seminar5materials / P4AFM-SQB_PDF_j08 / P4AFM-SQB-As_j08
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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)
Option (3), to cover your position in the forward market, is also riskless provided your client pays on the due date. Indeed, since the dollar is trading at a premium in the forward market, i.e. the market expects the value of the dollar to rise, it is possible for your client to make a “profit” of £1,047 by using this method of invoicing as compared with invoicing in sterling. However, if your client defaults on payment for whatever reason, you will still have to honour your contract to deliver $111,000 three months hence.
Another option is to invoice in dollars and convert the dollars at the spot rate prevailing in three months’ time. Depending on the strength of the dollar at that time, you could receive between £92,500 and £101,835. Compared with option (3) this gives a potential gain of £788 if the exchange rate moves to $1.09, and a potential loss of £8,547 if the rate moves to $1.20. These figures assume that management expectations of the future spot rate are correct.
Conclusions
Ultimately the choice must depend on the commercial considerations affecting your company. Although invoicing in sterling is the simplest solution, it is unlikely to lead to a sale. The choice is therefore between options (2) and (3). Under option (2) there is a chance that only £92,500 will be received, which could mean that a loss is made on the sale of the machine. Therefore, you will probably prefer the certain £101,047 given by a forward contract. To protect yourself against the possibility of a delay in payment by Jacquin Inc, I would suggest that you consider using an option date forward contract where delivery can take place between two dates rather than on a single date. You will receive less than £101,047 because the contract rate will be less favourable from your point of view, but the difference will not be great.
(c)Implications of a major export drive
If the company decides to engage in a major exports sales drive, there are four decisions to be made in which corporate financial management will have a major role to play.
(i)Choice of organisation
A company can sell its product in a variety of ways abroad, e.g. direct to customers or agents, via a branch or department established in that country or via a subsidiary company established in that country.
(ii)Financing branches/subsidiaries
Overseas branches/subsidiaries will require financing. Financial managers will need to consider both the cost of funds and exchange risk (e.g. whether a loan to finance a subsidiary should be taken in sterling or a foreign currency).
(iii)Protecting against exchange risk on receipts
This is the subject of part (a) of the question and can be covered by dealing in the forward markets as explained in part (b).
(iv)Assessing creditworthiness of overseas customers
A company may experience more problems in assessing the creditworthiness of overseas customers than of domestic customers. The risk of default by an overseas customer can be insured against via the Export Credits Guarantee Department. The ECGD also gives banks guarantees on cash advanced against such insurance policies, thus providing a company with the means to finance increased working capital requirements resulting from overseas sales.
1081
ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK
Answer 32 MANLING PLC
(a)Disintermediation refers to removal of intermediaries or “cutting out the middle man”. It occurs in the case of large public limited companies which wish to raise finance or to lend funds. Rather than dealing with a bank which serves the function of matching funds from depositors with loans required by companies, the companies deal directly between themselves i.e. they avoid using the bank, or other financial intermediaries.
Securitisation refers to the process of creating new financial instruments (or “paper”) which are tradable and issued to support fresh corporate debt. Bonds, floating rate notes (FRNs) and debentures are all examples of securitised paper.
Disintermediation and securitisation can help the financial manager in the following ways:
Disintermediation makes it possible to raise funds more cheaply than by borrowing from the bank – this assumes that the company has a suitable credit rating to be able to participate in borrowing from other non-financial corporates.
Certain types of bank loan have conditions attached to them e.g. provision of security. These conditions may be avoided by borrowing from others.
Securitisation offers more flexibility in terms of the type of borrowing obtained; for example, financial managers can tailor the maturity date to the exact financing needs of the company.
Securitisation raises the profile of corporate issuers, whose names are seen more prominently in the financial markets.
Securitisation makes debt easily marketable, producing finer interest rates for the borrowers and flexibility for lenders.
It avoids the queuing system which exists for some debt issues.
Alternative sources of finance and ways of investing surplus funds are made available to financial managers.
(b)(i) Evaluation of whether interest rate swap is beneficial
(1) |
Existing commitment: |
|
|
Fixed rate of |
12% |
|
|
__ |
|
Commitment after the swap: |
|
|
(A) Cost of fixed rate loan |
12% |
|
(B) Floating rate paid to the other company |
|
|
10 + 1½ |
11½% |
|
(C) Rate received from the other company |
(115/8%) |
|
|
___ |
|
Net rate incurred |
117/8% |
|
|
___ |
|
Saving in interest £14m × (12% – 117/8%) |
£ |
|
17,500 |
|
|
Arrangement fee |
(20,000) |
|
|
______ |
|
Increase in cost |
2,500 |
|
|
______ |
1082
STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)
Therefore, swap would not be beneficial, although the final cost, after tax, is mitigated to £2,500 (1 – t) = £2,500 (1 – 0.35) = £1,625
(2)Commitment after the swap:
(A) Cost of fixed rate loan |
12% |
(B)Floating rate paid to the other company
10 + 1½ |
11½% |
9 + 1½ |
|
(C) Rate received from other company |
(115/8%) |
|
______ |
11.875%
______
Saving in interest:
First six months £14m × (0.12 – 0.11875) × 6/12 Second six months £14m × (0.12 – 0.10875) × 6/12
Arrangement fee
Net benefit
12%
10½%
(115/8%)
______
10.875%
______
£
8,750
78,750
______
87,500
(20,000)
______
67,500
______
Therefore, swap is beneficial. After tax, the benefit of the swap over the year will equal £67,500 (1 – 0.35) = £43,875
(ii)Evaluation of whether both companies can benefit – given LIBOR remains at 10%
Cost to the other company |
|
|
(1) |
Cost of floating rate finance 10 + 11/8 |
111/8% |
(2) |
Fixed rate interest to Manling |
115/8% |
(3)Amount received from Manling floating rate of
10 + 1½ |
(111/2%) |
|
___ |
Net cost of fixed rate finance |
111/4% |
|
___ |
The other company would otherwise pay 11¾% for fixed rate finance, and is thus saving 11¾% – 11¼% = ½% under the swap.
Therefore, under the present swap agreement, with LIBOR = 10%, the savings being achieved are:
(1) |
Manling |
1/8% |
(2) |
Other company |
1/2% |
|
|
___ |
Total saving |
5/8% |
|
|
|
___ |
It is this saving which needs to be shared equally between the two firms.
Shared equally = 5/8 ÷ 2 = 5/16% to each company.
1083
ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK
At the moment, the other company obtains a 1/2% saving compared to the 5/16% it would obtain if savings were shared equally. It must therefore give, by way of the interest rates applied to the swap, 3/16% (1/2% – 5/16%) of additional benefit to Manling plc. This would give Manling an equal 1/8% + 3/16% = 5/16% benefit in comparison to the finance it would otherwise obtain.
Thus, the other company should either pay 5/16 more as a fixed interest charge to Manling (making that charge 115/8% + 5/16% = 1113/16%, or receive an interest rate of 5/16% less from Manling by way of floating rate charge – i.e. commit Manling to Paying LIBOR + 11/2% less 5/16% i.e. LIBOR + 15/16% (115/16% if LIBOR = 10%). In summary the overall finance costs for both companies under both options become either:
Fixed rate Floating rate Floating rate swap
Fixed rate swap (bal fig)
Overall cost
or:
12%
111/8% 111/2% (111/2%)
(1113/16%) 1113/16%
_____ _____
1111/16% 117/16%
_____ _____
Fixed rate
Floating rate
Floating rate swap
Fixed rate swap (bal fig)
Overall cost
Thus, the benefit to each company is:
14m × 5/16%
Less: Arrangement fee
Net benefit before tax
Net benefit after tax 23,750 × (1 – 0.35) = £15,437
12%
111/8% (115/8%) 115/8%
115/16% (115/16%)
_____ _____
1111/16% 117/16%
_____ _____
£
43,750
20,000
______
23,750
______
(c)The following short-term investments are available:
Short-term bank deposit in domestic or foreign currency.
Treasury Bills – issued by the government and risk-free.
Local authority debt – carrying slightly higher interest than Treasury Bills to reflect higher risk.
Certificates of deposit issued by British or foreign banks.
Bills of exchange and trade bills issued by companies.
Deposits with building societies.
Purchase of equity shares. This is likely to be undesirable because of the risk of capital loss and transaction costs.
1084
STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)
Placement in the money markets. Such placements are unsecured, but generally very low risk as borrowing counter parties will be prime organisations.
Purchase of commercial paper – i.e. promissory notes issued by prime borrowers. Such investment is highly flexible – commercial paper being easily sold when needed to realise cash.
Working capital. The company could look to see whether sales could be boosted to advantage by investing more in receivables or inventory.
The company could also consider discount availability on early settlement of creditor balances.
The factors to take into account when comparing these alternatives are yield, risk of default and marketability. The yield will normally be higher as the risk increases.
Answer 33 OMNIOWN PLC
(a)
A forward rate agreement (FRA) involves fixing the future interest rate now for the £5m. It involves an agreement tailor-made to the company’s requirement in terms of amount and dates. Once an FRA has been entered into Omniown must pay interest at the agreed rate. The rate offered will depend on the market’s current perception of future interest rates. The FRA is based on a notional principal i.e. it is independent from the underlying loan which should be arranged separately. It would protect the firm from rate increases but if the actual rate fell below the forward rate the company would not benefit from this decrease i.e. it would still have to pay the rate per the forward rate agreement.
The mechanics of an FRA are that if actual rates are in excess of the rate per the FRA, the bank will compensate the company by the amount of the excess. Similarly, if actual rates are below the agreed rate the company pays the difference to the bank.
There is no initial premium payable on an FRA. FRAs can normally be arranged for up to two years into the future.
Interest rate futures are contracts of standard amounts and for standard periods of time running from a limited number of dates. They are therefore less flexible than an FRA but are similarly binding on both parties. For Omniown protection against interest rate increases could be achieved by selling futures contracts now. As interest rates rise the value of futures contracts will fall. Hence Omniown can buy back the contracts at a lower price and make a profit. This profit should compensate the company for the increase in interest rates though this profit is unlikely to match perfectly the additional interest costs incurred. Interest rate futures involve payment of a small initial margin.
An interest rate guarantee (or cap) is an option which enables the treasurer to fix a maximum interest rate for a period in the future but if the rate falls the treasurer can choose not to use the option and take advantage of the lower rate. Because of this additional benefit – of taking advantage of lower rates – options tend to be more expensive: they involve payment of a premium in advance at the time the contract is entered into.
1085
ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK
(b)
Cost of a 2% increase in interest |
= |
5,000,000 × 1/100 × 6/12 |
||
|
|
|
= |
£50,000 |
Effect of a 1 tick move in price on one contract |
= |
500,000 × 0.0001 × 3/12 |
||
|
|
|
= |
£12.50 |
2% (i.e. 200 ticks) would cause a profit of |
= |
£2,500 per contract |
||
|
|
|
= |
£12.50 × 200 |
Therefore, need |
50000, |
= 20 contracts |
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|
|
|
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||
2500, |
|
|
|
|
(i)Extra interest
Effect on futures price:
(sell now at 86.25; buy in 3 months at 84.25) 2% = 200 ticks; this decrease in price of futures
will result in a gain of 12.50 × 200 × 20
Overall effect
100% hedge efficiency
(ii)Extra interest
Effect on futures price:
(sell now at 86.25; buy in 3 months at 84.75) Gain 1.5% = 150 ticks × 12.50 × 20
Net loss
Hedging efficiency = 5000037500,, × 100 = 75%
.
(iii)Reduction in interest 5,000,000 × 1/100 × 6/12 Effect on futures:
(sell now at 86.25; buy in 3 months at 87) Loss 0.75% = 75 ticks × 12.50 × 20
Net gain
Hedging efficiency = 1875025000,, × 100 = 133%
£
(50,000)
50,000
______
0
______
(50,000)
37,500
______
(12,500)
______
25,000
(18,750)
______
6,250
______
1086
STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)
(c)Evaluation of interest rate guarantee
(i)Cost using futures hedge
5,000,000 × 14/100 × 6/12
Cost using interest rate guarantee: Premium 5,000,000 × 0.002
Interest rates rise by 2%, therefore will use guarantee to pay 14%
Total cost
Therefore, futures hedge is cheaper.
(ii)Cost using futures hedge – per (i) above Add: Net increase
Cost using interest rate guarantee: Interest rates rise, therefore will again use guarantee to pay 14% and premium – per (i) above
Therefore, interest rate guarantee is cheaper.
£ £
350,000
10,000
350,000
_______
360,000
_______
350,000
12,500
_______
362,500
_______
360,000
_______
(iii)Cost using futures hedge Less: Net gain – per (ii) above
Net cost
Cost using interest rate guarantee: Interest rates fall, therefore will not use the guarantee. Instead take advantage of lower actual rates:
Cost: Interest 5,000,000 × (0.14 – 0.01) × 6/12 Add: Premium
Therefore, interest rate guarantee is cheaper.
350,000
6,250
_______
343,750
_______
325,000
10,000
_______
335,000
_______
1087
ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK
Answer 34 TURKEY PLC
(a)The company expects to have to borrow £3m for 4 months from 1 February and is fearful that short-term money market interest rates (CDs) might rise from their current level of 8.8%.
At the current level of interest rates, the loan interest cost (the target cost) would be: £3m × (4/12) × 0.088 = £88,000
To hedge their interest rate on the loan, the company needs to sell futures contracts as follows:
Number of contracts required: £3m/£0.5m = 6 × 4/3 = 8.
Sell 8 £ March futures at a price of 91.44.
The number of contracts used hedges Turkey’s full potential exposure to interest rate risk. If it is thought that there was a significant chance that substantially less than £3m might be required, then a judgement would have to be made by the company’s treasury department about how much risk exposure it would want to leave unhedged.
The March contracts would be the most suitable to use as they have the next expiry date after the loan would be drawn down.
The December contracts would obviously not be suitable as they would have expired before the loan was required. Although the June and September contracts could be used, it would be inadvisable to do so as they are likely to expose the company to a greater degree of basis risk.
The hedge is set up by selling futures because they represent selling interest on 3-month deposits at 100 – 91.44 = 8.56%. Thus if interest rates subsequently rise (which represents an adverse move as far as the company’s loan is concerned), the company will have profited by locking into a sale at a lower interest rate.
Finally, 8 contracts are required (rather than 6) because of the “maturity mis-match”. Threemonth interest rate futures are being used to hedge a four month loan. As a result, the number of contracts required to hedge the interest liability over four months has to be adjusted by the factor of 4/3.
(b)On 1 February, Turkey will borrow £3m at 11.2 interest:
|
|
£3m × (4/12) × 0.112 = |
£ |
Actual interest cost |
: |
112,000 |
|
Target interest cost |
: |
|
88,000 |
|
|
|
_______ |
Loss on target |
: |
|
24,000 |
|
|
|
_______ |
Company closes out its futures position by reversing the earlier deal:
Buy 8 £ March contracts at 89.34
1088
STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)
Profit on futures: |
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|
|
|
|
Bought at |
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|
|
|
89.34 |
Sold at |
|
|
|
|
91.44 |
|
|
|
|
|
_____ |
Profit |
|
|
|
|
2.1% = 210 ticks/contract |
|
|
|
|
|
_____ |
Total profit: 8 × 210 × £12.50 = |
£21,000 |
|
|||
Hedge efficiency = |
Profit |
= |
£21,000 |
|
= 87.5% |
Loss |
£24,000 |
|
|||
|
|
|
|
||
The hedging strategy has been reasonably successful. However, Turkey did not achieve a perfect (100% efficient) hedge because the futures price did not move precisely in line with interest rates:
Change in futures price |
: |
91.44 – 89.34 |
= |
2.1% |
Change in interest rates |
: |
11.2% – 8.8% |
= |
2.4% |
The 0.3% difference represents the shortfall of the futures profit over the loss on target:
£3m × (4/12) × 0.003 = £3,000 |
|
|
|
|
£ |
Loss on target |
: |
24,000 |
Profit on futures |
: |
21,000 |
|
|
______ |
Shortfall |
: |
3,000 |
|
|
______ |
Answer 35 MURWALD
(a)
The treasury team believe that interest rates are more likely to increase than to decrease, and any hedging strategy will be based upon this assumption. There is also a requirement that interest payments do not increase by more than £ 10,000 from current interest rates.
Current expectations
£ 12m deficit, interest payments £ 12m × 7.5% × 0.5 = £450,000
Futures hedges (Either March or June contracts may be used – or both.)
The suggested solution uses June contracts.
1089
ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK
(i)If interest rates rise
With an expected £12m deficit – using June contracts.
As a six months hedge is required the number of contracts will be
£12m |
|
|
|
———— |
× 2 = 48 contracts |
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|
£500,000 |
|
|
|
The tick value is £500,000 × 0.0001 × 3/12 |
= |
£12.50 |
|
Cash market |
|
Futures market |
|
Current cost £450,000
With 2% increase
£12m × 9.5% × 0.5 = £570,000
Extra cash market cost = £ 120,000
Net additional cost after hedging = £ 12,000
Dec 1 Sell three month sterling futures at 93.10
After interest rate increase Buy 48 three month sterling futures at 91.30
Futures gain 48 × 180 × £12.5 = £ 108,000
If Murwald expects basis risk to exist (i.e. the futures price moves by a different amount to the cash market interest rates), the number of contracts could be modified to reflect such risk. However, basis risk is difficult to predict.
(ii) |
If interest rates fall |
|
With an expected £ 1 2m deficit |
|
|
Cash market |
Futures market |
|
Current cost £450,000 |
Sell 48 contracts at 93.10 |
|
With 1 %decrease |
Buy 48 contracts at 94.00 |
|
£12m × 6.5% × 0.5 = £390,000 |
|
|
Cash market saving |
Futures market loss |
|
£60,000 |
|
48 × 90 >< £ 1 2.50 = £54,000 |
Overall net extra saving £6,000
Based upon these futures prices hedging in the futures market does not allow the company to guarantee that interest costs in the case of a deficit do not increase by more than £ 1 0,000.
Options hedges
The expectation is for interest rates to rise, therefore put options on futures will be purchased. (If interest rates rise the value of the put options will also increase.)
1090