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Date sent to marker

Date received from marker

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Student's overall mark

FINAL ASSESSMENT SCRIPT SUBMISSION FORM Script marking is only available to Classroom, Live Online and Distance Learning students enrolled on appropriate Kaplan courses.

ACCA – Paper P4 Advanced Financial Management

June 2015 Final Assessment

Instructions

• Please complete your personal details above. • All scripts should ideally be submitted to your Kaplan centre for marking via email to help speed up the marking process. Please scan this form and your answer script in a single PDF and email it to your Kaplan centre. • Alternatively you may post your script to us. If so, please use the correct Royal Mail tariff (large letter). • Classroom students may submit scripts to their local centre in person. You will be provided with the dated receipt below which you should retain as proof of submission.

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Marking Report

Notice to Markers

1 When commenting about the script performance, please ensure on individual questions and on overall assessment your comments cover areas of examination technique including:

• Time management

• Handwriting • Presentation and layout

• Use of English

• Points clearly and concisely made

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• Accuracy of calculations

• Calculations cross-referenced to workings

• All parts of the requirement attempted

• Length of answers equates to marks available

• Read the question carefully

2 For each question, please provide suitable constructive comments

Question Number

General Comments Exam Technique Comments



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ACCA FINAL ASSESSMENT

Advanced Financial Management June 2015

Time allowed Reading time: 15 minutes Writing time: 3 hours Answer the question in section A and TWO questions in section B Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination hall

Kaplan Publishing/Kaplan Financial

Pape

r P4



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ACCA P4 : ADVANCED F INANCIAL MANAGEMENT

2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2014

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, and consequential or otherwise arising in relation to the use of such materials.



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FINAL ASSESSMENT QUESTIONS

KAPLAN PUBLISHING 3

SECTION A

ANSWER THIS QUESTION

1 (a) NTC plc is a UK multinational with subsidiaries in Spain, Hong Kong and the USA. Transactions between companies within the group have historically been in all of the currencies of the countries where the companies are located and have not been centrally co-ordinated, with the currency of the transaction varying in each deal. Transactions due in approximately three months’ time are shown below. All receipts and payments are in thousand units of the specified currencies.

Assume that it is now mid-June.

Payments (read down) Receipts (read across) UK Spain Hong

Kong USA

UK – €210 HK$720 US$110 Spain £100 – €80 – Hong Kong HK$400 – – – USA US$430 €120 HK$300 –

Exchange rates: US$/£ Euro/£ HK$/£ Spot 1.4358 – 1.4366 1.6275 – 1.6292 11.1987 – 11.2050 3 months forward 1.4285 – 1.4300 1.6146 – 1.6166 11.1567 – 11.1602

Note:

The Hong Kong dollar is pegged against the US dollar.

Interest rates available to NTC and its subsidiaries (annual %):

Borrowing Investing UK 6.9 6.0 Spain 5.3 4.5 Hong Kong n.a. 6.1 USA 6.2 5.4 Currency options

Philadelphia stock exchange £/$ options, £31,250 contracts. Premium is in cents per £. Calls Puts Exercise price July August September July August September

1.42 1.42 2.12 2.67 0.68 1.42 2.15 1.43 0.88 1.60 1.79 1.14 1.92 3.12 1.44 0.51 1.19 1.42 1.77 2.51 4.35

Option premiums are payable upfront. Contracts may be assumed to expire at the end of the relevant month.



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4 KAPLAN PUBLISHING

Required:

(i) The parent company is proposing that inter-company payments should be settled in sterling via multilateral netting. Demonstrate how this policy would reduce the number of transactions. (Foreign exchange spot mid-rates may be used for this purpose.) (9 marks)

(ii) If payments were to continue to be made in various currencies, illustrate three methods by which the UK parent company might hedge its transaction exposures for the next three months. Discuss, showing relevant calculations, which method should be selected. Include in your discussion an evaluation of the circumstances in which currency options would be the preferred choice. (Note: NTC plc wishes to minimise the transaction costs of hedging.)

(15 marks)

(b) NTC plc has been approached by a Russian company that wishes to purchase goods from NTC plc in exchange for wheat. The Russian currency is not freely convertible.

Required:

Discuss the advantages and disadvantages of such countertrade to NTC plc. (6 marks)

(c) C plc is based in France and its corporate treasury team is deciding what strategy to adopt towards interest rate risk management. The company’s financial projections show an expected cash surplus in five month’s time of (€ = Euro) €4 million, which will last for a period of approximately six months. EURIBOR (which is the European equivalent of LIBOR) is currently 6.5% per year and C plc can borrow at 1.5% above EURIBOR, or invest at 1.5% below EURIBOR.

The corporate treasury team does not want interest receipts during the six-month period to decrease by more than €2,500 from the amounts that would be paid at current interest rates. It is now 1 October.

LIFFE prices (1 October)

Futures

LIFFE €1,000,000 three month euro interest rate (points of 100%)

December 93.35

March 93.20

June 92.85

Options

LIFFE €1,000,000 short euro options (points of 100%)

Exercise price Calls Puts December March June December March June

92.50 0.35 0.90 1.06 − − 0.08 93.00 0.18 0.54 0.78 − 0.22 0.39 93.50 0.12 0.24 0.45 0.20 0.62 0.93 94.00 − − 0.15 0.38 1.33 1.68



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KAPLAN PUBLISHING 5

Required:

Illustrate the results of futures and options hedges if, by 1 March:

• interest rates fall by 1% – futures prices move by 0.85%

• interest rates rise by 2% – futures prices move by 1.9%.

Explain how C plc should hedge its interest rate exposure. All relevant calculations must be shown. Taxation, transactions costs and margin requirements may be ignored. State clearly any assumptions that you make. (20 marks)

(Total: 50 marks)



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6 KAPLAN PUBLISHING

SECTION B

ANSWER TWO QUESTIONS ONLY

2 Larkin Motors plc (“LM”) is a long-established listed company. Its main business is the retailing of new and used motor cars and the provision of after-sales service. It has sales outlets in most of the major towns and cities in the UK. It also owns a substantial amount of land and property that it has acquired over the years, much of which it rents or leases on medium-long term agreements. Approximately 80% of its non-current asset value is land and buildings.

The company has grown organically for the last few years but is now considering expanding by acquisition. The Chief Executive is not in favour of hostile bids as he believes the bidder always pays too much to acquire the target. Any acquisition that LM makes will therefore need to be an agreed bid.

Brass Vehicles Limited (“BV”) owns a number of car showrooms in wealthy, semi-rural locations in the North of England. All of these showrooms operate the franchise of a well-known major motor company. BV is a long-established private company with the majority of shares owned by the founding family, many of whom still work for the company. The major shareholders are now considering selling the business if a suitable price can be agreed. The Managing Director of BV, who is a major shareholder, has approached LM to see if it would be interested in buying BV. He has implied that holders of up to 50% of BV’s shares might be willing to accept LM shares as part of the deal.

The forecast earnings of LM for the next financial year are £35 million. According to the Managing Director of BV, his company’s earnings are expected to be £4 million for the next financial year.

Financial statistics and other information on LM and BV are shown below:

LM BV Shares in issue (millions) 25 1.5 Earnings per share (pence) 112.5 153 Dividend per share (pence) 50.6 100 Share price (pence) 1,237 n/a Net asset value attributable to equity (£m) 350 45 Debt ratio 20 0 (outstanding debt as percentage of total market value of company) Forecast growth rate percentage (constant, annualised) 4 5 Cost of equity 9% n/a

BV does not calculate a cost of equity, but the industry average for similar companies is 10%.



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KAPLAN PUBLISHING 7

Required:

Assume you are a financial manager working with LM. Advise the LM Board on the following issues in connection with a possible bid for BV:

(a) methods of valuation that might be appropriate and a range of valuations for BV within which LM should be prepared to negotiate (12 marks)

(b) the financial factors relating to both companies that might affect the bid (6 marks)

(c) the most appropriate form of funding the bid and the likely financial effects on LM

(7 marks)

Note: A report format is NOT required for this question. (Total: 25 marks)

3 Emlyn Co is a company which owns and runs a large chain of bookshops located throughout the UK. Over the past three years the company has struggled to maintain its market share in the face of fierce competition from internet retailers and from large supermarket chains. Consequently, the company’s share price has fallen from £4.33 three years ago, to £2.71 at the end of last week, and all three of the big credit rating agencies (Moody’s, Fitch and Standard and Poor’s) have downgraded Emlyn Co’s rating on its corporate bonds.

Then, last weekend, an article by a respected financial analyst in The Sunday Times advised shareholders to sell their shares in Emlyn Co immediately. In 3 days of trading this week, the share price has fallen further, and now stands at £2.12.

The directors of Emlyn Co have just held an emergency board meeting. They have discussed the firm’s current plight, and have decided that the firm needs to reduce risk, secure future growth, and to ultimately aim to improve shareholder wealth.

In an attempt to achieve all three of these objectives, the directors have decided to consider a new strategy of diversification, by attempting to acquire an underperforming business in a different business sector.

You are an advisor to the board of directors. You have been asked to prepare some briefing notes in advance of next week’s follow-up board meeting.

Required:

(a) Briefly discuss whether diversification through acquisition is an effective means of reducing risk and securing future growth. (6 marks)

(b) Explain how a takeover may lead to an increase in wealth for the bidding company’s shareholders. (7 marks)

(c) Explain why a takeover may fail to deliver an expected increase in wealth for the bidding company’s shareholders. (7 marks)

(d) Briefly outline the role that financial analysts play in creating an efficient stock market. (5 marks)

(Total: 25 marks)



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8 KAPLAN PUBLISHING

4 You are employed in the derivatives markets division of a leading international bank and you have responsibility for the following client portfolio:

Client A requires a call option on 4,000 ordinary shares in Lambley plc. The option is a European option and will be exercisable in 3 month’s time. An exercise price of £1.50 has been requested.

The following data is available:

Current share price of Lambley’s shares £1.80 Risk free interest rate 10% pa Standard deviation (volatility) of Lambley’s shares 50% pa

Client B owns 10,000 shares in Lambley plc and, because of the current market uncertainty, wishes to construct a risk less hedge for these shares.

Client C wishes to purchase a European put option on 2,000 Lambley plc shares, exercise price £1.50 for 3 month exercise.

Client D has been studying the prices of $/£ call options and requires you to outline the determinants of the option premiums on these instruments.

Required:

(a) Calculate the value/premium of the call option on 4,000 shares in Lambley plc for client A. (9 marks)

(b) Demonstrate for client B how a delta hedge could be constructed to protect his position. (3 marks)

(c) Calculate the premium you would quote client C for a put option on 2,000 shares in Lambley plc. (5 marks)

(d) Briefly outline the determinants of the premium for a call option on sterling options. (8 marks)

(Total: 25 marks)



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KAPLAN PUBLISHING 9

MATHEMATICAL TABLES

Formulae and tables

Modigliani and Miller Proposition 2 (with tax)

ke = kie + (1 − T)(ki

e − kd) e

d

VV

The Capital Asset Pricing Model

E(ri) = Rf + βi(E(rm) − Rf)

The asset beta formula

βa = ))T1(V+V

)T1(V+

))T1(V+V(V

dde

de

de

e ββ-

--

The Growth Model

)gr()g+1(D

=Pe

oo -

Gordon’s growth approximation

g = bre

The weighted average cost of capital

)T1(kV+V

V+k

V+VV

=WACC dde

de

de

e -

The Fisher formula

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

Purchasing power parity and interest rate parity

)h+1()h+1(

×s=sb

co1

)i+1()i+1(

×s=fb

co0

Modified internal rate of return

( ) 1–r+1PVPV

=MIRR e

n1

I

R



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10 KAPLAN PUBLISHING

The Black-Scholes option pricing model

c = PaN(d1) – PeN(d2)e−rt

Where:

tst)s5.0+r(+)P/Pln(

=d2

ea1

tsd=d 12 -

The Put Call Parity relationship

p = c − Pa + Pee−rt



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KAPLAN PUBLISHING 11

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 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239

Discount rate (r)

Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194

10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065



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Annuity table

Present value of an annuity of 1, i.e. rr n- )+1(1

Where r = discount rate

n = number of periods


(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 8.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606


(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031

10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.968 4.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675



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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

.0000 .0398 .0793 .1179 .1554

.0040 .0438 .0832 .1217 .1591

.0080 .0478 .0871 .1255 .1628

.0120 .0517 .0910 .1293 .1664

.0160 .0557 .0948 .1331 .1700

.0199 .0596 .0987 .1368 .1736

.0239 .0636 .1026 .1406 .1772

.0279 .0675 .1064 .1443 .1808

.0319 .0714 .1103 .1480 .1844

.0359 .0753 .1141 .1517 .1879

0.5 0.6 0.7 0.8 0.9

.1915

.2257

.2580

.2881

.3159

.1950

.2291

.2611

.2910

.3186

.1985

.2324

.2642

.2939

.3212

.2019

.2357

.2673

.2967

.3238

.2054

.2389

.2703

.2995

.3264

.2088

.2422

.2734

.3023

.3289

.2123

.2454

.2764

.3051

.3315

.2157

.2486

.2794

.3078

.3340

.2190

.2517

.2823

.3106

.3365

.2224

.2549

.2852

.3133

.3389

1.0 1.1 1.2 1.3 1.4

.3413

.3643

.3849

.4032

.4192

.3438

.3665

.3869

.4049

.4207

.3461

.3686

.3888

.4066

.4222

.3485

.3708

.3907

.4082

.4236

.3508

.3729

.3925 4099 .4251

.3531

.3749

.3944

.4115

.4265

.3554

.3770

.3962

.4131

.4279

.3577

.3790

.3980

.4147

.4292

.3599

.3810

.3997

.4162

.4306

.3621

.3830

.4015

.4177

.4319

1.5 1.6 1.7 1.8 1.9

.4332

.4452

.4554

.4641

.4713

.4345

.4463

.4564

.4649

.4719

.4357

.4474

.4573

.4656

.4726

.4370

.4484

.4582

.4664

.4732

.4382

.4495

.4591

.4671

.4738

.4394

.4505

.4599

.4678

.4744

.4406

.4515

.4608

.4686

.4750

.4418

.4525

.4616

.4693

.4756

.4430

.4535

.4625

.4699

.4761

.4441

.4545

.4633

.4706

.4767

2.0 2.1 2.2 2.3 2.4

.4772

.4821

.4861

.4893

.4918

.4778

.4826

.4864

.4896

.4920

.4783

.4830

.4868

.4898

.4922

.4788

.4834

.4871

.4901

.4925

.4793

.4838

.4875

.4904

.4927

.4798

.4842

.4878

.4906

.4929

.4803

.4846

.4881

.4909

.4931

.4808

.4850

.4884

.4911

.4932

.4812

.4854

.4887

.4913

.4934

.4817

.4857

.4890

.4916

.4936

2.5 2.6 2.7 2.8 2.9

.4938

.4953

.4965

.4974

.4981

.4940

.4955

.4966

.4975

.4982

.4941

.4956

.4967

.4976

.4982

.4943

.4957

.4968

.4977

.4983

.4945

.4959

.4969

.4977

.4984

.4946

.4960

.4970

.4978

.4984

.4948

.4961

.4971

.4979

.4985

.4949

.4962

.4972

.4980

.4985

.4951 4963 .4973 .4980 .4986

.4952

.4964

.4974

.4981

.4986

3.0

.4987

.4987

.4987

.4988

.4988

.4989

.4989

.4989

.4990

.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 d1 > 0, add 0.5 to the relevant number above. If d1 < 0, subtract the relevant number above from 0.5.



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ACCA

Paper P4

Advanced Financial Management June 2015

Final Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the final assessment questions and submitted them for marking.

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2 KAPLAN PUBLISHING

© Kaplan Financial Limited, 2014

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, and consequential or otherwise arising in relation to the use of such materials.

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FINAL ASSESSMENT ANSWERS

KAPLAN PUBLISHING 3

1 NTC PLC AND C PLC

(a)

Tutorial note

The table of payments and receipts might be difficult to understand on first reading it. It shows, for example, that the UK division will (in 000s) pay £100 to the Spain division and receive €210 from Spain in the same period. Similarly, Spain will pay €210 to the UK and €120 to the USA, and receive €80 from Hong Kong.

(i) Receipts and payments in sterling at spot mid-rates:

Payments (read down) £000 Receipts (read across) UK Spain Hong

Kong USA Total

receipts UK – 128.96 64.27 76.59 269.82Spain 100.00 – 49.13 – 149.13Hong Kong 35.71 – – – 35.71USA 299.40 73.69 26.78 – 399.87 –––––– –––––– –––––– –––––– –––––– Total payments (435.11) (202.65) (140.18) (76.59) 854.53Net (165.29) (53.52) (104.47) 323.28

Tutorial notes

(1) Spot mid rates are US$1.4362/£1, €1.62835/£1 and HK$11.20185/£1.

(2) The receipts minus payments figures are calculated simply by subtracting the payments total for each currency from the receipts total shown in the right-hand column of the table.

As a result of multilateral netting the number of transactions may be reduced from nine to three, with the UK parent, the Spanish and Hong Kong subsidiaries each making one payment to the US subsidiary.

(ii) Forward contracts, money market hedging and currency options will be illustrated.

In order to minimise transaction costs, netting of trade will be used where possible. As the Hong Kong dollar is pegged against the US dollar, the exposure risk of the Hong Kong dollar will be hedged using US dollars.

This involves a slight risk, as the Hong Kong dollar might discontinue its pegged position. As interest rates are less than 1% different between the USA and Hong Kong, the economic pressure for the Hong Kong dollar to devalue is not likely to be strong at present.

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4 KAPLAN PUBLISHING

UK parent net exposures (in 000s):

Payments Receipts Net for hedging, ( ) is payment £100 – n.a.

– €210 €210 HK$400 HK$720 $HK320 = $US41.03 (at cross rate of $HK7.800/$US) US$430 US$110 (US$320). So net = (US320) – US41.03 = (US$278.97)

Only two exposures need to be hedged; receipts of €210,000 and payments of US$278,970.

Forward markets:

Euro 1.6166

€210,000= £129,902 receipt

US$ 1.4285

$278,970= £195,289 payment

Money markets:

Euro hedge:

Borrow Euro at 5.3% for three months:

Euro 1.01325

€210,000or 207,254 to repay Euro 210,000 in three months' time.

Convert Euro 207,254 at spot of E1.6292/£ to give £127,212.

Invest £127,212 for three months at 6.0% to yield £127,212 × 1.015 = £129,120.

US dollar hedge:

Borrow £191,708 at 6.9% for three months, total cost £195,015.

Convert £191,708 to dollars at the spot of $1.4358/£ to give $275,254.

Invest $275,254 for three months at 5.4% to yield $278,970.

Options:

September put options on £ are required as a payment in US dollars is due.

Exercise price 1.42:

Number of contracts 1.42

$278,970= £196,458,

£31,250£196,458

= 6.29 contracts

£31,250 × 6 × 1.42 = $266,250 is hedged, the remaining $12,720 will be bought forward at $1.4285/£ or a cost of £8,904.



$278,970= £195,084,

£31,250$195,084

= 6.24 contracts


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KAPLAN PUBLISHING 5



$278,970= £193,729,

£31,250$193,729

= 6.20 contracts


Premium costs (including three months financing at 6.9% per annum)

Exercise price:

1.42 £187,500 × 2.15c = $4,031 @ $1.4358/£ = £2,808 × 1.01725 = £2,856 1.43 £187,500 × 3.12c = $5,850 @ $1.4358/£ = £4,074 × 1.01725 = £4,145 1.44 £187,500 × 4.35c = $8,156 @ $1.4358/£ = £5,680 × 1.01725 = £5,778

Total cost if the option is exercised:

1.42 £187,500 + £2,856 + £8,904 = £199,260 1.43 £187,500 + £4,145 + £7,592 = £199,237 1.44 £187,500 + £5,778 + £6,279 = £199,557

Note: If the option is sold to include time value, rather than exercised, these costs would be slightly reduced.

In order for the option to be preferred to the best alternative, the money market hedge which has a cost of £195,015, the total cost of using the option must be less than the cost of the money market hedge. The necessary costs of the option component of the hedge are estimated below, along with the spot rates that would produce this result.

Money market

– (Forward + Premium) = Required option cost

Spot rate

1.42 £195,015 £8,904 £2,856 £183,255 266,250/183,255 1.43 £195,015 £7,592 £4,145 £183,278 268,125/183,278 1.44 £195,015 £6,279 £5,778 £182,958 270,000/182,958

The required spot rates for the option to be the preferred hedge are rates where the dollar is weaker than:

1.42 $1.4529/£ 1.43 $1.4629/£ 1.44 $1.4757/£

Conclusion:

A forward market hedge is recommended for the euro transaction.

For the $US payment a money market hedge or, alternatively, a currency option hedge with an exercise price of 1.42 is recommended. The 1.42 exercise price is chosen as this has a similar cost to the 1.43 option if it is exercised, but requires the dollar to depreciate less before the option hedge is the preferred alternative to the money market hedge.

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6 KAPLAN PUBLISHING

(b) As the Russian currency is not convertible, if NTC wishes to export to Russia, payment through countertrade may be the only way in which the deal may be arranged. There may also be restrictions in Russia in the use of convertible foreign currency reserves for the purchase of imports, and limited access to bank credits. Without countertrade there may be no trade in these circumstances.

Problems of countertrade include:

(i) It requires considerable time and effort to organise, and often has high administrative costs.

(ii) It may be difficult and expensive to establish a fair exchange ratio for goods to be countertraded.

(iii) The price for wheat that NTC will receive may be unknown, although a futures market exists in wheat.

(iv) The quality of the wheat is not known with certainty.

(v) One party has to bear transportation costs of the wheat.

(vi) Bank guarantees and other forms of security that exist in foreign trade through documentary letters of credit, bills of exchange, etc are unlikely to exist, possibly increasing the risk of trade for NTC.

Advantages of countertrade include:

(i) Allowing NTC to become known in the Russian market, which may generate future business.

(ii) Eliminating the risks concerned with foreign exchange rate movements.

Tutorial note

Countertrade involves the sale of goods (or services) to a customer in another country, usually a country whose currency is not freely convertible, and the receipt of payment from the customer in other goods rather than money. These goods are then sold on to another customer or distributor in a country with a freely convertible currency. For example, a Swiss exporter of optical equipment to a South American country might agree to take payment in other goods, say coffee beans, which could then be sold in the European markets for cash.

(c) Futures hedge:

Set up the current position: €4m × .05 × 6/12 = €100,000

Set up the hedge:

(a) Buy or sell: Deposit → Buy futures contracts.

(b) Number of contracts: contracts. 8=months3months 6

×€1m€4m

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KAPLAN PUBLISHING 7

(c) State the hedge: Buy 8 € March future contracts at a price of 93.20.

→ The play off: Now Rate agreed Profit and loss Company rates 5.0% 4.0% (1.0%) Futures prices 93.20 94.05 0.85%

–––––– Buy Sell (0.15%)

Profit on futures:

Profit = 85 ticks × €25.00 × 8 contracts = €17,000

The cash flows:

Actual interest payable/receivable €4m × .04 × 6/12 = €80,000 Profit on futures €17,000

––––––– The cash result €97,000

–––––––

The play off:

Now Rate agreed Profit and loss Company rates 5.0% 7.0% 2.0% Futures prices 93.20 91.30 (1.90%)

––––––– Buy Sell 0.10%

Loss on futures:

Loss = 190 ticks × €25.00 × 8 contracts = (€38,000)

The cash flows:

Actual interest payable/receivable €4m × .07 × 6/12 = €140,000 Profit on futures (€38,000)

–––––––– The cash result (€102,000)

–––––––– Options hedge

Set up hedge:

(a) Calls or Puts: Deposit → Buy futures contracts → Buy calls

(b) Choosing the exercise price: Call options – Deposit – Highest net receipt

Exercise price Implied interest rate

Cost of premium Net receipt

92.50 7.50% (0.90%) 6.60% 93.00 7.00% (0.54%) 6.46% 93.50 6.50% (0.24%) 6.26%

(c) Options on futures: Therefore 8 contracts as previously calculated.

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8 KAPLAN PUBLISHING

(d) State the hedge: Buy 8 € March call contracts at an exercise price of 92.50.

Cost of the option:

90 ticks × €25.00 × 8 contracts = €18,000

Decision point: Adverse movement Favourable movement Exercise to protect Allow the option lapse Actual interest paid 80,000 140,000 (note calculated already in futures part) Cost of the options (18,000) (18,000) Profit on futures Sell – 94.05 Buy – (92.50) ––––––

1.55 155 ticks × 25.00 × 8 contracts = 31,000

–––––– –

––––––– Total payment 93,000 122,000

Summary table approach:

The target in this question that interest receipts do not decrease by more than €2,500 from current rates. I have prepared a summary table to see if the specified target of €97,500 (i.e. €100,000 – €2,500) is achieved.

Summary table Futures Options Not hedged 1% fall 97,000 93,000 80,000 2% increase 102,000 122,000 140,000

Conclusions

Neither futures nor options hedges can guarantee that the interest receipts should be more than €97,500.

The company should hedge, if it did not it could end up receiving only €80,000.

It should hedge using futures as they give the highest receipt under both scenarios.

The collar comment:

In any option question always state that the company should consider the use of a collar. The collar is used to reduce the premium cost of the purchased option. The company would buy a call option (sets a minimum income) as normal but also sell puts options (sets the maximum income) on the same futures contract. Thus, the company is paid for limiting its ability to take advance of a favourable movement if the interest rate increases above the maximum rate the company does not benefit.

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KAPLAN PUBLISHING 9

Marking scheme Marks (a) (i) Spot mid rates 2

Completion of table, up to 6 Conclusion 1

(ii) Calculation of $HK to $UK rate 2

Forward contracts 2 Money market hedge € only 3 Put options $ only 5 Conclusion if consistent 1 Discussion points 1 Presentation 1

(b) 1 mark for each well explained point Max 6 (c) Futures

Buy March futures 2 Number of contracts 1 Hedge adverse movement, with outcome 2 Hedge favourable movement, with outcome 2 Options Buy 8 March call contracts 3 Cost of options 2 Cash flows: when adverse movement 3

when favourable movement 1 Summary table 1 Collar comment 3

–––– Total 50

––––

2 LARKIN MOTORS

(a) Valuations for BV

Three possible methods of valuation that could be used to value the shares of BV are:

• net assets basis

• dividend basis

• earnings basis.

Net assets attributable to equity of BV = £45m

Number of shares in issue = 1.5m

∴Net asset value per share = £30

Usually, the net assets value method of valuing a company is not very useful since a conventional balance sheet is drawn up using costs (not market values) and excludes many valuable assets (e.g. trained employees, business know-how, etc). However in the case of BV we have a company with a number of owned car showrooms and a valuable franchise. If the showrooms are measured on the balance sheet at their open market value, and if the franchise is included on the balance sheet at cost or fair value, then it is possible that the company’s net asset value will be relevant to LM.

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The dividend valuation model states that:

Company value = rate growth Annual equityof Cost

total dividend syear' Next–

= 0.05–0.1

1.05×£1 × 1.5m

= £31.5m

There are a number of points that should be made concerning this valuation:

• We have assumed that next year’s dividend will be this year’s dividend (£1 per share) increased by the general forecast growth rate. However, given that earnings are expected to almost double next year (from 1.5m × £1.53 = £2.3m, up to £4m), this estimate of next year’s dividend may be too modest.

• We have assumed a cost of equity of 10%, since this is the industry average for similar companies. Clearly we need to assess whether BV is anything like an ‘average’ company before we can use this figure.

• We have assumed that dividends will grow each year in the future at an annual rate equal to the 5% forecast growth rate for the company as a whole. Dividend policy is a matter for the directors of the company to decide, but in the long run this 5% rate may be reasonable. If LM acquires the company, it will be able to control the dividend policy directly.

The earnings valuation for a company is given by:

Company value = Earnings × Appropriate P/E ratio

= £4m × 5.112

237,1 = £44m

In this valuation, next year’s earnings (as forecast by the Managing Director of BV) have been used. The MD has an interest in being optimistic and overstating the forecast earnings figure. The alternative would be to use this year’s earnings figure of 1.5m × £1.53 = £2.3m, which would produce a much lower valuation.

There is no P/E ratio for BV, since it is a private company.

We have used the only P/E ratio provided in the question, that for LM.

P/E ratio = p5.112p237,1

=EPS

price Share = 11

It would be possible to adjust this P/E ratio arbitrarily either up or down to reflect the different characteristics of LM (a large public company with plenty of land and property) and BV (a smaller private company with good growth prospects), but since this adjustment could be either up or down, the simple decision has been taken to leave it unchanged.

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Conclusion

The following valuations for BV have been produced:

£m Net assets basis 45 Dividend valuation model 31.5 Earnings basis (using current earnings) £2.3 × 11 = 25.3 Earnings basis (using forecast earnings) £4.0 × 11 = 44.0

LM should be prepared to negotiate within the range of £40m to, say, £48m. There seems little prospect of the shareholders of BV selling for less than the £45m net asset value, but perhaps some assets are overstated in the balance sheet.

(b) Financial factors affecting the bid

It is unusual for the net assets basis of valuing a company to exceed the dividend basis and the earnings basis. There are many estimates used in the latter two bases, so perhaps they are inaccurate in this example. As stated in part (i), it would be unlikely that the shareholders of BV would agree to sell their shares for less than the net assets basis, so in this example we can forget the dividend basis and the earnings basis.

It is the Managing Director of BV who has approached LM, so the balance of power is such that LM can decide at its leisure whether to bid. LM has a market capitalisation of 25m × £12.37 = £309.25m. It is being asked to bid for a much smaller company, worth around £45m, in wealthy locations in the north of England. LM appears to be a volume player in the motor car market, with no apparent experience of semi-rural showrooms. Given LM’s lack of experience, perhaps it should not bother to bid for this much smaller company, or certainly it should not pay an excessive premium over net asset value.

Curiously, we see that LM’s net asset value (£350m) also exceeds its market valuation (£309.25m). It is possible that the motor car business is unfavourably valued by the market. It is also possible that the market has overlooked the high asset backing to LM’s shares. It is possible that, if it launches a bid for BV and becomes better known in the market as a result of the accompanying publicity, then LM itself could become a target for takeover bids.

What other investment opportunities are available for the £45m (or so) expected to be invested in the acquisition?

Do all the BV shareholders want to sell their shares, or will there be a significant minority interest that will want to hold on? LM might not want to acquire a company if less than 100% of the shares can be acquired.

(c) The form of funding the bid

We are looking to finance an acquisition costing in the region of £45m, and must decide whether to offer shares or cash as the consideration. The Managing Director of BV has indicated that holders of up to 50% of BV’s shares might accept shares.

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LM’s current debt ratio is 20%, thus:

£309.25m+ debt sLM'debt sLM'

= 0.2

∴ LM’s current debt = 808561

..£

= £77.3m

The most new gearing possible would be if all the BV shareholders were paid in cash, raised from new borrowings. Thus £45m of fresh debt would be issued.

LM’s new debt ratio = 2530945377

45377..

.+++

= 28%

This does not seem excessive for a large company such as LM, especially considering the excellent asset backing available to secure issues of debt.

On the other hand, a new equity issue would reduce the debt ratio, but this is not a pressing priority. In practice, some combination of shares and cash is likely to be negotiated, depending on the requirements and tax positions of individual BV shareholders.

Marking scheme Marks (a) Asset based valuation – calculation 1 – comment 1 Dividend valuation – calculation 2 – comment 3 Earnings valuation – calculation 2 – comment 3 Recommendations – range for negotiation 2 Max 12 (b) One mark per valid point Max 6 (c) One mark per valid point Max 7

–––– Total 25

––––

3 EMLYN CO

(a) A strategy of diversification does not always provide a sound rationale for a takeover.

One problem is that the synergies identified are often more difficult to achieve when two businesses, which are quite different in nature, are combined. Such differences may, for example, prevent Emlyn Co from benefiting from economies of scale or the use of complementary resources. Similarly, although the management team of Emlyn Co may be highly efficient and highly motivated, it may not have the necessary skills to replace the management team of the victim company.

There may also be problems in trying to integrate the operations of two different kinds of business because of differences in market needs, business culture and so on.

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Diversification is a useful way of dealing with risk and it is therefore intuitively appealing to see mergers and takeovers as a useful means to achieve this end. The question that must be asked however is whether the directors of the company should diversify or whether the shareholders should diversify. It is usually easier and cheaper for shareholders to diversify, by acquiring a diversified portfolio of shares, than for the directors to diversify.

When the directors of a company diversify, by taking over another company, a significant premium is often paid to the shareholders of the target company.

(b) In theory, shareholder wealth will increase if the NPV of the company’s cashflows increases. In order for this to happen, there needs to be an increase in cashflows and/or a reduction in the cost of capital following the acquisition.

There are various practical ways in which a gain may be achieved through a takeover. These include:

Eliminating competition

A business can take over another in order to eliminate market competition. By increasing market share, the combined business may be in a better position to influence prices and, in turn, profits. However, this can have an adverse effect on the consumer and so the government may intervene when mergers and acquisitions that have a significant effect on market share are being proposed.

Complementary resources

A business may decide to acquire another in order to gain access to resources or particular strengths that it lacks. For example, a business with a strong manufacturing base but with poorly-designed products may wish to acquire another business that has a strong manufacturing-design base. By combining the relative strengths of the two businesses, additional profits may be generated.

Benefits of scale

Acquiring another business will result in the creation of a larger business. This in turn, can lead to economies of scale. These economies may be gained through exerting market power (e.g. negotiating lower prices by purchasing in bulk) or by cost savings (e.g. avoiding costs where duplication occurs).

Underutilised resources

In some cases, the resources of a business may be underutilised. This may be due to a weak management team that has failed to exploit the full potential of the business. By taking over the business and installing a new management team, the resources of the business may be more fully utilised leading to additional profits being made.

(Examiner’s note. Other answers to this part, such as market imperfections leading to undervalued shares in the target company, would have been acceptable.)

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(c) There are various reasons why a takeover may not yield the expected benefits to the shareholders in the bidding company. These include:

Paying too much for the target company.

The management of the bidding company may pay too much for the target company. It is quite common for a premium to be paid to the shareholders of the target company in order to encourage them to sell their shares. Unless there are benefits accruing from the takeover, this premium paid will simply transfer wealth from the shareholders of the bidding company to the shareholders in the target company.

Hidden problems

Problems that were hidden at the time of the takeover may emerge later to eliminate any gains that were anticipated. These problems may have been deeply buried and so may have been difficult to unearth, even where proper due diligence procedures were carried out prior to a takeover agreement.

Integration issues

Integrating the two businesses following takeover may prove a difficult task. There may be differences in culture, management style, and organisational methods and systems that cannot be easily reconciled. Integration problems are most acute where there is an attempt to impose a common style and common systems following takeover. Where the former target company is allowed to maintain its own identity and its own systems, integration problems are likely to be much less of an issue.

Management attitudes and motivation

Once the takeover has been completed, managers may expect the enlarged business to achieve success without the need for much effort. They may feel that the takeover was the most important ingredient for success and expect that future operations will run smoothly. In some cases, an exhausting takeover struggle may leave managers with little energy or enthusiasm for ensuring that things go according to plan.

(d) Financial analysts play a key role in ensuring stock markets are efficient.

They provide information about listed companies to investors, which should help in ensuring that share prices reflect their ‘true value’.

In addition to disseminating information to others, they are constantly examining share prices in the hope of finding shares that are inefficiently priced. Where the price of a share in a listed company is below its ‘true value’, there is an incentive to buy the shares, assuming that the ‘true value’ will eventually be recognised by the market.

The effect of buying the shares will be to eliminate the price inefficiency and so bring the share price into line with the ‘true value’.

It is often claimed that an efficient market reflects a paradox. The search for inefficiently priced shares by financial analysts, investment managers and others is based on a belief that the market is inefficient. This search, however, eliminates any price inefficiencies that may exist and thereby helps to create an efficient market.

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Marking scheme Marks (a) Diversification – generally 1 mark per sensible point Max 6

key points are – should the company bother to diversify when investors can do so

for themselves?

– will any identified synergies actually be realised? (b) Increase in wealth

Theory – link to NPV 1 Up to 1½ marks per key practical point if well explained Max 6 –––––– Max 7

–––––– (c) Up to 2 marks per key practical point if well explained Max 7 (d) One mark per valid, well explained point Max 5

–––––– Total 25

––––––

4 LAMBLEY PLC

(a) Five key factors are:

Pa = 1.80

Pe = 1.50

r = 10% (0.1)

s = 50% (0.5)

t = 3 months (so 0.25 years)

Step 1: Calculate d1 and d2

d1 = t s

)t0.5s+(r + ) (Pa/Pe ln 2

d1 = 0.25 × 0.5

)0.250.5+(0.1 + ) (1.80/1.50 ln 3

d1 = 0.25

0.0563 + 0.1823

d1 = 0.95

d2 = d1 − s√T

= 0.95 − 0.5 × √0.25

= 0.70

Step 2: Use normal distribution tables to find the value of N(d1) and N(d2)

N(d1) = 0.5 + 0.3289 = 0.8289

N(d2) = 0.5 + 0.2580 = 0.7580

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Step 3: Plug these numbers into the Black- Scholes formula

Value of a call option = [Delta × Share price] – [Bank loan]

= Pa N(d1) – Pee–rT N(d2)

= 1.80 × 0.8289 – 1.50e–(0.1× 0.25) 0.7580

= 1.4920 – 1.4630 × 0.7580

= 0.3830 = Intrinsic value and Time value

(Reasonableness check: this exceeds the intrinsic value of 0.3 so it looks ok.)

A call option on 4,000 Lambley shares would be quoted at 4,000 × £0.3830 = £1,532.

(b) Client B purchased 10,000 shares and which to hedge the position, how many call options would he have to sell to construct a risk free investment?

0.8289 = sold callsof Number

10,000 = Sell 12,064 call options

(c) Using put call parity to value a put option

£0.3803 £1.80 Value of a call option Buy a share

+ = + Invest the PV Value of a put option

of the exercise price 1.50e–(0.1 × 0.25)

= £0.3830 + £1.4630 − £1.80 = Value of a put

= £0.0460

= 2,000 puts would therefore cost

= 2,000 × 0.046 = £92

(Reasonableness check: this option is out of the money so we would expect a low value.)

(d) The same basic principles apply to the value of a currency option as to an equity option. Imagine we wanted an option to buy sterling with US dollars (a call option on £). The value of the call option would depend upon:

1 The spot exchange rate. The higher the spot price of sterling ($ per £) the more valuable the option to buy it at a fixed price will be.

2 The exercise price. The lower the exercise price ($ per £) the more valuable the option.

3 The time to expiry. The longer the time period to expiry the more chance there is of the price of sterling rising ($ per £).

4 The volatility of the exchange rate. The more volatile the exchange rate the more chance there is of sterling rising.

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5 The counter currency ($) interest rate. As above the present value of the $ exercise price will fall as $ interest rates rise. As $ interest rates rise the option becomes more valuable.

6 The underlying currency (£) interest rate. The purchaser of a sterling option is paying the issuer a $ amount (the premium) for an option that can be exercised to buy a given amount of £. The purchaser is giving up £ interest that could have been earned on the premium

These factors are incorporated within the Grabbe variant of the Black-Scholes formula (not specifically examinable in the P4 syllabus).

This enables the financial manager to work out the value of a currency call (or put) option.

Marking scheme Marks (a) Value of call options – reward technique 9 (b) Delta hedge 3 (c) Value of a put option 5 (d) One mark per valid determinant 8

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