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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 50 BIOPLASM PLC

Using the Black-Scholes model for European options:

Ps is estimated to be either 350e(-0.067)(15) or 500e(-0.067)(15) = 128·11 or 183·02

The exercise price, X = 400

The interest rate, r = 0·05

Time, T = 15

Volatility, σ = 0·430

Using call price = Ps N(d1) – X e –rT N(d2).

If Ps is 128·11

d1 = ln (128·11/400)+0·05(15) + 0·5 (0·43) (15)5 0·43(15)5

or –0·233 + 0·833 = 0·600

d2 = d1 – σ (T)0·5 = 0·600 – 1·665 = –1·065

From normal distribution tables:

N(d1) = 0·5 + 0·226 = 0·726

N(d2) = 0·5 – 0·357 = 0·143

Inputting data into call price = Ps N(d1) – X e –rT N(d2)

Call price = 128·11 (0·726) – 400 e(0·143)(0·05)(15)

= 93·01 – 27·02 = £65·99 million

If Ps is 183·02

d1 = ln (183·02/400)+0·05(15) + 0·5 (0·43) (15)5 0·43(15)5

or –0·019 + 0·833 = 0·814

d2 = d1 – σ (T)0·5 = 0·814 – 1·665 = –0.851

From normal distribution tables:

N(d1) = 0·5 + 0·292 = 0·792

N(d2) = 0·5 – 0·303 = 0·197

Inputting data into call price = Ps N(d1) – X e–rT N(d2)

Call price = 183·02 (0·792) – 400 e(0·197)(0·05)(15)

= 144·95 – 37·22 = £107·73 million

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Under both scenarios the call option has a value in excess of the static NPV estimates. With a £350 million present value from sales the expected NPV is (£50 million), but the value of the call option is £66 million. With a £500 million present value from sales the expected NPV is £100 million, whilst the call option value is £108 million. If the data are correct then the option pricing model would suggest that the company should develop the patent no matter which present value occurs.

However, valuing a long-term option such as this is subject to restrictive assumptions and will be subject to a considerable margin of error. Possible problems include:

The accuracy of the present value forecasts, and the use of the correct discount rate to assess their risk.

The accuracy of the estimated development cost of the drug for commercial use. This estimate could be subject to substantial error as it relates to a new product and probably to new technology.

Accuracy of the estimated variance. As this is a new drug the variance of returns from other Biotech companies might not be relevant, and the Black-Scholes model is quite sensitive to this variable. The model also assumes that this volatility will be constant for the 15 year period which is very unlikely.

The Black-Scholes model was developed for European options. As development of the drug could take place at any time during the 15 year period the option is an American option rather than a European option.

What will happen after 15 years? Although competition will probably eliminate most abnormal returns the company is likely to have built up a strong brand image and could still generate positive NPVs after this time which have not been included in the above calculations.

How likely is it that a competitor might develop a superior drug? If this occurs the projections will be very adversely affected.

Because of the potential margin of error, Bioplasm should be cautious about accepting the values produced by the option pricing model, although they might be used as part of the overall decision process. This should also include the NPV estimates and strategic considerations. The company would also be advised to investigate possible cash flows after the patent period has expired.

Answer 51 FOLTER PLC

(a)

Folter can protect against possible falls in the share price by buying put options in Magterdoor’s shares. Ideally a put option would be purchased at the money i.e. at the current market price of the shares. This opportunity is not available. If an in the money price of 550 pence is selected, the outcome with a market price at the end of October of 485 pence would be:

550 (exercise price) – 51 (option premium) = 499 pence × 2 million shares = £9·98m.

If the exercise price of 500 pence is used the outcome would be: 500 – 24·5 = 475·5 × 2m = £9·51m

If no hedge were undertaken the shares would be worth £9·70m.

The success of the hedge would depend upon the exercise price selected.

However, if the price at the end of October was not 485, but was in excess of the relevant exercise price of the option, then the option would be allowed to lapse.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)

The purpose of a delta neutral hedge is to set up a risk-free portfolio. Any adverse movement in a share price would be offset by a similar favourable movement in the option price. A delta of 0·47 means that for every share held 1/0·47 call options would need to be sold to establish the delta neutral hedge.

Delta hedges are only valid for small movements in the share price. As the share price changes, so will the relevant delta, and the hedge would need to be frequently rebalanced in order to maintain the delta neutral position.

(c)

The intrinsic value of the January 550 call option is zero, as the exercise price exceeds the current market price. The option premium of 34 pence is the time value of the option. The time value depends upon the remaining time to the expiration of the option, the volatility of the option and the level of interest rates. As these variables increase, so will the time value of the option.

(d)

Apart from the obvious cost and risk associated with increasing the holding, an increase to six percent means that Folter would have to publicly declare its holding in Magterdoor, which might reveal that a take-over is being considered. Under the City Code on Take-overs and Mergers any holding over 3% must be disclosed to the target company.

The main advantage of increasing the percentage holding is that it makes achieving the ownership of more than 50% of the shares easier. It might be argued that if Folter has to reveal its holding to Magterdoor, a larger holding than 6% should be considered.

Answer 52 NETRA PLC

Tutorial note: To answer the question the cost of equity must be estimated. CAPM is considered to be a reasonably accurate theory but no data is provided to allow its use here. This leaves the dividend valuation model (DVM) but no dividend information is provided. Therefore the only way to produce an answer is to assume a dividend policy. The model answer below assumes the company distributes all post-tax profits as dividend. Different assumptions will produce completely different answers. In the exam you must be prepared to make bold assumptions in order to answer questions, make sure you clearly write all assumptions.

(a)Cost of capital

Assuming that all earnings are paid out as dividends, the current cost of equity (and overall cost of capital) is:

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(The market value of equity is two million shares × 420 pence per share = £8.4 million)

Miller and Modigliani state that if equity is replaced by debt the total value of the company will increase. This is because interest on debt is tax allowable, the company pays less tax which benefits shareholders who therefore value the company more highly. Mathematically:

Value geared = Value ungeared + Dt (Amount of debt × tax rate)

With £2 million debt, V geared = 8,400 + 660 = 9,060

V equity = V overall – V debt, 9,060 – 2,000 = 7,060

With £4 million debt, V geared = 8,400 + 1,320 = 9,720

V equity = V overall – V debt, 9,720 – 4,000 = 5,720

The higher the level of gearing the lower the cost of capital becomes, due to the benefit from tax relief on interest payments.

(b)Accuracy of estimates

As debt is introduced into the capital structure it is likely that the cost of capital will initially fall. However, the estimates produced in (a) may not be accurate because:

They rely on the assumptions of the Miller and Modigliani model, many of which are unrealistic. The assumptions are that the capital market is perfectly efficient, debt is risk free, information is costless and readily available, there are no transactions costs, investors are rational and make the same forecasts about the performance of companies, and investors and companies can borrow at the risk free rate.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Only corporate taxation is considered and not the impact of other forms of taxation including personal taxation.

MM assumed that debt is permanent. Netra’s debt has a five year time horizon.

The estimates ignore possible costs that might be incurred as gearing increases, which would reduce share price and increase the cost of equity (and possibly debt). These include bankruptcy costs, agency costs, and tax exhaustion.

Inaccuracies exist in the measurement of the data required for the model.

Answer 53 MERCHANT BANK

(a)Alpha values

The alpha value is any abnormal return that exists relative to the required return from an investment, as estimated by using the capital asset pricing model (CAPM). The beta of the companies’ shares may be estimated from:

The beta estimates are:

A positive alpha value implies that it is possible to make higher than normal return, for the systematic risk taken. A negative alpha implies a lower than normal return.

A financial manager wishing to invest in shares might favour those with a positive alpha, subject to the shares satisfying other selection criteria such as the desired level of risk.

If a positive or negative alpha exists for the shares of the company of the financial manager, and the market is at least semi-strong form efficient, the alpha would be expected to move to zero as the company’s share price changes due to arbitrage profit taking. For example in theory a company with a positive alpha would expect relatively high demand for its shares, increasing share price and thereby decreasing return until the alpha is zero.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(b)Existence of alpha values

Positive or negative alpha values exist for shares most of the time. If CAPM is a realistic model alpha values should only be temporary and the same alpha values would not be expected to exist in a year’s time. Alphas may exist due to inaccuracies and/or limitations of the CAPM model including:

CAPM tends to overstate the required return of high beta securities and to understate the required return of low beta securities. The returns of small companies, returns on certain days of the week or months of the year are observed to differ from those expected from CAPM.

Data input into the model may be inaccurate. For example it is impossible to accurately calculate the market risk and return.

Other factors in addition to systematic risk might influence required return. The arbitrage pricing theory (APT) suggests that a multi-factor model is necessary.

CAPM is based upon a number of unrealistic assumptions.

Answer 54 PHANTOM PLC

(a)Portfolio risk and return estimates

Mangeit and Altalk

Rp = (0. 5)11 + (0. 5)14 = 12.5%

The combination of Mangeit and Legi has a lower return but higher risk than Mangeit and Altalk and is therefore an inefficient portfolio. From the data provided it is not possible to ascertain which of Mangeit and Altalk or Altalk and Legi is more efficient. The portfolio of Mangeit and Altalk has a lower risk and a lower return than the portfolio of Altalk and Legi, but it is not clear whether or not this lower risk and return is more efficient than the higher risk and higher return of Altalk and Legi.

(b)Purchasing strategy

Phantom plc’s strategy should not be to purchase the most efficient portfolio of two shares. If the shares are intended as the first stage of a possible acquisition, Phantom should establish which of the three companies it would be best to purchase in order to fulfil its strategic plans, and shares in that company or those companies should be purchased. The investment decision should not be based upon the normal criteria for financial investment in shares.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Even if the investment was seeking only financial returns, a decision based upon the risk/return characteristics of two asset portfolios is not recommended. If portfolio theory is to be used, which might be the case if Phantom is not a well diversified company the portfolio relationships between all of Phantom’s investments and activities should be considered, not just these possible new investments. If Phantom is well diversified, the decision should be based upon the expected return related to the systematic risk of the investments, not the total risk as measured by portfolio theory.

Answer 55 KULPAR

(a)

The company’s existing gearing is £458 million equity to £305 million debt, or 60% equity, 40% debt.

A change in gearing will result in a change in the equity beta. Assuming the beta of debt is zero, the equity beta with no gearing may be estimated by:

If gearing was 80% equity, 20% debt by market values, the “ungeared” beta may be “regeared” to find the new equity beta:

Using CAPM, ke = Rf + (Rm – Rf) beta or 5·5% + (14% – 5·5%) 1·122 = 15·04%

If gearing was 40% equity, 60% debt by market values, this may be “regeared” to find the new equity beta:

Using CAPM, ke = Rf + (Rm – Rf) beta or 5·5% + (14% – 5·5%) 1·957 = 22·13%

The cost of debt depends on interest cover and the credit rating.

The interest payable is found by examining different interest rate and interest cover possibilities.

80% equity 20% debt must fall into the AA rating (if the interest rate was 9%, interest would be £13·73 million and cover 6·55, still AA cover)

40% equity, 60% debt must fall into the BB rating (interest of 9% would be £41·20 million, and cover 2·18 still in the BB rating).

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Weighted average cost of capital at 80% equity, 20% debt

WACC = 15·04% × 0·80 + 8·0% (1 – 0·3) 0·20 = 13·15%

Weighted average cost of capital at 40% equity, 60% debt

WACC = 22·13% × 0·40 + 11·0% (1 – 0·3) 0·60 = 13·47%

The existing cost of equity is: 5·5% + (14% – 5·5%) 1·4 = 17·4%

The existing WACC is 17·4% × 0·60 + 9% (1 – 0·3) 0·40 = 12·96%

The two alternative capital structures are expected to increase the cost of capital from its current level.

Corporate value:

Using the suggested equation, company cash flow = 90 (1 – 0·3) + 20 – 20 = 63

The growth rate is unknown. However, existing corporate value, company cash flow and weighted average cost of capital are known, allowing the growth rate to be estimated.

Assuming this growth rate remains unchanged corporate value with different gearing levels is estimated to be:

Altering the capital structure to either of the two suggested levels is expected to reduce corporate value from its current level of £763 million. It is recommended that the capital structure is kept at its current level of 60% equity, 40% debt.

(b)

The estimates of corporate value are only approximations and may be incorrect for many reasons including:

The assumption of constant growth may be incorrect.

Corporate value in this model is sensitive to the level of capital spending which might alter considerably from period to period.

The model ignores the cash flow impact of any changes in working capital.

Corporate cash flow would be better estimated by:

(EBIT – depreciation)(1 – t) + depreciation – capital spending + or – change in working capital

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Any change in gearing would involve transactions costs as shares were repurchased or issued, and debt was issued or redeemed.

Repurchases of shares might not be possible at the current market price.

The corporate tax rate might change

Credit rating agencies use other factors in addition to interest cover when deciding a company’s rating, such as the quality of the company’s management, or the volatility of a company’s cash flows.

Operating cash flow might itself be affected by a change in debt rating.

The valuation does not take account of any additional costs that might exist at high levels of gearing such as direct and indirect bankruptcy costs.

Tax exhaustion might exist at high gearing levels whereby the company can no longer benefit from tax relief on interest paid on incremental debt issues.

Corporate debt is not risk free and does not have a beta of zero. A positive beta will alter the cost of capital estimates.

Answer 56 MALTEC PLC

(a)

Portfolio return is the weighted average of the returns of the five investments. As the investments are of equal value the return is 735 = 14·6%

Portfolio diversification offers no enhancements to return, although it does offer the opportunity for improved combinations of risk and return.

As there is believed to be no correlation between any of the investments, portfolio risk may be estimated by:

((0·2)2 82 + (0·2)2 102 + (0·2)2 72 + (0·2)2 42 + (0·2)2 162 )0·5 = (19·4)0·5 = 4·4%

(The remaining terms in the portfolio risk equation are all zero)

With a portfolio of only five investments, the benefits of diversification have reduced portfolio risk, measured by the standard deviation of expected returns, to approximately that of the lowest risk individual investment. This portfolio risk reduction is quite large because of the lack of correlation between the investments. The further away the correlation coefficient is from +1, the greater the risk reduction through diversification.

(b)

In theory, a well diversified investor will not place any extra value on companies that diversify. On the contrary, as diversification is expensive, and might move companies away from their core competence, a diversified company might have a relatively low market value. However, not all investors are well diversified, and even well diversified investors might benefit from a diversified company. A diversified company might have a less volatile cash flow pattern, be less likely to default on interest payments, have a higher credit rating and therefore lower cost of capital, leading to higher potential NPVs from investments and a higher market value.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

If the diversification is international the benefits of diversification will depend upon whether the countries where the investments take place are part of any integrated international market, or are largely segmented by government restrictions (e.g. exchange controls, tariffs, quotas). If markets are segmented international diversification might offer the opportunity to reduce both systematic and unsystematic risk. An integrated market would only offer the opportunity to reduce unsystematic risk.

Most markets are neither fully integrated nor segmented meaning that international diversification will lead to some reduction in systematic risk, which would be valued by investors.

It is to be hoped that risk reduction is not the only objective of Maltec; returns and shareholder utility are also important.

Answer 57 GADDES PLC

(a) A yield curve may be upward sloping because of:

(i)

Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward sloping.

(ii)

Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading to an upward sloping yield curve.

(iii)

Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand in the longer term segment of the yield curve leading to lower bond prices and higher yields.

12% gilt with a semi-annual coupon

Present value of an annuity for 30 periods at 3% is 1-(1·03)-30 = 19·6004 0·03

———

158·80

If interest rates increase by 1%

Zero coupon (1·07)£10015 = £36·25, a decrease of £5·48 or 13·1%

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