Report to the BoD, Nahara Co
This report recommends whether or not Nahara Co should invest in a food packaging project in Khaza, following Khaza reducing its protectionist measures. It initially considers the value of the project without taking into account the offer made by Tahi Co to purchase the project after two years. Following this, Tahi Co’s offer is considered. The report concludes by recommending a course of action for the BoD to consider further.
Estimated value of the Khaza project and initial recommendation
The initial net present value of the project is negative at approximately $(451,000) (see Appendix 1). This would suggest that Nahara Co should not undertake the project.
Tahi Co’s offer is considered to be a real option for Khaza Co. Since it is an offer to sell the project as an abandonment option, a put option value is calculated based on the Finance Director’s assessment of the standard deviation and using the Black-Scholes option pricing (BSOP) model. The value of the put option is added to the initial net present value of the project without the option, to give the value of the project. Although Nahara Co will not actually obtain any immediate cash flow from Tahi Co’s offer, the real option computation indicates that the project is worth pursuing because the volatility may result in increases in future cash flows.
After taking account of Tahi Co’s offer and the Finance Director’s assessment, the net present value of the project is positive at approximately $2,942,000 (see Appendix 2). This would suggest that Nahara Co should undertake the project.
Assumptions
It is assumed that all the figures relating to variables such as revenues, costs, taxation, initial investments and their recovery, inflation figures and cost of capital are accurate. There is considerable uncertainty surrounding the accuracy of these, and in addition to the assessments of value conducted in Appendices 1 and 2, sensitivity analysis and scenario analysis are probably needed to assess the impact of these uncertainties.
It is assumed that future exchange rates will reflect the differential in inflation rates between the two countries. It is, however, unlikely that exchange rates will move fully in line with the inflation rate differentials.
It is assumed that the value of the land and buildings at the end of the project is a relevant cost, as it is equivalent to an opportunity benefit, even if the land and buildings are retained by Nahara Co.
It is assumed that Nahara Co will be given and will utilise the full benefit of the bi-lateral tax treaty and therefore will not pay any additional tax in the country where it is based.
It is assumed that the short-dated $ treasury bills are equivalent to the risk-free rate of return required for the BSOP model. And it is assumed that the Finance Director’s assessment of the 35% standard deviation of cash flows is accurate.
It is assumed that Tahi Co will fulfil its offer to buy the project in two years’ time and there is no uncertainty surrounding this. Nahara Co may want to consider making the offer more binding through a legal contract.
The BSOP model makes several assumptions such as perfect markets, constant interest rates and lognormal distribution of asset prices. It also assumes that volatility can be assessed and stays constant throughout the life of the project, and that the underlying asset can be traded.
Neither of these assumptions would necessarily apply to real options. Therefore, the BoD needs to treat the value obtained as indicative rather than definitive.
Additional business risks
Before taking the final decision on whether or not to proceed with the project, Nahara Co needs to take into consideration additional risks, including business risks, and where possible mitigate these as much as possible. The main business risks are as follows:
Investing in Khaza may result in political risks. For example, the current Government may be unstable and if there is a change of government, the new Government may impose restrictions, such as limiting the amount of remittances which can be made to the parent company. Nahara Co needs to assess the likelihood of such restrictions being imposed in the future and consider alternative ways of limiting the negative impact of such restrictions.
Nahara Co will want to gain assurance that the countries to which it will sell the packaged food batches remain economically stable and that the physical infrastructure such as railways, roads and shipping channels are maintained in good repair. Nahara Co will want to ensure that it will be able to export the special packaging material into Khaza. Finally, it will need to assess the likelihood of substantial protectionist measures being lifted and not re-imposed in the future.
As much as possible, Nahara Co will want to ensure that fiscal risks such as imposition of new taxes and limits on expenses allowable for taxation purposes do not change. Currently, the taxes paid in Khaza are higher than in Nahara Co’s host country and, even though the bi-lateral tax treaty exists between the countries, Nahara Co will be keen to ensure that the tax rate does not change disadvantageously.
Nahara Co will also want to protect itself, as much as possible, against adverse changes in regulations. It will want to form the best business structure, such as a subsidiary company, joint venture or branch, to undertake the project. Also, it will want to familiarise itself on regulations such as employee health and safety law, employment law and any legal restrictions around land ownership.
Risks related to the differences in cultures between the host country, Khaza, and the countries to which the batches will be exported would be a major concern to Nahara Co. For example, the product mix in the batches which are suitable for the home market may not be suitable for Khaza or where the batches are exported. It may contain foods which would not be saleable in different countries and therefore standard batches may not be acceptable to the customers. Nahara Co will also need to consider the cultural differences and needs of employees and suppliers.
The risk of the loss of reputation through operational errors would need to be assessed and mitigated. For example, in setting up sound internal controls, segregation of duties is necessary. However, personal relationships between employees in Khaza may mean that what would be acceptable in another country may not be satisfactory in Khaza. Other areas Nahara Co will need to focus on are the quality control procedures to ensure that the quality of the food batches is similar to the quality in the host country.
Recommendation
With Tahi Co’s offer, it is recommended that the BoD proceed with the project, as long as the BoD is satisfied that the offer is reliable, the sensitivity analysis/scenario analysis indicates that any negative impact of uncertainty is acceptable and the business risks have been considered and mitigated as much as possible.
If Tahi Co’s offer is not considered, then the project gives a marginal negative net present value, although the results of the sensitivity analysis need to be considered. It is recommended that, if only these results are taken into consideration, the BoD should not proceed with the project. However, this decision is marginal and there may be other valid reasons for progressing with the project such as possibilities of follow-on projects in Khaza.
Report compiled by:
Date:
(Max 14 marks)
APPENDICES
Appendix 1: Estimated value of the Khaza project excluding the Tahi Co offer
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(Cash flows in KPm)
Year |
1 |
2 |
3 |
4 |
5 |
Sales revenue (W2) |
1,209.6 |
1,905.1 |
4,000.8 |
3,640.7 |
2,205.4 |
Production and selling costs (W3) |
(511.5) |
(844.0) |
(1,856.7) |
(1,770.1) |
(1,123.3) |
Special packaging costs (W4) |
(160.1) |
(267.0) |
(593.7) |
(572.0) |
(366.9) |
Training and development costs |
(409.2) |
(168.8) |
0 |
0 |
0 |
Tax-allowable depreciation |
(125) |
(125) |
(125) |
(125) |
(125) |
Balancing allowance |
______ |
______ |
______ |
______ |
(125)
______ |
Taxable profits/(loss) |
3.8 |
500.3 |
1,425.4 |
1,173.6 |
465.2 |
Taxation (25%) |
(1.0) |
(125.1) |
(356.4) |
(293.4) |
(116.3) |
Add back depreciation |
125
______ |
125
______ |
125
______ |
125
______ |
250
______ |
Cash flows (KPm) |
127.8
______ |
500.2
______ |
1,194.0
______ |
1,005.2
______ |
598.9
______ |
(All amounts in $’000)
Year |
1 |
2 |
3 |
4 |
5 |
Exchange rate (W1) |
76.24 |
80.72 |
85.47 |
90.50 |
95.82 |
Cash flows ($’000) |
1,676.3 |
6,196.7 |
13,969.8 |
11,107.2 |
6,250.3 |
Discount factor for 12% |
0.893 |
0.797 |
0.712 |
0.636 |
0.567 |
Present values ($’000) |
1,496.9 |
4,938.8 |
9,946.5 |
7,064.2 |
3,543.9 |
Present value (PV) of cash flows approx. = $26,990,000
PV of value of land, buildings and machinery in Year 5 = (80% × KP1,250m + KP500m)/95.82 × 0.567 approx. = $8,876,000
PV of working capital = KP200m/95.82 × 0.567 approx. = $1,183,000
Cost of initial investment in $ = (KP2,500m + KP200m)/72 = $37,500,000
NPV of project = $26,990,000 + $8,876,000 + $1,183,000 – $37,500,000 = $(451,000)
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Workings
- Exchange rates
Year |
1 |
2 |
3 |
4 |
5 |
KP/$ 1 |
72 × 1.08/1.02
= 76.24 |
76.24 × 1.08/1.02
= 80.72 |
80.72 × 1.08/1.02
= 85.47 |
85.47 × 1.08/1.02
= 90.50 |
90.50 × 1.08/1.02
= 95.82 |
- Sales revenue (KPm)
Year |
1 |
2 |
3 |
4 |
5 |
|
10,000 × 115,200 × 1.05
= 1,209.6 |
15,000 × 115,200 × 1.052
= 1,905.1 |
30,000 × 115,200 × 1.053
= 4,000.8 |
26,000 × 115,200 × 1.054
= 3,640.7 |
15,000 × 115,200 × 1.055
= 2,205.4 |
- Production and selling (KPm)
Year |
1 |
2 |
3 |
4 |
5 |
 |
10,000 × 46,500 × 1.1 = 511.5 |
15,000 × 46,500 × 1.12 = 844.0 |
30,000 × 46,500 × 1.13 = 1,856.7 |
26,000 × 46,500 × 1.14 = 1,770.1 |
15,000 × 46,500 × 1.15 = 1,123.3 |
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- Special packaging (KPm)
Year |
1 |
2 |
3 |
4 |
5 |
 |
10,000 × 200 × 76.24 × 1.05 = 160.1 |
15,000 × 200 × 80.72 × 1.052 = 267.0 |
30,000 × 200 × 85.47 × 1.053 = 593.7 |
26,000 × 200 × 90.50 × 1.054 = 572.0 |
15,000 × 200 × 95.82 × 1.055 = 366.9 |
(Max 14 marks)
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Appendix 2: Estimated value of the Khaza project including the Tahi Co offer
Present value of underlying asset (Pa) = $30,613,600 (approximately)
(This is the sum of the PVs of the cash flows forgone in Years 3, 4 and 5)
Price offered by Tahi Co (Pe) = $28,000,000
Risk-free rate of interest (r) = 4% (assume government treasury bills are a valid approximation of the risk-free rate of return)
Volatility of underlying asset (s) = 35%
Time to expiry of option (t) = 2 years
d1 = [ln (30,613.6/28,000) + (0.04 + 0.5 × 0.352) × 2]/ [0.35 × 21/2] = 0.59
d2 = 0.59 – 0.35 × 21/2 = 0.10
N(d1) = 0.5 + 0.2224 = 0.7224
N(d2) = 0.5 + 0.0398 = 0.5398
Call value = $30,613,600 × 0.7224 – $28,000,000 × 0.5398 × e–0.04 × 2 = approx. $8,160,000
Put value = $8,160,000 – $30,613,600 + $28,000,000 × e–0.04 × 2 = approx. $3,393,000
Net present value of the project with put option = $3,393,000 – $451,000 = approx. $2,942,000
(Note. Credit will be given for relevant discussion and recommendation.)
(9 marks)
(Professional marks 4 marks)
(Total = 50 marks)
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QUESTION 02- LION CO
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Purchasing power parity (PPP) predicts that the exchange rates between two currencies depend on the relative differences in the rates of inflation in each country. Therefore, if one country has a higher rate of inflation compared to another, then its currency is expected to depreciate over time. However, according to PPP the ‘law of one price’ holds because any weakness in one currency will be compensated by the rate of inflation in the currency’s country (or group of countries, in the case of the euro).
Economic exposure refers to the degree by which a company’s cash flows are affected by fluctuations in exchange rates. It may also affect companies which are not exposed to foreign exchange transactions, due to actions by international competitors.
If PPP holds, then companies may not be affected by exchange rate fluctuations, as lower currency value can be compensated by the ability to raise prices due to higher inflation levels. This depends on markets being efficient.
However, a permanent shift in exchange rates may occur, not because of relative inflation rate differentials, but because a country (or group of countries) lose their competitive positions. In this case the ‘law of one price’ will not hold, and prices readjust to a new and long-term or even permanent rate. For example, the UK £ to US$ rate declined in the 20th century, as the US grew stronger economically and the UK grew weaker. The rate almost reached parity in 1985 before recovering. Since the financial crisis in 2009, it has fluctuated between roughly $1.5 to £1 and $1.7 to £1.
In such cases, where a company receives substantial amounts of revenue from companies based in countries with relatively weak economies, it may find that it is facing economic exposure and its cash flows decline over a long period of time.
(Max 6 marks)
Discussion paper to the BoD, Lion Co
Discussion paper compiled by:
Date:
Purpose of the discussion paper
The purpose of this discussion paper is:
- To consider the implications of the BoD’s proposal to use funds from the sale of its equity investment in the European company and from its cash flows generated from normal business activity over the next two years to finance a large project, instead of raising funds through equity and/or debt
- To assess whether or not the project adds value for Lion Co or not
Background information
The funds needed for the project are estimated at $40,000,000 at the start of the project. $23,118,000 of this amount is estimated to be received from the sale of the equity investment (Appendices 2 and 3). This leaves a balance of $16,882,000 (Appendix 3), which will be obtained from the free cash flows to equity (the dividend capacity) of $21,642,000 (Appendix 1) expected to be generated in the first year. However, this would leave only $4,760,000 available for dividend payments in the first year, meaning a cut in expected dividends from $0.27/share to $0.0595/share (Appendix 3). The same level of dividends will be paid in the second year as well.
Project assessment
Based on the dividend valuation model, Lion Co’s market capitalisation, and therefore its value, is expected to increase from approximately $360 million to approximately $403 million, or by just under 12% (Appendix 3). This would suggest that it would be beneficial for the project to be undertaken.
Possible issues
- The dividend valuation model is based on a number of factors such as: an accurate estimation of the dividend growth rate, a non-changing cost of equity and a predictable future dividend stream growing in perpetuity. In addition to this, it is expected that the sale of the investment will yield €20,000,000 but this amount could increase or reduce in the next 3 months. The dividend valuation model assumes that dividends and their growth rate are the sole drivers of corporate value, which is probably not accurate.
- Although the dividend irrelevancy theory proposed by Modigliani and Miller suggests that corporate value should not be affected by a corporation’s dividend policy, in practice changes in dividends do matter for two main reasons. First, dividends are used as a signalling device to the markets and unexpected changes in dividends paid and/or dividend growth rates are not generally viewed positively by them. Changes in dividends may signal that the company is not doing well and this may affect the share price negatively.
- Second, corporate dividend policy attracts certain groups of shareholders or clientele. In the main this is due to personal tax reasons. For example, higher rate taxpayers may prefer low dividend pay-outs and lower rate taxpayers may prefer higher dividend pay-outs. A change in dividends may result in the clientele changing and this changeover may result in excessive and possibly negative share price volatility.
- It is not clear why the BoD would rather not raise the required finance through equity and/or debt. The BoD may have considered increasing debt to be risky. However, given that the current level of debt is $70 million compared to an estimated market capitalisation of $360 million (Appendix 3), raising another $40 million through debt finance will probably not result in a significantly higher level of financial risk. The BoD may have been concerned that going into the markets to raise extra finance may result in negative agency type issues, such as having to make proprietary information public, being forced to give extra value to new equity owners, or sending out negative signals to the markets.
Areas for further discussion by the BoD
Each of these issues should be considered and discussed further by the BoD. With reference to point 1, the BoD needs to discuss whether the estimates and the model used are reasonable in estimating corporate value or market capitalisation. With reference to points 2 and 3, the BoD needs to discuss the implications of such a significant change in the dividend policy and how to communicate Lion Co’s intention to the market so that any negative reaction is minimised. With reference to point 4, the BoD should discuss the reasons for any reluctance to raise finance through the markets and whether any negative impact of this is perhaps less than the negative impact of points 2 and 3.
(9 marks)
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Appendix 1: Expected dividend capacity prior to large project investment
 |
$’000 |
Operating profit (15% x (1.08 x $300 million)) |
48,600 |
Less interest (5% of $70 million) |
(3,500) |
Less taxation (25% x ($48.6 million – 3.5 million)) |
(11,275) |
Less investment in working capital ($0.10 x (0.08 x $300 million)) |
(2,400) |
Less investment in additional non-current assets ($0.20 x (0.08 x $300 million)) |
(4,800) |
Less investment in projects |
(8,000)
_____ |
Cash flows from domestic operations |
18,625 |
Cash flows from Pinto Co’s dividend remittances (see Appendix 1.1) |
3,297 |
Additional tax payable on Pinto Co’s profits (5% x $5.6 million) |
(280)
____ |
Dividend capacity |
21,642 |
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Appendix 1.1: Dividend remittances expected from Pinto Co
 |
$’000 |
Total contribution $24 x 400,000 units |
9,600 |
Less fixed costs |
(4,000) |
Less taxation (20% x $5.6 million) |
(1,120) |
Profit after tax |
4,480 |
Remitted to Lion Co (80% x $4.48 million x 92%) |
3,297 |
(9 marks)
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Appendix 2: Euro (€) investment sale receipt hedge
Lion Co can use one of forward contracts, futures contracts or option contracts to hedge the € receipt.
Forward contract
Since it is a € receipt, the 1.1559 rate will be used.
€20,000,000 u 1.1559 = $23,118,000
Futures contracts
Go long to protect against a weakening € and use the June contracts to hedge as the receipt is expected at the end of May 20X6 or beginning of June 20X6 (in three months’ time).
Opening basis = futures rate – spot rate
Here the June futures rate (per $) is 0.8656 and the March spot rate (per $) = 1 / 1.1585 = 0.8632.
So, opening basis is 0.8656 – 0.8632 = 0.0024
There are 4 months to the expiry of the June futures contract so we can assume that when the futures contracts are closed out, one month before expiry, then ¼ of this basis will remain. So, closing basis is estimated as 0.0024 u ¼ = 0.0006.
The effective futures rate can be estimated as opening futures rate – closing basis
Tutorial note. Other methods are possible.
Here this gives 0.8656 – 0.0006 = 0.8650.
Expected receipt = €20,000,000/0.8650 = $23,121,387
Number of contracts bought = $23,121,387/$125,000 = approximately 185 contracts (resulting in a very small over-hedge and therefore not material)
(Full credit will be given where the calculations are used to show the correction of the over-hedge using forwards.)
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Option contracts
Purchase the June call option to protect against a weakening € and because receipt is expected at the end of May 20X6 or beginning of June 20X6.
Exercise price is 0.86, therefore expected receipt is €20,000,000/0.8600 = $23,255,814
Contracts purchased = $23,255,814/$125,000 = 186.05, say 186
Amount hedged = $125,000 x 186 = $23,250,000
Premium payable = 186 x 125,000 x 0.0290 = €674,250
Premium in $ = €674,250 x 1.1618 = $783,344
Amount not hedged = €20,000,000 – (186 x 125,000 x 0.8600) = €5,000
Use forward contracts to hedge €5,000 not hedged. €5,000 x 1.1559 = $5,780
(Full credit will be given if a comment on the under-hedge being immaterial and therefore not hedged is made, instead of calculating the correction of the under-hedge.)
Total receipts = $23,250,000 + $5,780 – $783,344 = $22,472,436
Advice and recommendation
Hedging using options will give the lowest receipt at $22,472,436 from the sale of the investment, while hedging using futures will give the highest receipt at $23,127,387, with the forward contracts giving a receipt of $23,118,000. The lower receipt from the option contracts is due to the premium payable, which allows the option buyer to let the option lapse should the € strengthen. In this case, the option would be allowed to lapse and Lion Co would convert the € into $ at the prevailing spot rate in three months’ time. However, the € would need to strengthen significantly before the cost of the option is covered. Given market expectation of the weakness in the € continuing, this is not likely to be the case.
Although futures and forward contracts are legally binding and do not have the flexibility of option contracts, they both give higher receipts. Hedging using futures gives the higher receipt, but futures require margin payments to be made upfront and contracts are marked to market daily. In addition to this, the basis may not narrow in a linear fashion and therefore the amount received is not guaranteed. All these factors create uncertainty in terms of the exact amounts of receipts and payments resulting on a daily basis and the final receipt.
On the other hand, when using forward contracts to hedge the receipt exposure, Lion Co knows the exact amount it will receive. It is therefore recommended that Lion Co use the forward markets to hedge the expected receipt.
(Note. It could be argued that in spite of the issues when hedging with futures, the higher receipt obtained from using futures markets to hedge means that they should be used. This is acceptable as well.)
(14 marks)
Appendix 3: Estimate of Lion Co’s value based on the dividend valuation model
If the large project is not undertaken and dividend growth rate is maintained at the historic level
Dividend history
Year to end of February |
20X3 |
20X4 |
20X5 |
20X6 |
Number of $1 equity shares in issue (‘000) |
60,000 |
60,000 |
80,000 |
80,000 |
Total dividends paid ($’000) |
12,832 |
13,602 |
19,224 |
20,377 |
Dividend per share |
$0.214 |
$0.227 |
$0.240 |
$0.255 |
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Average dividend growth rate = (0.255/0.214)1/3 – 1 = 1.0602 (or say 6%)
Expected dividend in February 20X7 = $0.255 x 1.06 = $0.270
Lion Co, estimate of value if large project is not undertaken
= $0.270/ (0.12 – 0.06) = $4.50 per share or $360 million market capitalisation
If the large project is undertaken
Funds required for project |
$40,000,000 |
Funds from sale of investment (Appendix 2) |
$23,118,000 |
Funds required from dividend capacity cash flows |
$16,882,000 |
Dividend capacity funds before transfer to project (Appendix 1) |
$21,642,000 |
Dividend capacity funds left after transfer |
$4,760,000 |
Annual dividend per share after transfer |
$0.0595 |
Annual dividend paid (end of February 20X7 and February 20X8) |
$0.0595 |
Dividend paid (end of February 20X9) |
$0.3100 |
New growth rate |
7% |
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Lion Co, estimate of value if large project is undertaken
= $0.0595 x 1.12–1 + $0.0595 x 1.12–2 + $0.3100 x 1.12–3 + [$0.3100 x 1.07/ (0.12 – 0.07)] x 1.12–3 = $5.04 per share or $403 million market capitalisation
(Note. A discussion paper can take many formats. The answer provides one possible format. Credit will be given for alternative and sensible formats; and for relevant approaches to the calculations and commentary.)
(8 marks)
(professional marks for part (b) 4 marks)