PRACTICE QUESTIONS ~ SECTION 8: SECTION 2 38 39 ‘MMC (JUN 11 ADAPTED) MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. itis expected that the game will be available to buy two months after the film’s release, by which time it will be possible to judge the popularity of the film with a high degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful, Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the flm has been released and the game is available for sale. MMC has forecast the following end of year cash flows for the four-year sales period of the game, Year 1 2 3 4 Cash flows ($ million) 2s 18 10 s MMC will spend $12 million immediately to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four- year sales period of the game. {t can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 59%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 50%, Required: (a) Estimate the financiat impact of the directors’ decision to delay the production and marketing of the game. The Black-Scholes Option Pricing model may be used, ‘where appropriate. All relevant calculations should be shown. (23 marks) (b) Briefly discuss the implications of the answer obtained in part (a) above. (6 marks) {€)__ MMC fs funded partly by equity and partly by debt. The yield on its five year debt is 5.2% and the yield on its ten year debt is 5.4% Le, MME faces an upward sloping yield curve, Required: Explain the possible reasons for an upward sloping yield curve. (6 marks) (Total: 25 marks) TISA CO (JUN 12 ADAPTED) — Tisa Co is considering an opportunity to produce an innovative component which, when fitted into motor vehicle engines, will enable them to utilise fuel more efficiently. The component can be manufactured using either process Omega or process Zeta. Although this is an entirely new line of business for Tisa Co, itis of the opinion that developing either process over a period of four years and then selling the productions rights at the end of four years to another company may prove lucrative. KAPLAN PUBLISHING 73AFM: ADVANCED FINANCIAL MANAGEMENT 79 THE ARMSTRONG GROUP (SEP/DEC 15) ‘The Armstrong Group Is a multinational group of companies. Today Is 1 September. The treasury manager at Massie Co, one of Armstrong Group's subsidiaries based in Europe, has just received notification from the group's head office that it intends to introduce a system of netting to settle balances owed within the group every six months. Previously inter- ‘roup indebtedness was settled between the two companies concerned. ‘The predicted balances owing to, and owed by, the group companies at the end of February are as follows: Owed by Owed to Local currency ‘milion (en) ‘Armstrong (USA) Horan (South Africa) ussi2a7 Horan (South Africa) Massie (Europe) saRaes, Giffen (Denmark) Armstrong (USA) DKr2129 Massie (Europe) ‘Armstrong (USA) us $19.78 ‘Armstrong (USA) Massie (Europe) as? Horan (South Africa) _—Giffen (Oenmark) Dxr16.35 Giffen (Denmark) Massie (Europe) ass ‘The predicted exchange rates, used in the calculations of the balances to be settled, are as follows: Dwr uss SAR € 1Oke= 3.0000 0.1823 1.9554 0.1341 1uss 5.4855 4.0000 10.7296 0.7358 1SAR= osi14 0.0332 1.0000 0.0686 ae 74871 1.3591 usr 3.0000 Settlement will be made in dollars, the currency of Armstrong Group, the parent company. Settlement will be made in the order that the company owing the largest net amount in dollars will frst settle with the company owed the smallest net amount in dollars. "Note: D Kr is Danish Krone, SA R is South African Rand, US $ is United States dollar and € is Euro. Required: (2) (i) Calculate the inter-group transfers which are forecast to occur for the next period. (8 marks) (li) Discuss the problems which may arise with the new arrangement. (3 marks) The most significant transaction which Massie Co is due to undertake with @ company outside the Armstrong Group in the next six months is that itis due to receive €25 million from Bardsley Co on 30 November. Massie Co's treasury manager intends to invest this money for the six months until 31 May, when it will be used to fund some major capital expenditure. However, the treasury manager is concerned about changes in interest rates. Predictions in the media range from a 0.5% rise in interest rates to a 0.5% fall. Because of the uncertainty, the treasury manager has decided to protect Massie Co by Using derivatives. The treasury manager wishes to take advantage of favourable interest rate movements. Therefore she is considering options on interest rate futures or interest rate collars as possible methods of hedging, but not interest rate futures. Massie Co can. invest at LIBOR minus 40 basis points and LIBOR is currently 3.6%, 126 KAPLAN PUBLISHINGPRACTICE QUESTIONS ~ SECTION B: SECTION 2 ‘The treasury manager has obtained the following information on Euro futures and options. She is Ignoring margin requirements. Three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. ‘September 95.94 December 95.76 March 95.44 Options on three-month Euro futures, €1,000,000 contract, tick size 0.01% and tick value €25. Option premiums are in annual %. calls Strike Puts September December March September December March 0.113 0.182 0.245 9650 0.002 0.128 0.198 0.017 0.032 ott 97000139 0.347 agi It can be assumed that settlement for the contracts is at the end of the month. It can also bbe assumed that basis diminishes to zero at contract maturity at a constant rate and that ‘time intervals can be counted in months. Required: {b) Based on the choice of options on futures or collars which Massie Co is considering land assuming the company does not face any basis risk, recommend a hedging strategy for the €25 million receipt. Support your recommendations with appropriate ‘comments and relevant calculations. (14 marks) (Total: 25 marks) 80 BURYECS CO (MAR/JUN 17) Buryecs Co Is an international transport operator based in the Eurozone which has been Invited to take over a rail operating franchise in Wirtonia, where the local currency is the dollar ($). Previously this franchise was run by a local operator in Wirtonia but its performance was unsatisfactory and the government in Wirtonia withdrew the franchise, Buryecs Co will pay $5,000 million for the rail franchise immediately. The government has stated that Buryecs Co should make an annual income from the franchise of $600 million in teach of the next three years. At the end of the three years the government in Wirtonia has offered to buy the franchise back for $7,500 million if no other operator can be found to ‘take over the franchise, ‘Today's spot exchange rate between the Euro and Wirtonia $ is €0.1430 = $1. The predicted Inflation rates are a follows: Year 1 2 3 Eurozone 6% 4% 3% Wirtonia 3% 8% 11% Buryecs Co's finance director (FD) has contacted its bankers with a view to arranging 2 ‘currency swap, since he believes that this will be the best way to manage financial risks ‘associated with the franchise. The swap would be for the intial fee paid for the franchise, ‘with a swap of principal immediately and in three years’ time, both these swaps being at today's spot rate. Buryecs Co's bank would charge an annual fee of 0.5% in € for arranging the swap. Buryecs Co would take 60% of any benefit of the swap before deducting bank fees, but would then have to pay 60% ofthe bank fees. KAPLAN PUBLISHING 127AFM: ADVANCED FINANCIAL MANAGEMENT 81 Relevant borrowing rates are: Buryees Co Counterparty Eurozone 4.0% 5.8% Wirtonia —Wirtonia bankrate —_Wirtonia bank rate 40.6% +0.4% In order to provide Buryecs Co's board with an alternative hedging method to consider, the FO has obtained the following information about over-the-counter options in Wirtonia $ from the company's bank. ‘The exercise price quotation is in Wirtonia $ per €2, premium is % of amount hedged, translated at today's spot rate. Exercise price Call options Put options 778 28% 1.6% 7.25 18% 2.7% Assume a discount rate of 14%. Required: (a) Discuss the advantages and drawbacks of using the currency swap to manage financial risks associated with the franchise in Wirtoni (6 marks) (b) (0) Calculate the annual percentage interest saving which Buryecs Co could make from using a currency swap, compared with borrowing directly in Wirtonia, demonstrating how the currency swap will work. (4 marks) (W) Evaluate, using net present value, the financial acceptability of Buryecs Co operating the rail franchise under the terms suggested by the government of Wirtonia and calculate the gain or loss in € from using the swap arrangement. (8 marks) (c) Calculate the results of hedging the receipt of $7,500 million using the currency ‘options and discuss whether currency options would be a better method of hedging this receipt than a currency swap. (7 marks) (Total: 25 marks) WARDEGUL CO (SEP/DEC 17) Wardegul Co, a company based in the Eurozone, has expanded very rapidly over recent years by a combination of acquiring subsidiaries in foreign countries and setting up its own operations abroad, Wardegul Co's board has found it increasingly difficult to monitor its activities and Wardegul Co's support functions, including its treasury function, have struggled to cope with a greatly increased workload. Wardegul Co's board has decided to restructure the company on a regional basis, wth regional boards and appropriate support functions. Managers in some of the larger countries in which Wardegul Co operates are unhappy with reorganisation on a regional basis, and believe that operations in their countries should be given a large amount of autonomy and be supported by internal functions organised on a national basi Assume it is now 1 October 20X7. The central treasury function has just received information about a future transaction by 8 newly-acquired subsidiary in Euria, where the local currency is the dinar (0). The subsidiary expects to receive D27,000,000 on 31 January 20x8. It wants this money to be invested locally in Euria, most probably for five months until 30 June 20X8. 128 KAPLAN PUBLISHINGPRACTICE QUESTIONS ~ SECTION B: SECTION 2 Wardegul Co's treasury team is aware that economic conditions in Euria are currently uncertain. The central bank base rate in Euria is currently 4.2% and the treasury team believes that it can invest funds in Euria at the central bank base rate less 30 basis points. However, treasury staff have seen predictions that the central bank base rate could increase by up to 1.1% or fall by up to 0.6% between now and 31 January 20X8, Wardegul Co's treasury staff normally hedge Interest rate exposure by using whichever of the following products is most appropriate: + Forward rate agreements (FRAs) © Interest rate futures ‘* Options on interest rate futures ‘Treasury function guidelines emphasise the importance of mitigating the impact of adverse ‘movements in interest rates. However, they also allow staff to take into consideration upside risks associated with interest rate exposure when deciding which instrument to use. A local bank in Euria, with which Wardegul Co has not dealt before, has offered the following FRA rates: 49: 5.02% 5-10: 5.10% The treasury team has also obtained the following information about exchange traded Dinar futures and options: ‘Three-month D futures, 500,000 contract size Prices are quoted in basis points at 100 ~ annual ye December 2017:94.84 March 20X8: 94.78 June 20x8: 94.66 ‘Options on three-month D futures 10500,000 contract size, option premiums are in annual % Strike Calls price Put December March June December March June 0.417 0.545 0678 = 9425.74 0.094 0.155, 0078 0.098 0160 95.25 0.393 0.529 0.668 It can be assumed that futures and options contracts are settled at the end of each month. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on ‘monthly time intervals. it can also be assumed that there is no basis risk and there are no ‘margin requirements. KAPLAN PUBLISHING 129AFM: ADVANCED FINANCIAL MANAGEMENT Required: fe (b) Recommend a hedging strategy for the 027,000,000 investment, based on the hedging choices which treasury staff are considering, if interest rates increase by 11.1% or decrease by 0.6%. Support your answer with appropriate calculations and discussion. (18 marks) Discuss the advantages of operating treasury activities through regional treasury functions compared with: © Each country having a separate treasury function. © Operating activities through a single global treasury function. (7 marks) (Total: 25 marks) 130 KAPLAN PUBLISHING