million million bank loan loan by the manufacturing division. (vii) If the restructuring and new investment does not take place, place, earnings before tax (after interest payments) are expected to stay at approximately the 2003 level. If new investment takes place, forecast earnings before interest and tax are expected to increase by £30 million as a result of some rationalisation of the network division. (viii) The current market price of ordinary shares is 10 pence, and of debentures £121. The par value and redemption value of each debenture is £100. (ix) Corporate Corporate tax is is at the rate rate of 30%. The risk risk free rate rate is 5% and the the market market return 14%. 14%. The equity equity beta of the the company is 1·15, with the manufacturing division equity beta approximately 0·9, and the network division equity beta approximately 1·35. The company’s analysts believe that market weighted gearing of about 60% equity,, 40% debt is appropriate for the entire sector, equity sector, but currently this cannot be achieved due to the low share price. (x)
Realisabl Real isable e values values of a assets ssets if not sold sold as part of a going concer concern n are estimat estimated ed to be: be: £ million Land and buil ild din ing gs 140 (includin ing g the surplus £40 million) Other fixed assets 50 Stock 100 Debtors 70
(xi) Redundancy Redundancy and closure closure costs costs of approximate approximately ly £100 million million would be payable payable if the company company was closed, closed, all payable before any other creditors. These costs relate equally to the two divisions. All realisable values and closure values are after tax. Required: Acting as an independent consultant prepare a report for the board of directors of Evertalk. Your report should consider the advantages and disadvantages of each of the three proposals, from the viewpoint of each group of existing stakeholders in the company. It should also identify any other strategy(ies) which might be possible for Evertalk plc. State clearly any assumptions that you make. (35 marks) 3
[P.T.O.
2
Hasder plc currently operates only in the UK, but is considering diversifying its activities internationally into either Europe or East Asia, the latter including several developing economies. Estimates have been obtained of the likely risk and return of investments in these parts of the world, which are expected to vary during different economic states of the UK. After either diversification approximately 30% of the market value of the company would be represented by overseas investments. UK economic state
Probability
Invest in Europe
Expected % IRR return Invest in East Asia
0·3 0·5 0·2
7 12 21
2 30 15
Low growth Average growth Rapid growth
Invest in UK 6 13 17
Standard deviation of expected returns: Europe East Asia UK
4·86 12·26 4·03
Covariances of expected returns: UK/Europe UK/East Asia
17·89 31·98
Members of Hasder’s board of directors have different views about such diversification. Director A believes that the company should focus exclusively upon the UK market as it always has, because ‘overseas investments are too risky’. Director B believes that overseas diversification will offer the company the opportunity to achieve a much better combination of risk and return than purely domestic investments, and ‘will open up new opportunities’. Director C considers that overseas investments are expensive, and overseas diversification will not be valued by shareholders who could easily achieve such diversification themselves. Director D is in favour of the diversification, but considers East Asia to be a much better alternative than Europe. Director E is also in favour of East Asia, but suggests that a much higher proportion of the company’s activities should be located there, possibly between 50% and 70%. Required: (a) Discuss the views views of each each of the five five directors. Include in your your discussion discussion relevant calculations calculations regarding regarding portfolio risks and returns. What other factors might influence the investment decision? State clearly any assumptions that you make.
(25 marks)
(b) Estimate and explain explain the implications of the correlation coefficients between: (i)) (i
UK//Eu UK Euro rop pe; an and d (6 marks)
(ii) (i i) UK UK/E /Eas astt Asia Asia.. (c) Hasder plc has also purchased CAPM based risk and return estimates from an investment bank.
Europe East Asia
Relevant ma market re return
Relevant ri risk fr free ra rate
Relevant in investment be beta
13% 18%
5% 8%
0·85 1·32
Assuming this information is accurate, show how it might be used to assist the diversification decision. (4 marks) (35 marks)
4
Section B – TWO questions ONLY to be attempted 3
(a) Dis Discus cusss the the adva advanta ntages ges of hed hedgin ging g with with int intere erest st rat rate e caps caps and col collar lars. s.
(6 marks)
(b) Current futures prices suggest that interest rates are expected to fall during the next few months. Troder plc expects to have £400 million available for short-term investment for a period of 5 months commencing late October.. The company wishes to protect this short-term investment from a fall in interest rates, but is concerned October about the premium levels of interest rate options. It would also like to benefit if interest rates were to increase rather than fall. The company’s advisers have suggested the use of a collar option. LIFFE short sterling options (£500,000), points of 100% Calls Strike price 95250 95500 95750
Sept 0·040 0 0
Puts Dec 0·445 0·280 0·165
Sept 0·040 0·250 0·500
Dec 0·085 0·170 0·305
LIBOR is currently 5% and the company can invest short-term at LIBOR minus 25 basis points. Required: (i)
Assume that it is now Assume now early Septem September ber.. The company company wishes wishes to receive receive more more than £6,750,00 £6,750,000 0 in interest from its investment after paying any option premium. Illustrate how a collar hedge may be used to achieve this. (N.B. It is not necessary to estimate the number of contracts for this illustration). (7 marks)
(ii) Estimate the maximum interest that could be be received with with your selected selected hedge.
(2 marks) (15 marks)
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[P.T.O.
4
Discos plc is negotiating an export contract with a customer in a developing coun try, Xeridia. Xeridia. Discos has not exported to the country before, and is concerned both about the risk of late or non-payment for the exports, and about the foreign exchange risks associated with the Xeridian peso. The contract specifies that Discos should receive 55 million Xeridian pesos in three months’ time. Discos will require short-term finance for the full value of the exports. Exchange rates (peso/£) Spot 32·34 – 32·89 3 months forward 33·82 – 34·55 6 months forward 35·17 – 35·90 Current short-term UK interest rates available to Discos plc: Borrowing 6·5% Investing 5·3% Discos is considering three different ways of protecting against the foreign trade risk: (i)
Insure the deal with Protect Trade Trade plc and undertake under take a forward market hedge. An insurance policy is available at a cost of 1·25% of the spot Sterling equivalent of the export value. The policy gives the following protection: 95% cover against non-payment as a result of political actions by a foreign government; 90% cover against other nonpayment. Any payment by the insurer would be after six months.
(ii) Use the services of a non-recourse export factor. The factor will guarantee that £1,590,000 is paid in three months’ time if the customer pays on time, or £1,530,000 in six months’ time if the customer makes a late payment or defaults. The factor is prepared to provide immediate trade finance of up to 80% of the value of the guaranteed sum, at an interest rate of 6·3%. The factor charges an administration fee of 2·5% of the sum guaranteed. (iii) Use a confirmed, irrevocable, documentary letter of credit. The letter of credit would include a 90 day bank bill of exchange that may be immediately discounted in the Xeridian money market at an annual rate of 25%, which is the short term borrowing rate in Xeridia. The fees associated with the letter of credit are £30,000. Discos has been advised that there is at least a 5% chance of late payment after six months or default by the client. The Xeridian government is not expected to take any action that is detrimental to foreign trade during the next six months. Required: Discuss the advantages and disadvantages of each alternative, and recommend which should be selected. Relevant calculations calculations should support your discussion. State clearly any assumptions that you make. (15 marks)
6
5
(a) Briefly discuss possible reasons for an upward sloping yield curve.
(4 marks)
(b) The financial manager of Gaddes plc’s pension fund is reviewing strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term bonds. Interest rates are expected expected to be quite volatile for the next few years. Among the pension fund’s current investments are two AAA rated bonds: 1) Zer Zero o coup coupon on June 201 2018 8 2) 12% Gilt Gilt June 2018 2018 (inter (interest est is payable payable semi-a semi-annually nnually)) The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield may be assumed to be 3%. Both bonds have a par value and redemption value of £100. Required: (i)
Estimate the Estimate the market market price price of each of of the bonds bonds if inter interest est rates rates (yield (yields): s): (a) increase by 1%; (b) decrease by 1%.
The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal amount at all points of the yield curve). (6 marks) (ii) Comment upon upon and briefly briefly explain explain the size size of the expected price movements movements from the the current prices, prices, and how such changes in interest rates might affect the strategy of the financial manager with respect to investing in the two bonds. (3 marks) (iii) How might the bond investment strategy of the financial manager be affected if the yield curve was expected to steepen (the gap between short- and long-term interest rates to widen), and interest rates are expected to rise? (2 marks) (15 marks)
6
(a) Dis Discus cusss why con confli flicts cts of of intere interest st might might exis existt betwe between en share sharehol holder derss and bond bondhol holder ders. s.
(8 marks)
(b) Provide examples examples of covenants that that might be attached to bonds, and briefly discuss discuss the advantages and and disadvantages to companies of covenants. (7 marks) (15 marks)
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[P.T.O.
Formulae Sheet
+ [E(rm ) – r f ] β j
E( r j ) = r f
Ke (i)
D1
(ii)
P 0
WACC Ke g
or Keu 1 –
+ g E
+ Kd (1 – t )
E+D
D E+D
Dt E + D
2 asset portfolio
σp
=
σ a2 x 2 + σ 2b (1 – x ) 2 + 2 x (1 – x ) p abσ aσ b i f – i uk
Purchasing power parity
βa
= β e
1 + i uk
E E + D(1 – t )
+ β d
D(1 – t ) E + D(1 – t )
Call Call pric price e for for a Eur Europ opea ean n opt optio ion n = Ps N( d1) – Xe – rT N ( d 2 ) d 1 = d2
1n ( Ps / X )
+
rT
σ T
= d1 – σ
T
8
+
0.5σ T
9
[P.T.O.
10
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 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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