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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 26 PAVLON

(i)Pavlon plc has recently obtained a listing on the Stock Exchange. 90% of the company’s shares were previously owned by members of one family but since the listing approximately 60% of the issued shares have been owned by other investors. Pavlon’s earnings and dividends for the five years prior to the listing are detailed below.

The number of issued ordinary shares was increased by 25% three years prior to the listing and by 50% at the time of the listing. The company’s authorised capital is currently £25 million in 25p ordinary shares, of which 40 million shares have been issued. The market value of the company’s equity is £78 million cum-dividend.

The board of directors is discussing future dividend policy. An interim dividend of 3.16 pence per share was paid immediately after the listing and a final dividend of 2.34 pence per share has just been declared.

The company’s stated objective is to maximise shareholder wealth.

Required:

(a)Comment upon the nature of the company’s dividend policy prior to the listing and discuss whether such a policy is likely to be suitable for a company listed on the Stock Exchange.

(b)Discuss whether the proposed final dividend of 2.34 pence is likely to be an appropriate dividend if the majority of the shares

(1)are owned by wealthy private individuals

(2)are owned by institutional investors.

(12 marks)

(ii)The company’s profit after tax is generally expected to increase by 15% per year for three years, and 8% per year after that. Pavlon’s cost of equity capital is estimated to be 12% per year. Dividends may be assumed to grow at the same rate as profits.

Required:

(a)Using the dividend valuation model, give calculations to indicate whether shares of Pavlon plc are currently undervalued or overvalued.

(b)Briefly outline the weaknesses of the dividend valuation model.

(8 marks)

(20 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 27 UNIGLOW PLC

(a)Briefly discuss the meaning and importance of the terms “delta”, “theta”, and “vega”

(b)Assume that your company has invested in 100,000 shares of Uniglow plc, a manufacturer of light bulbs. You are concerned about the recent volatility in Uniglow’s share price due to the unpredictable weather in the United Kingdom. You wish to protect your company’s investment from a possible fall in Uniglow’s share price until winter in three months’ time, but do not wish to sell the shares at present. No dividends are due to be paid by Uniglow during the next three months.

Market data:

Uniglow’s current share price: 200 pence Call option exercise price: 220 pence Time to expiry: 3 months

Interest rates (annual): 6%

Volatility of Uniglow’s shares 50% (standard deviation per year)

Assume that option contracts are for the purchase or sale of units of 1,000 shares.

Required:

(i)Devise a delta hedge that is expected to protect the investment against changes in the share price until winter. Delta may be estimated using N(d1). (8 marks)

(ii)Comment upon whether or not such a hedge is likely to be totally successful.

(2 marks)

(15 marks)

Question 28 THREE SMALL COMPANIES

The managers of three small UK companies are discussing their strategies towards foreign exchange risk.

Company one exports to several countries in Europe, Africa and the Americas. Company two exports to and imports from Europe. Company three is not engaged in any form of foreign trade. All three companies believe themselves to be risk averse.

All three have decided that there is no need to take any action due to foreign exchange risk. Their reasons for no action are:

Company one: Foreign exchange markets are efficient, and on balance my company is as likely to gain from foreign exchange movements as to lose from them. There is, therefore, no point in paying for hedging foreign exchange risk as overall the company will not gain by using such hedges.

Company two: My company only trades with Europe and the existence of the European Single Currency prevents foreign exchange losses.

Company three: As my company is not engaged in any form of foreign trade, foreign exchange rates are irrelevant to me.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

On the basis of this information the managing director proposes that activity is concentrated in countries 1 and 4, and operations are reduced in countries 2 and 3.

A non-executive director believes that the meeting should not be focusing on such long-term strategic dimensions, as he has just read the report of the finance director who has forecast a foreign exchange loss on net exposed assets on consolidation of £15 million for the current financial year. The non-executive director is concerned with the detrimental impact he expects this loss to have on the company’s share price. He further suggests a number of possible hedging strategies to be undertaken by Forun’s foreign subsidiaries in order to reduce the exposure and the consolidated loss. These include:

(i)early collection of foreign currency receivables;

(ii)early repayment of foreign currency loans;

(iii)reducing inventory levels in foreign countries.

Required:

Discuss whether or not you agree with the managing director’s proposed strategy with respect to countries 1 to 4. (8 marks)

Give advice as to the benefit of the non-executive director’s suggested hedging strategies.

(10 marks)

(b)Forun has a number of intra-group transactions with Its four foreign subsidiaries in six months time, and several large international trade deals with third parties. These are summarised below. Intra-group transactions are denominated in US dollars. All third party international trade is denominated in the currency shown.

Intra-group transactions

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Question 31 STORACE PLC

Storace plc (UK based) has recently finalised a contract with a US company, Jacquin Inc, for the supply of a machine. The selling price is £100,000. As this is the first export sale made by Storace plc, the currency settlement details were not discussed at the meeting when the sale of the machine was agreed. The management of Storace plc believes that Jacquin Inc will agree to whatever currency settlement is suggested, since Jacquin Inc is very anxious that the machine contract be finalised quickly. Delivery of the machine will take place in three months’ time when the amount will be settled immediately by Jacquin Inc.

The management of Storace plc is considering three possible methods of invoicing Jacquin Inc for the machine.

(i)Prepare the invoice in sterling (i.e. £100,000) and request payment in sterling on the settlement date.

(ii)Convert the sterling price at the current sterling/dollar spot rate and invoice Jacquin Inc in dollars. Buy sterling at the spot rate in three months’ time when the dollar settlement is made by Jacquin Inc.

(iii)Invoice Jacquin Inc in dollars, converting the sterling price at the spot rate (as in (ii)). Storace plc will then immediately cover the position in the forward exchange market, by selling the dollars receivable forward at the three month forward exchange rate.

The current spot rate between sterling and dollars in London is £1 = $1.11. The premium for the dollar for three month forward exchange contracts is quoted as 1.20–1.15 cents. The management of Storace plc believes that the sterling/dollar spot rate will be somewhere in the range of £1 = $1.20 to £1 = $1.09 in three months’ time.

Required:

(a)Calculate the amount of sterling to be received by Storace plc under each of the three

(b)Prepare a report to the management of Storace plc which sets out the advantages and

disadvantages of each method, and which contains your recommendation as to choice of method. (8 marks)

(c)Outline the implications for corporate financial management of undertaking a major

Ignore taxation.

(16 marks)

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 32 MANLING

(a)Explain and illustrate what is meant by disintermediation and securitisation. How can

(b)Manling plc has £14 million of fixed rate loans at an interest rate of 12% per year which are due to mature in one year. The company’s treasurer believes that interest rates are going to fall, but does not wish to redeem the loans because large penalties exist for early redemption. Manling’s bank has offered to arrange an interest rate swap for one year with a company that

has obtained floating rate finance at London Interbank Offered Rate (LIBOR) plus 11/8%. The bank will charge each of the companies an arrangement fee of £20,000 and the proposed

terms of the swap are that Manling will pay LIBOR plus 11/2% to the other company and receive from the company 115/8%.

Corporate tax is at 35% per year and the arrangement fee is a tax allowable expense. Manling could issue floating rate debt at LIBOR plus 2% and the other company could issue fixed rate debt at 113/4%. Assume that any tax relief is immediately available.

Required:

(i)Evaluate whether Manling plc would benefit from the interest rate swap:

(1)if LIBOR remains at 10% for the whole year;

(ii)if LIBOR remains at 10% evaluate whether both companies could benefit from the interest rate swap if the terms of the swap were altered. Any benefit would

(c)Manling expects to have £1 million surplus funds for three months prior to making a tax

(25 marks)

Question 33 OMNIOWN

(a)It is now 31 December 19X1 and the corporate treasurer of Omniown plc is concerned about the volatility of interest rates. His company needs in three months’ time to borrow £5 million for a six month period. Current interest rates are 14% per year for the type of loan Omniown would use, and the treasurer does not wish to pay more than this.

He is considering using:

(i)a forward rate agreement (FRA); or

(ii)interest rate futures; or

(iii)an interest rate guarantee (short-term cap).

Required:

To explain briefly how each of these three alternatives might be useful to Omniown plc

(10 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(b)The corporate treasurer of Omniown plc expects interest rates to increase by 2% during the next three months and has decided to hedge the interest rate risk using interest rate futures.

March sterling three months futures are currently priced at 86.25. The standard contract size is £500,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year of the contract size).

Required:

Show the effect of using the futures market to hedge against interest rate movements:

(i)if interest rates increase by 2% and the futures market price also moves by 2%;

(ii)if interest rates increase by 2% and the futures market moves by 1.5%;

(iii)if interest rates fall by 1% and the future market moves by 0.75%.

In each case estimate the hedge efficiency.

Taxation, margin requirements and the time value of money are to be ignored.(10 marks)

(c)If, as an alternative to interest rate futures, the corporate treasurer had been able to purchase an interest rate guarantee (cap) at 14% for a premium of 0.2% of the size of the loan to be guaranteed, calculate whether the total cost of the loan after hedging in each of situations (b)(i) to (b)(iii) above would have been less with the futures hedge or with the guarantee. The guarantee would be effective for the entire six month period of the loan.

Taxation, margin requirements and the time value of money are to be ignored. (5 marks)

(25 marks)

Question 34 TURKEY PLC

On 1 December, Turkey plc forecast a cash deficit of up to £3m for the four month period 1 February – 31 May, and proposed to take out a loan for this amount on 1 February. The corporate treasurer is worried that in the intervening period interest rates might rise.

Both 3-month and 6-month certificates of deposit (CDs) were quoted at 8.8% (annualised rate). The company can borrow at the CD rate.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The CD rate was 11.20% for both 3- and 6-month deposits. The loan was taken out as planned.

Required:

(a)Provide a reasoned analysis of Turkey plc’s problem, and recommend a suitable hedging strategy as at 1 December, justifying the type and number of contracts chosen.

(10 marks)

(b)Evaluate the success of your strategy using 1 February data, and explain why the hedge

(18 marks)

Question 35 MURWALD

The corporate treasury team of Murwald plc are debating what strategy to adopt towards interest rate risk management. The company’s financial projections show an expected cash deficit in three months time of £12 million, which will last for a period of approximately six months. Base rate is currently 6% per year, and Murwald can borrow at 1.5% over base, or invest at 1% below base. The treasury team believe that the European Central Bank will raise Euro-area interest rates by 2%, which could lead to a similar rise in UK interest rates.

The corporate treasury team believes that interest rates are more likely to rise than to fall, and does not want interest payments during the six month period to increase by more than £10,000 from the amounts that would be paid at current interest rates. It is now 1 December.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Required:

(a)Illustrate results of futures and options hedges if by 1 March:

(i)Interest rates rise by 2%. Futures prices move by 1.8%.

(ii)Interest rates fall by 1%. Futures prices move by 0.9%.

Recommend with reason, how Murwald plc should hedge its interest rate exposure. All relevant calculations must be shown. Taxation, transactions costs and margin requirements may be ignored. State clearly any assumptions you make. (22 marks)

(b)Discuss the advantages and disadvantages of other derivative products that Murwald

(30 marks)

Question 36 GLOBAL DEBT

(a)Discuss the reasons for the existence of the “global debt problem”. Explain briefly what

is meant by financial contagion and how financial contagion might affect the global debt problem. (7 marks)

(b)Explain the main attempts that have been made to resolve the global debt problem and

(15 marks)

Question 37 BEELA ELECTRONICS

The finance department of Beela Electronics has been criticised by the company’s board of directors for not undertaking an assessment of the political risk of the company’s potential direct investments in Africa. The board has received an interim report from a consultant that provides an assessment of the factors affecting political risk in three African countries. The report assesses key variables on a scale of –10 to + 10, with –10 the worst possible score and +10 the best.

The consultant suggests that economic growth and political stability are twice as important as the other factors.

The consultant states in the report that previous clients have not invested in countries with a total weighted score of less than 30 out of a maximum possible 100 (with economic growth and political stability double weighted). The consultant therefore recommends that no investment in Africa should be undertaken.

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