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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

If 70%;

[(4·03)2 (0·3)2 + (12·26)2 (0·7)2 + 2(0·3) (0·7) (31·98)]½

σp = 9·41

The potential returns increase significantly, as does risk. Unless Hasder is seeking very high returns and is prepared to take the extra risk, there is no evidence to support the view that a higher proportion should be invested in East Asia. Such a move would probably mean closing some UK operations with the resultant problems of redundancy, and would be a major strategic change from the company’s current position.

The risk and return evidence should only be part of the decision process. The data itself is likely to be subjective and inaccurate. It is impossible to know with any degree of accuracy what future returns will be, and the assignment of probabilities to different economic states is at best speculative.

Other factors that might influence the decision include:

How do the investments fit with Hasder’s strategic plans?

Has a full competitor/market analysis been undertaken?

Has the company any strategic reason for favouring Europe or East Asia?

Has political risk been considered, and its possible effects built into the cash flows?

Has foreign exchange risk been included?

Are there other investment alternatives?

What future options could arise from the investments?

What are the non-financial implications of the investments?

Is total risk the best measure of risk? Should systematic risk be used instead?

(b)The correlation coefficient may be estimated by:

Covariance

Standard deviation A×Standard deviation B

Although the returns between the UK and Europe and the UK and East Asia are both positively correlated, the degree of correlation is much higher for the UK and Europe at 0·91. This means that relatively little risk reduction will take place because of the strong relationship between the UK and Europe. This is evidenced by the portfolio standard deviation of 4·20, which is little different from the individual standard deviations.

The lower correlation coefficient of 0·65 between the UK and East Asia allows much more risk reduction from international diversification, with the standard deviation of East Asia alone (12·26) reducing to a much safer 5·91 as part of a portfolio with the UK.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(c)Using CAPM

Required return = Risk free rate + (Market return – Risk free rate) beta Europe: required return is 5% + (13% – 5%) 0·85 = 11.8%

The expected return is 12·3%. The European investment is expected to provide an abnormally good return for its systematic risk and on that basis would be recommended.

East Asia: required return is 8% + (18% – 8%) 1·32 = 21·2%

The expected return is 18·6%. The investment is not providing sufficient return for its systematic risk and would not be recommended.

However, strategic and non-financial factors should also play a major role in the decision process.

Answer 8 AVTO PLC

Report on the proposed investment in Terrania

The investment will be evaluated using both financial and non-financial criteria, including the possible political risk involved with investing in Terrania. However, international direct investment is sometimes undertaken for strategic reasons, which, at least in the short term, might outweigh financial considerations.

150,000 × 480 × 27·44 = 658·6 etc.

2Labour cost has been increased by a factor of 1·2 to reflect the use of 300 workers in order to gain use of the rent-free factory. The cost of 50 extra workers is (3,800 × 50,000)/5 or 38 million francs. The after tax costing of renting the factory would be 75 million × 0·8, or 60 million francs. Avto would select the rent free factory as the cost is lower.

330 × 50 × 27·44 = 41·16 etc.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The expected NPV is: (£6·46) million. The expected investment in Terrania if viewed alone does not appear to be financially viable. However, the closure or downsizing of UK operations should also be considered. Closure would have a net cost, after tax, of at least £4·5 million (more if the full existing market in the EU cannot be supplied from Terrania), and might have other adverse effects on the local community that have not been quantified, and on the government in terms of extra support for redundant workers and their families. Downsizing would still have some of these effects, but would also offer the opportunity of selling to a larger market that could not otherwise have been supplied from Terrania alone.

If the UK operation is downsized, the net cost, after tax, of downsizing is £4 million, and expected annual net cash flows are £4 million, less tax at 30%, £2·8 million. Increasing these by UK inflation:

The total present value of cash flows from downsizing is £5.03 million over the four-year period. Downsizing results in a much more favourable outcome than total closure. If a period of longer than four years were considered the expected present value from downsizing would be even larger.

Overall the investment in Terrania plus downsizing does not appear to be financially viable, with an expected NPV of (£1·43) million. However, one major problem with the cash flow estimates is the realisable value used for the Terranian assets in year 4. If the Terranian investment is to continue beyond four years, which is implied in the information provided, then the present value of cash flows beyond four years should be considered, not the realisable value of assets. This present value is likely to be substantially higher. For example, even ignoring growth, the value of operating cash flows (TF 179 million in year 4) for an additional ten years would be 179 × 5·019 = TF 898 million, rather than the TF 150 million estimated realisable value of assets.

(b)Wider commercial considerations

Aspects of the cash flows that would need to be investigated further before a decision was made include:

What rent would be payable for the factory after year 4?

How accurate are the forecasts of sales, costs, tax rates etc? Sensitivity analysis or simulation analysis might be used to investigate the effect of changes in key cash flows.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Will the investment lead to other opportunities (future options)? If so an attempt should be made to value such options.

The strategic importance of the investment to the company.

The political risk of Terrania. The fact that the country has had twelve changes of government in the last ten years does not necessarily mean that there is substantial political risk. Countries such as Italy have also experienced frequent changes of government. However, the degree of international indebtedness and potential lack of support from the IMF could affect the future prospects of the country. It would be useful to know the ability of Terrania to service its debt, given the problems with the banana crop and competition from neighbouring countries.

The existence of better opportunities elsewhere. For example would it be possible to produce the DVD players in neighbouring countries where labour costs are even lower?

(c)The impact of blocked remittances

Avto should investigate how likely further restrictions on remittances from Terrania are. If remittance restrictions are introduced Avto could partially mitigate their effects by investing in the Terranian money market, but the effect of the restrictions would still reduce the present value of excepted cash flows by approximately £1·83 million (see below) unless increased direct investment in Terrania was planned. Remittance restrictions might be avoided by increasing transfer prices paid by the foreign subsidiary to the parent company, or by trying to move cash out of Terrania by means of other forms of payment such as royalties, payment for patents, or management fees. It is likely that the Terranian government would try to prevent many of these measures being used.

If remittances were blocked for four years and the funds invested in the Terranian money market.

Present value of remittable funds (without additional UK tax) if no blockage exists is £12·26 million. The blockage would reduce the expected present value of cash flows by approximately £1·83 million.

Any final decision regarding investment in Terrania must also take into account other nonfinancial factors such as the nature of the country’s legal system, bureaucracy, efficiency of internal processes, cultural and religious differences, and local business practices and ethics.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Appendix:

(i)Based on purchasing power parity the expected exchange rates are:

(ii)The feasibility study is irrelevant as it is a sunk cost

(iii)Working capital is assumed to increase each year in line with inflation in Terrania, and to be released at the end of year 5.

(iv)Discount rates:

Terranian investment:

Ke = 4·5% + (11·5% – 4·5%) 1·5 = 15%

UK investment:

Ke = 4·5% + (11·5% – 4·5%) 1·1 = 12·2%

12% will be used as the discount rate for UK investments.

(v)Tax allowable depreciation (francs million)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 9 BOSTER PLC

(a)

Portfolio theory for a two asset portfolio may be used to estimate the risk and return combinations.

Portfolio return

Expected return Ammobia/Flassia (0·5) (21) + (0·5) (18) = 19·5%

Expected return Ammobia/Hracland (0·5) (21) + (0·5) (28) = 24·5%

Expected return Flassia/Hracland (0·5) (18) + (0·5) (28) = 23%

Portfolio risk:

As the investments are expected to be independent the final term of the two asset portfolio equation will be zero.

The coefficient of variation shows the amount of risk per pound of expected return

Ammobia/Flassia

19·5021·96 = 1·13

Ammobia/Hracland

24·5026·71 = 1·09

Flassia/Hracland

25·5223·00 = 1·11

(b)

The Ammobia/Hracland combination has the lowest coefficient of variation, and hence the lower risk relative to expected return. However, there is little to choose between the alternatives.

This information is of relatively little use to Boster plc and may be criticised for a number of reasons:

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The analysis only considers a sub-set of Boster’s overseas investments. Portfolio theory should examine the risk/return relationships of all the company’s investments.

Historic evidence of political instability and other political risk factors does not necessarily mean these will be repeated in the future.

The measures of political risk ignore many important variables such as economic growth, unemployment, GDP, legal and financial infrastructure, debt servicing capacity, capital flight, government type (democracy, autocracy etc.), and global risks such as terrorism and cyber attacks.

The political risk variables attempt to measure risk at the macro level. The actual risk faced by a company at the micro level may be quite different, and depend upon the commercial sector in which the company operates.

Overseas investment decisions should not be made on the basis of political risk alone. This might be an important part of the decision process, but other issues such as financial and strategic implications must also be considered.

(c)

Political risk assessment is often two stage. First a macro analysis of the country’s risks, then a micro analysis focusing upon the risks of the specific company, trying to identify where conflicts might occur between the company and host government.

Macro analysis will often involve the use of political risk measures, such as those produced by Euromoney, BERI (Business Environmental Risk Intelligence), and The Economist Intelligence Unit.

Micro analysis might involve:

Using the expertise of companies, journalists, diplomats and others who have first hand experience of the country.

Undertaking detailed fact finding visits to the countries.

Commissioning quantitative or qualitative consultancy reports on political risk specific to the company and its activities.

Answer 10 NOVOROAST

(a)Report on the proposed investment in the South American country by Novoroast plc.

Novoroast should assess the expected financial viability of the proposed investment using the net present value of expected sterling cash flows. However, international direct investment is sometimes undertaken for strategic reasons, which, at least in the short term, might outweigh financial considerations.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Any final decision must encompass all relevant non-financial factors of which little detail has been provided. Novoroast must, in particular, be satisfied that there is an acceptable level of political risk, and that there will be no problems with exchange controls and the remittance of funds. The expected period that the import tariff will continue for is important to the decision.

(b)Blocked remittances might be avoided by means of:

Increasing transfer prices paid by the foreign subsidiary to the parent company.

Lending the equivalent of the dividend to the parent company.

Making payments to the parent company in the form of royalties, payment for patents, or management fees.

Charging the subsidiary additional head office overhead

Parallel loans, whereby the subsidiary in the South American country lends cash to the subsidiary of another a company requiring funds in the South American country. In return the parent company would receive the loan of an equivalent amount of cash in the UK from the other subsidiary’s parent company.

The government of the South American country might try to prevent many of these measures being used.

(c)

Multinational companies may engage in activities which, whilst not illegal, are questionable ethically, and may have detrimental long-term effects on the company’s reputation. Ethical considerations include:

Would the investment cause pollution or other environmental damage in the South American country?

Does the investment involve experiments on animals, genetic modifications etc.?

Should the investment be undertaken if the country has a poor record on human rights?

If local officials ask for “inducements” to facilitate the investment process, should these be paid?

Would the investment in any way assist trading in drugs or arms?

Are wages to be paid in the South American country below subsistence level? Are working conditions of an acceptable standard?

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