seminar5materials / P4AFM-RQB_PDF_d08 / P4AFM-RQB-Qs_d08

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Required:

(a)Determine the likely effect on the company’s cost of capital and corporate value if the company’s capital structure was:

(i)80% equity, 20% debt by market values;

(ii)40% equity, 60% debt by market values.

Recommend which capital structure should be selected.

Any change in capital structure would be achieved by borrowing to repurchase existing equity, or by issuing additional equity to redeem existing debt, as appropriate.

The current total firm value (market value of equity plus market value of debt) is consistent with the growth model (CF1/(k – g)) applied on a corporate basis. CF1 is next year’s free cash flow, k is the weighted average cost of capital (WACC), and g the expected growth rate. Company free cash flow may be estimated using EBIT(1 – t) + depreciation – capital spending.

(b)Discuss possible reasons for errors in the estimates of corporate value in part (a) above.

(10 marks)

(30 marks)

Question 56 MATLEC PLC

Maltec plc is a company that has diversified into five different industries in five different countries. The investments are each approximately equal in value. The company’s objective is to reduce risk through diversification, and it believes that the return on any investment is not correlated with the return on any other investment. The estimated risk and return (in present value terms) of the five investments are shown below:

Required:

(a)Estimate the risk and return of the portfolio of five investments, and briefly explain the

(b)Discuss the validity to investors of Maltec’s objective of risk reduction through

(10 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Question 57 GADDES

(b)The financial manager of Gaddes plc’s pension fund is reviewing strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term bonds. Interest rates are expected to be quite volatile for the next few years. It is currently June 2003.

Among the pension fund’s current investments are two AAA rated bonds:

1)Zero coupon June 2018

2)12% Gilt June 2018 (interest is payable semi-annually)

The current annual redemption yield (yield to maturity) on both bonds is 6%. The semiannual yield may be assumed to be 3%. Both bonds have a par value and redemption value of £100.

Required:

(i)Estimate the market price of each of the bonds if interest rates (yields):

(a)increase by 1%;

(b)decrease by 1%.

The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal amount at all points of the yield curve). (6 marks)

(ii)Comment upon and briefly explain the size of the expected price movements from the current prices, and how such changes in interest rates might affect the strategy of the financial manager with respect to investing in the two bonds.

(3 marks)

(iii)How might the bond investment strategy of the financial manager be affected if

the yield curve was expected to steepen (the gap between shortand long-term

(a)Assume that it is now 1 December. The financial manager of a large corporate pension fund is concerned about the recent loss in value of the fund due to falling share prices. Although he believes that the equity market is probably near to its low point, and that prices could soon start to rise, there is no certainty of this happening.

In order to protect the fund’s portfolio against possible further falls in share prices he is considering the use of financial futures. The portfolio currently comprises eight major investments, as detailed below.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

On 1 December, the March FTSE 100 Index futures price is £3,850. The face value of a FTSE stock index contract is £10 per index point (the tick size), which implies a current contract value of £38,500.

Required:

Illustrate what hedge should be undertaken to protect the portfolio against possible falls in the share prices. (5 marks)

(b)Assume that on 31 March, the expiry date of the futures contract, the share prices have moved as shown below, and the FTSE 100 Index futures price is £3,625.

(The number of shares held in the portfolio has remained unchanged)

Required:

With hindsight, calculate the outcome of the hedge that was illustrated in (a) above. Comment upon your findings. (4 marks)

(c)Briefly discuss why the financial manager might use stock index futures to alter

(d)If the financial manager wished to halve the systematic risk of the portfolio by using

long-term interest rate futures, explain (but do not calculate) what hedge he might

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Question 59 ACTIVE PORTFOLIO MANAGEMENT

The managers of a pension fund follow an active portfolio management strategy. They try to purchase shares and bonds that show a positive abnormal return (positive alpha factor in the case of shares). The pension fund is required by law to hold at least 40% of its investments in bonds. £100 million is currently available for investment.

Three shares and three bonds are being considered for purchase.

The required return on bonds may be measured using a model similar to the capital asset pricing model, where beta is replaced by the relative duration of the individual bond (Di) and the bond market portfolio

(Dm). This is shown as DmDi

The risk free rate is 4%.

Required:

(a)Evaluate whether or not any of the shares or bonds are expected to offer a positive

(b)The pension fund currently has the maximum permitted investment in shares and wishes to continue this strategy. It has a market value of £1,000 million and a beta of 0·62.

Calculate the required return from the pension fund if any shares and bonds with positive abnormal returns are purchased.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 60 EWADE PLC

Ewade plc has recently issued £100 million par value of £100 zero coupon convertible debentures 2013 at a price of £71·10 per debenture. The debentures are redeemable at their par value of £100.

Conversion may take place at any time after three years from the issue date. The conversion terms are 12 ordinary shares of Ewade for each debenture. The current redemption yield on Ewade’s 8% coupon straight debt with seven years until maturity, and redeemable at the par value of £100, is 6%. The straight debt pays semi-annual interest.

Required:

(a)Estimate the redemption yield on the zero coupon convertible debentures, and the difference between the market price of the seven year straight debt and the seven year

zero coupon convertible debt. Explain the reasons for the different market prices and yields. (6 marks)

(b)Assume that in three years’ time the redemption yield of the zero coupon debt is 6% and the price of an ordinary share of Ewade is:

(i)550 pence

(ii)710 pence

Required:

For each share price, estimate the minimum price of the zero coupon convertible debentures. (4 marks)

(c)If Ewade held a portfolio including bonds with attached warrants and wished to protect

the value of the warrants, explain how the knowledge of the delta value and theta value

Discuss how a government might try to reduce a large, persistent, current account deficit on the balance of payments, and illustrate what impact such government action might have on a multinational company operating in the country concerned. Explain the possible role and impact of the International Monetary Fund (IMF) in this process.

(15 marks)

Question 62 FORECASTS

(a)Your managing director has received forecasts of Euro exchange rates in two years’ time from three leading banks.

The current spot mid-rate is Euro 1·667/£

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

A non-executive director of your company has suggested that in order to forecast future exchange rates, the interest rate differential between countries should be used. She states that “as short term interest rates are currently 6% in the UK, and 3·5% in the Euro bloc, the exchange rate in two years’ time will be Euro 1·747/£”.

Required:

(i)Prepare a brief report discussing the likely validity of the non-executive

(ii)Explain briefly whether or not forecasts of future exchange rates using current

(b)You have also been asked to give advice to the managing director about a tender by the company’s Italian subsidiary for an order in Kuwait. The tender conditions state that payment will be made in Kuwait dinars 18 months from now. The subsidiary is unsure as to what price to tender. The marginal cost of producing the goods at that time is estimated to be Euro 340,000 and a 25% mark-up is normal for the company.

Exchange rates

Euro/Dinar

Spot 0·256 – 0·260

No forward rate exists for 18 months’ time.

Required:

Discuss how the Italian subsidiary might protect itself against foreign exchange rate changes, and recommend what tender price should be used.

(15 marks)

Question 63 EXCHANGE RATE SYSTEMS

Discuss the possible foreign exchange risk and economic implications of each of the following types of exchange rate system for multinational companies with subsidiaries located in countries with these systems:

(a)a managed floating exchange rate;

(b)a fixed exchange rate linked to a basket of currencies; and

(c)a fixed exchange rate backed by a currency board system.

(15 marks)

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Question 64 WTO

(a)Provide examples of how countries might impose protectionist measures to control the

(b)Discuss the role and main objectives of the World Trade Organisation (WTO), and its

(c)Briefly discuss the possible effects of the activities of the WTO for a multinational

company with foreign direct investment in a developing country that has recently joined

Briefly explain what is meant by corporate governance and discuss the major differences that exist between corporate governance practice in the UK, US and Japan.

(10 marks)

Question 66 GOAL CONGRUENCE

Discuss the importance and limitations of ESOPs (executive share option plans) to the achievement of goal congruence within an organisation.

(10 marks)

Question 67 UK PLC

The following are extracts from the corporate governance guidelines issued by a UK plc:

(i)All auditors’ fees, including fees for services other than audit, should be fully disclosed in the annual report. In order to ensure continuity of standards the same audit partner, wherever possible, should be responsible for a period of at least three years.

(ii)The board shall establish a remuneration committee comprising 50% executive directors, and 50% non-executive directors. A non-executive director shall chair the committee.

(iii)The Chairman of the company may also hold the position of Chief Executive, although this shall not normally be for a period of more than three years.

(iv)The annual report shall fully disclose whether principles of good corporate governance have been applied.

(v)No director shall hold directorships in more than twenty companies.

(vi)Directors should regularly report on the effectiveness of the company’s system of internal control.

Required:

(a)Discuss the extent to which each of points (i) – (vi) is likely to comply with corporate

governance systems such as the UK Combined Code (N.B. The Combined Code results from the Cadbury, Greenbury and Hempel reports). (9 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(b)Prepare a brief report advising senior managers of your company who are going to work in subsidiaries in Germany, Japan and the US of the main differences in corporate

governance between the UK and any TWO of the above countries, and possible

(a)Discuss why conflicts of interest might exist between shareholders and bondholders.

(8 marks)

(b)Provide examples of covenants that might be attached to bonds, and briefly discuss the

(15 marks)

Question 69 ETHICS

Discuss, and provide examples of, the types of non-financial, ethical and environmental issues that might influence the objectives of companies. Consider the impact of these non-financial, ethical and environmental issues on the achievement of primary financial objectives such as the maximisation of shareholder wealth.

(15 marks)

Question 70 REMUNERATION

The remuneration committee of a plc is discussing the remuneration package that might to be offered to the company’s new managing director. Members of the committee have expressed different opinions. These include:

(i)The managing director must be offered a salary at least 20% more than the average of similar sized companies in order to attract the best candidates.

(ii)It is essential to offer a salary linked to turnover.

(iii)The managing director should be offered share options, exercisable in one year’s time, on at least 3,000,000 shares, at an exercise price of 25% below the current market price of 120 pence.

(iv)Remuneration should be a basic salary plus a proportion of the economic value added (EVA®) of the company. 1·5% per year was the suggested proportion.

In the ensuing debate one committee member stated that a friend had recently bought one year European style put options on the company’s shares at a price of 35 pence. The options to be granted to the new managing director would therefore be worth several million pounds. Such generosity would not be well received given recent newspaper commentary about the excessive remuneration of senior managers in some companies.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Relevant company and market data is shown below:

Notes:

(i)Accounting depreciation is approximately equal to economic deprecation.

(ii)Advertising has been £10 million per year for the last four years.

(iii)The company’s cost of equity is 12%

(iv)The company’s weighted average cost of capital is 9·5%

(v)The risk free rate is 4%

(vi)The corporate tax rate is 30%

Required:

(b)Some committee members have expressed concern about how much some of the suggestions might cost the company.

For both the share option and EVA® suggestions, estimate the potential cost to the

company, and comment on your findings. For EVA® the estimate should be based upon

“This company aims at all times to serve its shareholders by paying a high level of dividends and adopting strategies that will increase the company’s share price. Satisfying our shareholders will ensure our success. The company will reduce costs by manufacturing overseas wherever possible, and will attempt to minimise the company’s global tax bill by using tax haven facilities.”

Required:

Discuss the validity and implications of each of the comments and strategies in the above statement.

(15 marks)

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

ACCA Pilot Paper – Questions

Section A: BOTH questions are compulsory and MUST be attempted

1You are the chief financial officer of Fly4000 a large company in the airline and travel business whose principal market base is in Europe and the Middle East. Its principal hub is a major Northern European airport and Fly4000 has a small holiday business through its partnership with a number of independent tour operators. It has a good reputation as a business carrier within its European market, earned through very high standards of punctuality and service. Following the recent disinvestment of associated interests and a joint venture, it has cash reserves of $860 million.

FliHi is a smaller airline which also has its centre of operations at the same airport as Fly4000. It has, since it was founded in 1988, developed a strong transatlantic business as well as a substantial position in the long and medium haul holiday market. In the year to 31 December 2005 its reported turnover was in $1.7 billion and its profit after tax for the financial year was $50 million. The company’s net assets are $120 million and it has $150 million of long term loans. It has recently expanded its fleet of wide bodied jets suitable for its expanding holiday business and has orders placed for the Airbus 380 super-Jumbo to supplement its long haul fleet. FliHi has route licenses to New York and six other major US cities.

FliHi’s cash flow statement for the current and preceding year is as follows:

FliHi Consolidated Cash Flow Statement (extract)

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