seminar5materials / P4AFM-RQB_PDF_d08 / P4AFM-RQB-Qs_d08

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

(i)The parent company is proposing that inter-company payments should be settled in sterling via multilateral netting. Demonstrate how this policy would reduce the number of transactions.

(ii)If payments were to continue to be made in various currencies, illustrate three methods by which the UK parent company might hedge its transaction exposures for the next three months. Discuss, showing relevant calculations, which method should be selected. Include in your discussion an evaluation of the circumstances in which currency options would be the preferred choice.

(Note: NTC plc wishes to minimise the transaction costs of hedging.) (15 marks)

(c)NTC plc has been approached by a Russian company that wishes to purchase goods from NTC plc in exchange for wheat. The Russian currency is not freely convertible.

Discuss the potential advantages and disadvantages of such counter trade to NTC plc.

(6 marks)

(35 marks)

Question 17 POLYTOT PLC

Assume that it is now 1 July. Polytot plc has received an export order valued at 675 million pesos from a company in Grobbia, a country that has recently been accepted into the World Trade Organisation, but which does not yet have a freely convertible currency.

The Grobbian company only has access to sufficient $US to pay for 60% of the goods, at the official $US exchange rate. The balance would be payable in the local currency, the Grobbian peso, for which there is no official foreign exchange market. Polytot is due to receive payment in four months’ time and has been informed that an unofficial market in Grobbian pesos exists in which the peso can be converted into pounds. The exchange rate in this market is 15% worse for Polytot than the “official” rate of exchange between the peso and the pound.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Philadelphia SE £/$ options £31,250 (cents per pound)

Assume that options and futures contracts mature at the relevant month end.

Required:

(a)Discuss the alternative forms of currency hedge that are available to Polytot plc and calculate the expected revenues, in £ sterling, from the sale to the company in Grobbia

as a result of each of these hedges. Provide a reasoned recommendation as to which hedge should be selected. (17 marks)

(b)The Grobbian company is willing to undertake a counter-trade deal whereby 40% of the cost of the goods is paid for by an exchange of three million kilos of Grobbian strawberries. A major UK supermarket chain has indicated that it would be willing to pay between 50 and 60 pence per kilo for the strawberries.

Discuss the issues that Polytot should consider before deciding whether or not to agree to the counter-trade. (6 marks)

(c)The Grobbian company has asked for advice in using the Euromarkets to raise international finance.

Required:

Provide a briefing memo for the company discussing the advantages of the Euromarkets, and any potential problems for the Grobbian company in using them.

(7 marks)

(30 marks)

Question 18 GALEPLUS PLC

(a)From the perspective of a corporate financial manager, discuss the advantages and

(b)Galeplus plc has been invited to purchase and operate a new telecommunications centre in the republic of Perdia. The purchase price is 2,000 million rubbits. The Perdian government has built the centre in order to improve the country’s infrastructure, but has currently not got enough funds to pay money owed to the local constructors. Galeplus would purchase the centre for a period of three years, after which it would be sold back to the Perdian government for an agreed price of 4,000 million rubbits. Galeplus would supply three years of technical expertise and training for local staff, for an annual fee of 40 million rubbits, after Perdian taxation. Other after tax net cash flows from the investment in Perdia are expected to be negligible during the three year period.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Perdia has only recently become a democracy, and in the last five years has experienced inflation rates of between 25% and 500%. The managers of Galeplus are concerned about the foreign exchange risk of the investment. Perdia has recently adopted economic stability measures suggested by the IMF, and inflation during the next three years is expected to be between 15% per year and 50% per year. Galeplus’s bankers have suggested using a currency swap for the purchase price of the factory, with a swap of principal immediately and in three years’ time, both swaps at today’s spot rate. The bank would charge a fee of 0·75% per year (in sterling) for arranging the swap. Galeplus would take 75% of any net arbitrage benefit from the swap, after deducting bank fees. Relevant borrowing rates are:

N.B. PIBOR is the Perdian interbank offered rate, which has tended to be set at approximately the current inflation level. Inflation in the UK is expected to be negligible.

Required:

(i)Estimate the potential annual percentage interest saving that Galeplus might make from using a currency swap relative to borrowing directly in Perdia.

(6 marks)

(ii)Assuming the swap takes place as described, provide a reasoned analysis,

including relevant calculations, as to whether or not Galeplus should purchase the communications centre. The relevant risk adjusted discount rate may be assumed to be 15% per year. (8 marks)

(c)As alternatives to the currency swap the bank has suggested:

(i)A swaption with the same terms as the currency swap, and an upfront premium of £300,000.

(ii)A European style three year currency put option on the total expected net cash flow in year 3 at an exercise price of 160 rubbits/£, and an upfront premium of £1·7 million.

Assume that it is now 31 December. MJY plc is a UK based multinational company that has subsidiaries in two foreign countries. Both subsidiaries trade with other group members and with four third party companies (company 1 – company 4).

Projected trade transactions for three months’ time are shown below. All currency amounts are in thousands.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

Prepare a report for the managers of Lammer plc on how the five-month currency risk should be hedged.

Include in your report all relevant calculations relating to the alternative types of hedge.

(20 marks)

(15 marks are available for calculations and 5 marks for discussion)

(b)In a typical financial year Lammer plc has net dollar imports of $4·2 million. This is expected to continue for five years.

The company’s cost of capital is estimated to be 11% per year. Taxation may be ignored, and cash flows may be assumed to occur at the year end.

Required:

Assuming that there is no change in the physical volume or dollar price of imports,

estimate the effect on the expected market value of Lammer plc if the market expects the dollar to strengthen by 3% per year against the pound. (5 marks)

(c)Briefly discuss how Lammer plc might manage the economic exposure of any foreign

(30 marks)

Question 21 TAYQUER PLC

The directors of Tayquer plc are considering the use of options to protect the current interest yield from their company’s £9.75 million short-term money market investments. Having made initial enquiries they have been discouraged by the cost of the option premium. A member of the treasury staff has suggested the use of a collar as this would be cheaper.

Protection is required for the next eight months. Assume that it is now 1 June:

LIFFE interest rate options on three-month money market futures

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Tick size is 0.01%, and tick value £12.50.

The current interest rate received on Tayquer’s short-term money market investments is 7.5% per annum.

Assume that Tayquer can buy or sell options at the above prices. Commission, taxation and margins may be ignored.

Required:

Discuss how, and estimate at what cost, collars may be used to protect against the interest yield risk. Recommend at which exercise price(s) the collar should be arranged.

(10 marks)

Question 22 PZP PLC

PZP plc wishes to raise £15 million of floating rate finance. The company’s bankers have suggested using a five-year swap. PZP has an AAB rating and can issue fixed rate finance at 11.35%, or floating rate at LIBOR plus 60 basis points. Foreten plc has only a BBC credit rating and can raise fixed rate finance at 12.8%, or floating rate at LIBOR + 1.35%.

A five-year interest rate swap on a £15 million loan could be arranged with Gigbank acting as an intermediary for a fee of 0.25% per annum.

Question 23 INTEREST RATE SWAP

(a)Explain the possible benefits to a company of undertaking an interest rate swap. (4 marks)

(b)The following five-year loan interest rates are available to Stentor, an AA credit rated company, and to Evnor, a BB+ rated company.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

A bank is willing to act as an intermediary to facilitate a five-year swap, for an upfront fee of £20,000 and an annual fee of 0·05% of the swap value. Both of these fees are payable by EACH of the companies. Taxation may be ignored.

Required:

Evaluate, using an illustrative swap, whether or not an interest rate swap may be

The finance director of Shawter plc has recently reviewed the company’s monthly cash budgets for the next year. As a result of buying new machinery in three months time, the company is expected to require short-term financing of £30 million for a period of two months until the proceeds from a factory disposal become available. The finance director is concerned that, as a result of increasing wage settlements, the Central Bank will increase interest rates in the near future.

LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0·9%.

Derivative contracts may be assumed to mature at the end of the relevant month.

Three types of hedge are available:

three month sterling futures (£500,000 contract size, tick size 0.01%)

Options on three-month sterling futures (£500,000 contract size, premium cost in annual %)

FRA prices:

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Required:

Prepare a report for the finance director, which:

(i)briefly discusses the relative advantages and disadvantages of the three types of hedge;

(ii)illustrates how the short-term interest rate risk might be hedged, and the possible results of the alternative hedges, if interest rates increase by 0·5%.

All relevant calculations must be shown.

(b)Current futures prices suggest that interest rates are expected to fall during the next few months. Troder plc expects to have £400 million available for short-term investment for a period of 5 months commencing late October. The company wishes to protect this short-term investment from a fall in interest rates, but is concerned about the premium levels of interest rate options. It would also like to benefit if interest rates were to increase rather than fall. The company’s advisers have suggested the use of a collar option.

LIFFE short sterling options (£500,000), points of 100%

LIBOR is currently 5% and the company can invest short-term at LIBOR minus 25 basis points.

Required:

(i)Assume that it is now early September. The company wishes to receive more than £6,750,000 in interest from its investment after paying any option premium. Illustrate how a collar hedge may be used to achieve this. (N.B. It is not necessary to estimate the number of contracts for this illustration).(7 marks)

(ii)Estimate the maximum interest that could be received with your selected

(15 marks)

Question 26 FUTURES/FRA’S

Assume that it is now 1 June. Your company expects to receive £7·1 million from a large order in five months’ time. This will then be invested in high quality commercial paper for a period of four months, after which it will be used to pay part of the company’s dividend. The company’s treasurer wishes to protect the short-term investment from adverse movements in interest rates, by using futures or forward rate agreements (FRAs).

The current yield on high quality commercial paper is LIBOR + 0·60%.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

LIFFE £500,000 3 month Sterling futures. £12·50 tick size. September 96·25

December 96·60

Futures contracts mature at the month end. LIBOR is currently 4%.

FRA prices (%)

4 v 5 3·85 – 3·80

4 v 9 3·58 – 3·53

5 v 9 3·50 – 3·45

Required:

(a)Devise a futures hedge to protect the interest yield of the short-term investment, and

(b)Ignoring transactions costs, explain whether the futures or FRA hedge would provide

(c)If LIBOR fell by 0·5% during the next five months show the expected outcomes of each

(d)Explain why the futures market outcome might differ from the outcome in (c) above.

(3 marks)

(15 marks)

Question 27 ARNBROOK PLC

Arnbrook plc is considering a £50 million three year interest rate swap. The company wishes to have use of floating rate funds, but because of its AA credit rating has a comparative advantage over lower rated companies when borrowing in the domestic fixed rate market. Arnbrook can borrow fixed rate at 6·25% or floating rate at LIBOR plus 0·75%.

LIBOR is currently 5·25%, but parliamentary elections are due in six months’ time and future interest rates are uncertain. A swap could be arranged using a bank as an intermediary. The bank would offset the swap risk with a counterparty BBB rated company that could borrow fixed rate at 7·25% and floating rate at LIBOR plus 1·25%. The bank would charge a fee of £120,000 per year to each party in the swap. Arnbrook would require 60% of any arbitrage savings (before the payment of fees) from the swap because of its higher credit rating.

Any fees paid to the bank are tax allowable. The corporate tax rate is 30%.

Required:

(a)Discuss the risks that Arnbrook and a participating bank might face when undertaking

(b)Evaluate whether or not the proposed swap might be beneficial to all parties. (6 marks)

(c)If LIBOR was to increase immediately after the forthcoming election to 5·75% and then stay constant for the period of the swap, estimate the present value of the savings from the swap for Arnbrook plc. Interest payments are made semi-annually in arrears. Comment upon whether the swap would have been beneficial to Arnbrook plc.

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Question 28 LACETO PLC

(a)Laceto plc, a large UK based retail group specialising in the sale of clothing and electrical goods is currently considering a takeover bid for a competitor in the electrical goods sector, Omnigen plc, whose share price has fallen by 205 pence during the last three months.

Summarised data for the financial year to 31 March 2001:

The share price of Laceto is currently 380 pence, and of Omnigen 410 pence. Laceto has 80 million issued ordinary shares and Omnigen 30 million. Typical of Laceto’s medium and long-term liabilities is a 12% debenture with three years to maturity, a par value of £100, and a current market price of £108·80.

The finance team of Laceto has produced the following forecasts of financial data for the activities of Omnigen if it is taken over.

Corporate taxation is at the rate of 30% per year, payable in the year that the taxable cash flow occurs.

The risk-free rate is 6% per year and market return 14% per year. Omnigen’s current equity beta is 1·2. This is expected to increase by 0·1 if the company is taken over as Laceto would increase the current level of capital gearing associated with the activities of Omnigen. Laceto group’s gearing post acquisition is expected to be between 18% and 23% (debt to debt plus equity by market values), depending upon the final price paid for Omnigen.

Post-takeover cash flows of Omnigen (after replacement and growth expenditure) are expected to grow at between 3% and 5% per year after 2005.

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