Professional Level Options Module

Advanced Financial Management

Thursday 9 June 2011

Time allowed Reading and planning: Writing:

15 minutes 3 hours

This paper is divided into two sections: Section A BOTH questions are compulsory and MUST be attempted Section B TWO questions ONLY to be attempted Formulae and tables are on pages 812. Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper P4

Section A BOTH questions are compulsory and MUST be attempted 1 Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products. The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed. Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Cos current capital structure level. Information on Pursuit Co and Fodder Co Pursuit Co Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 118. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million. Fodder Co, Income Statement Extracts Year Ended 31 May 2011 All amounts are in $000 Sales revenue 16,146 Operating profit (after operating costs and tax allowable depreciation) 5,169 Net interest costs 489 Profit before tax 4,680 Taxation (28%) 1,310 After tax profit 3,370 Dividends 123 Retained earnings 3,247 31 May 2010 15,229 5,074 473 4,601 1,288 3,313 115 3,198 31 May 2009 14,491 4,243 462 3,781 1,059 2,722 108 2,614 31 May 2008 13,559 4,530 458 4,072 1,140 2,932 101 2,831

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 153. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels. However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings. For the next four years, Fodder Cos sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future. Information about the combined company Following the acquisition, it is expected that the combined companys sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable futue. After the first year the growth rate in sales revenue will be 58% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 64% on future borrowings. The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate. It can be assumed that the asset beta of the combined company is the weighted average of the individual companies asset betas, weighted in proportion of the individual companies market value. Other information The current annual government base rate is 45% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Cos interest in Pursuit Co There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Cos share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company. The rumours of SGF Cos interest have raised doubts about Pursuit Cos ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Cos board is keen to reduce the possibility of such a bid. The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend. Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Cos gearing level but suggested it may increase the companys share price and make Pursuit Co less appealing to SGF Co. Required: Prepare a report to the Board of Directors of Pursuit Co that (i) Evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Fodder Co and the combined company assuming that the combined companys capital structure stays the same as that of Pursuit Cos current capital structure. Include all relevant calculations; (16 marks) (4 marks)

(ii) Discusses the limitations of the estimated valuations in part (i) above;

(iii) Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co and concludes whether Pursuit Cos current capital structure can be maintained; (3 marks) (iv) Explains the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved; (4 marks) (v) Assesses whether the Chief Financial Officers recommendation would provide a suitable defence against a bid from SGF Co and would be a viable option for Pursuit Co. (5 marks) Professional marks will be awarded in question 1 for the format, structure and presentation of the report. (4 marks) (36 marks)

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Casasophia Co, based in a European country that uses the Euro (), constructs and maintains advanced energy efficient commercial properties around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months. Casasophia Co is planning to commence a major construction and maintenance project in Mazabia, a small African country, in six months time. This government-owned project is expected to last for three years during which time Casasophia Co will complete the construction of state-of-the-art energy efficient properties and provide training to a local Mazabian company in maintaining the properties. The carbon-neutral status of the building project has attracted some grant funding from the European Union and these funds will be provided to the Mazabian government in Mazabian Shillings (MShs). Casasophia Co intends to finance the project using the US$20 million it is due to receive and borrow the rest through a loan. It is intended that the US$ receipts will be converted into and invested in short-dated treasury bills until they are required. These funds plus the loan will be converted into MShs on the date required, at the spot rate at that time. Mazabias government requires Casasophia Co to deposit the MShs264 billion it needs for the project, with Mazabias central bank, at the commencement of the project. In return, Casasophia Co will receive a fixed sum of MShs15 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%. Financial Information Exchange Rates available to Casasophia Spot 4-month forward Per 1 US$13585US$13618 US$13588US$13623 Per 1 MShs116MShs128 Not available

Currency Futures (Contract size 125,000, Quotation: US$ per 1) 2-month expiry 5-month expiry 13633 13698

Currency Options (Contract size 125,000, Exercise price quotation: US$ per 1, cents per Euro) Exercise price 136 138 Calls 2-month expiry 5-month expiry 235 280 188 223 Puts 2-month expiry 5-month expiry 247 298 423 464 220% 1080% 180%

Casasophia Co Local Government Base Rate Mazabia Government Base Rate Yield on short-dated Euro Treasury Bills (assume 360-day year)

Mazabias current annual inflation rate is 97% and is expected to remain at this level for the next six months. However, after that, there is considerable uncertainty about the future and the annual level of inflation could be anywhere between 5% and 15% for the next few years. The country where Casasophia Co is based is expected to have a stable level of inflation at 12% per year for the foreseeable future. A local bank in Mazabia has offered Casasophia Co the opportunity to swap the annual income of MShs1.5 billion receivable in each of the next three years for Euros, at the estimated annual MShs/ forward rates based on the current government base rates.

Required: (a) Advise Casasophia Co on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. Include all relevant calculations. (15 marks) (b) Provide a reasoned estimate of the additional amount of loan finance Casasophia Co needs to obtain to undertake the project in Mazabia in six months. (5 marks) (c) Given that Casasophia Co agrees to the local banks offer of the swap, calculate the net present value of the project, in six months time, in . Discuss whether the swap would be beneficial to Casasophia Co. (10 marks) (30 marks)

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Section B TWO questions ONLY to be attempted 3 GNT Co is considering an investment in one of two corporate bonds. Both bonds have a par value of $1,000 and pay coupon interest on an annual basis. The market price of the first bond is $1,07968. Its coupon rate is 6% and it is due to be redeemed at par in five years. The second bond is about to be issued with a coupon rate of 4% and will also be redeemable at par in five years. Both bonds are expected to have the same gross redemption yields (yields to maturity). GNT Co considers duration of the bond to be a key factor when making decisions on which bond to invest. Required: (a) Estimate the Macaulay duration of the two bonds GNT Co is considering for investment. (9 marks)

(b) Discuss how useful duration is as a measure of the sensitivity of a bond price to changes in interest rates. (8 marks) (17 marks)

MesmerMagic Co (MMC) is considering whether to undertake the development of a new computer game based on an adventure film due to be released in 22 months. It is expected that the game will be available to buy two months after the films release, by which time it will be possible to judge the popularity of the film with a high degree of certainty. However, at present, there is considerable uncertainty about whether the film, and therefore the game, is likely to be successful. Although MMC would pay for the exclusive rights to develop and sell the game now, the directors are of the opinion that they should delay the decision to produce and market the game until the film has been released and the game is available for sale. MMC has forecast the following end of year cash flows for the four-year sales period of the game. Year Cash flows ($ million) 1 25 2 18 3 10 4 5

MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game. It can be assumed that all the costs and revenues include inflation. The relevant cost of capital for this project is 11% and the risk free rate is 35%. MMC has estimated the likely volatility of the cash flows at a standard deviation of 30%. Required: (a) Estimate the financial impact of the directors decision to delay the production and marketing of the game. The Black-Scholes Option Pricing model may be used, where appropriate. All relevant calculations should be shown. (12 marks) (b) Briefly discuss the implications of the answer obtained in part (a) above. (5 marks) (17 marks)

Mezza Co is a large food manufacturing and wholesale company. It imports fruit and vegetables from countries in South America, Africa and Asia, and packages them in steel cans, plastic tubs and as frozen foods, for sale to supermarkets around Europe. Its suppliers range from individual farmers to Government run cooperatives, and farms run by its own subsidiary companies. In the past, Mezza Co has been very successful in its activities, and has an excellent corporate image with its customers, suppliers and employees. Indeed Mezza Co prides itself on how it has supported local farming communities around the world and has consistently highlighted these activities in its annual reports. However, in spite of buoyant stock markets over the last couple of years, Mezza Cos share price has remained static. It is thought that this is because there is little scope for future growth in its products. As a result the companys directors are considering diversifying into new areas. One possibility is to commercialise a product developed by a recently acquired subsidiary company. The subsidiary company is engaged in researching solutions to carbon emissions and global warming, and has developed a high carbon absorbing variety of plant that can be grown in warm, shallow sea water. The plant would then be harvested into carbon-neutral bio-fuel. This fuel, if widely used, is expected to lower carbon production levels. Currently there is a lot of interest among the worlds governments in finding solutions to climate change. Mezza Cos directors feel that this venture could enhance its reputation and result in a rise in its share price. They believe that the companys expertise would be ideally suited to commercialising the product. On a personal level, they feel that the ventures success would enhance their generous remuneration package which includes share options. It is hoped that the resulting increase in the share price would enable the options to be exercised in the future. Mezza Co has identified the coast of Maienar, a small country in Asia, as an ideal location, as it has a large area of warm, shallow waters. Mezza Co has been operating in Maienar for many years and as a result, has a well developed infrastructure to enable it to plant, monitor and harvest the crop. Mezza Cos directors have strong ties with senior government officials in Maienar and the countrys politicians are keen to develop new industries, especially ones with a long-term future. The area identified by Mezza Co is a rich fishing ground for local fishermen, who have been fishing there for many generations. However, the fishermen are poor and have little political influence. The general perception is that the fishermen contribute little to Maienars economic development. The coastal area, although naturally beautiful, has not been well developed for tourism. It is thought that the high carbon absorbing plant, if grown on a commercial scale, may have a negative impact on fish stocks and other wildlife in the area. The resulting decline in fish stocks may make it impossible for the fishermen to continue with their traditional way of life. Required: Discuss the key issues that the directors of Mezza Co should consider when making the decision about whether or not to commercialise the new product, and suggest how these issues may be mitigated or resolved. (17 marks)

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Formulae Modigliani and Miller Proposition 2 (with tax) k e = kie + (1 T)(kie k d ) Vd Ve

Two asset portfolio sp = w2s2 + w2s2 + 2wawbrab sasb a a b b

The Capital Asset Pricing Model E(ri ) = Rf + i (E(rm ) Rf ) The asset beta formula V (1 T) Ve d a = e + d (Ve + Vd (1 T)) (Ve + Vd (1 T))

The Growth Model Po = Do (1 + g) (re g)

Gordons growth approximation g = bre

The weighted average cost of capital V V e d ke + k (1 T) WACC = Ve + Vd Ve + Vd d

The Fisher formula (1 + i) = (1 + r)(1+h)

Purchasing power parity and interest rate parity S1 = S0 x (1+hc ) (1+hb ) F0 = S0 x (1+ic ) (1+ib )

Modified Internal Rate of Return PV n MIRR = R 1 + re 1 PVI

1

The Black-Scholes option pricing model c = PaN(d1) PeN(d2 )e rt Where: d1 = ln(Pa / Pe ) + (r+0.5s2 )t s t

d2 = d1 s t The Put Call Parity relationship p = c Pa + Pee rt

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Present Value Table Present value of 1 i.e. (1 + r)n Where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1% 0990 0980 0971 0961 0951 0942 0933 0923 0941 0905 0896 0887 0879 0870 0861 2% 0980 0961 0942 0924 0906 0888 0871 0853 0837 0820 0804 0788 0773 0758 0743 3% 0971 0943 0915 0888 0863 0837 0813 0789 0766 0744 0722 0701 0681 0661 0642 4% 0962 0925 0889 0855 0822 0790 0760 0731 0703 0676 0650 0625 0601 0577 0555 5% 0952 0907 0864 0823 0784 0746 0711 0677 0645 0614 0585 0557 0530 0505 0481 6% 0943 0890 0840 0792 0747 0705 0665 0627 0592 0558 0527 0497 0469 0442 0417 7% 0935 0873 0816 0763 0713 0666 0623 0582 0544 0508 0475 0444 0415 0388 0362 8% 0926 0857 0794 0735 0681 0630 0583 0540 0500 0463 0429 0397 0368 0340 0315 9% 0917 0842 0772 0708 0650 0596 0547 0502 0460 0422 0388 0356 0326 0299 0275 10% 0909 0826 0751 0683 0621 0564 0513 0467 0424 0386 0305 0319 0290 0263 0239 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

(n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

11% 0901 0812 0731 0659 0593 0535 0482 0434 0391 0352 0317 0286 0258 0232 0209

12% 0893 0797 0712 0636 0567 0507 0452 0404 0361 0322 0287 0257 0229 0205 0183

13% 0885 0783 0693 0613 0543 0480 0425 0376 0333 0295 0261 0231 0204 0181 0160

14% 0877 0769 0675 0592 0519 0456 0400 0351 0308 0270 0237 0208 0182 0160 0140

15% 0870 0756 0658 0572 0497 0432 0376 0327 0284 0247 0215 0187 0163 0141 0123

16% 0862 0743 0641 0552 0476 0410 0354 0305 0263 0227 0195 0168 0145 0125 0108

17% 0855 0731 0624 0534 0456 0390 0333 0285 0243 0208 0178 0152 0130 0111 0095

18% 0847 0718 0609 0516 0437 0370 0314 0266 0225 0191 0162 0137 0116 0099 0084

19% 0840 0706 0593 0499 0419 0352 0296 0249 0209 0176 0148 0124 0104 0088 0074

20% 0833 0694 0579 0482 0402 0335 0279 0233 0194 0162 0135 0112 0093 0078 0065 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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Annuity Table
n Present value of an annuity of 1 i.e. 1 (1 + r) r

Where

r = discount rate n = number of periods Discount rate (r)

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

1% 0990 1970 2941 3902 4853 5795 6728 7652 8566 9471 1037 1126 1213 1300 1387 11% 0901 1713 2444 3102 3696 4231 4712 5146 5537 5889 6207 6492 6750 6982 7191

2% 0980 1942 2884 3808 4713 5601 6472 7325 8162 8983 9787 1058 1135 1211 1285 12% 0893 1690 2402 3037 3605 4111 4564 4968 5328 5650 5938 6194 6424 6628 6811

3% 0971 1913 2829 3717 4580 5417 6230 7020 7786 8530 9253 9954 1063 1130 1194 13% 0885 1668 2361 2974 3517 3998 4423 4799 5132 5426 5687 5918 6122 6302 6462

4% 0962 1886 2775 3630 4452 5242 6002 6733 7435 8111 8760 9385 9986 1056 1112 14% 0877 1647 2322 2914 3433 3889 4288 4639 4946 5216 5453 5660 5842 6002 6142

5% 0952 1859 2723 3546 4329 5076 5786 6463 7108 7722 8306 8863 9394 9899 1038 15% 0870 1626 2283 2855 3352 3784 4160 4487 4772 5019 5234 5421 5583 5724 5847

6% 0943 1833 2673 3465 4212 4917 5582 6210 6802 7360 7887 8384 8853 9295 9712 16% 0862 1605 2246 2798 3274 3685 4039 4344 4607 4833 5029 5197 5342 5468 5575

7% 0935 1808 2624 3387 4100 4767 5389 5971 6515 7024 7499 7943 8358 8745 9108 17% 0855 1585 2210 2743 3199 3589 3922 4207 4451 4659 4836 4988 5118 5229 5324

8% 0926 1783 2577 3312 3993 4623 5206 5747 6247 6710 7139 7536 7904 8244 8559 18% 0847 1566 2174 2690 3127 3498 3812 4078 4303 4494 4656 4793 4910 5008 5092

9% 0917 1759 2531 3240 3890 4486 5033 5535 5995 6418 6805 7161 7487 7786 8061 19% 0840 1547 2140 2639 3058 3410 3706 3954 4163 4339 4486 4611 4715 4802 4876

10% 0909 1736 2487 3170 3791 4355 4868 5335 5759 6145 6495 6814 7103 7367 7606 20% 0833 1528 2106 2589 2991 3326 3605 3837 4031 4192 4327 4439 4533 4611 4675 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

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Standard normal distribution table 000 00000 00398 00793 01179 01554 01915 02257 02580 02881 03159 03413 03643 03849 04032 04192 04332 04452 04554 04641 04713 04772 04821 04861 04893 04918 04938 04953 04965 04974 04981 04987 001 00040 00438 00832 01217 01591 01950 02291 02611 02910 03186 03438 03665 03869 04049 04207 04345 04463 04564 04649 04719 04778 04826 04864 04896 04920 04940 04955 04966 04975 04982 04987 002 00080 00478 00871 01255 01628 01985 02324 02642 02939 03212 03461 03686 03888 04066 04222 04357 04474 04573 04656 04726 04783 04830 04868 04898 04922 04941 04956 04967 04976 04982 04987 003 00120 00517 00910 01293 01664 02019 02357 02673 02967 03238 03485 03708 03907 04082 04236 04370 04484 04582 04664 04732 04788 04834 04871 04901 04925 04943 04957 04968 04977 04983 04988 004 00160 00557 00948 01331 01700 02054 02389 02704 02995 03264 03508 03729 03925 04099 04251 04382 04495 04591 04671 04738 04793 04838 04875 04904 04927 04945 04959 04969 04977 04984 04988 005 00199 00596 00987 01368 01736 02088 02422 02734 03023 03289 03531 03749 03944 04115 04265 04394 04505 04599 04678 04744 04798 04842 04878 04906 04929 04946 04960 04970 04978 04984 04989 006 00239 00636 01026 01406 01772 02123 02454 02764 03051 03315 03554 03770 03962 04131 04279 04406 04515 04608 04686 04750 04803 04846 04881 04909 04931 04948 04961 04971 04979 04985 04989 007 00279 00675 01064 01443 01808 02157 02486 02794 03078 03340 03577 03790 03980 04147 04292 04418 04525 04616 04693 04756 04808 04850 04884 04911 04932 04949 04962 04972 04979 04985 04989 008 00319 00714 01103 01480 01844 02190 02517 02823 03106 03365 03599 03810 03997 04162 04306 04429 04535 04625 04699 04761 04812 04854 04887 04913 04934 04951 04963 04973 04980 04986 04990 009 00359 00753 01141 01517 01879 02224 02549 02852 03133 03389 03621 03830 04015 04177 04319 04441 04545 04633 04706 04767 04817 04857 04890 04916 04936 04952 04964 04974 04981 04986 04990

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the Black-Scholes model of option pricing. If di > 0, add 05 to the relevant number above. If di < 0, subtract the relevant number above from 05.

End of Question Paper

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