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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

From year 4 onwards dividends grow at 8% and therefore the basic model may be used to obtain value t3. This must then be discounted back to t0, i.e.

8.36×1.08 × 0.712 = 160.71

0.12−0.08

According to the dividend model, shares in Pavlon should be worth 178.11p ex dividend. The current cum-dividend value is £1.95 cum dividend (£78m ÷ 40m). The ex dividend price (less the final dividend) is 192.66p. Therefore Pavlon’s shares are currently over-valued.

(b)Weaknesses of the dividend valuation model

(1)The dividend valuation model assumes that the share price is the discounted present value of future dividends. If the market uses some other model to value shares (e.g. one based on reported profits and a P/E ratio or which reflects the value of the underlying assets), the results of the model will be unreliable.

(2)The model as used here assumes constant growth in perpetuity, which is at best unrealistic.

(3)The results produced by the use of the model are only as good as the data

input. It is obviously difficult to estimate ks and topredictfuturedividend growthaccurately.

Answer 27 UNIGLOW PLC

(a)

Delta measures the change in the option price (premium) as the value of the underlying share moves by 1%.

It is measured by N(d1) in the Black-Scholes option pricing model.

As the share price falls delta falls towards zero. Delta may be used to construct a risk free hedge position, whereby overall wealth will not change with small changes in share price.

Theta measures the change in the option price as the time to expiry increases. The longer the time to expiry of an option, the greater its value. Theta may be used to estimate by how much the value of an option will fall as time to maturity reduces.

Vega measures the change in option price as a result of a 1% change in the share price volatility or variance. As volatility increases, the value of both call and put options increases.

All three are of use to treasury managers when hedging their investments. As their values approach zero the hedged position will become unaffected by changes in these variables.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b)

(i)

N(d1) is required in order to determine the delta hedge.

= – 0·19624

From normal distribution tables:

N(d1) = 0·5 – 0·0778 = 0·4222

Delta = 0·4222

In order to protect against a fall in Sunglow’s share price, the easiest hedge would be to write (sell) call options on Sunglow’s shares. A delta of 0·4222 means that the relevant hedge

ratio is 0·42221 = 2·368

To hedge 100,000 shares:

100,000×2·368 = 237 call options on Uniglow’s shares need to be written. 1,000

(ii)

A hedge such is this is only valid for a small change in the underlying share price. As the share price alters the option delta will alter and the hedge will need to be periodically rebalanced.

Answer 28 THREE SMALL COMPANIES

There is some evidence that foreign exchange markets are efficient (in the context of the efficient markets hypothesis) when foreign exchange rates are allowed to float freely. However, there are very few examples of currencies that are allowed to float freely in response to economic forces; where a floating exchange rate exists it is normally in the form of a managed float (or dirty float) where a government intervenes in the foreign exchange market to influence the price of its currency. Even if an efficient foreign exchange market exists the manager of company one would be engaging in a risky strategy. The effect of changes in the exchange rate on the company’s export transactions depends upon the strength of sterling relative to the currencies in the countries to which company one exports. It is possible that sterling could rise in value against all of these currencies simultaneously, and losses be made on the export sales due to exchange rate changes. The company might not be able to sustain such losses until more favourable exchange rate movements occur. Hedging, although it involves costs, can limit foreign exchange losses (if any) to a known amount.

Company two only trades within Europe. It might be thought that, as imports are contracted to be paid for in sterling, there is no foreign exchange risk with such transactions. Risk, however, does still exist, as is explained for company three.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The answer with respect to company two’s exports will depend upon whether or not the UK uses the Euro or continues to use £. At the time of writing the UK is choosing to remain outside “Euroland”. Alternative answers are:

(i)If the UK joins the European single currency

The company will not face exchange risk in dealing with other countries participating in the Euro. However the Euro itself of course floats against all other world currencies. Hence if the company exports outside Euroland, it will face foreign exchange risk.

(ii)If the UK does not join the Euro

The value of sterling can fluctuate against the Euro. Substantial foreign exchange gains or losses could occur on the company’s export transactions.

Although company three is not engaged in foreign trade, exchange rate changes are still likely to be relevant to the company. One form of foreign exchange risk is economic exposure, which relates to the effects of unexpected changes in exchange rate on future cash flows. Changes in exchange rates might affect the company’s competitive position. If exchange rate movements make foreign competitors’ products cheaper, company three could lose sales to such foreign competitors. Additionally, although the company is not directly engaged in foreign trade, if it purchases components from other UK companies such components might contain imported materials. If exchange rates change, this could directly affect the price company three has to pay for components, even though these are purchased from UK suppliers. There are several other ways in which exchange rate change could affect company three. Exchange rate changes are not irrelevant to this company.

Answer 29 FOURX LTD

(a)Buying and selling rates

(i)Buying French francs

French francs will be bought at 9.725 Ff/£. Ff 2,000 will cost

9.7252,000 = £205.66

(ii)Selling French francs

French francs will be sold at 9.735 Ff/£. Ff 100 will provide

9.735100 = £10.27

(b)Spot and forward rates

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(c)Forward market cover

=£15,448

(d)Money market cover

This involves

(i)investing the amount of foreign currency that will accumulate to the required sum to be paid at the required date

(ii)buying that amount of foreign currency in (i) in the spot market, and

(iii)borrowing sufficient sterling to buy the foreign currency in (ii).

Invest Ff1.025150,000 = Ff 146,341

Buy Ff 146,341 in the spot market for

146,3419.725 = £15,048

Borrow £15,048 and repay in three months’ time

£15,048 × 1.0275 = £15,462

The cost using money market cover (£15,462) is very similar to that using forward market cover (£15,448).

Answer 30 FORUN (a)(i)

The economic data presented by the managing director gives some indication of the likely future economic strength of the four countries, and could form part of a strategic evaluation.

According to the purchasing power parity theory all of the foreign currencies are expected to depreciate in value relative to the pound sterling with the smallest depreciation in countries 1 and 4, Although PPP may hold quite well in the long run, there may be significant deviations from PPP in the short run. The impact of the other variables may be summarised in many ways. The table below is a simple assessment with a + for the two best countries, and a – for the two worst.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Country 1 scores highly, except for inflation, economic growth and interest rates country 4 scores poorly, and is heavily indebted to the IMF relative to its small population size. Other data such as per capita GNP and international indebtedness other than to the IMF would be useful to the analysis. The managing director’s major concern is economic exposure, the impact of foreign exchange rate changes on the sterling expected NPV of overseas operations.

Strategic decisions should not be made on the basis of the above information alone.

The information provides a macro-economic analysis. Even with a relatively weak economy at the micro level a subsidiary within a particular industry may perform well. Examining macro-economic data fails to give a complete picture.

Additionally it is possible that a depreciation in the value of a foreign currency might have a beneficial effect rather than a detrimental effect on economic exposure of Forun. If the price elasticity of demand is such that export sales from the foreign subsidiary increase substantially because of the relatively cheaper prices in a depreciated currency, the overall effect in sterling NPV terms might be an increase, not a decrease. If the managing director is concerned about economic exposure one way to reduce such exposure is by diversifying international operations, and financing, among many different countries. Concentrating activities in two foreign countries might lead to greater economic exposure risk, not less. The manager’s strategy to concentrate on countries 1 and 4 is based upon incomplete information and is not recommended.

(ii)

The non-executive director is concerned about the effects of translation exposure, specifically on expected foreign exchange loss of £ 1 5 million.

If a foreign currency is expected to depreciate relative to sterling, translation exposure may be reduced by reducing net exposed assets.

Early collection by foreign subsidiaries of foreign currency receivables will not reduce net exposure (unless the foreign currency is expected to depreciate by more than the currency of the foreign subsidiary). A better tactic would be to delay collection of foreign currency receivables until after significant depreciation of the subsidiary’s currency had occurred, the receivables will then yield a higher amount of the subsidiary’s currency. From a group viewpoint early collection could increase translation exposure rather than reduce it.

Early repayment of foreign currency loans could be beneficial, if the loans are in relatively hard currencies, and if the subsidiary has the funds available to make such a repayment without detrimental effects on its operations.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Reducing inventory levels in foreign countries will reduce net asset exposure. However, before this, or any other balance sheet hedging techniques are used, the effect on the efficient operation of the company must be considered. There is little point in reducing inventory levels if this causes production bottlenecks or failure to satisfy customer demand, and potentially a loss of orders.

The non-executive director is concerned about a loss on translation of £15 million. Translation losses are not realised economic losses. Part of such a loss may be from translating the historic cost of overseas fixed assets; in reality the sterling economic value of such assets may be little changed if inflation in the foreign country increases the market value of such assets. Hedging against translation losses might result in reducing rather than increasing sterling NPV as such hedges may be opposite in direction to hedges that would be undertaken to protect against transaction exposure.

Will the reported £15 million loss have an adverse effect on Forun’s share price? If the stock exchange is efficient the company’s share price will react to relevant changes in the company’s expected cash flows, not reported translation losses. The reported loss could have little or no effect on share price. Hedging is normally undertaken to protect against the risk of transaction exposure, not translation exposure.

(b)(i)

Multilateral netting is an effective means of reducing the transactions costs associated with foreign exchange transactions that are payable to banks. The netting of Forun’s intracompany US dollar exposures gives the following net payments and receipts.

Some dollar payments will still need to be made from the UK, country 3 and country 4 to countries 1 and 2. However, such payments will total a maximum of $600,000 against the total trade value of $6,620,000, saving transactions and other costs on more than $6,000,000.

(ii)

As Forun is risk averse with respect to short-term foreign exchange risk, the company is recommended to hedge against any transaction exposure risk. In order to reduce foreign exchange transaction risk, hedging should take place after establishing the net exposure position in all currencies. The net group dollar exposure on the intra-company trade is of course zero, as dollar receipts equal dollar payments. Hedging will be undertaken on the net transaction exposure of third party trade.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(The value of a tick is 0.0001 × £62,500 expressed in $ or $6.25.)

The total expected receipts using futures is:

DM payments – DM are required, therefore sell £ contracts using December contracts:

This requires 84.97 or 85 contracts.

Sell 85 sterling December at 2.4480.

If the spot in six months is 2.383 DM/£ and assuming the futures price moves by the same amount as the spot price, in six months buy 85 sterling December contracts at 2.3 75.

Total expected cost using futures is:

DM13,000,000m = £5,293,160 + £162,149 – £162,469 = £5,292,840

2.4560

This is significantly less than the cost of forward cover calculated above, but ignores basis risk and the need to provide a margin deposit for futures transactions. Any differences in the tax treatments of the two alternatives are also ignored.

Currency options

$/£ options are available. Forun has a $12m receivable in six months time and wishes to protect against exchange risk. However, options, whilst protecting against downside risk, also allow companies to benefit from favourable exchange rate movements. Forun is likely to select December options as these cover the entire period of the currency exposure.

Call options are required as sterling is to be purchased with US dollars.

The exercise price selected will depend upon how much currency risk protection Forun requires. A $1.50/£ exercise price will protect the current spot rate ($1.499/£) at a relatively low premium cost. Both this and the $1.525/£ exercise price are out-of-money options offering relatively low cost protection. To provide better protection than from a forward contract at $1.46/£, an exercise price of $1.45/£ is necessary, with a much higher premium cost.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Premium cost £8,281,250 × 5.75 cents – $476,172 or £318,297 (at spot of $1.4960/£)

At 1.50 exercise price $1.5012m = £31,250£8m = 256 contracts

Premium cost = £8m × 1.95 cents = $156,000 or £104,278

The choice of hedging strategy for dollars will depend upon expectations of future exchange rates, always bearing in mind the objective of protecting against exchange risk.

The outcome of the following spot exchange rates would be:

Note: The 1.45 and 1.475 option contracts involve slightly more than the $12 million receipts, being $12,007,813 and $12,030,469 respectively. If the options are exercised Forun would have to purchase the extra dollars at spot to fulfil the full contract size, and would experience a foreign exchange loss or gain on the amounts purchased.

Unless the company expects the dollar to strengthen to around $1.40/£ in six months time, forward contracts are the recommended dollar hedge.

Answer 31 STORACE PLC

(a)Sterling receipts

(i)Price in sterling = £100,000

= 111,000

Exchange rate in three months’ time (spot rate)

= 1.20 – 1.09

Therefore, £ received is between £92,500 and £101,835

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