Advanced Financial Management (AFM)

Solution Pack
S. No Question ACCA Exam Paper Topics Covered

1 Okan Sep/Dec 2019 Advanced investment appraisal

2 Cadnam Sep/Dec 2019 Dividend policy
3 Kerrin Sep/Dec 2019 Mergers and acquisitions
4 Talam Mar/Jun 2019 Advanced investment appraisal
5 Lurgshall Mar/Jun 2019 Interest rate risk management
6 Newimber Mar/Jun 2019 Corporate reconstruction and re-organisation
7 Opao Dec 2018 Business valuation
8 Nutourne Dec 2018 Forex risk management
9 Amberle Dec 2018 Advanced investment appraisal
10 CMC Sep 2018 Specimen Forex risk management
11 Hav Sep 2018 Specimen Management buy-out
12 Burung Sep 2018 Specimen Advanced investment appraisal
13 Yilandwe Jun 2015 Investment appraisal and licensing
14 Bento Jun 2015 Management buy-out
15 Daikon Jun 2015 Treasury and advanced risk management
16 Keshi Dec 2014 Interest rate risk management
17 Riviere Dec 2014 Advanced investment appraisal
18 Kamala Dec 2014 Economic value added
19 Vogel Jun 2014 Business valuation
20 Makonis Dec 2013 Mergers and acquisitions
21 Nubo Dec 2013 Corporate reconstruction and re-organisation
22 Milma Jun 2013 Valuation, debt value and ethical issues
23 Kenduri Jun 2013 Forex risk management
24 Nente Jun 2012 Mergers and acquisitions
25 Pursuit Jun 2011 Mergers and acquisitions
26 Phobos Dec 2008 Interest rate risk management
 Okan Co

Part (a)

Adjusted present value (APV) classifies the cash flows based on the type. It allocates a specific discount
rate to each type of cash flow, depending on the risk factor. Conversely, net present value (NPV)
discounts all cash flows using a single discount rate, based on the average risk of a project.

By separating out different types of cash flows under APV, the company’s managers will be able to see
which part of the project generates what proportion of the project’s value.

Moreover, allocating a specific discount rate to a cash flow part helps determine the value added or
destroyed.

In the current scenario, Okan Co is able to determine how much value is being created by the
investment and how much by the debt financing.

Part (b)

Report to the board of directors (BoD), Okan Co

Introduction

This report evaluates whether Okan Co should pursue Project Alpha or Project Beta, based on the
important factors identified by the company, namely the returns generated by the projects, the projects’
risks and non-financial aspects. A justified recommendation is also included.

Evaluation

Financing

The use of forward market results in the higher receipt equalling Y$25,462,000 approximately. If the
money markets hedge is used the receipt is Y$25,234,936 (appendix 1). The forward market would,
therefore, minimise the amount of debt borrowing.

However, the amount receivable from the money markets hedge is based on the annual bank investment
rate available to Okan Co of 2·4%. Okan Co may be able to use the funds borrowed to generate a higher
return than the bank investment and therefore using money markets to undertake the hedge may be
financially advisable. Okan Co should investigate any opportunities for higher income, but based on the
current results, the forward market hedge is recommended to minimise the amount of debt finance
needed.

Minimum amount of debt borrowing required is Y$24,538,000 approximately.

Project returns and risk

Project Alpha Project Beta

Base case net present value (NPV)

(in six months’ time) Y$5,272,000 (appendix 2a) Y$5,100,000 (appendix 2a)
Adjusted present value (APV) Y$6,897,218 (appendix 2b) Y$6,725,218 (appendix 2b)
Project duration 3·04 years (appendix 2c) 2·43 years (given)

The base case NPVs and APVs of the two projects are similar to each other. However, Project Beta’s
project duration is significantly lower. This is because a higher proportion of Project Beta’s cash flows
come earlier in the project’s life, compared to Project Alpha. There is more certainty to earlier cash flows
and this is reflected in the lower duration for Project Beta. Project Beta’s risk is lower than Project Alpha.

Assumptions

It is assumed that inflation rates will not change during the life of the project.

It is also assumed that the future exchange rate between the Y$ and the £ will change in accordance
with the purchasing power parity differential.

Furthermore, it is assumed that the prices and costs related to Project Alpha will increase in line with
inflation during the six months before the project starts.

For Project Alpha, it is assumed that the initial working capital requirement is funded by the company
and not from the funds raised from the subsidised loan, similar to the assumption made for Project Beta.

In terms of the Project Alpha’s discount rate, it is assumed that the given discount rate accurately reflects
the business risk of the project. Whilst this level of detail is not provided for Project Beta, it is assumed
that similar assumptions will have been made for Project Beta as well.

In the case of both projects, Okan Co should assess the accuracy or reasonableness of the
assumptions, and if necessary, conduct sensitivity analysis to observe how much the projects’ values
change if input variables are altered.

Notwithstanding the assumptions and caveats made above, it would appear that Project Beta would be
preferable to Project Alpha, given that it has a similar APV but a significantly lower risk. Nevertheless,
there may be good strategic reasons why Okan Co may select Project Alpha over Project Beta.

Justification

Due to the substantially lower risk (as measured by the project duration) and similar APV, it is
recommended that Project Beta be selected by Okan Co. It is also recommended that forward markets
are used to hedge the income expected in six months’ time to part fund the project. This would minimise
the debt borrowing needed.

However, this decision is predicated on the fact that the implications of the assumptions and the wider
strategic reasons discussed above have been carefully considered by Okan Co.

Report compiled by:

Date
Appendices:

Appendix 1 (Part (b) (i)):

Expected receipt in six months’ time, using forward markets

€10,000,000 x 2·5462 = Y$25,462,000
Expected receipt in six months’ time, using money markets
€10,000,000/(1 + 0·022/2) = €9,891,197
€9,891,197 x 2·5210 = Y$24,935,708
Y$24,935,708 x (1 + 0·024/2) = Y$25,234,936
Minimum amount of debt borrowing Okan Co would require
Y$50,000,000 – Y$25,462,000 = Y$24,538,000

Appendix 2a (Part (b) (ii)): Projects Alpha and Beta, base case net present value, in six months’
time

Base case net present value before considering financing side effects. All figures are in Y$000s.

Year 0 1 2 3 4

Sales revenue (w1) 17,325 34,304 62,890 33,821

Less:
Production costs (w2) (6,365) (11,584) (24,095) (9,546)
Component costs (w3) (3,708) (5,670) (11,877) (4,578)
––––––– ––––––– ––––––– –––––––
Cash flows before tax 7,252 17,050 26,918 19,697
Tax (w4) 1,050 (1,535) (3,977) (1,721)
Working capital (1,733) (2,547) (4,288) 4,360 4,208
Plant purchase and sale (50,000) 10,000
––––––– ––––––– ––––––– ––––––– –––––––
Net cash flows (51,733) 5,755 11,227 27,301 32,184
––––––– ––––––– ––––––– ––––––– –––––––
Base case PV at 10% (51,733) 5,232 9,279 20,512 21,982
––––––– ––––––– ––––––– ––––––– –––––––

Approximate, base case net present value (NPV) of Project Alpha = Y$5,272,000.

Base case net present value (NPV) of Project Beta = Y$(8,450,000 + 19,360,000 + 22,340,000 +
4,950,000) – Y$50,000,000 = Y$ 5,100,000

Workings:

Working 1 (w1): Sales revenue

Year 1 2 3 4

Pre-inflated revenues (Y$ 000s) 15,750 28,350 47,250 23,100

Inflation x 1·11 x 1·12 x 1·13 x 1·14
Post-inflated revenues (Y$ 000s) 17,325 34,304 62,890 33,821
Working 2 (w2): Production costs

Year 1 2 3 4

Pre-inflated production costs (Y$ 000s) 6,120 10,710 21,420 8,160

Inflation x 1·041 x 1·042 x 1·043 x 1·044
Post-inflated production costs (Y$ 000s) 6,365 11,584 24,095 9,546

Component costs are not inflated, but future exchange rates are based on purchasing power parity
(PPP).

Working 3 (w3): Component cost

Year 1 2 3 4

PPP multiplier 3·03 x 3·09 x 3·15 x 3·21 x

1·04/1·02 1·04/1·02 1·04/1·02 1·04/1·02
Forecast Y$ per £1 3·09 3·15 3·21 3·27
Component cost (£) 1,200 1,800 3,700 1,400
Component cost (Y$) 3,708 5,670 11,877 4,578

Working 4 (w4): Tax

Year 1 2 3 4

Cash flows before tax 7,252 17,050 26,918 19,697

Tax allowable depreciation (12,500) (9,375) (7,031) (11,094)
Taxable cash flows (5,248) 7,675 19,887 8,603
Tax payable (20%) (1,050) 1,535 3,977 1,721

Appendix 2b (Part (b) (ii)): Projects Alpha and Beta, adjusted present value (APV), in six months’
time

Issue costs = 3/97 x Y$24,538,000 = Y$758,907

Annual tax shield = 2·1% x Y$24,538,000 x 20% = Y$103,060
Annual interest saved on subsidised loan = 2·9% x Y$24,538,000 x 80% = Y$569,282
Annuity factor, years 1 to 4 at 5% interest = 3·546

Present value of the tax shield and loan subsidy benefit = (Y$103,060 + Y$569,282) x 3·546 =
Y$2,384,125

Project Alpha APV Y$

Base case NPV of Project Alpha (appendix 2a) 5,272,000
Issue costs (758,907)
Present value of the tax shield and loan subsidy benefit 2,384,125
––––––––––
APV 6,897,218
––––––––––

Project Beta APV Y$

Base case NPV of Project Beta (appendix 2a) 5,100,000
Issue costs (758,907)
Present value of the tax shield and loan subsidy benefit 2,384,125
––––––––––
APV 6,725,218
––––––––––
Appendix 2c (Part (b) (ii)): Project Alpha’s duration based on its base case present values of cash
flows

Project Alpha

Year 1 2 3 4

PVs x years 5,232,000 x 1 9,279,000 x 2 20,512,000 x 3 21,982,000 x 4

= 5,232,000 = 18,558,000 = 61,536,000 = 87,928,000

Total PVs x time = 173,254,000 approximately

Total PVs = 57,005,000 approximately

Project Alpha duration = 173,254,000/57,005,000 = 3·04 years

Part (c)

Explanation of why the subsidiary company may be exposed to economic risk and how it may be
managed

Companies face economic exposure when their competitive position is affected due to macroeconomic
factors such as changes in currency rates, political stability, or changes in the regulatory environment.
Long-term economic exposure or economic shocks can cause a permanent shift in the purchasing power
and other parity conditions. Normally, companies face economic exposure when they trade
internationally. However, even companies which do not trade internationally nor rely on inputs sourced
internationally may still face economic exposure.

In the case of Okan Co’s subsidiary company, economic risk may have occurred because interest rates
have been kept at a high level, causing the original parity conditions to break down. High interest rates
will be attractive to international investors, as they can get higher returns and may lead to the Y$
becoming stronger relative to other currencies. This in turn would allow international competitors to
produce goods more cheaply than the subsidiary company and thereby enhance their competitive
position relative to the subsidiary company.

Managing economic exposure is difficult due to its long-lasting nature and because it can be difficult to
identify. Financial instruments, such as derivatives, and money markets cannot normally be used to
manage such risks. Okan Co’s subsidiary company can try tactics such as borrowing in international or
eurocurrency markets, sourcing input products from overseas suppliers and ultimately shifting production
facilities overseas. None of these are easy or cheap, and can expose the company to new types of risks.
Okan Co would also need to assess that any action it takes to manage economic risk fits into its overall
risk management strategy

Part (d)

How each category or risk may be managed

Risks which fall into the severe and frequent category need immediate attention, as they could threaten
the company’s survival or derail its long-term strategy. The aim here would be to reduce the severity of
the risks and the frequency with which they occur quickly. It may mean avoiding certain actions or
abandoning certain projects, even if they could be profitable in the long term. Where a company has a
real option, and does not need to take action which will result in high frequency and high severity of risk,
it may prefer to wait and see what happens.

Where the frequency of risks occurring is high but their impact is not severe, action needs to be taken so
that such risks do not become severe in the future. For example, the company could put systems into
place to detect these risks early and plans to deal with them if they do occur. Where the same kind of
risks occur often, the company may decide to have set processes for dealing with them. For example,
where there is a loss of relatively unskilled staff, the company may decide to replace staff quickly with
casual workers, but also have appropriate training facilities in place.

If there are risks which are severe but only happen occasionally or infrequently, the company should try
to insure against these. Contingency plans could also be put into place to mitigate the severity. For
example, if the consequences of IT failure are high when a business decides to move to a new system, it
could put appropriate contingencies into place. These may include secondary backup IT systems or
initially trialling the new system on a few business units before undertaking a complete role out.

Risks which are neither severe, nor frequent, should be monitored and kept under review, but no
significant action should be taken. It is possible that any significant action would incur costs which would
likely be higher than the benefits derived from eliminating such risks. Monitoring such risks will ensure
that should they move out of this category into the more severe/frequent categories, the company can
start to take appropriate action.
 Cadnam Co

Part (a)

Dividend capacity
$m

Operating profit 2,678

Less: Interest (8% x $10,250m) (820)
Less: Taxation (30% x ($2,678m – $820m)) (557)
Less: Investment in additional assets (25% x 0·03 x $2,678m/(1·03 x 0·02)) (975)
––––––
Forecast dividend capacity 326
––––––

Part (b)

Growth in profit after tax

20X3 20X4 20X5 Annual growth rate

% % % %
Cadnam 8·0 4·0 1·9 4·6
Holmsley 7·1 6·9 7·6 7·2

Dividend payout ratios

20X2 20X3 20X4 20X5

% % % %
Cadnam 55·4 56·4 59·7 64·6
Holmsley 37·7 37·1 36·5 35·7

Growth in dividends

20X3 20X4 20X5 Annual growth rate

% % % %
Cadnam 9·8 10·1 10·3 10·1
Holmsley 5·4 5·3 5·3 5·3

Residual profit (after tax-profit for the year – dividend – new investment)

20X2 20X3 20X4 20X5

% % % %
Cadnam 333 338 41 (304)
Holmsley 330 375 419 486
Growth in share price

20X3 20X4 20X5 Annual growth rate

% % % %
Cadnam 9·6 4·9 2·5 5·6
Holmsley 3·8 6·1 6·8 5·6

Commentary:

Dividends

Cadnam Co’s dividends increased at around 10% each year, and Holmsley Co’s dividends increased at
around 5% over the last three years. Holmsley Co’s policy appears to be sustainable at present,
whereas it is doubtful whether Cadnam Co’s policy is sustainable. In order to maintain its rate of dividend
increase, Cadnam Co has had to pay out an increasing proportion of earnings each year. In 20X5,
Cadnam Co’s residual profits became negative, and the dividend capacity calculation for 20X6 suggests
that a much lower level of dividends would be appropriate.

Gearing

Based on industry average, Holmsley Co’s gearing appears to be optimal. Up to 20X4, Cadnam Co
could perhaps have been taking advantage of debt capacity to increase its debt towards this level.
However, its gearing now appears to be on a rising trend, of necessity increasing significantly in 20X5 to
fund both additional investment and increasing dividends, despite the rise in its share price. Cadnam
Co’s gearing is predicted to increase further in 20X6, but how long this is sustainable is uncertain.

Share price

The average increase for the last four years has been same for both companies. The percentage
increase over the last two years for Holmsley Co has been higher than for Cadnam Co. This suggests
that the market has placed more significance on the higher % growth in Holmsley Co’s after-tax profits
than in Cadnam Co’s higher % growth in dividends. This could be an indication that Holmsley Co’s
strategy has been more successful and is more likely in future to deliver higher share price growth.

Part (c)

Dividend policy

The fact that the statement in the annual report fairly reflects the likely future dividend policy of Cadnam
Co is questionable. The report gives the impression that the current dividend policy will be sustained,
whereas the figures suggest that this may not be the case. If the policy proves not to be sustainable, it
would suggest a failure either of integrity or lack of sustainability. The directors may be questioned by the
auditors about whether this statement is true and fair.

There is also the question of balancing the interests of different stakeholders. To some degree, criticism
of rises in dividend and director remuneration levels versus increases in employee salary levels could be
said to be a matter of opinion.

The government enquiry into low pay in the sector suggests that pay levels are lower than what society
deems desirable. The force of the criticisms may be enhanced by the statements which Cadnam Co has
made about developing an integrated reporting approach. Integrated reporting is not just about extra
details in the annual report, but also reflects an underlying policy of carrying out business which includes
responsiveness to the needs of different stakeholders.
The dividend capacity and gearing figures suggests that Cadnam Co’s board is taking excessive risks.
Paying out increasing dividends in future may mean that the company is likely to have inadequate
resources to sustain its business, and may be jeopardising the interests of lenders and employees as
well as stakeholders. There are doubts about maintenance of future income levels with a number of
contracts coming up for renewal and terms possibly being tightened by clients. Clients may be doubtful
about renewing contracts if Cadnam Co’s solvency appears doubtful.

Directors’ remuneration

The directors’ remuneration packages are also questionable. Comparison with Holmsley Co shows that
salary, which is not dependent on performance, is a more significant element of the remuneration
packages at Cadnam Co than Holmsley Co. Both companies have bonuses which depend to some
degree on performance. However, Cadnam Co’s directors are also rewarded by loyalty bonuses, which
again do not depend on performance but staying with the company. Cadnam Co’s remuneration scheme
appears only to reward short-term profitability, possibly meaning that the directors may neglect the
longer-term success and possibly even viability of the company.
 Kerrin Co

Part (a)

Financial synergies

Acquisitions are typically justified for higher profitability or growth of the combined organisation. The
expectation is that the acquisition will generate greater expected cash flows or a lower cost of capital,
creating value for shareholders. The additional value created is commonly called synergy, the sources of
which can be categorised into three types: revenue, cost and financial synergies.

There are a number of possible sources of financial synergies in the current scenario. As a private
company, Danton Co is experiencing a funding constraint whereas Kerrin Co has significant cash
reserves but limited growth opportunities. The combination of the two can create additional value since
Danton Co may be able to utilise Kerrin Co’s cash resources to fund its expansion.

The cash flows of the combined company will be less volatile than the individual companies operating
independently. This reduction in volatility enables the combined company to borrow more and possibly
cheaper financing than would otherwise have been possible.

Further benefits may arise if Kerrin Co is able to utilise Danton Co’s unrelieved tax losses. Whilst Danton
is no longer loss making and could offset these tax losses independently, the combined company may
be able to obtain tax relief earlier since the acquisition increases the availability of profits against which
carried forward tax losses can be offset.

Overestimation of synergy value

The bidding companies often overestimate the value of synergy arising from a potential acquisition.
Consequently, they often end up paying too much for their target. When this happens, there is
destruction in wealth for the bidding company’s shareholders. There are a number of possible
explanations for this problem.

Firstly, merger and acquisition activity tends to be driven by the availability of cheap credit. At the peak of
a wave of activity, there may be competition for targets, thereby increasing acquisition premiums.

Secondly, conflicts of interest may lead to a biased evaluation process. Deal advisers such as
investment banks earn a large proportion of their fees from mergers and acquisitions. Their advice on
whether an acquisition makes sense is potentially biased if they do not look after their clients’ interests.

Finally, there may be difficulties integrating the companies due to different work cultures and conflicts of
interest.

Steps to address this problem

The responsibility for delivering synergy needs to be allocated to someone who can ensure spare cash is
utilised to invest in new growth opportunities, that tax losses are offset as efficiently as possible and that
the combined company avails itself of cheaper financing. Companies which allocate this responsibility
and monitor and review performance tend to be more successful in creating value.
Part (b)

Pre-acquisition valuations

Kerrin Co number of shares = 375m/0·5 = 750m

Kerrin Co market value = 750m x $5·28 = $3,960m
Future maintainable earnings (FME) = ($381·9) x 0·8 = $305·5m
Price earnings (PE) ratio = $3,960m/$305·5m = 12·96

Danton Co future maintainable earnings = ($116·3m + $2·5m) x 0·8 = $95·0m

Danton Co PE ratio = 12·96 x 1·20 = 15·55
Danton Co PE valuation = 15·55 x $95m = $1,477·3m

Combined Co pre-acquisition valuation = $3,960m + $1,477·3m = $5,437·3m

Post-acquisition valuation including synergies

Combined Co FME = $305·5m + $95m + ($20·5m x 0·8) = $416·9m

Combined Co PE ratio 12·96 x 1·1 = 14·3
Combined Co post-merger valuation = 14·3 x $416·9m = $5,961·7m
Value created based on synergies = $5,961·7m – $5,437·3m = $524·4m

Share-for-share offer

Kerrin Co Danton Co
$m $m

Pre-acquisition valuation 3,960·0 1,477·3

Add premium ($1,477·3m x 0·3) 443·2
Balance of excess value to Kerrin Co:
$524·4m – $443·2m 81·2
Post-merger valuation 4,041·2 1,920·5
Relative valuation 2·1 1

Kerrin Co new share issue = 750m/2·1 = 357·14m

Number of existing Danton Co shares = 35m x 4 = 140m

Therefore share-for-share offer = 357·14/140, i.e. approximately 18 Kerrin Co shares for every 7 Danton
Co old shares

Advice on terms of share-for-share offer

Danton Co shareholders would receive 140m x (18/7) = 360m new Kerrin Co shares.

Total Kerrin Co shares = 750m + 360m = 1,110m.

Kerrin Co shareholders own 67·6% (750m/1,110m) and Danton Co shareholders 32·4% (360m/1,110m)
of the post-acquisition company.
Impact on shareholder wealth

Kerrin Co Danton Co
$m $m

Pre-acquisition valuation 3,960·0 1,477·3

Cash offer

Danton Co shareholders cash received:

$13·10 x 140m shares 1,834·0
Kerrin Co post-acquisition equity valuation:
$5,961·7m less acquisition cost of $1,834·0m 4,127·7
Increase in shareholder wealth 4·2% 24·1%

Share-for-share offer
Post-acquisition value
Kerrin Co: (750/1,110) x $5,961·7 4,028·2
Danton Co (360/1,110) x $5,961·7 1,933·5
Increase in shareholder wealth 1·7% 30·9%

The terms of the share-for-share offer meet the criteria specified by Danton Co’s directors

Part (c)

Cash offer

The main advantage of a cash offer is that it provides Danton Co’s shareholders with a certain and
immediate return. However, the premium is lower compared to the share-for-share offer and may be
reduced even further if the realised gain gives rise to a tax liability. By indicating their preferred premium
under both offers, it is possible the shareholders have priced in the risks associated with an uncertain
share-for-share offer and on this basis may be indifferent between the two. The cash offer may give rise
to agency issues since Danton Co’s founders no longer have a stake in the business even though Kerrin
Co’s board is keen to ensure the founders remain in position after the acquisition. The information
provided is too limited to read too much into the intentions of the venture capitalist. However, typically a
venture capitalist would be expected to exit within three to five years. In this case, they may prefer the
certainty of the cash offer.

The cash offer transfers more of the added value to Kerrin Co without the need for dilution, which may
appeal to the shareholders. As indicated in the question, Kerrin Co’s existing reserves are sufficient to
fund the cash offer although this may constrain future dividends and/or investment decisions.

Share-for-share offer

Both sets of shareholders benefit from increased wealth as a result of the share offer, albeit only
marginally so in the case of Kerrin Co’s shareholders. Another drawback is that Kerrin Co’s
shareholders’ percentages are also diluted under this method. However, a share-for-share offer would
ensure that Danton Co’s founders’ interests are aligned with Kerrin Co’s shareholders, reducing possible
agency costs. It also provides Danton Co’s shareholders with the right to participate in the future growth
of the larger company, which the cash offer would prevent.

No basis has been provided for the synergistic benefits; the increase in shareholder wealth is so
marginal even a minor deviation from the estimates could result in a reduction in shareholder wealth for
the owners of Kerrin Co. On this basis, it is quite likely they will not approve a share-for-share offer
without further negotiation around the acquisition premium.
 Talam

Part (a)
Making a decision with real options will improve the overall decisions being made as they generally offer
more flexibility than the investment models presented such as the NPV calculation.

One real option is that the investment and start date for the investment can be delayed or rescheduled
and the work may be phased out more than it is allowed for in the NPV. There is the option to change
the project mid way through as well if there is a change in the risk appetite of the company or in the
economic climate.

Incorporating real options also allow managers better decisions as to whether a project should be
undertaken or not as there is likely to be more flexibility in the decision making process than in the model
presented. Real options would look to incorporate macro conditions than investment models often
ignore.

Presenting Talam with real options as well will ensure that the management make a better informed
decision around the investment and ensure that the project is the correct fit for the company overall.

Part (b)
Report to the directors of Talam Co.

This report shows all of the relevant information that needs to be considered when assessing the Uwa
project. There is a break down of the calculations methodology and also the assumptions that were
used.

Assessment of the Project

The value of the project based purely on the NPV is a slightly negative amount of around $6 per the
appendix attached. This would suggest that the project is not worth pursuing. The offer from Honua co
and the Jigu project, once the real options method is used would give an estimated value in excess of
$17M. This outcome is far in excess of the NPV on offer and this would indicate that the Uwa project
should be undertaken.

Assumptions:
The following assumptions have been made when calculating the values that are provided in the
appendices in both 1 and 2.

The Uwa project is in a different industry than the one that Talam Co currently operates in, there is a
project specific risk adjustment made to the cost of capital to 11%. This is based on the 11% that Honua
Co uses at their asset beta. The assumption is that this would provide a good approximation for the
business risk that is inherent in the drone production.

THe Black and Scholes option pricing model is being used in the example to estimate the real option
values of the Jigu Project and the Honua Co offer. The model was developed for financial products and
not for physical products upon which real options are applied. The BSOP model also assumes that the
market exists in the trade of the underlying project without any restrictions.

The BSOP model also assumes that the real option is a European style option that can only be
exercised upon the date upon which the option expires. In some cases there may be a more strategic
option where a more representative American style option can be applied. This would be done prior to
the expiry date. The BSOP model may then underestimate the true value of the option.

The BSOP Model does not take into account the behavioural anomalies which may be displayed by the
managers when they are making decisions.

It has been assumed that all of the variables used to calculate the values of the projects in appendices 1
and 2 are correct and accurate.
Furthermore it is assumed that all of the variable rates such as inflation and tax will remain reasonable
for the length of the forecast. Time periods related to the project aond the offer from Honua is deemed to
be accurate and reasonable.

Conclusion:
The recommendation is that the Uwa project should be undertaken when the offers from Honua Co and
the Jigu project are included. Taken together the resulting NPV figure will represent a largely positive
NPV. It must be noted that there are a number of assumptions that have been made and the
assumptions are subject to a certain degree of change, the occurrence of which may impact on the NPV
of the project and the various options.

Appendix 1: b (i)

Year 0 1 2 3 4

Revenue W1 0 5,160 24,883 49,840 38,405

Less

Fixed Costs 2,700 2,970 3,267 3,594

Variable Costs W2 2,064 9,581 18,476 13,716

Training Costs 4,128 5,749 1,848 1,372

Cash Flows before Tax (3,732) 6,583 26,249 19,723

TAX W3 1,796 (276) (4,200) (1,495)

Working Capital (1,032) (1,972) (2,496) 1,144 4,356

Machinery Purchase and Sale (35,000) 7,000

Net Cash Flows (36,032) (3,908) 3,820 23,193 29,584

PV discounted @ 11% (36,032) (3,521) 3,100 16,959 19,488

Approx net Present value of the project = $-6

W1: Revenue

Year 1 2 3 4

Unit Produced and Sold 4,300 19,200 35,600 25,400

Selling Price 1,200 1,296 1,400 1,512

Revenue 5,160 24,883 49,840 38,405

W2: Variable Costs

Year 1 2 3 4

Unit Produced and Sold 4,300 19,200 35,600 25,400

Variable Cost PU 480 499 519 540

Total Variable Costs 2,064 9,581 18,476 13,716

W2: Tax

Year 1 2 3 4

CF before Tax (3,732) 6,583 26,249 19,723

Tax Allowable Depreciation (5,250) (5,250) (5,250) (12,250)

Taxable Cash Flows (8,982) 1,333 20,999 7,473

Tax Payable (1,796) 267 4,200 1,495

Appendix 2 Part b (ii)

Jingu Project
Asset Value → $46,100,000
This is presented as a PV of future cash flows for the project.
→ 70,000,000 x 1.11 ^-4 = 60 M + 10 M

Honua Co
Asset Value = $16,959,000 + $19,488,000 = $36,447,000.
Exercise Price = $30,000,000
Exercise Date = 2 Years
Risk Free Rate = 2,30%
Volatility = 30%

Value of the Offer from Honua Co.

The Call value = $36,477,000 x 0.7821 - $30,000,000 x 0.6387 x -0.023^2 = $10,205,640.
Put value = $10,205,640 - $36,447,000 + $30,000,000 x 0.023^2 = $2,409,899

Estimated total value from the 2 real options:

Value of Jigu Project: $15,258,399
Value of Honua Co Offer: $2,409,899

→ Estimated total value from the 2 options:

$2,409,899 + $15,258,399 = $17,668,298.

Part (c)
There is a clear conflict between the need to provide strong financial results and the stated aim of the
company to bring environmental and affordable friendly products. This is complicated further by the fact
that the company also want to maintain high ethical standards as this may also impact on the financial
results.

Producing profitable products will improve the financial results of the company. This is turn should make
the company a good option to invest in for shareholders. The company will need to ensure that the
products that they produce are affordable for their customers at the same time. This conflict between
making a profit and maintaining affordability for the product is a different balance to maintain.

One potential solution for the company is to try to lower their product costs. They can be achieved by
moving the manufacturing base to a lower cost location. This would allow the company to reduce their
costs will still managing to increase profits will still being able to keep the product affordable for the
farmers. The conflict here is that in a location such as Dunia use young children in their work force. This
would not allow Talam to maintain their high ethical standards. This may also have a knock on impact
both on their reputation and financial bottom line.

The company will need to prioritize which option they will make as their main aim as both of the options
are mutually exclusive. The company may need to focus on the ethical guidelines at the expense of
lowering production costs. This is likely to impact on the affordability of the product for some customers.

Talam may need to consider if there are other locations available that would help to lower production
costs while also keeping up the ethical guidelines. This may be a better solution but there also may be
an impact on the relationship between the companies in Dunia with Talam. It could take a lot of time or
financial resources to develop a new relationship with new companies.

Talam might have to explore the option to explore the existing production in Dunia further. It may be
possible to ensure that local working conditions are improved while still keeping the cost of production
down. This would also allow the company to adhere to their high ethical standards as well.

In conclusion it would appear that Talam should continue to produce the Drones in Dunia. Talam will
need to ensure that working conditions are improved in Dunia for the local workers. The company could
also look to invest in a public relations department to ensure as well that the improved conditions are
demonstrated and that Talam are helping to improve the future of the workers.
 Lurgshall

Part (a)
Buy put options as need to hedge against a rise in interest rates.

Number of contracts required: $84,000,000/$2,000,000 x 6/3 = 84

Total basis = current price (1 May) – futures price = (100 – 4·50) – 95·05 = 0·45

Unexpired basis on 1 September = 0·45 x 1/5 = 0·09

Expected futures price = 100 – 5·1 – 0·09 = 94·81

Exercise price 95·25

Futures price as above 94·81
Exercise? Yes
Gain in basis points 44

Interest paid ($84,000,000 x 5·6% x 6/12) 2,352,000

Gain from options
0·0044 x $2,000,000 x 3/12 x 84 (184,800)
Premium
0·00411 x $2,000,000 x 3/12 x 84 172,620
––––––––––
Net payment 2,339,820
––––––––––
Effective annual interest rate
2,339,820/84,000,000 x 12/6 5·57%
Swaps
Lurgshall Co Counterparty Interest rate differential
Fixed rate 5·60% 6·10% 0·50%
Floating rate LIBOR + 0·50% LIBOR + 1·50% 1·00%

Lurgshall Co has an advantage in borrowing at both fixed and floating rates, but the floating rate
advantage is larger.

Gain % for Lurgshall Co = 50% (1 – 0·5 – 0·2) = 0·15

Lurgshall Co Counterparty
Rate without swap (5·60% ) (LIBOR + 1·50% )
Benefit 0·15% 0·15%
Net result (5·45% ) (LIBOR + 1·35% )

Swap
Borrows at (LIBOR + 0·50% ) (6·10 )
Lurgshall Co pays (4·85% ) 4·85%
Counterparty pays LIBOR (LIBOR )
Bank fee (0·10% ) (0·10% )
Net result (5·45% ) (LIBOR + 1·35% )

Overall
The swap will give an outcome that is worse than the forward rate agreement. The options give a worse
result as well and should not be chosen.

There are some key risks to be considered here as well. The option to use Birdam Bank should mean
that there would be lower risks for the forward rate agreements and in the case of the swaps. This would
only be true however if the banks are bearing the risk of counterparty defauting.
There are other factors to consider in relation to interest rates. Rates may increase or decrease beyond
what is included in the forecast. If the rates increased or the borrowing is for an increased length of time
then the swap will be a better opportunity than the other hedging options.

Part (b)
Advantage of Swaps
The main advantage of swaps are that the transaction costs are generally lower. If Lurgshall was able to
conduct the swap themselves ,they would be able to reduce the transactional costs overall and the swap
would be limited to only the legal fees.

Swaps are straightforward and can be arranged and carried out as a relatively easily. This is a real
advantage as there is unlikely to be much in the way of fluctuations in the short term. This stability is a
large advantage to any forecasting that Lurgshall Co may produce.

The length of the swap is a key consideration as well, as the longer the swap is for, will impact on its
overall advantage. If the borrowing was to be longer than six months, the swap will then will most likely
turn out to be a better option than other opportunities.

Swaps are available over varying time periods. This is a large advantage over other options where the
time period offered may be too short.

Disadvantage of Swaps
With any swap there is a risk that the swap may not work out as well as expected and Lurgshall Co may
end up losing out on the swap or that the other party may default on the swap altogether.

A 3rd party such as a bank may be used to secure the swap however this is likely to cost more money.
This can increase the cost of the swap overall.

Swaps conditions may also be set months in advance. This can mean that if conditions such as interest
rates change, the swap may end up costing more than was originally expected.

Part (c)

The attitude of the Chief Executive appears to have a flawed point of view as they appear to have
underestimated the knowledge and the skills that staff will need. This is likely to cause issues as staff
may lack the knowledge needed to deal with complex issues.

Staff may lack the skills needed to make judgement calls in some cases. This may lead to more
mistakes or losses for the company overall. The poor decisions may lead to the company to make poor
investments.

Experienced staff would be able to set out guidelines and the standards that the company would be
expected to work at. Junior staff members may not be able to achieve and set the same standards. This
may cause issues for the company and cost more in training.

More senior staff would be aware of current issues and developments as they happen due to past exp.
This would be important for any company that wants to be compliant. Failure to do so may cost the
company both financially and reputationally.

A lack of experienced staff will make any future expansion plans more difficult for the future as staff will
not be able to act as the required business advisors as may be expected for the company. Having more
experienced staff would be a useful asset to aid with any expansion plans.
 Newimber

Part (a)
Advantages of the demerger

There are a number of expected benefits to the proposed demerger. One of the main advantages is the
lack of confusion around management and their priorities. This means that the management will now be
able to focus their attention on the new clothing company and not having to deal with other issues within
the sport wear division.

Another advantage if the demerger is that the company will have a clean break and will be able to
become financially independent from the old company. Management will be able to make their own
decisions around financing and are not bound to the financial costs of the clothing division.

There is a potential advantage that the new smaller companies may become more agile in their
operations. As smaller operations, management may be able to implement changes quicker and this
could help the company to achieve their strategic goals faster.

Disadvantages of the demerger

There are some disadvantages to the demerger as well. The legal costs that will be faced due to the
demerger will cost the company a lot in resources, in particular the cost to list as a separate company.

Another concern around the demerger is the new smaller size of both companies. There is a potential
that as smaller companies, the economies of scale may be lost and this can impact both on the financial
position of the company and also the productivity of the company overall.

Part (b)
WACC of Newimber Co.

Ke is 11.8% and Kd 4.5%

Annuity factor 4.5% for 5 years ( 1 - (1+.0.045)^-5 / 0.045 = 4.390
Loan per $100 = ($5.90 x 4.390) + ($105.00 x 1.045^-5) = $110.16
MVd = $100.16 /100 x $200 million = $220 Million

WACC = ((585x 11.8%) + (220 x 4.5% x 0.72) / 805 = 9.5%

New WACC
MVe = $351M
𝛃e = 1.21 (351 + ( 220 (1-0.28))) / 351) = 1.76
Ke = 3.4% + (1.76 x 6%) = 14%
WACC = ((351 x 14% ) + ( 220 x 4.5% x 0.72)) / 571 = 9.9%

This is an increase of 0.4%

WACC Poynins Co
Current 𝛃a of Newimber Co = 1.4 ( 585/(585 + 220( 1 - 0.28))) = 1
𝛃 Poynins co = (1.10 - (0.6 x 1.21)) / 0.4 = 0.935
WACC Poynins Co = 3.4% + ( 0.935 x 6% ) = 9%
Free Cash Flows Poynins Co

Year 1 2 3

Cash Flows 45 54 62.1

TAX (12.6) (15.1) (17.4)

Post Cash Flows 32.4 38.9 44.7

Investment Assets (20) (22) (22)

Free Cash Flows 12.4 16.9 22.7

DCF @ 9% 0.917 0.842 0.772

DCF CFs 11.4 14.2 17.5

DCFs 1-3 = $43.1m

Discounted post tax cash flows from year 4 and onwards = $502.8M
(44.7m (1 +0.02) / 0.09 - 0.02 = $651.3 x 0.772 → 502.8M

Discounted investment in assets from year 4 onwards = 25 / 0.09 = $277.8 x 0.772 = $214.5M

Poynins Cos valuations: $43.1 + $502.8 - $214.5 = $331.4

Discussion:
If the managers’ estimates of the sportswear division’s future free cash flows are realistic, then the
valuation using free cash flows ($331·4m) exceeds the current valuation ($585m – $351m = $234m).

The valuation is dependent on an ambitious growth target in years 1-3. This is further pressure here
given the loss of economies of scale.

There is a consideration as well to the restructuring and this will lead to a marginal increase in the
WACC for Newimver as the financial risk increases with more gearing. The directors may need to
monitor the credit rating as Newimber’s credit rating could fall.

Part (c)
Requirements to be considered
Poynins Co will have the same requirement and listing requirements as Newimber Co currently has. This
then will also include the requirements of the business review.

Investors will want to know about the future plans of the company and how these strategies may differ
from recently pursued strategies. Investors are also likely to be interested in the attitude of the managers
of the company in relation to risk and risk management. There seems to be a new attitude towards risk
than the older division.

Communication
There is a need for the management of Poynins Co to communicate with the major shareholders. This
should be done on a regular basis and the shareholders will require relevant information.

The manner in which the messages are communicated is important as well to ensure that shareholders
are understanding the key messages. Employees and other key stakeholders such as customers and
suppliers are likely to be very important here as well as the company looks to enforce operational
efficiencies. Employees may resist these changes and suppliers may not like dealing with a smaller
company as this may give the perception of a larger operational risk for them. Customers may not want
to be associated with the company if there is reputation risk to the company.

Changing reporting methods

The directors of Poynin should consider the use of integrated reporting. They are not forced by the
decision of Newimber to start using the integrated reporting framework. Should they choose not to use it
however this may be seen as a lack of transparency by the key stakeholders in the business.

If management opt to make the change to integrated reporting it may take a while for the company to be
able to effectively communicate the value proposition to the investors and to their employees internally.
This would mark a fundamental change in the operations and reporting for the company.
 Opao
a) A management buy-out involves the company’s current management team taking over the business
from its existing owners. In contrast to this, a management buy-in occurs when the company is sold
to a new, external management team.
The sale of Burgut by means of a management buy-in, i.e. to a management team not currently
involved in the business, may have been chosen by Opao’s Board of Directors for a number of
reasons, including:

 A higher level of experience and skills possessed by the external team as compared to
Burgut’s existing management. The Board may have felt that an outside team would be
better placed to bring fresh ideas, strategy and drive to make Burgut thrive.
 The external team may have had better and quicker access to the financing needed to
support the deal.
 It is also possible that the existing management teams of Burgut and Opao may have had a
difficult relationship in the past, making the prospect of structuring a mutual deal difficult to
imagine.

b) A portfolio restructuring involves changing the mix of subsidiary companies by acquiring new
companies and disposing of existing business, either entire companies, business units or significant
individual assets by means of demergers, spin-offs and divestments. On the other hand,
organisational restructuring involves changing the way a business is organised, for example by
modifying company structure, processes or its governance. In both cases, the restructuring is
undertaken with the aim of enhancing performance and driving up company value.

Opao is restructuring itself from a conglomerate to a company focused on just two industries:
financial services and food manufacturing, with other businesses and segments being disposed of.
Such action is often undertaken so as to focus on areas in which a company’s management have
expertise, which in turn, allows for the maximisation of company value.

Another reason for such focus is the reluctance of many investors, especially institutional, who
typically hold well-diversified equity portfolios, to invest in conglomerates without clear industry focus.
Such investors can easily achieve the risk minimisation benefits associated with diversification by
managing broad asset portfolios. They do not therefore see value in the management of individual
companies undertaking further industry diversification by expanding into unrelated business
segments. As Opao’s shareholder base changes from investors whose wealth was entirely invested
in a single business to a less coherent but more professional investor profile, the need for Opao to
provide diversification benefits becomes less relevant and should give way to more focus on
selected industries.

c) Report to the Board of Directors (BoD) of Opao Co

Introduction
This report provides an estimate of the additional value created if Opao Co were to acquire Tai Co,
and the gain for each company’s shareholders based on a cash offer, a share-for-share offer and a
mixed offer. It evaluates the likely reaction of the two companies’ shareholders to each payment
method.

Summary of the estimates from the appendices

From appendix 1
Opao Co equity value pre-acquisition: $5,000m
Tai Co equity value pre-acquisition: $1,000m
Combined company equity value post-acquisition: $6,720m
From appendix 2
Additional value based on synergy benefits: $720m or 12% ($720m/$6,000m)

Estimated percentage gain in value:

Opao Co Tai Co

Cash offer 11·2% 15·8%

Share-for-share offer 6·4% 40·0%

Mixed offer 9·7% 23·4%

Tai Co’s shareholders are likely to consider all the offers made, because they all fall within the range
of premiums paid in previous acquisitions of 15% to 40%. The cash offer is at the lower end of the
range, the share-for-share offer at the top end of the range and the mixed offer lies in between. It is
likely that Tai Co’s shareholders will be more attracted to the share-for-share offer as it maximises
their return. However, this offer is reliant on the fact that the expected synergy benefits will be
realised and Tai Co will probably need to analyse the likelihood of this. Cash payment, although
much lower, gives a certainty of return. The mixed offer provides some of the certainty of a cash
payment, but also offers a higher return compared to the cash offer. This return is roughly in the
middle of the premium range. It may therefore prove to be the best option for Tai Co’s shareholders.

Opao Co’s shareholders benefit less from the acquisition compared to Tai Co’s shareholders. In
each case, they receive less than the additional percentage value created of 12%, with the cash
payment offering the highest return of 11·2%, which is just below the 12% overall return. The share-
for-share offer gives the least return at just over half (6·4%) of the overall return of 12%.
Nevertheless, with this option, cash is retained within Opao Co and can be used for other value
creating projects. Opao Co’s shareholders may also prefer the mixed offer, because the return they
are expecting to receive is between the cash and share-for-share offers. Also, less cash resources
are used compared to the cash offer, and they still benefit from a significant proportion of the
additional value created.

Conclusions
Based on the benefits accruing to both groups of shareholders, it is not possible to conclusively say
that one method of acquisition payment would be acceptable to both sets of shareholders. However,
both groups may be persuaded that the mixed offer provides a reasonable compromise between the
100% cash and the share-for-share terms. Given that synergy benefits are shared (even if not
equally), both companies’ share prices should increase if the deal goes through, as long as the
valuation estimates are reasonably accurate.

Report compiled by:

Date
Appendices:
Appendix 1 (Part c.i)

Opao Co pre-acquisition equity value:

$2.50 per share x 2,000m shares = $5,000m

Tai Co pre-acquisition equity value:

Free cash flows to the firm = $132.0m x (1 – 20%) + $27.4m - $24.3m = $108.7m
Company value = $108.7 x 1.03 / (0.11 – 0.03) = $1,400m
Equity value = $1,400m - $400m = $1,000m

Post-acquisition equity value of combined company (all figures in $ millions)

Year 1 2 3 4
Sales revenue 7,351 7,720 8,108 8,515
(years 2 – 4: growth at 5.02% per annum)
Pre-tax profit (15.4% of sales revenue) 1,132 1,189 1,249 1,311
Less: Tax (20%) (226) (238) (250) (262)

Less: Additional investment required (109) (114) (120) (126)

(years 2 – 4: $0.31 per $1 of revenue growth)
Free cash flows 797 837 879 923
Discount factors (at 10%) 0.909 0.826 0.751 0.683
PV of free cash flows 724 691 660 630

Company (combined) value (years 1 – 4) = $2,705m

Company (combined) value (after year 4) = [923 x 1.024/(0.10 – 0.024)] / 1.14 = $8,494m
Total company (combined) value = $2,705m + $8,494m = $11,199m
Equity value of combined company = 60% x $11,199 = $6,720m

Appendix 2 (Part c.ii)

Additional equity value created from acquisition: $6,720m – ($5,000m + $1,000m) = $720m

Tai Co value per share = $1,000m / 263m shares = $3.80 per share

Cash offer
 Percentage gain for Tai Co shareholders: ($4.40 - $3.80) / $3.80 = 15.8%
 Additional value created for Tai Co shareholders: 263m shares x ($4.40 - $3.80) =
$157.8m
 Additional value created for Opao Co shareholders: $720m - $157.8m = $562.2m
 Percentage gain to Opao Co shareholders: $562.2m/$5,000m = 11.2%

Share-for-share offer
 Additional value created for Opao Co shareholders: $720m x 44.5% = $320.4m
 Additional value created for Tai Co shareholders: $720m x 55.5% = $399.6m
 Percentage gain to Opao Co shareholders: $320.4m / $5,000m = 6.4%
 Percentage gain to Tai Co shareholders: $399.6m / $1,000m = 40%

Alternatively:
 Opao Co post-acquisition equity value: $5,000m + $320.4m = $5,320.4m
  Opao Co post-acquisition estimated share price: $5,320.4m/2,000 shares = $2.66 per
share
 Number of Opao Co shares to be allocated to Tai Co shareholders:
($1,000m + $399.6m)/$2.66 shares = approximately 526 shares

Share offer must therefore involve 2 Opao Co shares for every share in Tai Co (526/263
= 2).

 Percentage gain to Opao Co shareholders: ($2.66 - $2.50) / $2.50 = 6.4%

 Percentage gain to Tai Co shareholders: (2 x $2.66 - $3.80)/$3.80 = 40%

Mixed offer
 Percentage gain to Tai Co shareholders: ($2.60 + $2.09)/$3.80 – 1 = 23.4%

 Additional value created for Tai Co shareholders: $1,000 x 23.4% = $234m

 Additional value created for Opaco Co shareholders: $720m - $234m = $486m
 Percentage gain to Opao Co shareholders: $486m / $5,000m = 9.7%

d) An initial public offering (IPO) is the conventional way to obtain a stock exchange listing and
involves the company issuing and offering shares to the public. In doing so, the company will
follow the normal procedures and processes required by the stock exchange, complying with
regulatory requirements.

A reverse takeover is typically aimed at achieving a listing without going through the IPO
process. The BoD of Burgut Co would initially take control of a ‘shell’ listed company by buying
some shares in that company and taking over as its BoD. The ‘shell’ listed company was
probably a normal listed company previously but is no longer trading. New equity shares in the
listed company would then be exchanged for Burgut Co’s shares, with the external appearance
that the listed company has taken over Burgut Co. Normally, the name of the original listed
company would then be changed to Burgut Co.

Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is
cheaper, takes less time and ensures that Burgut Co will obtain a listing on a stock exchange. An
IPO can cost between 3% and 5% of the capital being raised because it involves investment
banks, lawyers, and other experts. A marketing campaign and issuing a prospectus are also
needed to make the offering attractive and ensure shares to the public do get sold. A reverse
takeover does not involve any of these and therefore avoids the related costs.

The IPO process can typically take one or two years to complete. Additionally, the regulatory
process and stock exchange procedures need to be complied with. With a reverse takeover,
none of these are required and therefore the process is quicker.

Finally, there is no guarantee that an IPO will be successful. In times of uncertainty, economic
downturn or recession, it may not attract the attention of investors and a listing may not be
obtained. With a reverse takeover, because the transaction takes place between two parties, it is
sure to happen and Burgut Co will be listed.

However, obtaining a listing through a reverse takeover can have issues attached to it. The listed
‘shell’ company may have potential liabilities which are not transparent at the outset, such as
potential litigation action. Accordingly, a full due diligence of the listed company should be
conducted before the reverse takeover is initiated. Additionally, the IPO process is probably
better at helping provide the senior management of Burgut Co with knowledge of the stock
exchange and its regulatory environment. The involvement of experts and the time senior
management need to devote to the listing process will help in this regard. Due to the marketing
effort involved with an IPO launch, it will probably have an investor following, which a reverse
takeover would not enjoy. Therefore, a company which has gone through an IPO would probably
find it easier to raise extra funds in the future.

Overall, neither option of obtaining a listing has a clear advantage over the other. Ultimately, the
choice of listing method will depend on the company undertaking the listing and the purpose for
which it is doing so.
 Nutourne

a) Nutourne Co will have be receiving CHF in six months’ time and therefore needs to hedge against
the CHF weakening relative to the dollar.

Futures

Sell Swiss futures using June futures contracts.

No. of contracts = CHF12,300,000/125,000 = 98·4, say 98, hedging CHF12,250,000

Remainder to be hedged on the forward market is CHF12,300,000 – CHF12,250,000 = CHF 50,000

Forward contract receipt = CHF50,000 x 1·0358= $51,790

Computation of futures price:

Assume that basis reduces to zero at contract maturity in a linear fashion. Estimate price from
March and June futures contract rates:

Predicted futures rate at the end of May = 1·0345 + ([1·0369 – 1·0345] x 2/3) = 1·0361

Expected futures receipt = CHF12,250,000 x 1·0361 = $12,692,225

Overall outcome (receipt) = $51,790 (from forward) + $12,692,225 (from futures) = $12,744,015

Options

Nutourne Co should purchase CHF June put options.

Number of contracts – 98 (as for futures contract).

Amount not hedged, hedged by forward contract, producing $51,790 as before.

Assuming the options are exercised:

Receipt 12,709,375 98 x CHF125,000 x $1.0375/CHF

Premium (105,350) 98 x 125,000 x $0.0086

Forward receipt 51,790

12,655,815

The options would give the higher receipt if they were not exercised and the spot rate moved
sufficiently in Nutourne Co’s favour. If Nutourne Co allowed the option to lapse, it would obtain the
same receipt as under the futures if the US$/CHF spot rate was y, such that:

12,692,225 = (125,000 x 98)y – 105,350

 12,250,000y = 12,692,225 + 105,350

y = $1·0447/CHF

Comments

If the options are exercised, the futures would give the higher receipt. The options give a lower
receipt because of the premium which needs to be paid. The futures will be subject to the risk that
basis (the difference between the futures price and the spot price) may not decrease linearly as the
futures approach maturity as was assumed in the above calculations. This will mean that the hedge
of the CHF 12,250,000 is imperfect, and the receipt may still be difficult to predict.

b) Benefits of a forward contract

A forward contract would not involve payment of a large premium upfront to the counterparty.

Also, a forward contract is a simple arrangement to understand, whereas the basis of calculation of
the premium for an over‑the‑counter (OTC) option may be unclear.

Additionally, a forward contract gives a certain receipt for the purposes of budgeting.

Drawbacks of a forward contract

A forward contract has to be fulfilled, even if the transaction which led to the forward contract being
entered into is cancelled. Exchange rate movements may mean that the contract has to be fulfilled
at an unfavourable rate. An OTC option can be allowed to lapse if it is not needed.

A forward contract does not allow the holder to take advantage of favourable exchange rate
movements. An OTC option need not be exercised if the exchange rate moves in the holder’s
favour.

A forward contract may only be available for a short time period, depending on what currencies are
involved. An OTC option may be purchased for a longer time period, over a year.

The rate offered on a forward contract will be determined by a prediction based on expected interest
rates. The rate offered on an OTC option may be more flexible. This may suit a holder who is
prepared to tolerate the risk of some loss in order to have the opportunity to take advantage of
favourable exchange rate movements, but who wishes to use the option to set a limit to possible
losses.

Reasons why exchange-traded derivatives are used

One of the main reasons why the treasury function uses exchange-traded derivatives is that the
contracts can be bought and sold as required. Additionally, because the markets are regulated by
an exchange, counterparty risk is minimised.

c) The mark-to-market process begins with Nutourne Co having to deposit an amount (the initial
margin) in a margin account with the futures exchange when it enters the contract. The margin
account will remain open as long as the futures are open. The profit or loss on the futures is
calculated daily and the margin account is adjusted for the computed profit or loss.

The maintenance margin is the minimum balance which has to be maintained on the margin
account. If the losses on the futures are so large that the balance on the account drops below the
maintenance level, then the futures exchange will make a demand (a margin call) for an extra
payment (the variation margin) to increase the balance on the account back to the maintenance
level.

In the example, initial margin = $1,450 x 98 = $142,100

Maintenance margin = $1,360 x 98 = $133,280

Loss in ticks = 0·0011/0·0001= 11

Total loss = 11 ticks x $12·50 x 98 = $13,475

Balance on margin account = $142,100 – $13,475 = $128,625

This is less than the maintenance margin, so Nutourne Co would have to deposit an extra
($133,280 – $128,625) = $4,655

On some exchanges, a variation margin may be required to increase the balance on the account
back to its initial margin level. Therefore, in this case, the variation margin amount would equal
$13,475
($142,100 – $128,625).
 Amberle

a)

Year 0 1 2 3 4

$m $m $m $m $m

Post-tax operating cash flows 28.50 36.70 44.40 50.90

Investment (150.00)

Realisable value 45.00

Working capital (W1) (6.00) (0.48) (0.39) (0.34) 7.21

(156.00) 28.02 36.31 44.06 103.11

Discount factor at 12% (W2) 1.0 0.893 0.797 0.712 0.636

Present value (156.00) 25.02 28.94 31.37 65.58

NPV = - 5.09

Working 1: Working capital

Year 0 1 2 3 4

$m $m $m $m $m

6.0 6.48 6.87 7.21 0

Required
(6.0 x 1.08) (6.48 x 1.06) (6.87 x 1.05)
(6.0) (0.48) (0.39) (0.34) 7.21
(Increase) / release

Working 2:

Discount rate assuming all-equity financing (using asset beta)

4% + 1.14 x (11% - 4%) = 12%

Financing side effects

Working 3: Issue costs

Gross subsidized loan proceeds:

 $80m / 0.97 = $82,474,227

Issue costs = $82,474,227 x 3% = $2,474,227

Working 4: Tax shield on subsidised loan:

Discount factor for 4-year annuity at 8% (Amberle’s normal borrowing rate). The risk-free rate could
also be used:

$80m x 3.1% x 30% x 3.312 = 2,464,128

Working 5: Tax shield on bank loan

Annual repayment: 70,000,000 / 3.312 = $21,135,266

Year 1 2 3 4

$m $m $m $m

19,567
Opening balance 70,000 54,465 37,687

1,565
Interest at 8% 5,600 4,357 3,015

(21,135)
Repayment (21,135) (21,135) (21,135)

(3)
54,465 37,687 19,567
470
Tax shield on interest (at 30%) 1,680 1,307 905
0.735
Discount factor (at 8%) 0.926 0.857 0.794
345
Present value 1,556 1,120 719

NPV 3,740

Working 6: Subsidy benefit

Benefit = $80m x (8% - 3.1%) x (1 – 30%) x 3.312 = $9,088,128

Working 7: Financing side-effects

 Financing side effects $000

Issue cost (W3) (2,474)

Tax shield on subsidised loan (W4) 2,464

Tax shield on bank loan (W5) 3,740

Subsidy benefit 9,088

Total financing benefits 12,818

Adjusted present value = -5.09 + 12.82 = $7.73m

Financing the project in this way would add $12·82 million to its value. The adjusted present value of
the project is $7·73 million and so it should be accepted. Sensitivity analysis should be undertaken
on all significant variables. Further analysis may be needed, particularly of the assumptions which lie
behind the post-tax cash flows, such as sales and the tax rate. The realisable value of $45 million
may be questionable. On the other hand, the time horizon of four years seems low and analysis
should be done of potential cash flows beyond that time.

b) Amberle Co’s board can use various principles to determine its long-term finance mix. The directors
may aim to follow consistent long-term policies, or they may have preferences which adapt as
circumstances change.

Long-term policy factors

At present Amberle Co is using a mix of finance, raising the question of whether the directors are
aiming for an optimal level of gearing, or there is a level which they do not wish gearing to exceed. If
the board wishes to maintain gearing at an optimal level, this is likely to be determined by a balance
of risks and advantages.

The main risks are not being able to maintain the required level of payment to finance providers,
interest to debt providers or required level of dividend to shareholders. Advantages may include
lower costs of debt, tax relief on finance costs as shown in the APV calculation or, on the other
hand, not being legally required to pay dividends in a particular year.

Another issue is whether Amberle Co’s board has preferences about what source of finance should
be used and in what order. One example of this is following the pecking order of retained earnings,
then debt, then equity. The board may prefer this pecking order on the grounds that avoiding a new
equity issue means that the composition of shareholdings is unchanged, or because retained
earnings and longer-term debt are judged low risk, or because the market will assume that an equity
issue is being made because directors want to take advantage of Amberle Co’s shares being over-
priced.

Other specific sources of finance may have benefits which attract the directors or drawbacks which
deter them. This investment highlights the aspect of whether the board prefers to match sources of
finance with specific investments. Matching arguably gives greater flexibility and avoids committing
Amberle Co to a long-term interest burden. However, to adopt this approach, the board will need
assurance either that the investment will be able to meet finance costs and ultimately repayment
burdens, or these can be met from surpluses from other operations.
CMC
(d) MEMORANDUM
From:
To: The Board of Directors, CMC Co
Date: xx/xx/xxxx
Subject: Discussion of the proposal to manage foreign exchange and interest rate exposures,
and the proposal to move operations to four branches and consequential agency issues

This memo discusses the proposal of whether or not CMC Co should undertake the
management of foreign exchange and interest rate exposure, and the agency issues resulting
from the proposal to locate branches internationally and how these issues may be mitigated.
Each proposal will be considered in turn.

(i) Proposal One: Management of foreign exchange and interest rate exposure
The non-executive directors are correct if CMC Co is in a situation where markets are
perfect and efficient, where information is freely available and where securities are priced
correctly. In this circumstance, risk management or hedging would not add value and if
shareholders hold well diversified portfolios, unsystematic risk will be largely eliminated.
 The position against hedging states that in such cases companies would not increase
shareholder value by hedging or eliminating risk because there will be no further
reduction in unsystematic risk. Furthermore, the cost of reducing any systematic risk will
equal or be greater than the benefit derived from such risk reduction. Shareholders would
not gain from risk management or hedging; in fact, if the costs exceed the benefits, then
hedging may result in a reduction in shareholder value.

Risk management or hedging may result in increasing corporate (and therefore

shareholder) value if market imperfections exist, and in these situations, reducing the
volatility of a company’s earnings will result in higher cash inflows. Proponents of hedging
cite three main situations where reduction in volatility or risk may increase cash flows - in
situations: where the rate of tax is increasing; where a firm could face significant financial
distress costs due to high volatility in earnings; and where stable earnings increases
certainty and the ability to plan for the future, thus resulting in stable investment policies
by the firm.

Active hedging may also reduce agency costs. For example, unlike shareholders,
managers and employees of the company may not hold diversified portfolios. Hedging
allows the risks faced by managers and employees to be reduced. Additionally, hedging
may allow managers to be less concerned about market movements which are not within
their control and instead allow them to focus on business issues over which they can
exercise control. This seems to be what the purchasing director is contending. On the
other hand, the finance director seems to be more interested in increasing his personal
benefits and not necessarily in increasing the value of CMC Co.

A consistent hedging strategy or policy may be used as a signalling tool to reduce the
conflict of interest between bondholders and shareholders, and thus reduce restrictive
covenants.

It is also suggested that until recently CMC Co had no intention of hedging and
communicated this in its annual report. It is likely that shareholders will therefore have
created their own risk management policies. A strategic change in the policy may have a
negative impact on the shareholders and the clientele impact of this will need to be taken
into account.

The case of whether to hedge or not is not clear cut and CMC Co should consider all the
above factors and be clear about why it is intending to change its strategy before coming
to a conclusion. Any intended change in policy should be communicated to the
shareholders. Shareholders can also benefit from risk management because the risk
profile of the company may change, resulting in a reduced cost of capital.

(ii) Proposal Two: International branches, agency issues and their mitigation
Principal–agent relationships can be observed within an organisation between different
stakeholder groups. With the proposed branches located in different countries, the
principal–agent relationship will be between the directors and senior management at
CMC Co in Switzerland, and the managers of the individual branches. Agency issues can
arise where the motivations of the branch managers, who are interested in the
performance of their individual branches, diverge from the management at CMC Co
headquarters, who are interested in the performance of the whole organisation.

These issues may arise because branch managers are not aware of, or appreciate the
importance of, the key factors at corporate level. They may also arise because of
differences in cultures and divergent backgrounds.

Mitigation mechanisms involve monitoring, compensation and communication policies. All

of these mechanisms need to work in a complementary fashion in order to achieve goal
congruence, much like the mechanisms in any principal–agent relationship.
Monitoring policies would involve ensuring that key aims and strategies are agreed
between all parties before implementation, and results monitored to ensure adherence
with the original agreements. Where there are differences, for example due to external
factors, new targets need to be agreed. Where deviations are noticed, these should be
communicated quickly.

Compensation packages should ensure that reward is based on achievement of

organisational value and therefore there is every incentive for the branch managers to act
in the best interests of the corporation as a whole.

Communication should be two-way, in that branch managers should be made fully aware
of the organisational objectives, and any changes to these, and how the branch
contributes to these, in order to ensure their acceptance of the objectives. Furthermore,
the management at CMC Co headquarters should be fully aware of cultural and
educational differences in the countries where the branches are to be set up and fully
plan for how organisational objectives may nevertheless be achieved within these
differences.

(Note: Credit will be given for alternative, relevant approaches to the calculations,
comments and suggestions/recommendations)
 Hav
Synergies may be classified into three types: revenue, cost and financial synergies.
The first manifest themselves by higher revenue of the combined entity than the sum of the revenue of
the two companies operating on a standalone basis. Revenue synergies are also associated with a
higher return on equity and a longer period when the combined business is capable of maintaining a
competitive advantage in the market.
Cost synergies typically result from the elimination of duplicated functions such as finance, HR or in-
house legal and from taking advantage of economies of scale. Financial synergies are commonly
associated with funding decisions, such as the decision to transfer funds between group companies or
from an increased capacity to take on debt.
In the case of the proposed Strand acquisition, several potential sources of synergies exist:
● Financial synergies: Hav is described as possessing significant cash reserves, whereas Strand is
apparently lacking funds, creating conditions for a transfer. The funds available from Hav could
be used to provide financing for Strand’s ventures into innovative products which previously
could not be pursued. The merger could also have the effect of increasing the combined entity’s
debt capacity.
● Cost synergies: Although the scenario does not provide any direct hint of cost synergies resulting
from the proposed acquisition, it is likely that a larger, combined company will be in a position to
negotiate better terms with suppliers. Furthermore, certain costs, especially those pertaining to
support and head office functions may be scaled down as duplicated functions are identified and
eliminated.
● Revenue synergies: Hav’s management is described as being highly talented and very good in
getting products to market quickly. They may therefore help Strand in the commercialisation of its
products, which is something that the company has apparently been having trouble with.

a) Maximum acquisition premium:

Based on excess earnings:

Average pre-tax earnings over past 3 years = (397 + 370 + 352)/3 = $373m
Average capital employed = [(300 + 183 + 400) + (300 + 166 + 400) + (300 + 159 + 400)]/3 = $869.3m
Before-tax annual premium = $373m – (20% x $869.3m) = $199.1m
After-tax annual premium = $199.1m x (1 – 20%) = $159.3m
PV of annual premium (assuming perpetuity), i.e. maximum premium = $159.3m/0.07 = $2,275.7m

Based on PE ratio:

Strand estimated PE = 16.4 x 1.1 = 18.0

Strand after-tax profit = $397m x (1 - 20%) = $317.6m
Hav after-tax profit = $1,980 x (1 – 20%) = $1,584m

Strand current value = $317.6m x 18.0 = $5,716.8m

Hav current value = (600 x 4)shares x $9.24 per share = $22,176.0m

Combined company value = ($1,584m + $317.6m + $140m) x 14.5 = $29,603.2

Maximum premium = $29,603.2m – ($22,176m + $5,716.8m) = $1,710.4m

b) Strand current value per share = $5,716.8m/(300m x 4)shares = $4.76 per share
Maximum % premium based on excess earnings = $2,275.7m/$5,716.8m = 39.8%
Maximum % premium based on PE ratio = $1,710.4m/$5,716.8m = 29.9%

Cash offer: premium (%)

($5.72 - $4.76)/$4.76 = 20.2%

Cash and share offer: premium (%)

1 Hav share for 2 Strand shares
Hav share price = $9.24, giving $4.62 ($9.24/2) per each share in Strand
Cash payment per Strand share = $1.33
Total cost per Strand share= $4.62 + $1.33 = $5.95

Premium (%) = ($5.95 - $4.76)/$4.76 = 25%

Cash and bond offer: premium (%)

Strand shares have a nominal value of $0.25 each, therefore a single convertible bond is issued per
20 shares in Strand ($5.0/$0.25 = 20)
Bond value (per Strand share) = $100/20 = $5.0
Cash payment per Strand share = $1.25
Total cost per Strand share = $5.0 + $1.25 = $6.25
Premium (%) = ($6.25 - $4.76)/$4.76 = 31.3%

From the perspective of Stand Co’s current shareholders, the cash and bond offer provides the
highest percentage premium above the company’s current share price. What is more, the bonds may
be converted into 12 Hav shares each, giving a conversion price of $8.33 ($100/12), meaning that
the conversion option is already in-the-money. If the share price increases over the coming 10 years,
then the conversion option will further gain value. The 31.3% premium calculated in respect of this
option falls between the maximum premiums computed under the PE ratio and the excess earnings
approaches.

Strand shareholders may nevertheless attach more value to the higher cash component of the cash
and share offer. This option also allows them to immediately sell the shares which they will receive in
Hav (instead of having to wait 10 years, as is the case with the convertible bonds).

The pure cash offer provides an immediate and definite return to Strand shareholders, but it is the
lowest of the three offers.
 Burung

Part (a)

All figure are presented in $ million.

Year 0 1 2 3 4
Sales revenue (inflated at 8% p.a.) 24.87 42.69 61.81 36.92
Direct project costs (inflated at 4% (14.37) (23.75) (33.12) (19.05)
p.a.)
Incremental profit 10.5 18.94 28.69 17.87

Taxation (W1) (0.50) (3.39) (5.44) (3.47)

Working capital investment (W2) (4.97) (3.57) (3.82) 4.98 7.38
Machinery (38.00) 4.00
Net cash flows (42.97) 6.43 11.73 28.23 25.78
Discount factors (at 12% - see W3) 1 0.893 0.797 0.712 0.636
Present values (42.97) 5.74 9.35 20.10 16.40

Net present value = $8.62 million

Working 1 – taxation

Year 0 1 2 3 4
Incremental profit 10.50 18.94 28.69 17.87
Depreciation (8.00) (2.00) (1.50) (0.50)
50% x 16 25% x 8 25% x 6 residual
Taxable profit 2.50 16.94 27.19 17.37
Taxation (at 20%) 0.50 3.39 5.44 3.47

Working 2 – working capital investment

Year 0 1 2 3 4
Working capital requirement 4.97 8.54 12.36 7.38
(20% of revenue)
Working capital invested / (released) 4.97 3.57 3.82 (4.98) (7.38)

Working 3 – Discount rate

Lintu MVe = 40 million x $3.20 = $128 million

Lintu Co MVd = $34 million x 0.94 = $31.96
Lintu Co’s asset beta = 1.5 x $128 / ($128 million +$31.96 million x 0.80) = 1.25

All-equity financed discount rate = 2% + 1.25 x 8% = 12%

Financing side effects:

$’000
Issue costs (2/98 x $42,970,000) (876.94)

Annual tax relief = [$42,970,000 x 60% x (2.5% - 1.0%) x 20%]

+ [$42,970,000 x 40% x (2.5% + 1.50%) x 20%] = $214,850
PV of annual tax relief (at 4% discount rate) = $214,850 x 3.63 779.91

Annual subsidy benefit (funding below Burung’s standard 4% borrowing rate)

= [$42,970,000 x 60% x (4.0% - 1.5%) x 80%] = $515,640
PV of subsidy benefit annuity (at 4% discount rate) = $515,640 x 3.63 1,871.77
Net benefit of financing side effects 1,774.74

Incorporating the net PV of financing side effects into the project NPV computation yields an APV result
of approximately $10.4 million ($8.62 million + $1.77 million). The project should therefore be accepted.

Part (b)

Corrections made to the original NPV computation:

Whenever different cash flows are subject to different rates of inflation, applying a real discount rate to
non-inflated amounts does not yield a correct NPV result. Accordingly, item-specific inflation rates were
used to adjust the revenue and cost estimates.

Interest should not normally be included in the NPV computation as a specific cost. It is more appropriate
to incorporate the cost of debt financing into the rate of discount or, as in this case – reflect the side
effects of debt financing in the computation of APV.

The adjusted NPV computation includes the investment and recovery of working capital.

Depreciation has been taken account, so as to arrive at the correct amount of taxation charged in
respect of each year.

Approach taken

The calculation of adjusted present value involves:

• Fist, evaluating a base-case NPV on the assumption that the project is all-equity financed, and
• Second, adjusting the result for the present value of the side effects associated with the chosen form
of financing.

This approach allows for the separate assessment of the value created from the project as such and the
additional value derived from the way in which it is financed.

Assumptions made

It is assumed that all of the figures provided are accurate and all estimates made are reasonable.

It is also assumed that the initial investment into working capital will be financed from the borrowing,
whereas subsequent investments will be financed from the cash flows generated by the project itself.

Finally, it is assumed that the asset beta computed in respect of Lintu reflects fairly the business risk of
the project.
 Yilandwe

(a) Benefits of own investment as opposed to licensing

 Yilandwe’s government is very keen to attract foreign investors. As a result, if Imoni Co decide to set
up their own assembly plant in the country, they are likely to benefit from the tax concessions being
offered as well as access to prime locations. In contrast, both benefits are likely to be off-limits to
existing local companies.
 Setting up its own assembly facility would grant Imoni better control over the quality of operations.
 Establishing proprietary operations would allow Imoni to better protect its technology from the risk of
imitation.

Drawbacks of own investment as opposed to licensing

 Setting up an own assembly plant would likely be associated with a significantly higher upfront
investment than would be the case with licensing. If Imoni Co does have other potential investment
opportunities available that saved money could be put to better use, or perhaps, returned to
shareholders.
 Entering a foreign country directly by establishing operations on the ground would expose Imoni to
political, cultural and legal risks. Given Yilandwe’s difficult past and the drastic nature of the
economic policies adopted by the country’s current government, the risk of political and legal
fluctuations and accompanying lack of predictability remain significant. It may be argued that
entering the country with a local licensing partner, means that these risks are shared and therefore
reduced from the perspective of Imoni’s shareholders.
 Licensing the assembly operation to an already established local partner would probably allow Imoni
to achieve its target output levels more quickly and efficiently. A well-selected local partner is likely to
have a good understanding of Yilandwe’s business environment, saving Imoni from the effort of
getting accustomed with the inner-workings of the local market, its regulations and customs.

(b) Report on the proposed assembly plant in Yilandwe

This report evaluates whether Imoni Co should set up a parts assembly plant in Yilandwe. It considers
the financial projections presented in appendices 1 and 2, discusses the assumptions made in arriving at
the projections and discusses other non-financial issues which should be considered. The report then
provides a reasoned recommendation on the acceptability of the project.

Assumptions made in producing the financial projections

It is assumed that the estimates provided in the scenario, especially those relating to the number of units
sold, the unit selling price, the level of variable and fixed costs, as well as the inflation and exchange rate
forecasts will turn out as stated in the scenario.

It is also assumed that Imoni would be able to negotiate a more favourable transfer price for the
components that it will be selling to the assembly plant, as well as a higher royalty fee which it will earn.
Imoni ought to consider whether this assumption is in fact realistic before the ultimate decision to invest
is made.

Another important assumption is that the project will only last for four years and that the initial investment
made into land, buildings and machinery will not have any residual value which Imoni could recover.
Deviating from these assumptions by changing the project length or making the residual value different
to zero would definitely impact the project’s net present value.

Lastly, it is assumed that the cost of capital relevant to the project to be 12% as opposed to the 9%
which Imoni typically uses. There was in fact no justification provided for why 12% ought to be used, and
accordingly, this assumption, which has an obvious impact on the level of computed NPV, should be
researched further.

Other risks and issues

The scenario states that strict monetary and fiscal measures introduced by the current government have
proved unpopular in rural parts of the country. Before making the decision to invest, Imoni Co would be
advised to assess the political stability of the country. A question that needs to be considered is whether
a possible new government would share the same level of enthusiasm for attracting foreign direct
investment as the current one and whether it would honour and uphold the concession granted to foreign
companies in respect of tax benefits and access to favourable locations.

A second issue relates to the fact that providing room for Imoni Co’s assembly plant will require an
existing and functioning school to close with the students having to relocate to other schools in the area.
This is likely to prove unpopular amongst the Yilandwe population and Imoni may face local opposition
as a result. In any case, the closure of the school may hurt Imoni’s image and reputation and may go
against the company’s set of ethical principles.

A third issue, and one which is quite common in many cross-border investment projects, is the need to
accommodate for the cultural differences between Yilandwe and the US, where Imoni Co is based. The
country is still a developing one, and significant differences may exist in the way that business is done.
What is more, the local workforce, despite being described as well-educated and ambitious, may require
significant training before they acquire the skills and knowledge necessary to carry out Imoni’s assembly
processes.

Finally, there is a need to evaluate the risk that the laws and regulations currently in place, especially
those which grant foreign investors favourable tax treatment and access to prime locations will be
changed.
Recommendation
The financial projections presented in Appendix 1 reveal a positive net present value, which suggests
that the project ought to be accepted. However, before a final decision is made, the accuracy of the
assumptions listed in the first section of the report should be carefully assessed. What is more, the other
issues and concerns highlighted above should also be considered. In particular, Imoni must consider the
non-monetary costs associated with the school closure and the negative effect that this may have on its
reputation. Perhaps, Imoni should carry out a comprehensive sensitivity analysis, so as to test how
critical some of the inputs into the calculation are from the perspective of achieving a positive NPV.

Report compiled by:

Date:

Appendix 1
All amounts in YR millions

Year 0 1 2 3 4

Sales revenue (App 2) 18,191 66,775 111,493 60,360

Parts costs (App 2) (5,188) (19,060) (31,832) (17,225)

Variable costs (App 2) (2,921) (10,720) (17,901) (9,693)

Fixed costs (App 2) (5,612) (6,437) (7,068) (7,760)

Royalty fee (App2) (4,324) (4,813) (5,130) (5,468)

Tax allowable depr’n (4,500) (4,500) (4,500) (4,500)

Taxable profit / (loss) (4,354) 21,245 45,062 15,714

Tax loss carried fwd - - (4,354) -

Adjusted taxable profit / (loss) (4,354) 21,245 40,708 15,714

Taxation 0 0 (16,283) (6,286)

Add back tax loss carried forwards 4,354

Add back depreciation 4,500 4,500 4,500 4,500

After tax cash flows 146 25,745 33,279 13,928

Working capital investment (App 2) (9,600) (2,112) (1,722) (1,316) 14,750

Land, buildings, machinery (39,000)

Cash flows (48,600) (1,966) 24,023 31,963 28,678

All amounts in $’000

Year 0 1 2 3 4
Exchange rate 101.4 120.1 133.7 142.5 151.9

Remittable flows (479,290) (16,370) 179,678 224,302 188,795

Contribution on sale of parts 18,540 61,108 95,723 48,622

Royalty income 36,000 36,000 36,000 36,000

Tax on contribution and royalty (10,908) (19,422) (26,345) (16,924)

Cash flows (479,290) 27,262 257,364 329,680 256,493

Discount factors (12%) 1 0.893 0.797 0.712 0.636

Present values (479,290) 24,345 205,119 234,732 163,130

NPV = (479,290) + 24,345 + 205,119 + 234,732 + 163,130 = 148,036

Appendix 2 – Workings

Year 1 2 3 4

Unit selling price (€) 700 x 1.05 =735 735 x 1.05 =772 772 x 1.04 = 803 803 x 1.04 = 835

Sales revenue 150 x 735 x 165 480 x 772 x 730 x 803 x 190.2 360 x 835 x 200.8
(YR millions) = 18,191 180.2 = 111,493 = 60,360
= 66,775
Unit parts costs ($) 280 x 1.03 = 288 288 x 1.03 = 297 297 x 1.03 = 306 306 x 1.03 = 315

Parts costs 150 x 288 x 120.1 480 x 297 x 730 x 306 x 142.5 360 x 315 x 151.9
(YR millions) = 5,188 133.7 = 31,832 = 17,225
= 19,060
Unit variable costs 15,960 x 1.22 = 19,471 x 1.147 = 22,333 x 1.098 24,522 x 1.098
(YR) 19,471 22,333 = 24,522 = 26,925
Variable costs 19,471 x 150 = 22,333 x 480 24,522 x 730 26,925 x 360
(YR million) 2,921 = 10,720 = 17,901 = 9,693
Fixed costs 4,600 x 1.22 = 5,612 x 1.147 6,437 x 1.098 7,068 x 1.098
(YR millions) 5,612 = 6,437 =7,068 = 7,760
Royalty fee 36 x 120.1 = 36 x 133.7 = 36 x 151.9 =
36 x 142.5 = 5,130
(YR millions) 4,324 4,813 5,468
9.8% x (9,600 + Recovery of
Add. Inv. in working 0.22% x 9,600 14.7% x (9,600 +
2,112 + 1,722) 14,750 (9,600 +
capital (YR millions) = 2,112 2,112) = 1,722
= 1,316 1,722 + 1,316)

480 x 120 x 360 x 120 x

Contribution on 150 x 120 x 1.03 730 x 120 x (1.03)3
(1.03)2 (1.03)4
sale of parts ($’000) = 18,540 = 95,723
= 61,108 = 48,622
Bento
 Daikon
Part (a)

Daikon’s borrowing period is 6 months long (11 months – 5 months)

Daikon’s current borrowing cost = $34,000,000 x 6/12 x (3.6% + 0.7%) = $731,000
Borrowing cost if interest rates increase by 80 basis points = $34,000,000 x 6/12 x (4.4% + 0.7%) =
$867,000
Increase in borrowing cost = $867,000 - $731,000 = $136,000

Using futures contracts

Daikon needs to protect itself against an increase in interest rates. It should therefore establish a short
position in December futures contracts.

Number of contracts required = ($34,000,000 / $1,000,000) x (6 months / 3 months) = 68 contracts

Basis:
Current price (on 1 June 2015) – futures price = total basis
(100 – 3.6) – 95.84 = 0.56
Unexpired basis (on 1 November 2015 – in five months’ time) = 0.56 x 2/7 = 0.16

If interest rates increase by 0·8% to 4·4%:

Expected futures price: 100 – 4.4 – 0.16 = 95.44
Gain on futures position (9584 – 9544) x 68 x $25 $68,000
Net additional borrowing cost ($136,000 - $68,000) $68,000

Using options on futures

Daikon needs to protect itself against an increase in interest rates. It should therefore buy put options. As
before, it needs 68 December calls.

If interest rates increase by 0·8% to 3·6%:

Exercise price 95.50 96.00
Futures price (as before) 95.44 95.44
Exercise Yes Yes
Basis point gain 6 56
Gain on options:
6 x $25 x 68 $10,200
56 x $25 x 68 $95,200
Premium
30.4 x $25 x 68 $(51,680)
50.8 x $25 x 68 $(86,360)
Net benefit / (cost) $(41,480) $8,840
Net additional borrowing cost
($136,000 + $41,480) $177,480
($136,000 - $8,840) $127,160
Using a collar on options

The strategy involves buying 68 95.50 December puts and selling 68 96.00 December calls.

If interest rates increase by 0·8% to 3·6% Buy put Sell call

Exercise price 95.50 96.00
Futures price (as before) 95.44 95.44
Exercise Yes No
Gain on options: 6 x $25 x 68 $10,200
Premium paid (30.4 – 22.3) x $25 x 68 $(13,770)
Net cost of the collar $(3,570)
Net additional borrowing cost ($136,000 + $3,570) $139,570

Based on the expectation that interest rates will increase by 80 basis points in the coming five months, it
is the futures hedge which provides the lowest net additional borrowing cost, significantly outperforming
both the options and collar strategies in this respect.

However, it must be pointed out that if interest rates do not increase as expected, the options and to
some extent the collar as well, provide more flexibility as they do not have to be exercised if interest
rates move in Daikon’s favour. Given the high premiums involved, this move would have to be fairly large
for the initial cost to be recovered.

Part (b)

Mark-to-market – daily settlements:

2 June: 8 basis points loss (95.76 – 95.84) x $25 x 50 contracts = $10,000 loss

3 June:
• 10 basis point loss (95.66 – 95.76) x $25 x 50 contracts = $12,500 loss, AND
• 5 basis point loss (95.61 – 95.66) x $25 x 30 contracts = $3,750 loss

4 June: 8 basis point gain (95.74 – 95.66) x $25 x (50 – 30 contracts) = $4,000 gain

The mark-to-market mechanism and the margin system serve to reduce counterparty risk, i.e. the risk of
non-payment by a party to a derivative contract.

Mark-to-market works by computing the day’s gains or losses relative to the current settlement price and
adjusting the investor’s margin account by the amount of those gains or losses. If Daikon suffers losses
on its positions, then its margin account will shrink, and the company may be requested to post
additional funds to restore the account to appropriate levels. On the other hand, in the case of gains,
Daikon will be able to withdraw surplus funds from the account.

If Daikon sells its options before expiry, it will receive a price which includes two components: time value
and intrinsic value (if the option is in-the-money). Exercising the options at the end of the hedge period
(prior to expiry) would mean that Daikon would only receive an amount equal to the options’ intrinsic
value, hence selling is the more favourable alternative.
 Keshi
(a)

An option is a right but not an obligation to buy something (Call Option) or sell something (Put Option). In
this case, the option is to buy or sell the future contract at a future date at a price agreed now.

The Futures Contract is a derivative, and its movement will reflect the movement in interest rates. In this
case, the futures contract is the 3-months dollar future with a contract size of $1,000,000. The price of
the future is now quoted at a 100 minus the interest rate.

A basis risk is a risk that arises because the price of the future does not exactly reflect the interest rate.
As the future contract comes closer to expiry, the difference, the basis, will reduce until at expiry the
price will be exactly the same as the interest rate.

Current interest rate = 3.8%

Current basis on March futures = 44 points = 0.44%

Interest rate reflected in the current price of the future = 3.80% + 0.44% = 4.24%

The current price of the future = 100 - Interest rate = 100 - 4.24% = 95.76%
The gain or loss on the future will be the equivalent to the gain or loss on $1,000,000 borrowed or lent for
3 months. In other words, a 0.5% movement in interest rates will lead to a gain or loss equivalent to:

0.5% x $1,000,000 x 3/12 = $1,250 (Gain or Loss)

Since the price of the future is a 100 minus the interest rate, a rise in the interest rates will lead to a fall in
the price of the future:

So how would we use the future to hedge against the rise in interest rates? We would enter into an
agreement now to sell the future contract in the future at a price agreed now:

- If interest rates rise and the price of the future falls, we would close our position by buying the
future at a lower price and immediately sell it, i.e. deliver it, at the agreed higher price and
making a profit on the difference. This profit would offset the extra cost of our actual borrowing;
- If interest rates fall and the price of the future goes up, we would be obliged to buy the future at a
 higher price to close our position and we would make a loss.

To avoid the potential loss, rather than sell the future now, we can enter into an option to sell the future
at a price agreed now, which is the strike price. This would be a Put Option:

- If interest rates rise, the price of the future will fall, we will buy the future at a lower price,
exercise our put option and sell it at a higher strike price;
- If interest rates fall and the price of the future rises above the strike price, we will let our option
lapse and avoid making a loss.

However, unlike a future, an option has a cost, a non-refundable premium. The premium is payable
whether or not we exercise the option. We are told that the premium on the March put option at a strike
price of 95.50 is 0.662%.

Cost of the option = 0.662% x 1,000,000 x 3/12 = $1,655 per contract

Now let’s use the put options. The first thing is deciding how many contracts. Each contract we set will
reflect the movement in interest rates on $1,000,000 for 3 months. We are going to borrow $18,000,000
for 7 months. So the number of contract needed is calculated as follows:

Number of contracts = ($18,000,000 / $1,000,000) * (7/3) = 42 contracts

Remember: The decision on a number of contracts is based upon a period of borrowing.

So, on the 1st of December 2014 we buy 42 put options on the March contract. We can choose a strike
price of either 95.50 or 96.00. The higher the price at which we have the option to sell the future, the
higher the premium. Let’s look at both strike prices:

1) Strike price is 95.50. We buy 42 put options on the March contract at a strike price of 95.50 and we
pay a premium of:

Premium = 0.00662 x $1,000,000 x (3/12) x 42 = 69,510

On the 1st of February interest rates have risen by 0.5%. The interest rate, therefore, will be:

Interest rate = 3.8% + 0.5% = 4.30%

 We are told that the remaining basis risk will be 22 points or 0.22%, which means that the interest
rate reflected in the price of the future at the 1st of February will be:

Interest rate reflected in the price of the future = 4.30% + 0.22% = 4.52%

Price of the future = 100 - 4.52 = 95.48

We have the put option to sell the future at 95.50, so we will exercise our option. We can buy on the
market at 95.48, exercise the put option and sell at 95.50, which gives us a gain of:

Net gain = 95.48 - 95.50 = 0.02% = 0.0002

Overall gain = 0.0002 x $1,000,000 x (3/12) x 42 = $2,100

This strategy will not overall be beneficial:

Option Cost (Premium is Sunk Cost) $69,150

Total Cost of Borrowing 4.30% + 0.4% 4,70%
Interest rate (A) $18,000,000 x 4.7% x (7/12) 493,500
Premium on Option (B) 69,510
Gain on Exercise (C) 2,100
Total Cost A+B-C $560,910

Annualised cost $560,910 x (12/7) $961,560

Interest rate $961,560 / $18,000,000 5.34%

2) Strike price is 96.00. The premium will be 0.902% or 0.00902:

Premium = 0.00902 x $1,000,000 x (3/12) x 42 = 94,710

On the 1st of February, the price of the future will be 95.48. We will exercise our option again. We
can buy on the market at 95.48, exercise the put option and sell at 96.00, which gives us a gain of:

Net gain = 95.48 - 96.00 = 0.52% = 0.0052

Overall gain = 0.0052 x $1,000,000 x (3/12) x 42 = $54,600

Again, the overall strategy will not be beneficial:

Interest rate (A) $18,000,000 x 4.7% x (7/12) 493,500

Premium on Option (B) 94,710
Gain on Exercise (C) 54,600
Total Cost A+B-C $533,610

Annualised cost $533,610 x (12/7) $914,760

Interest rate $914,760 / $18,000,000 5.08%

Now let’s look at the outcome if interest rates have fallen by 0.5%.
 The actual rate = 3.8% - 0.5% = 3.3%

The price of a future = 3.3% + 0.22% = 3.52%

Future price = 100 - 3.52 = 96.48

In both cases, we would have to buy the future at 96.48 and then sell at the lower strike price of 95.50 or
96.00. So, in both cases, we will let the option lapse and take advantage of the lower interest rates.
However, we will still have the cost of the premiums.

Let’s look at our overall cost of borrowing, if we had chosen a strike price of 95.50:

Interest Cost 3.30% + 0.4% 3.70%

Interest Rate (A) $18,000,000 x 3.7% x (7/12) 388,500
Premium on Option (B) 69,510
Total Cost A+B $458,010
Effective Annual Rate ($458,010 / $18,000,000) x (12/7) 4.36%

If we had chosen a strike price of 96.00, the overall cost of borrowing would be:

Interest Cost 3.30% + 0.4% 3.70%

Interest Rate (A) $18,000,000 x 3.7% x (7/12) 388,500
Premium on Option (B) 94,710
Total Cost A+B $483,210

Effective Annual Rate ($483,210 / $18,000,000) x (12/7) 4.60%

Now let’s look at the Swap.

We start by looking to see if a Swap can be beneficial to the company and the bank. Keshi will either
borrow fixed and Swap into a floating rate loan or borrow floating and Swap into a fixed rate loan. There
is no advantage to Keshi from the first option.

Floating rate loan @ Libor + 0.3% + Bank charge of 0.1% = Libor + 0.4%

This is the same as the company can borrow at floating itself. Furthermore, the bank would end up with a
fixed rate loan of 5.5% from Keshi, so there is no benefit to be shared. The only valuable swap is to
borrow floating at Libor + 0.4% and to swap into a fixed rate loan from the bank at 4.6%.

We are told that Keshi will receive 70% of the overall benefit from undertaking the swap. So what is the
overall benefit to the Keshi and the bank?

Type Keshi Bank Difference

Fixed 5.5% 4.6% 0.9%
Floating Libor + 0.4% Libor + 0.3% 0.1%

Net benefit = Benefit to Keshi - Loss to bank = 0.9% - 0.1% = 0.8%

70% of 0.8% = 0.56% (before bank charge of 0.1%)

Cost of swapping rather than borrowing is calculated as follows:

 Cost if borrowed at a fixed rate (A) 5.5%
70% of 0.8% savings for Swap (B) 0.56%
Bank charge for Swap (C) 0.10%
Overall cost (A - B + C) 5.04%

There are a number of ways that the bank could design the Swap. The net effect of the swap with the
bank for Keshi, however, is that it should end up borrowing floating at Libor + 0.4% swapping into a fixed
loan at 4.6% with the overall cost including the bank charge of 5.04%:

One possible structure would be the Keshi borrows at Libor + 0.4%. The bank pays Keshi at Libor giving
a net cost to Keshi of 0.4%. Keshi then pays the bank 4.54% plus the bank fee of 0.10% giving a total
cost of 5.04%.

Discussion

Let’s look at the various possible costs to Keshi:

Scenario Do nothing Option @ 95.50 Option @ 96.00 Swap

Floating 4.7%
Interest rates rise by
5.34% 5.08% 5.04%
0.5%
Fixed 5.5%

Floating 3.7%
Interest rates fall by
4.36% 4.60% 5.04%
0.5% Fixed 5.5%

- Doing nothing and borrowing floating gives Keshi the best outcome if interest rates either rise or fall
by 0.5%, but leaves Keshi open to the full cost of any big increase in interest rates;
- If Keshi wants protection against interest rates rises, then the put option at 95.50 or 96.00 will allow
some of the benefits of a fall in interest rates by protecting against any significant rise in interest
rates;
- If Keshi wants certainty and to avoid all risks, then the swap is much better than borrowing fixed
itself.

Recommendation

A put option at 96.00 effectively caps the interest rate at 5.08% allowing for some possible changes in
basis risk, while allowing some of the benefits of an interest rate fall.

(b)

A shareholder value is maximised when income is increased and costs reduced. This should be the
objective of any decision of a centralised treasury function. Both centralised treasury and decentralised
treasury have some advantages:

Advantages of centralised treasury Advantages of decentralised treasury

- The company can borrow or lend at more - It gives local management more control of
effective rates due to larger amounts; resources allowing it to take advantage of
investment opportunities;
 - By moving funds between subsidiaries it can - Greater control is more motivational for local
avoid situations where one subsidiary is senior management;
borrowing while another has a cash surplus;

- It can avoid the higher costs of currency - Local management will better understand local
transactions by using multilateral netting; customs and practices (such as Islamic finance)

- Treasury department can employ the expertise to - Using Salam contracts rather than traditional
enable it to use more sophisticated financial derivatives
instruments to minimise the risk and maximise its
return;

(c)

The point of Salam contracts is to avoid speculation and uncertainty. With a Salam contract, the buyer
and the seller agree the price, the quality, the quantity, the delivery, and the payment is made when the
contract is entered into.

Future contracts are financial instruments which, although generally used to reduce risk, may be used
alone speculatively. And also their price movement over time can fluctuate.
Riviere
 Kamala

(a) Advantages of EVATM

The Economic value added attempts to gauge the true economic profit generated by a business. In
particular, it takes into account the cost of the various sources of a company’s financing, and shows a
positive result only, if profits outweigh the cost of capital employed in the business. Accordingly, EVA
provides a measure of value added from a shareholder perspective.

Another advantage of economic value added is that it manages to capture the above considerations into
a single number which may easily be compared across companies operating within the same industry.

Lastly, EVA is conceptually easy to understand making it an appealing measure of company success.

Drawbacks of EVATM

It focuses on annual numbers and may therefore lead to an emphasis on short-term performance as
opposed to long-term value creation. This could be true if, for the sake of boosting the performance in a
single year, a company adopts short-term projects instead of longer-term, higher yielding ventures,
which nevertheless require a longer time frame to start bringing in promised results.

Another disadvantage relates to the fact that EVA is an absolute measure of performance and therefore
may not easily facilitate comparisons of the value-creation ability of companies in different industries and
therefore of different size.

(b) EVATM Calculation – Kamala Co

Year ended Year ended

All figures in $ million
30 November 2013 30 November 2014
Operating profit 819 1,098

Add: depreciation expense 826 1,150

Less: economic depreciation (990) (1,380)

Add: non-cash expenses (excl. dep’n) 150 170

(205) (275)
Less: tax expense (excl. finance costs)
[25% x 819] [25% x 1,098]
Economic profit 600 763

Opportunity cost of capital 371 538

[10% x (2,226 + 1,484)] [10% x (2,577 + 2,184 + 616)]
EVA 229 225
(c) Additional Ratio Trends

2012 2013 2014

ROCE 19.2% 17.2% 16.7%

Asset turnover 1.01 0.85 0.79

Kamala PE ratio 11.0 12.3 13.0

Construction operating profit margin 19.0% 18.5% 18.9%

Hospitals and biomedical operating profit margin 19.0% 23.4% 25.8%

Evaluation of Performance

Kamala shows consistent growth in sales revenue, which also translates into growing figures reported in
respect of operating profit and net profit for the year. This is accompanied by positive EVA measures in
both 2013 and 2014, implying that the company continues to generate shareholder value. There is also
improvement in some of the remaining ratios provided, namely operating profit margin, dividend cover
and earnings per share. It is also true that Kamala’s share price has been rising. In fact, the growth
averaged over 26% per annum which did indeed; surpass the overall market, which grew at an average
pace of approximately 20% per year.

In order to assess Kamala’s performance more broadly, and perhaps, find arguments to support the
more pessimistic outlook adopted by the analyst, there is a need to compute some additional measures,
starting with the return on capital employed. The steady drop in the return on capital employed seems to
reflect the considerable investment in Kamala’s asset base, which almost doubled over the two year
period. This was not accompanied by the same growth in operating profits, pointing to a drop in the
effectiveness of the company’s assets. Further confirmation of the deteriorating ability to turn assets into
revenue-dollars is provided by the asset turnover. It is also worthwhile to note that even though Kamala’s
performance as measured by economic value added remains positive, the result computed in respect of
2014 is lower than that for 2013, which lends further support to the notion that the scale of the
company’s capital investment may have been too big.

The scenario provides the average price to earnings ratio for the industry in which Kamala operates. The
outcome is a PE ratio of approximately 11. An analogous computation performed in respect of the
subsequent two years yields results of 12.3 and 13, suggesting an upward trend. The computed ratios
should nevertheless be contrasted against industry comparables. This reveals that although in 2012
Kamala’s PE ratio was higher than the industry average, in 2013 the two were almost on par, whereas in
2014, the ratio computed in respect of Kamala fell short of that of its peers. Adding strength to this trend,
is the fact that although Kamala’s share price grew at a higher pace than the broad market average, it
fell below the rate of growth experienced by the industry index, which averaged approximately 30% per
annum.

The reasonableness of the CEO’s push for growth in just the construction segment and apparent neglect
of the hospitals and biomedical segment also needs to be considered. In order to shed more light on this
matter, there is a need to compute and compare the operating profit margins for the two segments. For
the year 2012, the operating profit margin is 19% in respect of both. However, from 2013, the results
start to diverge, with the operating profit margin of the construction segment dropping to 18.5% and the
ratio for hospitals and biomedical increasing to 23.4%. This trend continues in 2014, with the profit
margin for construction staying below 19%, and that of the other segment approaching 26%. It is
therefore clear that the profitability of the hospitals and biomedical segment keeps improving. Despite
this the company seems to be increasing its involvement in the construction sector and allowing the
share of revenue generated by the more profitable segment to systematically drop.

Finally, the CEO has proposed strategy for financing the planned acquisition, comprising a fresh issue of
bonds accompanied by a smaller rights issue. In light of the fact that Kamala did not raise any equity
capital over the period presented in the financial statements but has systematically been increasing its
reliance on bank loans and bonds, this approach seems problematic. The company’s gearing ratio has
shot up to 54% from an initial 40% just two year ago. Even if Kamala can support the additional pressure
on its profitability and cash flows created by the need to service the additional debt, the increased level
of financial risk which this will generate may not necessarily be welcomed by investors.
 Vogel
Part (a)
There are several reasons which may explain the shift from organic growth to growth by acquisitions:
 Acquiring a company which holds expertise, technological know-how or product ideas may be
less costly than attempting to build these strengths internally.
 Horizontal acquisitions allow for the building of market share and allow a company to achieve
economies of scale. Vertical acquisitions help achieve a secure and efficient supply chain.
 Organic growth is typically slow and requires a company’s management to possess the
knowledge and expertise required to move into new areas. Moreover, in a mature and saturated
market, there may be few opportunities for organic growth.

Part b)
The following actions may be taken if Vogel wishes to reduce the risk of the Tori acquisition failing to
increase shareholder value:
 Much of the work leading to a successful acquisition is done before the deal itself. This involves
performing proper due diligence with the aim of assessing the true benefits of an acquisition as
well as its inherent risks. Armed with this data, Vogel should be able to carry out a valuation so
as to determine the maximum price which it is willing to pay for the target.
 Once a value is established, Vogel must calculate a premium which it is willing to pay and
procedures need to be in place to make sure that this is not exceeded in negotiations. Managers
of acquiring companies are often unwilling to withdraw from overpriced deals, afraid of the
reputational consequences of a broken transaction and the wasted costs of due diligence and
other preparatory work.
 Acquisitions often fail to provide value to shareholders because they are undertaken without a
good business reason but rather for the benefit of the acquiring company’s management. The
responsibility for making sure that this does not happen rests very much with the non-executive
directors.
 And finally, for an acquisition to be successful, procedures need to be in place to ensure the
integration of the staff and systems of the target company with those of the acquirer. Giving the
target a larger degree of autonomy makes this less of an issue but will have a detrimental effect
on the synergies which the deal is likely to achieve.

Part (c)
The maximum premium payable may be calculated as the maximum additional benefit created from the
acquisition of Tori Co. This assumes no value creation for the shareholders of Vogel, which is unlikely to
be accepted by the shareholders themselves.

The additional benefit is computed as the sum of the gains from the sale of Dept C, spinning off Dept B
and integrating Dept A, less the current values of Vogel and Tori.

Cash from selling the assets of Dept C:

20% x ($98.2m + (90% x $46.5m) - $3m - $20.2m = $4.81m

Value from spinning Dept B off into Ndege Co:

$ million
Dept B’s current PBDIT (40% x $37.4m) 14.96
Less: sales to Dept C (10% x $14.96) (1.50)
Less: tax allowable depreciation (40% x $98.2m x 10%) (3.93)
Profit before tax 9.53
Tax (20%) (1.91)
Free cash flow 7.62

Value of Ndege Co:

PV of free cash flow to the firm: ($7.62m x 1.2)/(0.1 – 0.052) = $190.5m
Value attributable to shareholders (less unsecured bond) = $190.5m - $40m = $150.5m

Value of Vogel Co:

Vogel’s current equity value = $3 x (190m x 2) = $1,140m
Vogel’s PE ratio before the acquisition: $1,140m / ($158.2 x 0.80) = 9.0
Vogel’s PE ratio after the acquisition: 9.0 x 1.15 = 10.35
Tori’s PE ration before the acquisition = 9 x 1.25 = 11.25
Tori’s current value = ($23m x 0.80) x 11.25 = $207m

Vogel’s post-transaction value:

[($158.2m + 50% x $23.0m) x 80% + $7m] x 10.35 = $1,477.57m

Maximum premium = ($1,477.57 + $150.5m + $4.81m) – $1,140m - $207m = $285.5m

Assumptions:
It is assumed that all of the forecasts and ratios provided are reasonable. Vogel needs to assess
whether this is the case. It appears that Ndege’s free cash flows are projected to keep growing despite
the fact that the company is assumed to carry out capital investments equal to the amount of tax
allowable depreciation. Another critical assumption is the growth in the PE ratio following the acquisition.
A recommended approach would involve performing sensitivity analysis on these inputs to see how their
changes would affect the overall result. Given its disappointing acquisitions history, Vogel ought to be
extra careful to estimate these numbers as accurately as possible.
 Makonis
Part (a)

Cost of capital estimation for combined company:

Makonis MVe = $5.80 x 210m = $1,218

Nuvola MVe = $2.40 x 200m =$480m

Combined asset beta: (0.9 x 1,218 + 1.2 x 480) / (1,218 + 480) = 0.985

Equity (levered) beta = 0.985 x (60 + 40 x 0.80) / 60 = 1.51

Cost of equity = 2% + 1.51 x 7% = 12.57%

Combined company cost of capital = 12.57% x 0.6 + 4.55% x 0.4 x 0.80 = 9:0%

Combined company value (years 1 – 4) in $ millions:

Year 1 2 3 4
Free cash flow (growing at 226.80 238.14 250.05 262.55
5%) before synergies
Synergy benefits 20.00 20.00 20.00 20.00
Free cash flow 246.80 258.14 270.05 282.55
Discount factor (9%) 0.917 0.842 0.772 0.708
PV of free cash flow 226.32 217.35 208.48 200.05

Total PV of cash flows (years 1 – 4): $852.2 million

PV of ash flows (years 5 into perpetuity): [(262.55 x 1.0225)/(0.09 – 0.0225)]/1.094 = $2,817.51 million

Total free cash flow to the firm = $852.2 million + $2,817.51 million = $3,669.71 million

Value attributable to equity = $3,669.71 million x 60% = $2,201.83 million

Additional equity value created from combining Nuvola and Makonis = $2,201.83m – ($5.80 x 210m +
$2.40 x 200m) = $503.83 million or ca. 30% of current combined value of both companies.

The equity beta of the combined companies is higher than that of Makonis on its own, which is
attributable to the higher level of Nuvola’s business risk. Despite this, the increased cash flow and
synergies from the merger lead to a value of the combined company which is approximately 30% higher
than that of the two companies operating as standalone businesses.

The valuation is based on a series of assumptions, whose significance may be tested using sensitivity
analysis:
• that free cash flows will increase at a stable rate into perpetuity,
• that the combined company’s asset beta may be approximated by a weighted average of the two
standalone betas, and
• that all figures presented in the scenario: cash flow and synergy projections, growth rates, the risk
free rate of return, market premium and tax rates are accurate.

Part (b)

Nuvola MVe = $2.40 x 200 million = $480 million

30% premium = 1.3 x $480 million = $624 million

50% premium = 1.5 x $480 million = $720 million

Number of Makonis shares post-acquisition = 200m/2 + 210 = 310 million

Loss in value (per share of combined company) if 50% premium is paid instead of 30%
= ($720m - $624m)/310m = $0.31 per share

Increasing the premium to 50% would cause a drop of $0.31 per share, which equals approximately
5.3% of Makonis’ current share value of $5.80.
Part (c)

Increasing the premium to 50% would cause a $96 million ($720m - $624m) increase in the cash
required to fund the acquisition. This may be funded by taking on more debt, but such a move would
have the effect of increasing the overall cost of capital, which in turn would have a detrimental effect on
the creation of company value. Another possibility would be to issue more shares, but current
shareholders may be unwilling to participate, knowing that the proceeds from the issue would be used to
fund an acquisition premium.

The additional premium may be affected by adjusting the proportions of the cash and share
consideration. However, this would further dilute the portion of the shares held by the current owners of
Makonis.
 Nubo
Part (a)

Separate sale of assets of supermarkets division:

Proportion of assets of the supermarkets division:

Non-current assets = 70% x $550 million = $385 million
Current assets = 70% x $122 million = $85.4 million

Expected proceeds from sale of assets = $385 million x 115% + $85.4 million x 80% = $511.07 million

Sale of supermarkets division as a going concern:

Profit after tax of supermarkets division (50% of overall profit) = $166 million/2 = $83 million

Estimated value of supermarkets division = $83 million x 7 = $581 million

Nubo’s current and non-current liabilities = $387 million + $95 million = $482 million
Both sale options generate sufficient proceeds to cover Nubo’s liabilities. The sale as a going concern
generates a higher cash inflow and is therefore more favourable.

Additional funds available to Nubo following the sale:

Assets remaining within Nubo: 30% x ($550 million + $122 million) = $201.6 million
Additional cash available after paying down liabilities ($581 million - $482 million) = $99 million

Maximum debt capacity (10% of total assets of downsized company, incl. cash) = $201.6 million + $99
million = $300.6 million

Total additional funds (cash and debt) available to Nubo = $99 million + $300.6 million = $399.6 million

Part (b)

Following a demerger Nubo Co would be split into two companies which would operate independently.
The existing shareholders of Nubo would retain an equity stake in both businesses.

A demerger typically allows for a more fair valuation of the company’s different parts, especially when
those parts have widely different PE ratios. The equity of the supermarkets division alone has been
valued at $581 million as part of the previous requirement. The value of the aircraft division, computed in
a similar manner, is $996 million ($83 million x 12), producing a combined valuation of $1,577 million. If
the company’s current value is less than this, then a demerger may be an attractive proposition. What is
more, a demerger would allow Nubo’s shareholders to retain the benefits of diversification, which would
be lost in the case of a sale.

On the other hand, we must note that a demerger would not result in the inflow of the additional $99
million in cash. The newly formed aircraft company would only be able to borrow up to $201.6 million
(100% of its assets), instead of the $300.6 million resulting from a sale.
Part (c)

If the financing were provided under a Mudaraba contract, then:

• Ulap Bank would provide 100% of the financing required, and

• Pilvi Co would provide the expert knowledge required to manage the project.

Profits from the venture would be shared in accordance with a preagreed ratio. Potential losses,
however, would be borne solely by the Bank. In effect, Ulap’s role would be akin to that of a minority
shareholder, who does not hold a big enough equity stake to have a say in the decisions taken by a
company’s management.

On the other hand, if the financing were provided under a Musharaka contract, then both the profits and
losses of the project would be shared between the parties. Ulap would also be given an opportunity to
get involved in the management of the venture. Effectively, the Bank’s role would be more akin to that of
a provider of venture capital.

Ulap Bank may prefer the Musharaka contract because of the desire to have hands-on control over the
project and the ability to closely monitor its performance, especially given the uncertainties involved and
the long time frame. A Mudaraba agreement, where Pilvi would be acting as an agent to Ulap, would
expose the Bank to significant agency issues, e.g. Pilvi could engage in excessive spending or
unjustified risk taking (as it would effectively hold a call option on the project’s performance). This risk
would probably be lower in the case of a Mudaraba contract, where both parties act as principals.

Nubo Co’s concerns would probably centre around whether it can work with Ulap Bank as an additional
partner to the venture. A contract where three parties are involved in the management of the project will
surely be more complex to draw up and operate efficiently.

Further complicating matters is the fact that Nubo would probably wish to be clearly left out of the
Musharaka contract and would want clear rules to be established with regard to the sharing of profits and
losses, as well as the exact involvement of the various parties in the day-to-day management of the
company.

As Ulap Bank may lack experience in the aircraft parts industry, their involvement as a decision maker
may complicate the running of the company, causing important decisions to be delayed, making it more
difficult to accomplish the aim of the joint venture.
 Milma
(a)

(i)

There are two main factors that affect the company’s cost of capital:

- Business risk. This is the risk a business has or faces because of the industry it operates in;
- Gearing (or Debt risk). Debt in the capital mix affects the cost of capital in two ways:

a) Because debt ranks ahead of equity, the existence of debt affects the risk to equity and, therefore,
the cost of equity;
b) The cost of debt is part of the cost of capital, and debt is cheaper than equity because it faces less
risk and because interest payments are allowable for tax.

As Milma is in the same industry as Ziwa, its business risk should be the same as Ziwa’s. And because it
will have no debt, its cost of capital will be just its cost of equity.

Milma cost of capital = Ziwa cost of equity ungeared

So let’s fund Ziwa’s ungeared cost of equity:

Ziwa
Cost of capital 9.4%
Cost of equity geared 16.83%
Cost of debt (pre-tax) 4.76%
Tax rate 25%

Market value of equity 200m @ $7 = $1,400m

Market value of debt 1,700m @ 105 = $1,785

16.83% = Ke1 + (1 - 0.25) x (Ke – 4·76%) x 1,786/1,400 = 10.92% (say 11%)

So it follows that Milma’s cost of capital equals 11%. It worth noting that this is an approximation -
Milma’s business risk may be different from Ziwa’s business risk.
(ii)

The value of Milma will be the present value of its future cash flows discounted at its cost of capital which
is calculated at 11%:

Historic mean sales revenue growth = (389.1/344.7) 1/2 – 1 = 0.625 or 6·25%

Next four years annual growth rate of sales revenue = 120% of 6.25% = 7.5%

- Current year sales (389.1) growing at 1.075 gives us sales for years 1,2,3, and 4;
- We are also told that operating profit margins are expected to maintain at the same level, so we can
assume that operating profits will also grow at 7.5%;
- Depreciation = Capital expenses. That is the way of telling us that the depreciation is effectively a
cash flow and we don’t have to add it back;
- Additional capital investment will be 30c per $1 of increase in sales:

Year 1 Year 2 Year 3 Year 4

389.1 418.3 449.7 483.4
418.3 449.7 483.4 519.7
Difference 29.2 31.4 33.7 36.3
x 30c per $1 8.8 9.4 10.1 10.9

Year 1 Year 2 Year 3 Year 4

Sales revenue 418.3 449.7 483.4 519.7
Operating profit 62.7 67.5 72.5 78
Tax (25%) (15.7) (16.9) (18.1) (19.5)
Additional capital investment (8.8) (9.4) (10.1) (10.9)
Free cash flows 38.2 41.2 44.3 47.6
PV of free cash flows (@ 34.4 33.4 32.4 31.4
11%)

Total PV of the first 4 years = 34.4 + 33.4 + 32.4 + 31.4 = 131.6m

We are told that the growth will continue into foreseeable future at 3.5%. So to calculate PV after 4
years, we will use Growth model:
 (47·6 x 1·035)
PV after four years = x 1·114 = 432.7m
(0·11 – 0·035)

PV years 1-4 $131.6m

PV Thereafter $432.7m
Total value $564.3m

Bahari Project

Base case present value

Growth rate Free Cash flows DF PV (11%)

Year 1 x 100% 4 1.11 3.6
Year 2 x 100% 8 1.112 6.5

Year 3 x 15% 16 1.113 11.7

Year 4 x 15% 18.4 1.114 12.1

Year 5 21.2 1.115 12.6
(5.889 x 21.2m) /
Year 6 to 15 21.2 74
115
Total 120.5

Cost of investment $150m

PV of return $120.5m
NPV -$29.5m

Now let’s consider the benefits of the subsidised loan at 3% on $150m. When discounting the benefit of
the Subsidy, we will use the company’s normal cost of debt - 7%, because that best reflects the
appropriate level of risk for the company.

Normal cost of debt = 7%

 Benefit of Subsidy = 4%
Annuity factor (7%, 15 years) = 9.108

PV of benefit = 9.108 x 6 (4% of 150) x (1 - 0.25) = 40.98

Annual tax shield benefit interest paid = 3% x $150m x 25% x 9.108 = $10.02m

Base case PV 120.50

PV of subsidy 40.98
PV of tax shield 10.02
Total PV 171.50
Investment 150.00
NPV 21.50

So the value of the company with the Bahari project is calculated as follows:

Previous value 564.3

NPV of the project 21.5
NPV 585.5

(iii)

We have to first of all work out what the market value of the debt is and also what the market value of the
shares is.

Market value of the Bond is the PV of the cash flows on the bond, discounted at the company’s normal
cost of debt. We use the company’s normal cost of debt to discount the cashflows rather than the
coupon rate of the bond because it is the rate at which the company could issue new debt and,
therefore, reflects the market’s view of the risk of the company and, therefore, the market value of the
bond.

Nominal value of the bond = 40m

Coupon rate = 13%

Annual payments = 13% x $40m = $5.2m

10-year annuity at 7% = 7·024

Discount factor (10 years, 7%) = 0.508

Bond value = $5.2m x 7.024 + $40m x 0.508 = $56.8m

Now let’s consider the equity which the bondholders are being asked to swap into.

Without project With project

Value of the Milma 564.3 585.8
Price per share* 5.64 5.86
 20% discount 4.51 4.69

Milma is considering issuing 100 million shares, of which 10% would be offered to the bondholders, in
exchange for the bond. In order to make this attractive, the 10 million shares would have to be in excess
of $56.8m. It is only if the shares were issued at full price with the project, at $5.86.

If the share price was to be issued as low as $4.51, the company would have to consider offering in
excess of 12.5 million shares to make the swap attractive.
(iv)

Assumptions made regarding the information used:

- All our projections are into the future and are based on past figures. So how accurate our
estimates of future growth rates and what information do we have to support those?
- Will interest rates remain constant throughout the life of the projects?
- Are the profit margins are accurate and will these margins continue into the future?
- Will the margins be affected by the growth in sales or any other changes in import costs?
- The tax rates we use is the current tax rate. Will this change over the life of the project?
- Will costs and capital investment grow in line with sales in the foreseeable future?
- What is the capital investment based on and how detailed are our projections?

Cost of capital used:

- How similar is Milma’s business to Ziwa’s? They may face different business risks;
- Acceptance of the Bahari project may change the risk profile of Milma and, therefore, affect the
cost of capital.

Reasons for changing a status from a private company to a listed one:

- Raise money to repay debt;

- It is easier to raise funds;
- It provides a value for current shareholders;
- It gives liquidity to current shareholders, enabling them to more easily sell shares;

Possible reasons for issuing shares at a discount:

- Shares are less attractive because majority of control will remain with original shareholders and
we may need discount to sell to the public;
- It makes shares more attractive to the public and increases a likelihood of the offer being
successful.

If 20 million shares are issued to the public, the amount raised will be approximately $90 million, of which
$80 million is being used to redeem the secured bond, leaving only $10 million available for other
purposes. Being listed also brings with it additional costs in terms of reporting, etc.

(b)

As a listed company, Mlima can expect a higher level of scrutiny and should consider these issues in the
context of its ethics and accountability code.

Farmers

It may take the view that the farmers' relocation is between the farmers and the government, who may
be moved irrespective of whether Mlima takes the project.
If it goes ahead, it should ensure that it uses its influence to ensure the farmers are well treated by the
government. It may also consider offering jobs or training to farmers / their families if they did not want to
relocate.

CEO / President relationships

Knowledge of the relationship puts additional responsibility on Mlima's directors, to ensure that all
dealings are done transparently, and ensure that no unethical or illegal behaviour occurs.
Kenduri
 Nente
(i)

Since we are looking at a free cash flow to the firm, we want the cash flow before payments to providers
of capital. So we exclude interest payments because interest is a return to debt providers. We will start
with PBIT and then adjust for other cash and non-cash items:

Annual tax payable (before interest) = $1,230,000 x 20% = $246,000

$
PBIT 1,230,000
Add non-cash expenses (depreciation, etc.) 1,206,000
Less expenses (1,010,000)
Less tax (246,000)
Free Cash Flow 1,180,000

To value the business, we use the Growth Model (given in the formula sheet).

D0 (1 + g)
P0 =
re - g

D0 - the cash flow for the year = 1,180,000

g - the growth rate = 25%
re - the cost of capital = 11%

The PBIT has grown now over the last 3 years from $970,000 to $1,230,000 giving an annual compound
rate of growth of:

Growth in the future is going to be 25% of this level which means we can expect annual growth of 2.06%
(8.23% x 0.25).

Plugging these numbers into our growth model, the value of the business is:

1,180,000 x 1.0206
Value of the business = = $13,471,000
0.11 - 0.0206

This gives us the total value of the business, which is a combination of both debt and equity. To get the
value of the equity, we deduct the debt:

Total sale $13,471,000

Less debt $6,500,000

 Value of equity $6,971,000

$6,791,000
Value per share = = $2.90
2,400,000

(ii)

Cash offer

The current value of a Nente share is $2.90, so the cash offer of $2.95 would give an increase to the
Nente Co’s shares of 1.7%:

2.95 - 2.90
=
1.7%
2.90

As for the effect on a Mije Co shares, additional earnings per share is equal to:

770,000
= 7.7 cents per share
10,000,000

Increase in the value of share = 15 x 7.7c = $1.16

The cash paid by Mije Co to buy Nente would reduce the value of each Mije’s share. The amount paid is:

Amount paid = $2,95 x $2,400,000 = $7,080,000

7,080,000
= 0.71 cents
10,000,000

So we would expect that the price of a Mije share after the acquisition would be:

$4,80
The additional value + $1,16
Cost of acquisition - $0.71
$5.25

5.25 - 4.80
Increase in value per share = = 9.4%
4.80
Share for share exchange

Let’s start by working out the value of the Mije share after the acquisition. Mije’s earnings would be:
 $3,200,000
Plus 770,000
Total $3,970,000

The number of shares would be:

Original number of shares 10,000,000

Plus:

2,400,000
Additional number of shares = x2= 1,600,000
3

Total number of shares 11,600,000

Earnings per share = 3,970,000 / 11,600,000 = 34.2 cents (after the acquisition)

Increase in the value of share = 15 x 34.2c = $5.13

So, the overall increase per share to a Nente shareholder would be:

3 Nente shares: Increase in value = 3 x $2.90 = $8.70

2 Meje shares: Increase in value = 2 x $5.13 = $10.26

10.26 - 8.70
Overall increase in value per share = = 17.90%
8.70
For a Meje shareholder, the shares will have gone up in value from $4.80 to $5.13, giving an increase of
6.9%:

5.13 - 4.80
= 6.9%
4.80
(iii)

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Start End

On a straightforward NPV basis we can see that the project has a positive NPV:

NPV outflow (2,029)

NPV inflow 2,434
 NPV 405

But rather than looking at a basic NPV, which assumes that we must commit to the project now, let’s
look at this project as a call option - we have the right but not the obligation to undertake the follow on
project. We can use the Black and Scholes valuation model to value this call option:

C = Pa*N*(d1) - Pe*N*(d2)*e-rt

This call option allows us to delay the decision for two years, so rather than buying the asset now, i.e.,
committing to the project, we can buy the right to undertake the project or not undertake it in two years
time.

Let’s look at the variables:

Pe - Strike price or Exercise price. If we were buying a share, an exercise price would be the price at
which we could buy a share in the future. In our case the exercise price is the cost we would incur if we
exercise the call option and undertake the project, that is $2,500,000.

Pa - Current value. If we were buying a share, this would be the current market price of the share. In our
case, this is the present value of the future cash flows of the product, which is $2,434,000.

- The time to expiry is 2 years;

- The standard deviation / volatility is 42%;
- As we told that Nente pays 3.8% higher than the government base rate, the risk-free rate equals 7%
- 3.8% = 3.2%.

ln(2,434 / 2500) + (0.032 + 0.5 x 0.422) x 2

d1 = = 0.359
0.42 * 2 1/2

d2 = d1 - s * t1/2= 0.235
To find N(d1) and N(d2), we need to look at the table. If dn is greater than zero, add 0.5 to result from the
distribution table:

N(d1) = 0.5 + (0.1368 + 0.9 x (0.1406 - 0.1368)) = 0.6402

N(d2) = 0.5 - (0.0910 + 0.5 x (0.0948 - 0.0910)) = 0.4071

Value of option to delay the decision = 2,434,000 x 0.6402 – 2,500,000 x 0.4071 x e-(0.032 x 2) =
$1,558,247 - $954,655 = $603,592

The project increases the value of the company by $603,592 or 25.1c per share ($603,592/2,400,000
shares). In percentage terms, this is an increase of about 8.7% (25·1c/290c).
(iv)

The cash offer is only a premium of 1.7% to the value of Nente, which is not enough to motivate
shareholders to sell. They would expect a premium of at least a 20%.

They would, however, be receiving cash for shares in an unlisted and therefore illiquid company, which
could be tempting.

The share for share exchange between a Nente shareholder a premium of 17.9% which is closer to a
minimum 20% gain. It also allows them to participate in the future growth opportunities of Nente and Mije
and to receive some of the benefits of the follow on products. Premium is greater than the increase in
value from the follow on product.

From the point of view of a Mije shareholder, the cash offer is more attractive because it increases the
value of their shares by 9.4% and also avoids the dilution of future earnings that would occur from its
issue of additional shares in the share for share exchange. The share for share exchange is still
attractive to them because it also increases their share value by 6.9% They would also expect their
director to compare this acquisition on opportunities which might make better use of the cash available.

Assumptions made include:

- We assumed that the growth will continue on 2.06% into the future;
- We also assumed that 11% reflects the cost of capital - remember it is on unlisted company without
a market price;
- With regard to the combined entity we assumed that synergies of 150,000 are achievable and that a
P/E of 15 will be achieved;
- For a Black & Scholes valuation model, any variations in the variables, cash flows, volatility, interest
rates, or time could significantly affect the value of the call option.

Nente shareholder point of view:

- Share for share exchange is the best option;

- Unlike the cash offer, the value of shares received is dependent on the success of Mije;
- Shareholders might also consider putting pressure on Mije to increase the offer in order to cover the
benefits of the follow-on product.
 Pursuit
(i)

The value of the company is a present value of its future cash flows, discounted at the cost of capital. So
we will start with the Free Cash Flow. We can see from the profit and loss extract that sales have grown
from 13,559 to 16,146. The average growth is calculated as follows:

This will give us sales over the next four years growing at 6%:

Year 1 Year 2 Year 3 Year 4

17,115 18,142 19,231 20,385

To get the Free Cash Flow, we will need the operating profit margin:

2008 2009 2010 2011 Total

Sales 13,559 14,491 15,229 16,146 59,425
Operating profit 4,530 4,243 5,074 5,169 19,016

Operating profit 19,016

Operating profit margin = = = 32%
Sales 59,425

If we apply the same margin for next four years, we get the following operating profits:

Year 1 Year 2 Year 3 Year 4

Sales 17,115 18,142 19,231 20,385
Operating profit @ 32% 5,477 5,805 6,154 6,523

Notes:
- Since we are looking at the Free Cash Flow to the firm, we will exclude interest payments and
dividends from the cash flow because they are payments to providers of capital;
- We don’t need to add back depreciation as we are told that the tax allowable depreciation is
equivalent to the amount of investment needed to maintain current operational levels.

We will require additional cash investment to find the growth in sales - 22 cents per $1 sales increase.
Cash flows from tax are calculated as follows:

Having calculated the cash flow for the next four years, our next task is to find the discount rate. Since
we are using the cash flow before interest, we will use a discount rate that looks at the return required by
both equity and debt, i.e. the WACC.

We will use the equity beta to calculate the cost of equity using the CAPM:

Now we will calculate the WACC:

 To get the present value of Fodder’s cash flow for the first four years, we discount:

1 2 3 4

Sales revenue 17,115 18,142 19,231 20,385

Operating profit 5,477 5,805 6,154 6,523

Less tax (28%) (1,534) (1,625) (1,723) (1,826)
Less additional investment (22c / $1 of
(213 (226) (240) (254)
sales revenue increase)
Free cash flows 3,730 3,954 4,191 4,443
PV (13%) 3,301 3,097 2,905 2,725

Total present value of first four years = $12,025,000

We know that for the next four years the growth will be 3%, i.e. half of the 6% growth. So we can use the
growth model:

This is the present value of the cash flows from year four onwards at year four. So to get the present
value now we must discount this back 4 years:
Total present value = 45,762,900 x 0.6133 = $28,067,000

So the value of Fodder is calculated as follows:

Total value = $12,025,000 (PV for Years 1-4)+ $28,067,000 (PV of cashflows Year 4 onwards) =
$40,095,000
In order to decide if the acquisition would be beneficial to Pursuit company and its shareholders, we will
look at the value of the combined companies and compare this with the original value of Pursuit Co, and
see if the increase in value is great enough to justify the acquisition.

Combined Co cash flow and value computation ($’000)

Sales revenue growth rate = 5.8%, Operating profit margin = 30% of sales revenue

Year 1 2 3 4
Sales revenue 51,952 54,965 58,153 61,526
Operating profit 15,586 16,490 17,446 18,458
Less tax (28%) (4,364) (4,617) (4,885) (5,168)
Less additional investment (18c / $1
(513) (542) (574) (607)
of sales revenue increase)
Free cash flows 10,709 11,331 11,987 12,683
PV (9%) 9,825 9,537 9,256 8,985

Cash investments in assets:

To get the asset beta, we need to ungear the equity beta. If we assume a nil beta for debt, the asset beta
is calculated as follows:

The asset beta of the combined companies is calculated as follows:

To get the equity beta of the combined company, we have to regear the asset beta according to the
combined company’s ratio of debt to equity. We are told that the debt to equity ratio will be the same for
the combined company as it was for pursuit:

To get the cost of equity, we plug that into our CAPM formula:

So we discount the first four years cash flow using a discount rate of 9%:

To get the value at Year 4 for the cash flows going forward, we will use the growth model, and then we
need to discount this amount to get the value at Year 0:

So the total value of the combined company will be calculated as follows:

To decide if the acquisition is beneficial, we need to consider whether the value of the combined
companies greater than the value of the two companies individually and whether the premium that we
are paying to acquire Fodder is justified:
 $’000
Value of combined companies 189,169,000
Value of Pursuit 140,000,000
Value of Fodder 40,095,000
Total 180,095,000
Benefit of combination (synergy benefits) 9,074,000

Total value 40,095,000

Equity is 90% (i.e., 9:1 ratio) 36,086,000
Premium @ 25% 9,022,000

Net benefit to Pursuit Shareholders 52,000

Conclusion: The benefit of only $52,000 does not justify the acquisition.

(ii)

1. The growth over the next four years may change. How reliable are our estimates?
2. Growth rates into the future beyond year 4 may change. How reliable are our estimates?
3. May we require greater investment in assets?
4. Will capital investment grow in line with sales?
5. Will tax rates remain stable?
6. How accurate are our Beta calculations (especially for Fodder, which is a private company)?
7. Do the discount rates accurately reflect the costs of equity and debt?
8. Will the capital structures change?
9. Will the costs and profit margins remain constant?
10. Will sales grow as predicted?
11. The estimates of sales, costs margins, etc. for the combined company may be subject to
considerable variation.

It may be more useful to produce a range of possible outcomes and assign probabilities to them.

(iii)

Pursuit’s current capital structure is 50% equity and 50% debt. The total market value is $140,000,000.
So the current debt, therefore, is $70,000,000.

The combined company’s capital structure will remain the same. The combined market value will be
$189,169,000. To maintain the capital structure, the debt will be limited to $94,584,500. So the additional
borrowings will be available:

Debt 94,584,500
Less Current debt 70,000,000
Additional debt capacity 24,584,500

We are told that Pursuit has reserves available of $20,000,000, giving us total funds available to acquire
Fodder of $44,584,000.

The cost of Fodder, including paying off its debt will be:
 $’000
Debt 10% of 40,095,000 4,009
Equity 90% of 40,095,000 36,086
Premium required 9,022
Total cost 49,117

This gives us a shortfall of $4,533,000, which means that additional debt is required if we are to acquire
Fodder and, therefore, the capital structure can’t be maintained.

(iv)

By taking on more debt, or by following the CFO’s recommendation of using all debt to finance the
acquisition, the capital structure will change. This will affect the equity beta of the combination and,
therefore, the cost of equity. The ratio of debt to equity will also change, therefore, changing the WACC.
The net result will be a change to the discount rate and, therefore, the valuation of the company.

Various combinations of debt and equity can be tested with adjusted Betas and WACCs until a desired
combination, which maximises value, is achieved.

(v)

Firstly, we must ensure that any action taken does not contravene regulatory framework.

Distribution of the cash reserves may make Pursuit less attractive to SGF.

We should also ask why the share price has been depressed. Distribution may have a positive effect on
the share price, also making the company less attractive to SGF.

Taking on additional borrowings to fund the acquisition may increase the risk profile of the company,
further reducing its share price. Additional borrowings may also reduce debt capacity of the company,
making it difficult to grow in the future through acquisition.

It worth noting that acquisition is not really attractive at the first place to shareholders.
 Phobos
(a) (i)

First of all, we need to know how much the company is going to borrow, when, and for how long. From
the scenario we can see that the company is expecting to borrow in two months, on the 1st of March,
therefore, it must now be the 1st of January, and will repay in six months from now. So we are going to
borrow 30 million for four months commencing on the 1st of March.

As for the short term sterling futures, we are going to use a settlement price because that is the price
that we are going to actually settle at.

The contract is a 3-months and £500,000 future. This does not mean that the future will last for 3 months
but rather that any movement in the price of the future will be the same as a change in interest rates of
£500,000 borrowed or lent for three months. A 1% movement in interest rates will equal:

1% x £500,000 x 3/12 = £1,250

1% = 100 Ticks

Tick value = £12.50

100 Ticks = £1,250

The price of the future is quoted at a 100 minus the interest rate, so an interest rate of 6% would give us
a future price of:
100 - 6% = 94

Interest rate = 7% Future price = 100 - 7% =93

The key question is how many contracts do we use and do we buy or sell them. We are trying to hedge a
borrowing of £30,000,000 for four months. The gain or loss on each future contract will reflect an interest
rate movement on £500,000 for three months. So for £30,000,000 we would need 60 contracts. And
since we borrowing for 4 months, not 3 months, we need to divide by 3 and multiply by 4, so we require
80 contracts:

£30,000,000 x 4 = 80 contracts
£500,000 3

We are trying to hedge an interest rate rise between now, the 1st of January, and the date on which our
borrowing commences, the 1st of March. If interest rates do rise, the price of the future will go down.
Therefore, we want to sell the future now, that is we enter into a contract to deliver the future at a future
date at a price agreed now. If the price goes down, we will close our position on the 1st of March by
buying the futures contract on the market at a lower price, deliver them at the agreed price, and make a
profit on the difference. This profit will offset the extra interest we pay on the actual borrowing.
In the question we are given three contracts and we need to decide which contract to use. We have a
choice of any of the three, we can close our position at any time of the expiry of the contract, and since
the contract expires at the end of each month, we can choose any of them.

Since the one with the closest expiring date will most accurately reflect the current interest rate, we will
choose the March contract. So we decide to sell 80 March contracts with an open price of 93.80 and a
settlement price of 93.88. Although futures don’t require us to pay a premium, the exchange requires a
margin deposit.

To calculate the gain or loss on the future, we need to know the price of the future on the 1st of March
when we close our position. Although we are not given the future price on the 1st of March, we are given
enough information to calculate a possible price.

Basis risk = Spot price - Future price

The price of the future is 93.88 and reflects an interest rate of 6.12%:

100 - 93.88 = 6.12%

Interest rate in the question is 6% on the 1st of January, giving us the difference of 12 basis points or
ticks (or 0.12%). At the 1st of January, the contract has three months to expiry, so the basis will eliminate
evenly over the three months at a rate of 4 basis points for month. So, on the 1st of March, the remaining
basis will be 4 basis points or 4 ticks.

So, on the 1st of March, if interest rates rise by 1% to 7%, we can expect the price of the future to be
92.96:

100 - 7 = 93 - 4 basis points = 92.96

We sold the future on the 1st of January at 93.88. We now go into the market and buy it back to deliver
and settle on the 1st of March at 92.96, which gives us a gain of 92 basis points:

Total gain = 93.88 - 92.96 = 92 basis points @ £12.50 x 80m contracts = £92,000

On the actual borrowing the company will pay an interest of 7.5%, that is LIBOR, which is 7%, plus the
50 basis points of difference we told the company will have to pay.

So, our Net Cost will be:

£30,000,000 x 7.5% x 4 months - 92,000 of Gain on the future = £658,000

That gives an annualised interest rate of 6.58%.

Now let's look at the cost of the interest if the interest rates were to fall by 1% to 5%. The price of the
future will be 94.96:

100 - 5 = 95 - 4 basis points = 94.96

Now we have a loss on the future. We sold the future on the 1st of January at 93.88, and now in order to
settle our position on the 1st of March we have to buy back the future contract at 94.96, giving us a loss
of 108 basis points:

Part (a) (ii)

Now let's look at the position if the interest rate exposure is hedged using the options on short sterling
futures.
A call option is an option or a right but not the obligation to buy something in the future at the price
agreed now. The strike price is the exercise price.

A put option is a right but, again, not the obligation to sell something in the future at a price agreed now.
Again, the strike price is the exercise price.

The short sterling option is an option on the future contract. The option gives us the right to buy the
contract (a call option) or sell the contract (a put option) at the strike price or the exercise price.

In the case of options, we must pay a non-refundable premium. The price of the premium is expressed in
ticks or points of 1%.

So in deciding of how we use the option, we first ask how we would use the future. We’ve already
decided to sell 80 March futures contracts, so if we use the options, we will buy a put option with the
option to sell on 80 March futures contracts. Although we could choose any of the possible strike prices
for the purpose of our solution, we are going to choose 94000, which is 94.

So we buy 80 put options on the March futures at an exercise price of 94,000 and with the premium of
0.168 or 16.8 ticks (this is our non-refundable premium).

16.8 Ticks x £12.50 x 80 contracts = £16,800

Now, jumping forward to the 1st of March. We’ve already calculated that if interest rates rise to 7%, the
likely price of the future will be 92.96. We have a put option, which is the option to sell that future at
94.00. We will go to the market, buy the future at 92.96, exercise our option to sell it at 94 and make a
profit on difference:

94.00 - 92.96 = 1.04 gain = 104 Ticks @ £12.50 x 80 contracts = £104,000

So our net interest cost, as before, is calculated as follows:

£750,000 Actual borrowing cost - £104,000 Gain on the option + £16,800 Cost of the premium =
£662,800

This gives an annualised interest cost of 6.63%.

If interest rates fall to 5%, the price of the future is likely to rise to 94.96. Our put option allows us to sell
the future at 94.00. Since we would have to buy the future at 94.96, to sell it at 94.00, we would make a
loss. So we will let the option lapse. Our cost would be:

£550,000 Actual borrowing cost + £16,800 Cost of the premium = £566,800

This gives an annualised interest cost of 5.67%

So, to summarise, the likely cost will be:

Without Hedging
7% 7.5%
5% 5.5%

With Hedging
7% 6.58%
5% 6.58%

With Options
7% 6.63%
5% 5.67%
If we hedge using futures, this is the only strategy which comes within the requirement of the Director to
have our total interest rate cost below 6.60%. So if interest rates rise or fall, we will still pay 6.58%.
Therefore, we are not going to with the future to be able to take benefit of the fall of the interest rates to
5%.

The option strategy has an interest rates cost of 6.63%, which is just above the required threshold of
6.6% but with an expected payoff of 6.15% (given equal likelihoods of a rise or a fall in interest rates).
Given the absence of a time value estimate on close out, and the possibility of capturing the benefit of
fall in rates, the use of options should be the preferred alternative.

Interest rate at close out 7.00% 5.00%

Future price at close out 92.96 94.96
Exercise price 94.00 94.00
Option payoff 104 0
Position payoff on 80 contracts at £12.50 per tick 104,000 0
Cost of loan in spot market 750,000 550,000
Less option payoff (104,000) 0
Less premium 16,800 16,800
Net cost of loan 662,800 566,800
Annual equivalent 6.63% 5.67%
Expected payoff assuming equal likelihoods 6.15%

Part (b)

Derivatives offer an opportunity for a firm to vary its exposure to interest rate risk at a given rate of
interest on the underlying principal (hedging) or to decrease the rate of interest on its principal at an
increased level of risk exposure. For hedging purposes derivatives permit the management of exposure
either for the long term (swaps) or for the short term (Forward Rate Agreements (FRAs), Interest Rate
Futures (IRFs), Interest Rate Options (IROs) and hybrids). With forward and futures contracts, the
mechanism of hedging is the same in that an offsetting position is struck such that both parties forego
the possibility of upside in order to eliminate the risk of downside in the underlying rate movements.
Where the option to benefit from favourable rate movements is required or in situations where there is
uncertainty whether a hedge will be required, then an IRO may be the more appropriate but higher cost
alternative. Such hedging can be more or less efficient depending upon the ability to set up perfectly
matched exposures with zero default risk. Matching depends upon the nature of the contract. With OTC
agreements the efficiency of the match may be perfect but the risk of default remains. With traded
derivatives, the efficiency of the match may be less than perfect either through size effects or because of
the lack of a perfect match on the underlying (for example the use of a LIBOR derivative against an
underlying reference rate which is not LIBOR). There will also be basis risk where the maturity of the
derivative does not coincide exactly with the underlying exposure.

Where a company forms a view that future spot rates will be lower than those specified by the forward
yield curve they may decide to alter their exposure to interest rate risk in order to capture the benefit of
the reduced rate. This can be achieved through the use of IROs. Alternatively, leveraged swap or
leveraged FRA positions can be taken to avoid the upfront cost of an IRO. For example, taking multiples
of the variable leg of a swap (i.e. agreeing to swap fixed for variable) where a higher than market fixed
rate is swapped for ‘n’ multiples of the variable rate. However, as a number of cases have demonstrated
it may be very difficult with these types of arrangement to gauge the degree of risk exposure and to
ensure that they are effectively managed by the firm. In the 1990s a number of companies in the US and
elsewhere took leveraged positions, without recognising the degree of their exposure and took losses
that threatened the survival of the firm.