4P Fin Asses Dec 14 (Freeaccastudymaterial.blogspot.com)

ACCA FINAL ASSESSMENT

Advanced Financial Management December 2014

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

Kaplan Publishing/Kaplan Financial

Pape

r P4

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ACCA P4: ADVANCED FINANCIAL 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, 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 PCO Inc operates in oil and related industries. Its shares are quoted on a major Stock Exchange. In its retailing operations the company has concentrated on providing high-quality service and facilities at its service stations rather than competing solely on the price of petrol. Approximately 75% of its revenue and 60% of its profits are from petrol, the remainder coming from other services (car wash and retail sales from its convenience stores which are available at each service station).

The company has been highly profitable in the past as a result of astute buying of petroleum products on the open market. The company does not enter into supplier agreements with the major oil companies except on very short-term deals. However, profit margins are now under increasing pressure as a result of intensifying competition and the cost of complying with environmental legislation.

The managing director of the company is assessing a possible acquisition that would help the company increase the percentage of its non-petroleum revenue and profits. OT Inc specialises in oil distribution from the depots owned by the major oil companies to their retail outlets. Its shares have been quoted on a smaller Stock Market (similar to the Alternative Investment Market in the UK) for the past two years. It operates a fleet of oil tankers, some owned and some leased. PCO Inc has used its services in the past and knows it has an up-to-date and well-managed fleet. However, a bid for OT Inc would almost certainly be hostile and, as the directors and their families own 40% of the shares, a successful bid is far from assured.

Extracts from PCO Inc’s statement of financial position at 31 December 20X3

$M Assets Property, plant and equipment 160.00 Cash and marketable securities 105.00Accounts receivable and inventories 95.00 –––––– 360.00 ––––––Equity and liabilities Share capital (authorised $50 million) Issued 40.00 Accumulated profits 165.00 ––––––Total equity 205.00 Secured loan stock 7% repayable 20X9 80.00 Current liabilities 75.00 –––––– 360.00 ––––––



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4 KAPLAN PUBLISHING

PCO Inc’s financial advisors have produced estimates of the expected NPV and the first full year post-acquisition earnings of PCO Inc and OT Inc:

Estimated post-acquisition earnings

in first full year following acquisition

Estimated NPV of combined

organisation

PCO Inc plus OT Inc $70 million $720 million

Summary financial statistics Last year end PCO Inc OT Inc 31 December 20X3 31 December 20X3Shares in issue (millions) 40 24 Earnings per share (cents) 106 92 Dividend per share (cents) 32 21 Share price (cents) 967 1,020Book value of non-current and current assetsless current liabilities ($ million) 285 145 Debt ratio (outstanding debt as % of total market value) 17.0 14.0 Forecast growth rate % (constant, annualised) 5 9Beta co-efficient 0.9 1.2

Required:

(a) Calculate, for PCO Inc and OT Inc before the acquisition:

(i) the current market value and P/E ratio

(ii) the cost of equity using the CAPM, assuming the return on the market is 8% and the return on the risk-free asset is 4%

(iii) the prospective share price and market value using the dividend valuation model. (8 marks)

(b) Prepare a report for the managing director which covers the following issues:

(i) the price to be offered to the target company’s shareholders. You should recommend a range of terms within which PCO Inc should be prepared to negotiate

(ii) the most appropriate form of funding the bid and the financial effects (assume cash or share exchange are the options)

(iii) the business implications (effect on existing operation, growth prospects, risk and so on). (26 marks)

Marks are split roughly equally between sections of part (b) of the question.

Professional marks will be awarded in part (b) for the appropriateness and format of the report. (4 marks)

(c) Discuss how a government might try to reduce a large, persistent, current account deficit on its country’s balance of payments, and illustrate what impact such government action might have on a multinational company operating in the country concerned. Explain the possible role and impact of the International Monetary Fund (IMF) in this process. (12 marks)

(Total: 50 marks)



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KAPLAN PUBLISHING 5

SECTION B

Answer two questions only

2 Assume that it is now mid-December.

The finance director of Shawter plc, a UK-based company, has recently reviewed the company’s monthly cash budgets for the next year. As a result of buying new machinery in three months’ time, the company is expected to require short-term financing of £30 million for a period of two months until the proceeds from a factory disposal become available. The finance director is concerned that, as a result of increasing wage settlements, the Central Bank will increase interest rates in the near future.

LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0.9%.

Derivative contracts may be assumed to mature at the end of the month.

Three types of hedge are available:

Three months sterling future (£500,000 contract size, £12.50 tick size)

December 93.870 March 93.790 June 93.680

Options on three months sterling futures

(£500,000 contract size, premium cost in annual %)

Calls Puts December March June December March June 93750 0.120 0.195 0.270 0.020 0.085 0.180 94000 0.015 0.075 0.115 0.165 0.255 0.335 94250 0 0.030 0.085 0.400 0.480 0.555

FRA prices:

3 v 6 7.01 – 6.91 3 v 5 7.08 – 7.00 3 v 8 7.28 – 7.20

Required:

Prepare a report for the finance director, which:

(i) discusses the relative advantages and disadvantages of the three types of hedge;

(ii) illustrates how the short-term interest risk might be hedged, and the possible results of the alternative hedges, if interest rates increase by 0.5%.

All relevant calculations must be shown. (25 marks)



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6 KAPLAN PUBLISHING

3 Extracts from the annual report of Noifa Leisure plc, a UK listed company, are shown below:

Chairman's report

'The group's financial position has never been stronger. Turnover has risen 209% and the share price has almost doubled during the last four years, between 20X6 and 20X9. Since the end of the financial year the company has acquired Beddall Hotels for £100 million, financed at only 9% per year by a Euro floating rate loan which has little risk. Our objective is to become the largest hotel group in the United Kingdom within five years.'

Statement of profit or loss summaries for the years ending 31 December

20X6 20X7 20X8 20X9 £m £m £m £m Turnover 325 370 490 680 ––––– ––––– ––––– ––––– Operating profit 49 60 75 92 Investment income 18 10 3 1 ––––– ––––– ––––– ––––– 67 70 78 93 Interest payable 14 16 24 36 ––––– ––––– ––––– ––––– Profit before tax 53 54 54 57 Taxation 20 19 19 20 ––––– ––––– ––––– ––––– Profit after taxation 33 35 35 37 Exceptional items1 (3) – – 4 ––––– ––––– ––––– ––––– Profit attributable to shareholders 30 35 35 41 Dividends 12 12 12 12 ––––– ––––– ––––– ––––– Retained earnings 18 23 23 29 ––––– ––––– ––––– –––––

1Loss/gain on disposal of non-current assets

Statement of financial position summaries as at 31 December

20X6 20X7 20X8 20X9 £m £m £m £m Non-current assets

Tangible assets 165 260 424 696Investments 120 68 20 4 ––––– ––––– ––––– –––––

285 328 444 700 Current assets

Inventory 40 45 70 110 Receivables 56 52 75 94 Cash 2 3 4 5 ––––– ––––– ––––– –––––

98 100 149 209 ––––– ––––– ––––– ––––– TOTAL ASSETS 383 428 593 909 ––––– ––––– ––––– –––––



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KAPLAN PUBLISHING 7

Equity: Ordinary shares (10 pence nominal value) 50 50 50 50Share premium 22 22 22 22 Revaluation reserve – – – 100 Revenue reserves 74 97 120 149 ––––– ––––– ––––– –––––

Shareholders' funds 146 169 192 321Long term liabilities:

Bank loans 42 42 102 102 13% debenture (9 years to redemption) 80 80 80 180

Current liabilities Trade payables 82 94 130 176Taxation 18 19 19 20 Overdraft – – 42 68 Other 15 24 28 42 ––––– ––––– ––––– –––––

TOTAL EQUITY AND LIABILITIES 383 428 593 909 ––––– ––––– ––––– –––––

Analysis by type of activity

20X6 20X7 20X8 20X9 Turnover Profit1 Turnover Profit Turnover Profit Turnover Profit £m £m £m £m £m £m £m £m Hotels 196 36 227 41 314 37 471 45 Theme park 15 (3) 18 (2) 24 3 34 5Bus company 24 6 28 8 38 14 46 18 Car hire 43 7 45 8 52 12 62 15 Zoo2 5 (1) 6 (1) 9 0 10 (1) Waxworks 10 1 11 3 13 4 14 5Publications 32 3 35 3 40 5 43 5 ––––– –––– ––––– –––– ––––– –––– ––––– –––– 325 49 370 60 490 75 680 92 ––––– –––– ––––– –––– ––––– –––– ––––– ––––

(1) 1Operating profit before taxation.

(2) 2The zoo was sold during 20X9.

20X6 20X7 20X8 20X9 Noifa plc average share price (pence) 82 104 120 159 FT 100 Share Index 1,500 1,750 1,800 2,300 Leisure industry share index 178 246 344 394 Leisure industry PE ratio 10:1 12:1 19:1 25:1

Required:

In his report the chairman stated that 'the group's financial position has never been stronger.' From the viewpoint of an external consultant appraise whether you agree with the chairman. Discussion of the group's financing policies and strategic objective, with suggestions as to how these might be altered, should form part of your appraisal. Relevant calculations must be shown. (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 months 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

V

V

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(

Vd

de

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+V

V=WACC d

de

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

( ) 1r+1PV

PV=MIRR e

n1

I

R

The Black-Scholes option pricing model

c = PaN(d1) – PeN(d2)e−rt

Where:

ts

t)s5.0+r(+)P/Pln(=d

2ea

1

tsdd 12 −=

The Put Call Parity relationship

p = c − Pa + Pee−rt



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10 KAPLAN PUBLISHING

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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KAPLAN PUBLISHING 11

Annuity table

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

Where r = discount rate

n = number of periods

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 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 6.495

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

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 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

December 2014

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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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, consequential or otherwise arising in relation to the use of such materials.



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FINAL ASSESSMENT ANSWERS

KAPLAN PUBLISHING 3

1 PCO INC

(a) (i) P/E ratios and market values

PCO Inc OT Inc Information in case (shown here for convenience) EPS – cents 106 92 Share price – cents 967 1,020 No. of shares in issue (millions) 40 24

P/E ratio 9.1 11.1 (SP/EPS) Market value ($ million) 386.8 244.8 (No. of shares × SP)

(ii) Cost of equity using CAPM

PCO Inc OT Inc E(ri) = Rf + βi(E(rm) − Rf) Rf rate (given) 0.04 0.04 Market return (given) 0.08 0.08 Beta 0.9 1.2 Cost of equity 7.6% 8.8%

(iii) Share price and market value using DVM

)gr()g1(DP

e

oo −

+=

Share price – cents 1,292 n/a

[(32¢ × 1.05)/ [(21¢ × 1.09)/

(0.076 – 0.05)] (0.088 – 0.09)]

Market value – $ million 517 n/a

(b) REPORT

To: The managing director

From: Consultant

Subject: Takeover of OT Inc

Introduction

This report has been prepared to analyse the potential purchase of OT Inc. It discusses the price which should be offered to the OT Inc shareholders, the most appropriate form of funding the bid, and the business implications of combining the two businesses. Calculations are presented in an Appendix (answer to part (a)).

Advice on price and form of funding

(i) Price to be offered

• The market value of OT Inc can be determined most easily by reference to the current share price.



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4 KAPLAN PUBLISHING

• The constant growth version of the DVM will not work because estimated growth is greater than the cost of equity. It would be possible to use an adjusted version of the model but information on future cash flows would be necessary.

• Using current market values, PCO Inc is worth $387 million and OT Inc, $245 million, a total of $632 million before any acquisition gains.

• The financial advisors have estimated that the NPV of the combined companies is $720 million, a post-acquisition gain of $88 million.

• The price to be offered will depend on the negotiating abilities of the two companies. Clearly, PCO Inc will not be able to retain all, or possibly even most, of the acquisition gains.

• A key factor may be that it is likely to be a hostile bid. This will inevitably raise the price to be paid and most research has shown that hostile bids result in a fall in wealth for the bidder’s shareholders.

• A realistic starting point may be to allocate the gains in the proportion of the relative current market values of the two companies. This would be $88 million in the proportions 61% and 39%.

• This would mean PCO Inc would take $54 million of the gain and OT Inc $34 million.

• The price to be offered would, therefore, be $279 million ($245 million market value + $34 million share of merger gains) or 1,162 cents per share.

• PCO Inc would also, presumably, take on OT Inc’s outstanding debt of approximately $40 million, but the terms of the debt contract would need to be investigated.

(ii) Form of funding

Cash

• PCO Inc could not offer cash without raising additional debt funding.

• Assuming it was prepared to use all its cash reserves of $105 million (assuming the balance has not been used recently) this would mean an additional $174 million debt, or $214 million if OT Inc’s $40 million debt has to be repaid under the terms of the debt contract and PCO Inc is required to refinance it.

• PCO Inc’s debt ratio (debt as a proportion of market value) would then increase substantially – much would depend on how the share price moved following the acquisition. If the market value of the combined group is worth $632 million, then the gearing in market value terms (assuming debt trading at par) would rise from 17% to 29%. This might be quite acceptable, although the effect on the cost of capital must be considered.



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KAPLAN PUBLISHING 5

Shares

• The opening bid would be based on current market prices, i.e. 967 cents and 1,020 cents.

• Suggests an exchange ratio of 1.05 of a PCO Inc share for every OT Inc share, which would almost certainly be rejected as inadequate, as OT Inc’s shareholders would have no incentive to accept the offer.

• If all the gains were to be given to OT Inc’s shareholders the share price would be 1,387 cents for OT Inc ($333 million/24 million). This would suggest a ratio of 1.43 PCO Inc shares per OT Inc share, and 34.32 million new shares would need to be issued to OT Inc shareholders.

• If first-year earnings are forecast as $70 million, this would be an EPS of 94.3 cents – a decline on current EPS for PCO Inc, which might not satisfy shareholders.

• A strong statement from management would be needed.

• PCO Inc has only 50 million shares authorised and 40 million are issued. A share offer would require increasing authorised share capital. This might give a signal to the market that PCO Inc might be considering a bid for a large company, which would have an effect on the share price. Whether this is up or down would depend on market perceptions and sentiment towards PCO Inc at the time. If the share price rose, then this is to PCO Inc’s advantage in any share exchange. If it fell, then a share exchange might be considered unwise.

Combination

• A combination offer could be considered; for example, shares plus cash or shares plus debt.

(iii) Business implications

• It is likely to be a hostile bid, which will involve extensive advisors’ costs and PCO Inc will probably eventually pay all acquisition gains (and possibly more) to OT Inc’s shareholders.

• Advantages include the diversification aspects of the acquisition, which is after all why PCO Inc wants to acquire another company. However, PCO Inc has no experience of the industry.

• OT Inc operates in an area in which PCO Inc does not have any particular expertise, so it is difficult to see where any additional value can be created. Some synergies as a result of vertical integration might be claimed but these are likely to be small, and accompanied by a reduction in PCO Inc’s flexibility to change suppliers. It is in the oil business so, again, it does not really look like a diversification move.

• The required investment is likely to be large by PCO Inc’s standards. The company would be taking on a substantial amount of debt in the form of OT Inc’s existing borrowings. A rights issue is possible, perhaps conditional upon the bid being successful.



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6 KAPLAN PUBLISHING

• A share offer would need to be a bit above one-for-one, given the current market prices. This would require a prior increase in PCO Inc’s authorised capital, since only 10 million shares remain unissued, and might give a signal that an acquisition was being considered. A possibility is a choice between shares in PCO Inc or cash. Provided no more than half of OT Inc’s shareholders opted for cash, this would leave a reasonable capital structure but, to be comfortable, the company would still need to increase authorised share capital.

• An evaluation of the acquisition should look in more detail at the effect on business growth, risk of the company, effect on capital structure and cost of capital and so on.

• An exercise to identify other possible acquisition targets could (should?) be launched.

(c) A large current account deficit means that the value of exports of goods, services, investment income and current transfers is much less than the value of imports of these items. If the government believes that the deficit is not a temporary phenomenon, which will be largely self-correcting, it may attempt to reduce the deficit by taking one or more of a selection of economic measures. However, a country with large foreign currency reserves may decide to finance the deficit by running down some of those reserves, and may not take significant additional actions for some time.

1 Monetary policy. A government will often take deflationary measures to reduce the money supply. This may be through increases in interest rates, or attempting to reduce the money supply through actions such as credit restrictions, wage and/or price controls, and reductions in government expenditure. Increased interest rates will tend to reduce local borrowing and demand for imports, and attract overseas funds into the country to take advantage of the higher interest rates (until interest rate and exchange rates are in equilibrium once more).

2 Fiscal policy. Governments often reduce consumer spending, including spending on imports, by increasing taxation.

3 Devaluation. If the country is part of a fixed exchange rate system, the currency may be devalued in order to make imports expensive and exports more competitive.

4 Exchange controls, tariffs, and quotas are all measures, which may be used to reduce imports, and to reduce a current account deficit. However, these may be contrary to World Trade Organisation (WTO) agreements.

5 Export stimulation through government subsidies, although these too are often restricted by the WTO.

6 Borrowing. The government may finance the deficit by borrowing from international commercial banks or international organisations such as the IMF. Such borrowing, however, may not tackle the underlying symptoms of the deficit.



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KAPLAN PUBLISHING 7

The IMF may provide loans to help finance a balance of payments deficit. An important feature of most IMF loans is the conditions attached to the loans. Countries receiving IMF loans are required to take strong economic measures to try to improve or eliminate the economic problems that made the loans necessary, and to stimulate medium- to long-term economic development.

The actions of the IMF help to reduce volatility in international exchange rates, and to facilitate world trade. This has beneficial effects on the trading activities of multinational companies. However, the strong influence of the IMF on the macroeconomic policies of developing nations often leads to short-term deflation, and to reductions in the size of markets for multinational companies' products.

Most of the government policies discussed above tend to reduce domestic economic growth and increase unemployment, and are detrimental to a multinational company operating in the country concerned. For example, the impact of higher interest rates usually results in higher borrowing costs for a multinational company.

A possible beneficial effect is when the multinational exports a high proportion of its products, and the incremental demand stimulated by the devaluation/fall in value of the local currency results in an overall increase in the present value of cash flows to the multinational.

Marking scheme

Marks 1 2 2 3 8

Max 9 Max 9 Max 9

Max 26 Max 4

Max 7 Max 3 Max 3

Max 12 ––––

50 ––––

(a) P/E ratios – ½ each Market value – 1 each ke from CAPM – 1 each Value from DVM – 1½ each

Total (b) Award 1 mark per sensible, well explained point, subject to:

– points on price to be offered – points on cash v shares – points on business implications

TotalProfessional marks – look for heading, introduction, report format, good presentation

(c) Award 1 mark per sensible, well explained point, subject to:

– methods of reducing deficit – role of IMF – impact on multinational

Total Total



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8 KAPLAN PUBLISHING

2 SHAWTER

Report on hedging alternatives

The current cost of borrowing for two months is 000,345£122%9.6000,000,30£ =××

Futures

The company may use futures contracts to attempt to make a gain on the futures market that will offset any potential loss in the cash market.

Futures are market-traded instruments that are only available with fixed contract sizes and maturity dates, and only on a limited selection of financial instruments. Hence it might not be possible to hedge exactly the cash market exposure. Futures also require the deposit of a margin, either in cash or approved securities.

The financing will be needed in three months’ time, in mid-March. March contracts will be used as they have the closest expiry date after the date the funds are needed.

As the period at risk is two months, the number of contracts needed may be estimated as:

000,500£000,000,30£

× 4032 = contracts

To protect against an increase in the interest rate, 40 contracts would be sold.

Tutorial note: We must sell interest rate futures to hedge the risk of a rise in interest rates. If interest rates do rise, futures prices will fall, and we can close the position by buying futures, to make a profit between the selling and the buying price.

Basis is the current LIBOR rate of 94.00 less the March futures price, 93.79 = 0.21

This will fall to 0 when the contract expires, and it is assumed that it will fall at an even rate over time. There are three-and-a-half months until the contract expires. The funds are needed in three months. The expected basis at the time of borrowing is therefore:

.03.07121.0 =×

The reduction/change in basis after three months is 0.18.

If the interest rate (LIBOR) does rise by 0.5%, the expected futures price in three months is:

93.79 – 0.5 + 0.18 = 93.47.

Tutorial note

Another way of calculating this figure is to use the new LIBOR of 93.50 less the

remaining basis of 0.03 = 93.50 – 0.03 or 93.47.



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KAPLAN PUBLISHING 9

The expected futures gain if futures are closed out in three months will then be:

Selling price 93.79 Purchase price to close position 93.47 –––––– Gain per contract 32 (× 40 contracts × £12.50) £16,000

The overall cost of the loan is expected to be as follows.

Borrow £30 million for 2 months at LIBOR + 0.9% = 7.4% £ Interest cost: £30 million × 7.4% × 2/12 370,000 Gain on futures position 16,000 –––––– Net cost 354,000 ––––––

Note: The futures price at the close-out date might differ from 93.47, as the decline in basis might not be linear.

Options

The option contracts specified are also market traded, with similar limitations to the futures, but it is also possible to obtain OTC (over the counter) interest rate options that are tailored directly to a company’s needs.

The obvious disadvantage of options is that a premium is payable, often upfront. However, if interest rates were to fall rather than rise the option would be allowed to lapse, and the company would take advantage of the lower market interest rates. In the case of a futures contract this would not be possible.

Hedge

Buy 40 March put options on sterling futures.

Tutorial note: The hedge is provided by the ability to sell futures, so you need to buy put options on the futures.

Premium cost: Strike price

93750 £30,000,000 × 0.085% × 2/12 = £4,250

94000 £30,000,000 × 0.255% × 2/12 = £12,750

94250 £30,000,000 × 0.480% × 2/12 = £24,000

Tutorial note

The premium cost is an annual percentage cost, so multiply by 2/12 because the option

is required for just two months.

If the interest rate increases by 0.5%, the options will be exercised and the futures contracts sold at the exercise price.



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The profit on options contracts will be the exercise price less the expected futures price multiplied by 100%, the tick value and the number of contracts.

Exercise Profit

93750 (93.75 – 93.47) × 100 × 40 × £12.5 = £14,000

94000 (94.00 – 93.47) × 100 × 40 × £12.5 = £26,500

94250 (94.25 – 93.47) × 100 × 40 × £12.5 = £39,000

Overall cost

Exercise price

Cost of borrowing at 7.4% for 2 months

Gain on option position

Cost of option

Net cost

£ £ £ £

93750 370,000 –14,000 +4,250 = 360,250

94000 370,000 –26,500 +12,750 = 356,250

94250 370,000 –39,000 +24,000 = 355,000

The 94,250 exercise price has an expected overall cost of only £1,000 more than the expected futures cost. It might be worth buying this contract in case interest rates fall, which would allow the company to let the option lapse and take advantage of the lower cash market rates.

A collar option that has lower net premium costs, but that restricts the benefits from a fall in interest rates might also be considered.

FRAs

FRAs are OTC instruments, which allow the rate on borrowing at some future period to be fixed today (similar to a forward contract in the foreign exchange market). As with futures, FRAs do not allow the buyer or seller to take advantage of favourable interest rate movements. Unlike futures, FRAs have no margin requirement.

As the company wishes to borrow funds in three months’ time for a period of two months, the appropriate FRA would be the 3 v 5 contract.

To hedge against the risk of a rise in interest rates, the company would buy an FRA covering the amount of £30,000,000.

The contract effectively locks in the rate to the FRA rate of 7.08%

The overall cost is £30,000,000 × 7.08% × 2/12 = £354,000

The futures hedge and the FRA have the same expected total cost. However, because of basis risk the futures cost is not certain, and the futures contracts require margin payments. For these reasons the FRA might be preferred to futures. If there is believed to be a chance of a fall in interest rates, the 94250 option might be selected for the hedge.



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Marking scheme Marks

2 1 2 1 1

1 1 1 2

1 1 1

Max 10 –––––– Max 25 ––––––

Futures Sell March futures Number of contracts Calculation of closing futures price (basis adjustment) Gain on futures Net position (interest cost net of futures gain) Options Buy 40 March put contracts Premium cost of options Profit if options exercised Total cost calculation / identifying 94250 as best option FRA 3v5 7.08% Overall cost Commentary – 1 mark per sensible, well explained comment Total

3 NOIFA PLC

The chairman states in his report that turnover has risen dramatically (by 209%) and that the share price has almost doubled during the last four years. These comments are both accurate. However, he also states that the company's objective is to become the largest hotel group in the United Kingdom. This might suggest that a greater emphasis is being given to sales revenue maximisation rather than profit maximisation. Such a policy may result in a financial position which is not particularly strong. A more detailed analysis is performed below.

(1) Profitability

20X6 20X7 20X8 20X9 Return on turnover 21% 19% 16% 14%

(Profit before tax and interest ÷ turnover)

Return on capital employed 25% 24% 21% 15% (Profit before tax and interest

÷ shareholders' funds and debt)

Return on total assets 17% 16% 13% 10% (Profit before tax and interest

÷ non-current assets and current assets)

Each of the profitability ratios calculated above shows a marked decline over the four-year period, indicating that levels of profitability have not kept pace with the rapid expansion.



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(2) Working capital and liquidity

20X6 20X7 20X8 20X9

Inventory turnover (Turnover ÷ inventory)

8.1× 8.2× 7.0× 6.2×

Debtor days (Receivables ÷ average daily sales)

63 51 56 50

Current ratio (Current assets ÷ current liabilities)

0.85 0.73 0.68 0.68

Acid test ratio (Current assets less inventory

0.50 0.40 0.36 0.32

÷ current liabilities)

The general trend in the company's collection period from customers shows an improvement. However, the inventory turnover has decreased over the period, perhaps due to less efficient management as expansion has occurred.

The liquidity ratios, on the other hand, are of greater concern since they show a steady deterioration, with the result of an overdraft being necessary for financing working capital from 20X7.

(3) Gearing

20X6 20X7 20X8 20X9 Total debt (including the overdraft) 83% 72% 117% 109%

÷ shareholders' funds

Total debt ÷ total assets 62% 61% 68% 65%

Interest cover (Profit before tax and interest ÷ interest)

4.8× 4.4× 3.3× 2.6×

Gearing has increased substantially in 20X8 and then reduced slightly in 20X9. However, since 20X9 the company has acquired Beddall Hotels which involves an additional £100 million of debt, thus increasing the total debt: shareholders' funds to

%140=321

100+68+180+102

taking the 20X9 figures.

The interest cover has declined dramatically, partly as a response to the increased gearing, but also due to the lower profitability of the company.

(4) Market factors

20X6 20X7 20X8 20X9 Earnings per share (pence) (Profit after tax and exceptional item ÷ 500 million shares)

6.0 7.0 7.0 8.2

Price earnings ratio (Share price ÷ earnings per share)

13.7 14.9 17.1 19.4

Both the earnings per share and price earnings ratio have increased over the few years. Given that there have been no new share issues, the earnings per share figures simply represent the modest increase in total profit which has not kept pace with the substantial increase in turnover.



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The price earnings ratio appears to show a strong position until it is compared with the equivalent ratio for the leisure industry. In 20X6 Noifa has a P/E ratio in excess of that for the industry (13.7 against 10), but by 20X9 that position has been reversed with Noifa's P/E ratio being 19.4 and that of the industry 25. Similarly the increase in Noifa's share price (to which the chairman makes mention) is not particularly impressive when compared to the share index of the leisure industry. The latter shows an increase over the period of 121% ((394 − 178)/178) whereas the increase in Noifa's share price is only 94% ((159 − 82)/82).

(5) Analysis by activity

In order to perform a meaningful analysis, it is necessary to convert the turnover and profit figures into percentage terms:

20X6 20X7 20X8 20X9 Turnover Profit Turnover Profit Turnover Profit Turnover Profit Hotels 60.4 73.5 61.3 68.4 64.0 49.3 69.3 49.0Theme park 4.6 (6.1) 4.9 (3.3) 4.9 4.0 5.0 5.4Bus company

7.4 12.2 7.6 13.3 7.8 18.7 6.8 19.6

Car hire 13.2 14.3 12.2 13.3 10.6 16.0 9.1 16.3Zoo 1.5 (2.0) 1.6 (1.7) 1.8 0 1.5 (1.1)Waxworks 3.1 2.0 3.0 5.0 2.7 5.3 2.1 5.4Publications 9.8 6.1 9.4 5.0 8.2 6.7 6.3 5.4 ––––– ––––– ––––– ––––– ––––– ––––– ––––– ––––– 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 ––––– ––––– ––––– ––––– ––––– ––––– ––––– –––––

Whereas there has been growth in most of the company's activities the most substantial expansion has been in the hotel business with turnover increasing from 60.4% of the total in 20X6 to 69.3% in 20X9. However, despite the increase in the proportion of turnover, the profit contributed has fallen dramatically from 73.5% of the total in 20X6 to 49.0% in 20X9. Therefore it is clearly the hotel expansion which has resulted in the overall decline in relative profitability.

(6) Conclusion and recommendation

The analysis of the different segments of the business above would indicate that it may be preferable for the company to turn its attention away from hotel expansion to a more profitable area, such as the theme park (which has become profitable) or the bus company or the waxworks. This would involve a change in the stated objective of becoming the largest hotel group in the UK, but would probably benefit the shareholders in terms of the wealth maximising criterion.

A second consideration is concerned with the financing and gearing ratio of the company. It has been shown above that the gearing level has increased dramatically over the four-year period and that it has subsequently risen still further as a result of the euro loan to finance the acquisition of Beddall Hotels. Although the company has a large asset base to support the debt (£696 million of tangible fixed assets which will comprise hotel buildings with a high market value) the interest cover is deteriorating. Therefore if the hotel expansion does not become more profitable, the company could have difficulties in meeting its obligations.



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An alternative means of financing future acquisitions, including that of Beddall Hotels, would therefore be desirable. Although the euro loan is low risk, it has increased the gearing further and will also introduce foreign currency risk. Therefore an alternative of equity finance via a new issue of shares should be considered to reduce both the financial risk introduced through gearing and the currency risk.

Marking scheme

Marks

Max 4 Max 4 Max 4 Max 4 Max 3 Max 4 Max 4

–––––

Max 25 –––––

Give 1 mark per well explained point throughout Profitability ratios / comments Liquidity ratios / comments Gearing ratios / comments Market ratios / comments Analysis by activity calculations / comments Comments on strategy Comments on financing Total

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

–––––– Total Max 25

––––––



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4P Fin Asses Dec 14 (Freeaccastudymaterial.blogspot.com)

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