The WTO was set up to continue to implement the General Agreement on Tariffs and Trade (GATT), and its main aims are to reduce the barriers to international trade. It does this by seeking to prevent protectionist measures such as tariffs, quotas and other import restrictions. It also acts as a forum for negotiation and offering settlement processes to resolve disputes between countries.

The WTO encourages free trade by applying the most favoured nation principle between its members, where a reduction in tariffs offered to one country by another should be offered to all members.

Whereas the WTO has had notable success, some protectionist measures between groups of countries are nevertheless allowed and some protectionist measures, especially non-tariff-based ones, have been harder to identify and control.

Khaza could benefit from reducing protectionist measures because its actions would make other nations reduce their protectionist measures against it. Normally countries retaliate against each other when they impose protectionist measures. A reduction in these may allow Khaza to benefit from increased trade and economic growth. Such a policy may also allow Khaza to specialise and gain competitive advantage in certain products and services, and compete more effectively globally. Its actions may also gain political capital and more influence worldwide.

Possible drawbacks of reducing protectionist policies mainly revolve around the need to protect certain industries. It may be that these industries are developing and in time would be competitive on a global scale. However, inaction to protect them now would damage their development irreparably. Protection could also be given to old, declining industries which, if not protected, would fail too quickly due to international competition, and would create large-scale unemployment making such inaction politically unacceptable. Certain protectionist policies are designed to prevent ‘dumping’ of goods at a very cheap price, which hurts local producers.

Note. Credit will be given for alternative relevant discussion.

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

(Cash flows in KPm)

(All amounts in $’000)

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)

Workings

1. Exchange rates

2. Sales revenue (KPm)

3. Production and selling (KPm)

4. Special packaging (KPm)

(Max 14 marks)

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)

QUESTION 02- LION CO

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:

1. 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
2. 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

1. 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.
2. 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.
3. 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.
4. 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)

Appendix 1: Expected dividend capacity prior to large project investment

Appendix 1.1: Dividend remittances expected from Pinto Co

(9 marks)

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.)

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

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

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)

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific discount rate to each type of cash flow, dependent on the risk attributable to that particular type of cash flow. Net present value (NPV) discounts all cash flows by the average discount rate attributable to the average risk of a project.

One reason why APV may be preferable to NPV is because by separating out different types of cash flows, the company’s managers will be able to see which part of the project generates what proportion of the project’s value. Furthermore, allocating a specific discount rate to a cash flow part helps determine the value added or destroyed. In this example, Wayne Co is able to determine how much value is being created by the investment and how much by the debt financing. For complex projects, investment related cash flows could be further distinguished by their constituent risk factors, where applicable.

Discussion paper to the BoD, Lion Co

Discussion paper compiled by:

Date:

Purpose of the discussion paper

The purpose of this discussion paper is:

1. 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
2. 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

1. 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.
2. 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.
3. 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.
4. 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)

Appendix 1: Expected dividend capacity prior to large project investment

Appendix 1.1: Dividend remittances expected from Pinto Co

(9 marks)

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.)

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

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

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)

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific discount rate to each type of cash flow, dependent on the risk attributable to that particular type of cash flow. Net present value (NPV) discounts all cash flows by the average discount rate attributable to the average risk of a project.

One reason why APV may be preferable to NPV is because by separating out different types of cash flows, the company’s managers will be able to see which part of the project generates what proportion of the project’s value. Furthermore, allocating a specific discount rate to a cash flow part helps determine the value added or destroyed. In this example, Wayne Co is able to determine how much value is being created by the investment and how much by the debt financing. For complex projects, investment related cash flows could be further distinguished by their constituent risk factors, where applicable.

Report to the board of directors (BoD), Wayne Co

Introduction

This report evaluates, and provides a justification and decision, on whether Wayne Co should pursue Project Red or Project Blue, based on the important factors identified by the company, namely the returns generated by the projects, the projects’ risks and non-financial aspects.

Evaluation

Financing Using forward markets to hedge the expected receipt in six months’ time results in the higher receipt equalling Y$25,462,000 approximately. If the money markets hedge is used the receipt is Y$25,234,936 (appendix 1).

Using forward markets to hedge the expected receipt would therefore minimise the amount of debt borrowing. However, the amount receivable from the money markets hedge is based on the annual bank investment rate available to Wayne Co of 2·4%. Wayne Co may be able to use the funds borrowed to generate a higher return than the bank investment and therefore using money markets to undertake the hedge may be financially advisable. Wayne Co should investigate any opportunities for higher income, but based on the current results, the forward market hedge is recommended to minimise the amount of debt finance needed.

Minimum amount of debt borrowing required is Y$24,538,000 approximately.

Project returns and risk

Project Red’s and Project Blue’s base case NPVs and APVs are similar to each other, with Project Red expected to yield a small amount in excess to the yield expected from Project Blue. However, Project Blue’s project duration is significantly lower. This is because a higher proportion of Project Blue’s cash flows come earlier in the project’s life, compared to Project Red. There is more certainty to earlier cash flows and this is reflected in the lower duration for Project Blue. Project Blue’s risk is lower than Project Red.

In estimating the base case NPV and APV for Project Red, it is assumed that the cash flows are known with reasonable certainty and the inflation rates will not change during the life of the project. It is also assumed that the future exchange rate between the Y$ and the £ will change in accordance with the purchasing power parity differential. Furthermore, it is assumed that the prices and costs related to Project Red will increase in line with inflation during the six months before the project starts. For Project Red, it is assumed that the initial working capital requirement is funded by the company and not from the funds raised from the subsidised loan, similar to the assumption made for Project Blue. However, for both projects, Wayne Co needs to consider, and take account of, the opportunity costs related to this.

In terms of the Project Red’s discount rate, it is assumed that the given discount rate accurately reflects the business risk of the project.

Whilst this level of detail is not provided for Project Blue, it is assumed that similar assumptions will have been made for Project Blue as well. In the case of both projects, Wayne Co should assess the accuracy or reasonableness of the assumptions, and if necessary, conduct sensitivity analysis to observe how much the projects’ values change if input variables are altered. Notwithstanding the assumptions and caveats made above, it would appear that Project Blue would be preferable to Project Red, given that it has a similar APV but a significantly lower risk.

Nevertheless, there may be good strategic reasons why Wayne Co may select Project Red over Project Blue. For example, these reasons may include providing access to new markets, enabling Wayne Co to erect barriers to entry against competitors or looking at follow-on opportunities as possible real options.

Justification

Due to the substantially lower risk (as measured by the project duration) and similar APV, it is recommended that Project Blue be selected by Wayne Co. It is also recommended that forward markets are used to hedge the income expected in six months’ time to part fund the project. This would minimise the debt borrowing needed.

However, this decision is predicated on the fact that the implications of the assumptions and the wider strategic reasons discussed above have been carefully considered by Wayne Co.

Report compiled by:

Date

(Note: Credit will be given for alternative and valid evaluative comments)

APPENDICES:

Appendix 1 (Part (b) (i)):

Expected receipt in six months’ time, using forward markets

€10,000,000 x 2·5462 = Y$25,462,000

Expected receipt in six months’ time, using money markets

€10,000,000/ (1 + 0·022/2) = €9,891,197 €9,891,197 x 2·5210 = Y$24,935,708

Y$24,935,708 x (1 + 0·024/2) = Y$25,234,936

Minimum amount of debt borrowing Wayne Co would require

Y$50,000,000 – Y$25,462,000 = Y$24,538,000

Appendix 2a (Part (b) (ii)): Projects Red and Blue, base case net present value, in six months’ time

Base case net present value before considering financing side effects. All figures are in Y$000s.

Approximate, base case net present value (NPV) of Project Red = Y$5,272,000.

Base case net present value (NPV) of Project Blue = Y$(8,450,000 + 19,360,000 + 22,340,000 + 4,950,000) – Y$50,000,000 = Y$ 5,100,000

Workings:

Working 1 (w1): Sales revenue

Working 2 (w2): Production costs

Component costs are not inflated, but future exchange rates are based on purchasing power parity (PPP)

Working 3 (w3): Component cost

Working 4 (w4): Tax

Appendix 2b (Part (b) (ii)): Projects Red and Blue, adjusted present value (APV), in six months’ time

Issue costs = 3/97 x Y$24,538,000 = Y$758,907

Annual tax shield = 2·1% x Y$24,538,000 x 20% = Y$103,060

Annual interest saved on subsidised loan = 2·9% x Y$24,538,000 x 80% = Y$569,282

Annuity factor, years 1 to 4 at 5% interest = 3·546

Present value of the tax shield and loan subsidy benefit

= (Y$103,060 + Y$569,282) x 3·546 = Y$2,384,125

Appendix 2c (Part (b) (ii)): Project Red’s duration based on its base case present values of cash flows

Project Red

Total PVs x time = 173,254,000 approximately

Total PVs = 57,005,000 approximately

Project Red duration = 173,254,000/57,005,000 = 3·04 years

(professional marks for part (b) 4 marks)

Explanation of why the subsidiary company may be exposed to economic risk and how it may be managed

Companies face economic exposure when their competitive position is affected due to macroeconomic factors such as changes in currency rates, political stability, or changes in the regulatory environment. Long-term economic exposure or economic shocks can cause a permanent shift in the purchasing power and other parity conditions. Normally, companies face economic exposure when they trade internationally. However, even companies which do not trade internationally nor rely on inputs sourced internationally may still face economic exposure.

In the case of Wayne Co’s subsidiary company, economic risk may have occurred because interest rates have been kept at a high level, causing the original parity conditions to break down. High interest rates will be attractive to international investors, as they can get higher returns and may lead to the Y$ becoming stronger relative to other currencies. This in turn would allow international competitors to produce goods more cheaply than the subsidiary company and thereby enhance their competitive position relative to the subsidiary company.

Managing economic exposure is difficult due to its long-lasting nature and because it can be difficult to identify. Financial instruments, such as derivatives, and money markets cannot normally be used to manage such risks. Wayne Co’s subsidiary company can try tactics such as borrowing in international or eurocurrency markets, sourcing input products from overseas suppliers and ultimately shifting production facilities overseas. None of these are easy or cheap, and can expose the company to new types of risks. Wayne Co would also need to assess that any action it takes to manage economic risk fits into its overall risk management strategy.

d. How each category or risk may be managed

Risks which fall into the severe and frequent category need immediate attention, as they could threaten the company’s survival or derail its long-term strategy. The aim here would be to reduce the severity of the risks and the frequency with which they occur quickly. It may mean avoiding certain actions or abandoning certain projects, even if they could be profitable in the long term. Where a company has a real option, and does not need to take action which will result in high frequency and high severity of risk, it may prefer to wait and see what happens.

Where the frequency of risks occurring is high but their impact is not severe, action needs to be taken so that such risks do not become severe in the future. For example, the company could put systems into place to detect these risks early and plans to deal with them if they do occur. Where the same kind of risks occur often, the company may decide to have set processes for dealing with them. For example, where there is a loss of relatively unskilled staff, the company may decide to replace staff quickly with casual workers, but also have appropriate training facilities in place.

If there are risks which are severe but only happen occasionally or infrequently, the company should try to insure against these. Contingency plans could also be put into place to mitigate the severity. For example, if the consequences of IT failure are high when a business decides to move to a new system, it could put appropriate contingencies into place. These may include secondary backup IT systems or initially trialling the new system on a few business units before undertaking a complete role out.

Risks which are neither severe, nor frequent, should be monitored and kept under review, but no significant action should be taken. It is possible that any significant action would incur costs which would likely be higher than the benefits derived from eliminating such risks. Monitoring such risks will ensure that should they move out of this category into the more severe/frequent categories, the company can start to take appropriate action.

(Note: Credit will be given for alternative and valid explanatory and discussion comments)

A reverse takeover enables a private, unlisted company, like Johnson Co, to gain a listing on the stock exchange without needing to go through the process of an initial public offering (IPO). The private company merges with a listed ‘shell’ company. The private company initially purchases equity shares in the listed company and takes control of its board of directors. The listed company then issues new equity shares and these are exchanged for equity shares in the unlisted company, thereby the original private company’s equity shares gain a listing on the stock exchange. Often the name of the listed company is also changed to that of the original unlisted company.

Advantages relative to an IPO

1. An IPO can take a long time, typically between one and two years, because it involves preparing a prospectus and creating an interest among potential investors. The equity shares need to be valued and the issue process needs to be administered. Since with the reverse takeover shares in the private company are exchanged for shares in the listed company and no new capital is being raised, the process can be completed much quicker.
2. An IPO is an expensive process and can cost between 3% and 5% of the capital being raised due to involvement of various parties, such as investment banks, law firms, etc, and the need to make the IPO attractive through issuing a prospectus and marketing the issue. A reverse takeover does not require such costs to be incurred and therefore is considerably cheaper.
3. In periods of economic downturn, recessions and periods of uncertainty, an IPO may not be successful. A lot of senior managerial time and effort will be spent, as well as expenditure, with nothing to show for it. On the other hand, a reverse takeover would not face this problem as it does not need external investors and it is not raising external finance, but is being used to gain from the potential benefits of going public by getting a listing.

Disadvantages relative to an IPO

1. The ‘shell’ listed company being used in the reverse takeover may have hidden liabilities and may be facing potential litigation, which may not be obvious at the outset. Proper and full due diligence is necessary before the process is started. A company undertaking an IPO would not face such difficulties.
2. The original shareholders of the listed company may want to sell their shares immediately after the reverse takeover process has taken place and this may affect the share price negatively. A lock-up period during which shares cannot be sold may be necessary to prevent this. [Note. An IPO may need a lock-up period as well, but this is not usually the case.]
3. The senior management of an unlisted company may not have the expertise and/or understanding of the rules and regulations which a listed company needs to comply with. The IPO process normally takes longer and is more involved, when compared to a reverse takeover. It also involves a greater involvement from external experts. These factors will provide the senior management involved in an IPO, with opportunities to develop the necessary expertise and knowledge of listing rules and regulations, which the reverse takeover process may not provide.
4. One of the main reasons for gaining a listing is to gain access to new investor capital. However, a smaller, private company which has become public through a reverse takeover may not obtain a sufficient analyst coverage and investor following, and it may have difficulty in raising new finance in future. A well-advertised IPO will probably not face these issues and find raising new funding to be easier.

As a private company, Johnson Co is able to ensure that the needs of its primary stakeholder groups –finance providers, managers and employees – are taken into account through the supervisory board. The supervisory board has representatives from each of these groups and each group member has a voice on the board. Each stakeholder group should be able to present its position to the board through its representatives, and decisions will be made after agreement from all group representatives. In this way, no single stakeholder group holds primacy over any other group.

Once Johnson Co is listed and raises new capital, it is likely that it will have a large and diverse range of equity shareholders, who will likely be holding equity shares in many other companies. Therefore, there is likely to be pressure on Johnson Co to engage in value creating activity aimed at keeping its share price buoyant and thereby satisfying the equity shareholders. It is, therefore, likely that the equity shareholders’ needs will hold primacy over the other stakeholder groups and quite possibly the power of the supervisory board will diminish as a result of this.

(Max 4 marks)

REPORT TO THE BOARD OF DIRECTORS, TREE CO

EVALUATION OF WHETHER THE PRODUCTION OF X-IT SHOULD MOVE TO BRUNEI

This report evaluates the possibility of moving the production of the X-IT to Brunei from the USA. Following the initial evaluation, the report discusses the key assumptions made, the possible impact of a change in the government in Brunei after the elections due to take place shortly and other business factors that should be considered before a final decision is made.

Initially a base case net present value calculation is conducted to assess the impact of the production in Brunei. This is then adjusted to show the impact of cash flows in the USA as a result of the move, the immediate impact of ceasing production and the impact of the subsidy and the tax shield benefits from the loan borrowing.

Based on the calculations presented in the appendix, the move will result in a positive adjusted present value of just over $2.4 million. On this basis, the initial recommendation is that the production of X-IT should cease in the USA and the production moved to Brunei instead.

Assumptions

It is assumed that the borrowing rate of 5% is used to calculate the benefits from the tax shield. It could be argued that the risk-free rate of 3% could be used as the discount rate instead of 5% to calculate the present value of benefits from the tax shields and the subsidies.

In adjusted present value calculations, the tax shield benefit is normally related to the debt capacity of the investment, not the actual amount of debt finance used. Since this is not given, it is assumed that the increase in debt capacity is equal to the debt finance used.

It has been assumed that many of the input variables, such as for example the tax and tax allowable depreciation rates, the various costs and prices, units produced and sold, the rate of inflation and the prediction of future exchange rates based on the purchasing power parity, are accurate and will change as stated over the four-year period of the project. In reality any of these estimates could be subject to change to a greater or lesser degree and it would appropriate for Tree Co to conduct uncertainty assessments like sensitivity analysis to assess the impact of the changes to the initial predictions.

Government change

From the facts of the case, it would seem that a change of government could have a significant impact on whether or not the project is beneficial to Tree Co. The threat to raise taxes may not be too significant as the tax rates would need to increase to more than 30% before Tree Co would lose money. However, the threat by the opposition party to review ‘commercial benefits’ may be more significant.

Just over 40% of the present value comes from the tax shield and subsidy benefits. If these were reneged then Tree Co would lose a significant of the value attached to the project. Also, the new government may not allow remittances every year, as is assumed in part (i). However, this may not be significant since the largest present value amount comes from the final year of operation.

Other business factors

Tree Co should consider the possibility of becoming established in Brunei, and this may lead to follow-on projects. The real options linked to this should be included in the analysis.

Tree Co’s overall corporate strategy should be considered. Does the project fit within this strategy? Even if the decision is made to close the operation in the USA, there may be other alternatives and these need to be assessed.

The amount of experience Tree Co has in international ventures needs to be considered. For example, will it be able to match its systems to the Brunein culture? It will need to develop strategies to deal with cultural differences. This may include additional costs such as training which may not have been taken into account.

Tree Co needs to consider if the project can be delayed at all. From part (i), it can be seen that a large proportion of the opportunity cost relates to lost contribution in years 1 and 2. A delay in the commencement of the project may increase the overall value of the project.

Tree Co needs to consider the impact on its reputation due to possible redundancies. Since the production of X-IT is probably going to be stopped in any case, Tree Co needs to communicate its strategy to the employees and possibly other stakeholders clearly so as to retain its reputation. This may make the need to consider alternatives even more important.

Conclusion

Following from a detailed sensitivity analysis, analysis of a possible change in the government and an evaluation of the financial benefits accruing from the other business factors discussed above, the BoD can make a decision of whether to move the production to Brunei or not. This initial evaluation suggests that moving the production of the X-IT to Brunei would be beneficial.

APPENDIX

Brunein Project Operating Cash Flows

(All amounts in BND/$000s)

Net present value (NPV) of the cash flows from the project is approx. $2,018,000.

Workings:

(W1) Exchange rates

(W2) Sales revenue (BND 000s)

(W3) Local variable costs (BND 000s)

(W4) Imported component (BND 000s)

(W5) Local variable costs (BND 000s)

(W6) Brunei project all-equity financed discount

Tree Co equity beta = 1.17

MVe = $2.40 × 25m shares = $60m

MVd = $40m × $1,428/$1,000 = $57.12m

Tree Co asset beta (assuming debt is rate risk free)

1.17 × 60m/ (60m + 57.12m × 0.7) = 0.70

Project asset beta = 0.70 + 0.40 = 1.10

Project all-equity financed discount rate = 3% + 6% × 1.1 = 9.6%

(W7) Additional tax, additional contribution and opportunity cost ($000s)

(W8) Tax shield and subsidy benefits ($/BND 000s)

NPV of tax shield and subsidy benefit is approx. $1,033,000

(35 marks)

(Professional marks for part (a) 4 marks)

A triple bottom line (TBL) report provides a quantitative summary of performance in terms of economic or financial impact, impact on the environment and impact on social performance. TBL provides the measurement tool to assess a corporation’s or project’s performance against its objectives.

The principle of TBL reporting is that true performance should be measured in terms of a balance between economic (profits), environmental (planet) and social (people) factors; with no one factor growing at the expense of the others. The contention is that a corporation that accommodates the pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as long as the benefits that accrue from producing such a report exceeds the costs of producing it.

For example, in the case of the X-IT, reporting on the impact of moving the production to Brunei, in terms of the impact on the employees and environment in the USA and in Brunei will highlight Tree Co as a good corporate citizen, and thereby increase its reputation and enable it to attract and retain high performing, high calibre employees. It can also judge the impact on the other business factors mentioned in the report above.

Portfolio theory suggests that shareholders holding well-diversified portfolios will have diversified away unsystematic or company specific risk, and will only face risk systematic risk, i.e., risk that cannot be diversified away. Therefore, a company cannot reduce risk further by undertaking diversification within the same system or market. However, further risk reduction may occur if the diversification is undertaken by the company, on behalf of the shareholders, into a system or market where they themselves do not invest. Some studies indicate that even shareholders holding well-diversified portfolios may benefit from risk diversification where companies invest in emerging markets.

In the case of Tree Co and the X-IT, it is not clear whether diversification benefits will result in the investment in Brunei. The benefits are dependent on the size of the investment, and on the nature of the business operations undertaken in Brunei by Tree Co. And whether these operations mirror an investment in a significantly different system or market. If the investment is large, the operations are similar to undertaking a Brunein company. Tree Co’s shareholders who do not hold similar companies’ shares in their portfolios may then gain risk diversification benefits from the Brunein investment.

The foreign exchange exposure of the dollar payment due in four months can be hedged using the following derivative products:

Forward rate offered by Kaira Bank

Exchange-traded futures contracts; and

Exchange-traded options contracts

Using the forward rate

Payment in Swiss Francs = US$5,060,000/1.0677 = CHF4,739,159

Using futures contract

Since a dollar payment needs to be made in four months’ time, Chaiwala Co needs to hedge against Swiss Francs weakening.

Hence, the company should go short and the six-month futures contract is undertaken. It is assumed that the basis differential will narrow in proportion to time.

Predicted futures rate = 1.0647 + [(1.0659 — 1.0647) × 1/3] = 1.0651

[Alternatively, can predict futures rate based on spot rate: 1.0635 + [(1.0659 – 1.0635) × 4/6] = 1.0651]

Expected payment = US$5,060,000/1.0651 = CHF4,750,728

No. of contracts sold = CHF4,750,728/CHF125,000 = approx. 38 contracts

Using options contracts

Since a dollar payment needs to be made in four months’ time, Chaiwala Co needs to hedge against Swiss Francs weakening. Hence, the company should purchase six-month put options.

Exercise price US$1.06/CHF1

Payment = US$5,060,000/1.06 = CHF4,773,585

Buy 4,773,585/125,000 = 38.19 put contracts, say 38 contracts

CHF payment = CHF4,750,000

Premium payable = 38 × 125,000 × 0.0216 = US$102,600

In CHF = 102,600/1.0635 = CHF96,474

Amount not hedged = US$5,060,000 — (38 × 125,000 × 1.06) = US$25,000

Use forward contracts to hedge this = US$25,000/1.0677 = CHF23,415

Total payment = CHF4,750,000 + CHF96,474 + CHF23,415 = CHF4,869,889

Exercise price US$1.07/CHF1

Payment = US$5,060,000/1.07 = CHF4,728,972

Buy 4,728,972/125,000 = 37.83 put contracts, say 38 contracts (but this is an over-hedge)

CHF payment = CHF4,750,000

Premium payable = 38 × 125,000 × 0.0263 = US$124,925

In CHF = 124,925/1.0635 = CHF117,466

Amount over-hedged = US$5,060,000 – (38 × 125,000 × 1.07) = US$22,500

Using forward contracts to show benefit of this = US$22,500/1.0677 = CHF21,073

Total payment = CHF4,750,000 + CHF117,466 – CHF21,073 = CHF4,846,393

Advice

Forward contracts minimise the payment and option contracts would maximise the payment, with the payment arising from the futures contracts in between these two. With the option contracts, the exercise price of US$1.07/CHF1 gives the lower cost. Although transaction costs are ignored, it should be noted that with exchange-traded futures contracts, margins are required and the contracts are marked-to-market daily.

It would therefore seem that the futures contracts and the option contract with an exercise price of US$1.06/CHF1 should be rejected. The choice between forward contracts and the 1.07 options depends on Chaiwala Co’s attitude to risk. The forward rate is binding, whereas option contracts give the company the choice to let the option contract lapse if the CHF strengthens against the US$. Observing the rates of inflation between the two countries and the exchange-traded derivatives this is likely to be the case, but it is not definite. Moreover, the option rates need to move in favour considerably before the option is beneficial to Chaiwala Co, due to the high premium payable.

It would therefore seem that forward markets should be selected to minimise the amount of payment, but Chaiwala Co should also bear in mind that the risk of default is higher with forward contracts compared with exchange-traded contracts.

Chaiwala Co has a comparative advantage in borrowing at the fixed rate and the counterparty has a comparative advantage in borrowing at the floating rate. Total possible benefit before Kaira Bank’s fee is 1.2%, which if shared equally results in a benefit of 0.6% each, for both Chaiwala Co and the counterparty.

After paying the 20-basis point fee, Chaiwala Co will effectively pay interest at the yield curve rate and benefit by 40 basis points or 0.4%, and the counterparty will pay interest at 3.4% and benefit by 40 basis points or 0.4% as well.

Examiner’s note: Full marks will be given where the question is answered by estimating the arbitrage gain of 1.2% and deducting the fees of 0.4%, without constructing the above table.

Annuity factor, 4 years, 2% = 3.808 Equal annual amounts repayable per year = CHF60,000,000/3.808 = CHF15,756,303

Macaulay duration

(15,756,303 × 0.980 × 1 year +

15,756,303 × 0.961 × 2 years +

15,756,303 × 0.942 × 3 years +

15,756,303 × 0.924 × 4 years)/60,000,000

= 2.47 years

Modified duration = 2.47/1.02 = 2.42 years

The equation linking modified duration (D), and the relationship between the change in interest rates (Ai) and change in price or value of a bond or loan (AP) is given as follows:

∆P = [–D × ∆i × P]

(P is the current value of a loan or bond and is a constant)

The size of the modified duration will determine how much the value of a bond or loan will change when there is a change in interest rates. A higher modified duration means that the fluctuations in the value of a bond or loan will be greater, hence the value of 2.42 means that the value of the loan or bond will change by 2.42 times the change in interest rates multiplied by the original value of the bond or loan.

The relationship is only an approximation because duration assumes that the relationship between the change in interest rates and the corresponding change in the value of the bond or loan is linear. In fact, the relationship between interest rates and bond price is in the form of a curve which is convex to the origin (i.e., non-linear). Therefore, duration can only provide a reasonable estimation of the change in the value of a bond or loan due to changes in interest rates, when those interest rate changes are small.

MEMORANDUM

From:

To: The Board of Directors, Chaiwala Co

Date: xx/xx/xxxx

Subject: Discussion of the proposal to manage foreign exchange and interest rate exposures, and the proposal to move operations to four branches and consequential agency issues

This memo discusses the proposal of whether or not Chaiwala Co should undertake the management of foreign exchange and interest rate exposure, and the agency issues resulting from the proposal to locate branches internationally and how these issues may be mitigated. Each proposal will be considered in turn.

1. Proposal one: Management of foreign exchange and interest rate exposure

The non-executive directors are correct if Chaiwala Co is in a situation where markets are perfect and efficient, where information is freely available and where securities are priced correctly. In this circumstance, risk management or hedging would not add value and if shareholders hold well diversified portfolios, unsystematic risk will be largely eliminated. The position against hedging states that in such cases companies would not increase shareholder value by hedging or eliminating risk because there will be no further reduction in unsystematic risk. Furthermore, the cost of reducing any systematic risk will equal or be greater than the benefit derived from such risk reduction. Shareholders would not gain from risk management or hedging; in fact, if the costs exceed the benefits, then hedging may result in a reduction in shareholder value.

Risk management or hedging may result in increasing corporate (and therefore shareholder) value if market imperfections exist, and in these situations, reducing the volatility of a company’s earnings will result in higher cash inflows. Proponents of hedging cite three main situations where reduction in volatility or risk may increase cash flows – in situations: where the rate of tax is increasing; where a firm could face significant financial distress costs due to high volatility in earnings; and where stable earnings increases certainty and the ability to plan for the future, thus resulting in stable investment policies by the firm.

Active hedging may also reduce agency costs. For example, unlike shareholders, managers and employees of the company may not hold diversified portfolios. Hedging allows the risks faced by managers and employees to be reduced. Additionally, hedging may allow managers to be less concerned about market movements which are not within their control and instead allow them to focus on business issues over which they can exercise control. This seems to be what the purchasing director is contending. On the other hand, the finance director seems to be more interested in increasing his personal benefits and not necessarily in increasing the value of Chaiwala Co.

A consistent hedging strategy or policy may be used as a signalling tool to reduce the conflict of interest between bondholders and shareholders, and thus reduce restrictive covenants.

It is also suggested that until recently Chaiwala Co had no intention of hedging and communicated this in its annual report. It is likely that shareholders will therefore have created their own risk management policies. A strategic change in the policy may have a negative impact on the shareholders and the clientele impact of this will need to be taken into account.

The case of whether to hedge or not is not clear cut and Chaiwala Co should consider all the above factors and be clear about why it is intending to change its strategy before coming to a conclusion. Any intended change in policy should be communicated to the shareholders. Shareholders can also benefit from risk management because the risk profile of the company may change, resulting in a reduced cost of capital.

(9 marks)

1. Proposal two: International branches, agency issues and their mitigation

Principal–agent relationships can be observed within an organisation between different stakeholder groups. With the proposed branches located in different countries, the principal–agent relationship will be between the directors and senior management at Chaiwala Co in Switzerland, and the managers of the individual branches. Agency issues can arise where the motivations of the branch managers, who are interested in the performance of their individual branches, diverge from the management at Chaiwala Co headquarters, who are interested in the performance of the whole organisation.

These issues may arise because branch managers are not aware of, or appreciate the importance of, the key factors at corporate level. They may also arise because of differences in cultures and divergent backgrounds.

Mitigation mechanisms involve monitoring, compensation and communication policies. All of these mechanisms need to work in a complementary fashion in order to achieve goal congruence, much like the mechanisms in any principal– agent relationship.

Monitoring policies would involve ensuring that key aims and strategies are agreed between all parties before implementation, and results monitored to ensure adherence with the original agreements. Where there are differences, for example, due to external factors, new targets need to be agreed. Where deviations are noticed, these should be communicated quickly.

Compensation packages should ensure that reward is based on achievement of organisational value and therefore there is every incentive for the branch managers to act in the best interests of the corporation as a whole.

Communication should be two-way, in that branch managers should be made fully aware of the organisational objectives, and any changes to these, and how the branch contributes to these, in order to ensure their acceptance of the objectives. Furthermore, the management at CHAIWALA Co headquarters should be fully aware of cultural and educational differences in the countries where the branches are to be set up and fully plan for how organisational objectives may nevertheless be achieved within these differences.

(Note: Credit will be given for alternative, relevant approaches to the calculations, comments and suggestions/recommendations).

(9 marks)

(Professional marks for part (d) 4 marks)

Synergy might exist for several reasons, including:

Economic efficiency gains

Gains might relate to economies of scale or scope.

Economies of scale occur through such factors as fixed operating costs being spread over a larger production volume, equipment being used more efficiently with higher volumes of production, or bulk purchasing reducing costs.

Economies of scope may arise from reduced advertising and distribution costs when companies have complementary resources. Economies of scale and scope relate mainly to horizontal acquisitions and mergers. Economic efficiency gains may also occur with backward or forward vertical integration which might reduce production costs as the ‘middle man’ is eliminated, improve control of essential raw materials or other resources that are needed for production, or avoid disputes with what were previously suppliers or customers.

Economic efficiency gains might also result from replacing inefficient management as the result of a merger/takeover.

Financial synergy

Financial synergy might involve a reduction in the cost of capital and risk.

The variability (standard deviation) of returns of a combined entity is usually less than the weighted average of the risk of the individual companies. This is a reduction in total risk, but does not affect systematic risk, and hence might not be regarded as a form of synergy by shareholders. However, reduced variability of returns might improve a company’s credit rating making it easier and/or cheaper to obtain a loan.

Another possible financial synergy exists when one company in an acquisition or merger is able to use tax shields, or accumulated tax losses, which would otherwise have been unavailable to the other company.

Market power

A large organisation, particularly one which has acquired competitors, might have sufficient market power to increase its profits through price leadership or other monopolistic or oligopolistic means.

REPORT TO THE BOARD OF DIRECTORS, NIGHT CO

IMPACT OF THE TAKEOVER PROPOSAL FROM MOJO CO AND PRODUCTION RIGHTS OF THE FOLLOW-ON PRODUCT

The report considers the value of the takeover to Night Co and Mojo Co shareholders based on a cash offer and on a share-for-share offer. It discusses the possible reaction of each group of shareholders to the two offers and how best to utilise the follow-on product opportunity. The significant assumptions made in compiling the report are also explained.

The appendices to the report show the detailed calculations in estimating the equity value of Night Co, the value to Night Co and Mojo Co shareholders of acquiring Night Co by cash and by a share-for-share exchange, and the value to Night Co of the exclusive rights to the follow-on product. The results of the calculation are summarised below:

Estimated price of a Night Co share before the takeover offer and follow-on product is £2.90/share (Appendix i)

Estimate of the value per share of the follow-on product to Night Co is 8.7% (Appendix iii)

It is unlikely that Night Co shareholders would accept the cash offer because it is little more than the estimated price of a Night Co share before the takeover offer.

However, the share-for-share offer gives a larger increase in value of a share of 17.9%. Given that the normal premium on acquisitions ranges from 20% to 40%, this is closer to what Night Co shareholders would find acceptable. It is also greater than the additional value from the follow-on product. Therefore, based on the financial figures, Night Co’s shareholders would find the offer of a takeover on a share-forshare exchange basis the most attractive option. The other options considered here yield lower expected percentage increase in share price.

Mojo Co shareholders would prefer the cash offer so that they can maximise the price of their shares and also not dilute their shareholding, but they would probably accept either option because the price of their shares increases. However, Mojo Co shareholders would probably assess whether or not to accept the acquisition proposal by comparing it with other opportunities that the company has available to it and whether this is the best way to utilise its spare cash flows.

The calculations and analysis in each case is made on a number of assumptions. For example, in order to calculate the estimated price of a Night Co share, the free cash flow valuation model is used. For this, the growth rate, the cost of capital and effective time period when the growth rate will occur (perpetuity in this instance) are all estimates or based on assumptions. For the takeover offer, the synergy savings and P/E ratio value are both assumptions. For the value of the follow-on product and the related option, the option variables are estimates and it is assumed that they would not change during the period before the decision. The value of the option is based on the possibility that the option will only be exercised at the end of the two years, although it seems that the decision can be made any time within the two years.

The follow-on product is initially treated separately from the takeover, but Night Co may ask Mojo Co to take the value of the follow-on product into consideration in its offer. The value of the rights that allow Night Co to delay making a decision are themselves worth $603,592 (Appendix iii) and add just over 25c or 8.7% to the value of a Night Co share. If Mojo Co can be convinced to increase their offer to match this or the rights could be sold before the takeover, then the return for Night Co’s shareholders would be much higher at 26.6% (17.9% + 8.7%).

In conclusion, the most favourable outcome for Night Co shareholders would be to accept the share-for-share offer, and try to convince Mojo Co to take the value of the follow-on product into consideration. Prior to accepting the offer Night Co shareholders would need to be assured of the accuracy of the results produced by the computations in the appendices.

Report compiled by: XXX

Date: XXX

(Note: Credit will be given for alternative relevant discussion and suggestions)

APPENDICES

Appendix i: Estimate of Night Co Equity Value Based on Free Cash Flows

Company value = Free cash flows (FCF) × (1 + growth rate (g))/ (cost of capital (k) – g)

k = 11%

Past g = (latest profit before interest and tax (PBIT)/earliest PBIT)1/no. of years of growth – 1

Past g = (1,230/970)1/3 – 1 = 0.0824

Future g = ¼ × 0.0824 = 0.0206

FCF Calculation

FCF = PBIT + non-cash flows – cash investment – tax

FCF = $1,230,000 + $1,206,000 – $1,010,000 – ($1,230,000 × 20%) = $1,180,000

Company value = $1,180,000 × 1.0206/ (0.11 – 0.0206) = $13,471,000

Equity value = $13,471,000 – $6,500,000 = $6,971,000 Per share = $6,971,000/2,400,000 shares = $2.90

Appendix ii: Estimated Returns to Night Co and Mojo Co Shareholders

 Cash Offer

Gain in value to a Night Co share = ($2.95 – $2.90)/$2.90 = 1.7%

Additional earnings after acquisition = $620,000 + $150,000 = $770,000

Additional EPS created from acquisition = $770,000/10,000,000 = 7.7c/share

Increase in share price based on P/E of 15 = 7.7c × 15 = $1.16

Share-for-share Offer

Earnings combined company = $620,000 + $150,000 + $3,200,000 = $3,970,000

Shares in combined company = 10,000,000 + 2,400,000 × 2/3 = 11,600,000

EPS = 34.2c/share [$3,970,000/11,600,000]

Expected share price = 34.2c × 15 = 513c or $5.13/share

Three Night Co shares = $2.90 × 3 = $8.70

Gain in value to a Mojo Co share = ($5.13 – $4.80)/$4.80 = 6.9%

Gain in value to a Night Co share = ($10.26 – $8.70)/$8.70 = 17.9%

Appendix iii: Increase in Value of Follow-On Product

Based on conventional NPV, without considering the value of the option to delay the decision, the project would increase the value of the company by $405,000.

Considering the value of the option to delay the decision

d₁ = [ln (2,434/2,500) + (0.032 + 0.5 × 0.422) × 2]/ (0.42 × ^21/2) = 0.359

d₂ = 0.359 – (0.42 × 2^1/2) = –0.235

N(d₁) = 0.5 + (0.1368 + 0.9 × (0.1406 – 0.1368)) = 0.6402

N(d₂) = 0.5 – (0.0910 + 0.5 × (0.0948 – 0.0910)) = 0.4071

Value of option to delay the decision

= 2,434,000 × 0.6402 – 2,500,000 × 0.4071 × e^{– (0.032 × 2)}

= $1,558,247 – $954,655 = $603,592

The project increases the value of the company by $603,592 or 25.1c per share ($603,592/2,400,000 shares). In percentage terms this is an increase of about 8.7% (25.1c/290c).

Using the BSOP model in company valuation rests upon the idea that equity is a call option, written by the lenders, on the underlying assets of the business. If the value of the company declines substantially then the shareholders can simply walk away, losing the maximum of their investment. On the other hand, the upside potential is unlimited once the interest on debt has been paid.

The BSOP model can be helpful in circumstances where the conventional methods of valuation do not reflect the risks fully or where they cannot be used. For example, if we are trying to value an unlisted company with unpredictable future growth.

There are five variables which are input into the BSOP model to determine the value of the option. Proxies need to be established for each variable when using the BSOP model to value a company. The five variables are: the value of the underlying asset, the exercise price, the time to expiry, the volatility of the underlying asset value and the risk-free rate of return.

For the exercise price, the debt of the company is taken. In its simplest form, the assumption is that the borrowing is in the form of zero-coupon debt, i.e., a discount bond. In practice such debt is not used as a primary source of company finance and so we calculate the value of an equivalent bond with the same yield and term to maturity as the company’s existing debt. The exercise price in valuing the business as a call option is the value of the outstanding debt calculated as the present value of a zero-coupon bond offering the same yield as the current debt.

The proxy for the value of the underlying asset is the fair value of the company’s assets less current liabilities on the basis that if the company is broken up and sold, then that is what the assets would be worth to the long-term debt holders and the equity holders.

The time to expiry is the period of time before the debt is due for redemption. The owners of the company have that time before the option needs to be exercised, that is when the debt holders need to be repaid.

The proxy for the volatility of the underlying asset is the volatility of the business’ assets.

The risk-free rate is usually the rate on a riskless investment such as a short-term government bond.

The relative advantages and disadvantages of the use of a money market hedge versus exchange traded derivatives

A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified rate without recourse to the forward FOREX market. If a company is able to achieve preferential access to the short-term money markets in the base and counter currency zones then it can be a cost-effective substitute for a forward agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it requires borrowing/lending agreements to be established denominated in the two currencies.

Exchange traded derivatives such as futures and foreign exchange options offer a rapid way of creating a hedge and are easily closed out. For example, currency futures are normally closed out and the profit/loss on the derivative position used to offset the gain or loss in the underlying. The fixed contract sizes for exchange traded products mean that it is often impossible to achieve a perfect hedge and some gain or loss on the unhedged element of the underlying or the derivative will be carried. Also, given that exchange traded derivatives are priced in a separate market to the underlying there may be discrepancies in the movements of each and the observed delta may not equal one. This basis risk is minimised by choosing short maturity derivatives but cannot be completely eliminated unless maturity coincides exactly with the end of the exposure. Furthermore, less than perfectly hedged positions require disclosure under IFRS 9. Although rapid to establish, currency hedging using the derivatives market may also involve significant cash flows in meeting and maintaining the margin requirements of the exchange. Unlike futures, currency options will entail the payment of a premium which may be an expensive way of eliminating the risk of an adverse currency movement.

With relatively small amounts, the OTC market represents the most convenient means of locking in exchange rates. Where cross border flows are common and business is well diversified across different currency areas then currency hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur then the simplest solution is to engage in the forward market for hedging risk. The use of a money market hedge as described may generate a more favourable forward rate than direct recourse to the forex market. However, the administrative and management costs in setting up the necessary loans and deposits are a significant consideration.

Report on possible hedging strategies for the foreign exchange exposure in five months’ time.

Only relevant net dollar exposures should be hedged. Net dollar imports in five months’ time are $1,150,000. This is the amount to be hedged. The transactions in sterling are not exposed and should not be hedged. The exposure may be hedged using the forward foreign exchange market, a money market hedge, currency futures hedge or currency options hedge. A combination of these hedges is also possible, or alternatively a partial hedge may be selected that protects only part of the exposure.

Forward market hedge:

No five-month forward rate is given. The rate may be interpolated from the three-month and one-year rates for buying dollars.

The estimated five-month forward rate is:

1.9066 ×  + 1.8901 ×  = 1.9029

Hedging with a forward contact will fix the £ payment at:

Money market hedge:

In order to protect against any future strengthening of the dollar, Limini could borrow £ now and convert £ into dollars to ensure that the company is not exposed if there are changes in the $/£ exchange rate.

Borrow £595,373 at 5.5% per annum for five months, total cost £609,017

Convert into dollars at the spot rate of $1.9156/£ to yield $1,140,496

Invest in the USA at 2.0% per annum to yield a total of $1,150,000, which will be used to make payment for the imports.

($1,140,496 × 1.008333 = $1,150,000)

A money market hedge is more expensive than the forward hedge.

Currency futures hedge:

The currency exposure is in five months’ time. To protect against the risk of the dollar strengthening, December futures should be sold.

The basis is 1.9156 – 1.8986 = 1.7 cents. This relates to a futures contract maturing in seven months’ time.

The expected basis in five months’ time is 1.7x  x 2= 0.486 cents

The expected lock-in futures rate may be estimated by:

1.8986 + 0.00486 = 1.9035

This is slightly more favourable than the forward market rate, but there are a number of possible disadvantages of using currency futures:

1. Basis risk might exist. The actual basis at the close-out date in five months’ time might be different from the expected basis of 0.486 cents.
2. Currency futures will involve either under hedging or over hedging as an exact number of contracts for the risk is not available.

• Currency futures involve the upfront payment of a margin (security deposit). If daily losses are made on the futures contracts additional margin will need to be provided to keep the futures contracts open.

Currency options hedge:

As dollars need to be purchased, Limini will need to buy December put options on £.

It is assumed that Limini will under hedge using 19 contracts and will purchase the remaining dollars in the forward market (in reality it would probably wait and use the spot market in five months’ time); 19 contracts is £593,750.

Worst-case outcomes if the options are exercised:

Tutorial note

• This lengthy calculation has shown that the exercise price of 1.9000 is likely to be most attractive to Limini (it has the lowest overall cost of £618,698. To reduce the amount of time spent on this calculation, you could have identified the cheapest exercise price right at the start as follows:

• The (A)–(B) column shows the net amount of $ receivable, after paying the premium, for each £1 covered. The 1.9000 exercise price corresponds to the highest net $ receipt, so is the preferred option. Once you have identified the preferred exercise price, just present calculations for that one to save time.

As is normal, the currency options worst-case outcomes are much more expensive than alternative hedges. However, if the dollar weakens relative to the pound, option contracts allow the company to purchase the required dollars in five months’ time in the spot market and let the options lapse (or alternatively sell the options to take advantage of any remaining time value). In this situation the dollar would have to weaken to about 1.98/£ before the currency options became more favourable than the forward contract or futures hedge. This is possible, but unlikely, especially as the forward market expects the dollar to strengthen rather than weaken.

Forward contracts or futures contracts appear to be the best form of hedge.

c. Estimated effect on value:

The strengthening of the dollar is expected to reduce the present value of cash flows, and, if the market is efficient, the market value of Limini, by £727,370.

Economic exposure relates to the change in the value of a company as a result of unexpected changes in exchange rates.

Unless there are known contractual future cash flows it is difficult to hedge economic exposure using options, swaps, or other financial hedges, as the amount of the exposure is unknown.

Economic exposure is normally managed by internationally diversifying activities, and organising activities to allow flexibility to vary the location of production, the supply sources of raw materials and components, and international financing, in response to changes in exchange rates.

To some extent multinational companies may offset economic exposure by arranging natural hedges, for example by borrowing funds in the USA, and then servicing the interest payments and the repayment of principal on the borrowing with cash flows generated by subsidiaries in the USA.

Marketing strategies may also be used to offset the effects of economic exposure. For example, if UK products were to become relatively expensive in the USA due to a fall in the value of the dollar, a UK company might adopt an intensive marketing campaign to create a better brand or quality image for its products.

Director A’s focus is on reducing the risk in the business through diversification and thereby increasing its value. A strategy of risk diversification resulting in greater value can work in situations where the equity holders are exposed to both unsystematic and systematic risks, for example, when their investment is concentrated in one company. In such situations, the shareholders would be subject to unsystematic risk and diversification would reduce this risk.

In the case of Ching Co, this is unlikely to be the case as a large proportion of shares are owned by institutional shareholders and it is likely that their investment portfolios are already well-diversified and therefore, they are not exposed to unsystematic risk. Further diversification will be of no value to them. In fact, it may be construed that managers are only taking this action for their own benefit, as they may be closely tied to the company and therefore be exposed to total risk (both unsystematic and systematic risks). This may then become a source of agency related conflict between the management and the shareholders.

However, diversification overseas into markets which have some barriers to entry might reduce both systematic and unsystematic risks as well.

Director B, on the other hand, seems to be suggesting that Ching Co should focus on its core business and increase value through identifying areas of synergy benefits. It may be the case that Ching Co’s management and directors are well placed to identify areas where the company can gain value by acquiring companies with potential synergy benefits.

The types of synergy benefits, which may arise in established pharmaceutical companies, can include:

Identifying undervalued companies, where the management is not effective in unlocking the true value of company. By replacing the existing management, Ching Co may be able to unlock the value of the company.

Acquiring companies which have strategic assets or product pipelines. Ching Co may be well placed to identify companies which have a number of product pipelines, which those companies are not exploiting fully. By acquiring such companies, Ching Co may be able to exploit the product pipelines.

Through acquisitions, Ching Co may be able to exploit economies of scope by eliminating process duplication or economies of scale where its size may enable it to negotiate favourable terms.

Fish Co may benefit if Ching Co acquires it because it is struggling to raise funding for its innovative products. Ching Co is an established company but has few new product innovations coming in the future. Therefore, it may have spare cash resources which Fish Co may be able to utilise.

Tutorial note

The marking scheme here allowed for credit to be given for any alternative but relevant discussion.

Traditional investment appraisal methods such as net present value assume that an investment needs to be taken on a now or never basis, and once undertaken, it cannot be reversed. Real options take into account the fact that in reality, most investments have within them certain amounts of flexibility, such as whether or not to undertake the investment immediately or to delay the decision; to pursue follow-on opportunities; and to cancel an investment opportunity after it has been undertaken. Where there is increasing uncertainty and risk, and where a decision can be changed or delayed, this flexibility has value, known as the time value of an option.

Net present value captures just the intrinsic value of an investment opportunity, whereas real options capture both the intrinsic value and the time value, to give an overall value for an opportunity. When a company still has time available to it before a decision needs to be made, it may have opportunities to increase the intrinsic value of the investment through the strategic decisions it makes.

Investing in new companies with numerous potential innovative product pipelines may provide opportunities for flexibility where decisions can be delayed and the intrinsic value can be increased through strategic decisions and actions taken by the company. Real options try to capture the value of this flexibility within companies with innovative product pipelines, whereas net present value does not.

Report to the board of directors (BoD), Ching Co

Introduction

This report evaluates whether the acquisition of Fish Co would be beneficial to Ching Co’s shareholders by estimating the additional equity value created from the synergies resulting when the two companies are combined. The market values of equity of the two companies as separate entities are considered initially and then compared with the equity value of the two companies together. The free cash flow to firm valuation method is used to estimate the values of the companies and the limitations of this method are discussed.

The market value of equity of Ching Co is given as $12,600 million. Based on the free cash flow to firm valuation method:

The current market value of equity of Fish Co is estimated at $986 million (appendix 1), and

The market value of equity of the combined company is estimated at $14,993 million (appendix 2).

Therefore, the additional market value of equity arising from synergy benefits when the two companies are combined is estimated at $1,407 million (appendix 3), which is then split between Fish Co’s shareholders receiving $296 million (a 30% premium) and Ching Co’s shareholders receiving the balance of $1,111 million, which is approximately 8.8% excess over the original equity value (appendix 3).

However, the valuation method used has a number of limitations, as follows:

• The values of both Fish Co and the combined company are based on estimations and assumptions, for example,
• Fish Co’s future growth rate of free cash flows is based on past growth rates and it is assumed that this will not change in the future;
• It is not explained how Fish Co’s cost of capital is estimated/calculated. Such an estimate may be more difficult to make for private companies;
• The assumption of perpetuity is made when estimating the values of Fish Co and the combined company, and this may not be valid.
• The basis for the synergy benefits such as higher growth rates of sales revenue and profit margins needs to be explained and justified. It is not clear how these estimates have been made.
• Whereas it may be possible to estimate the asset beta of a listed company such as Ching Co, it may be more difficult to provide a reasonable estimate for the asset beta of Fish Co. Therefore, the estimate of the cost of capital of the combined company may not be accurate.
• The costs related to the acquisition process would need to be factored in.

Therefore, whereas the free cash flow method of estimating corporate values is theoretically sound, using it in practice to estimate values is open to errors and judgements.

Conclusion

The valuations indicate that Ching Co’s shareholders would benefit from the acquisition of Fish Co and the value of their shares should increase by 8.8%. However, the method used to estimate the value created makes a number of estimates and assumptions. It is therefore recommended that a range of valuations is made under different assumptions and estimates, through a process of sensitivity analysis, before a final decision is made. As well as this, the limitations of the valuation method used should be well understood and taken into account.

Report compiled by:

Date

((Discussion in report and appendix 3) 7 marks)

APPENDICES:

Appendix 1 (Part (c) (i)): Fish Co, estimate of current value

Cost of capital = 10%

Growth rate of profits and free cash flows = ($91.0m/$83.3m)1/3 – 1 = 0.03 = 3%

Free cash flow to firm (FCFF) = PBIT + non-cash expenses – additional cash investment – tax FCFF = $192.3m + $112.0m – $98.2m – (20% × $192.3m) = $167.6m

Fish Co, estimated value = ($167.6m × 1.03)/ (0.10 – 0.03) = $2,466.1m

Current estimated market value of equity of Fish Co = $2,466.1m × 40% = $986.4m, say $986m approximately.

(6 marks)

Appendix 2 (Part (c) (ii)): Estimate of value created from combining Ching Co and Fish Co

Asset beta of combined company = (0.800 × $12,600m + 0.950 × $986.4m)/ ($12,600m + $986.4m) = 0.811

Equity beta of combined company = 0.811 × (0.70 + 0.30 × 0.80)/0.70 = 1.089

Cost of equity, combined company = 2% + 1.089 × 7% = 9.6% approx.

Cost of capital, combined company = 9.6% × 0.7 + 5.3% × 0.3 × 0.8 = 8% approx.

Combined company, free cash flows and value computation ($ millions)

Sales growth rate, years 2 to 4 = 7% per annum; operating profit margin = 20%

Market value of equity of the combined company = 70% × $21,419m = $14,993m

(11 marks)

Appendix 3: Synergy benefits and their distribution Additional market equity value created by combining the two companies

$14,993m – ($12,600m + $986m) = $1,407m

Therefore, synergy benefits resulting from combining the two companies: $1,407m

Premium payable to Fish Co shareholders: 30% × $986m = $296m

Balance of synergy benefits going to Ching Co’s shareholders: $1,111 m

As a percentage of current value: $1,111m/$12,600m × 100% = 8.8%

(professional marks for part (c) 4 marks)

Both the mandatory bid rule and the principle of equal treatment are designed to protect minority shareholders, where an acquirer has obtained a controlling interest of the target company. The mandatory bid rule provides minority shareholders with the opportunity to sell their shares and exit the target company at a specified fair share price. This price should not be lower than the highest price paid for shares, which have already been acquired within a specified period. The principle of equal treatment requires the acquiring company to offer the same terms to minority shareholders as were offered to the earlier shareholders from whom the controlling interest was acquired. Both these regulatory devices are designed to ensure that the minority shareholders are protected financially and are not exploited by the acquirer.

The purpose of both poison pills and disposal of crown jewels is to make the target company unattractive to the acquirer. Poison pills give existing shareholders in the target company the right to buy additional shares in their company at a discount once the acquiring company has bought a certain number of shares in the target company. The aim is to make the target company more expensive to purchase, as the acquirer needs to buy more shares. Disposal of crown jewels involves selling the target company’s most valuable assets, and therefore making the target company less attractive to the acquirer. The effectiveness of either defence tactic can be limited, as the company’s management would need its shareholders to authorise such moves (although there are ways in which poison pills can be incorporated without gaining prior authorisation from shareholders). Shareholders may not be willing to do this as they normally get premiums on their shares during takeover battles. Additionally, disposing of key strategic assets could substantially weaken a company’s competitive advantage and therefore its future potential. Such action may be detrimental to the company and therefore shareholders would probably not approve that course of action.

Report To: Board of Directors, Milkyway Co

From: AN Consultant

Subject: Initial public listing: price range and implications

Date: XX/XX/XX

This report considers a range of values for Milkyway Co to consider in preparation for the proposed public listing. These values are based on 100 million shares being issued. The assumptions made in determining these values are discussed and the likelihood of the equityfor-debt swap being successful is also considered. Finally, the report will evaluate other reasons for listing and also why the shares should be issued at a discount.

Milkyway Co cost of capital

Zoro Co’s ungeared cost of equity represents the return Zoro Co’s shareholders would require if Zoro Co was financed entirely by equity. This return would compensate the shareholders for the business risk of Zoro Co’s operations.

Since Milkyway Co is in the same industry, and therefore faces the same business risk, this required rate of return should also compensate Milkyway Co’s shareholders. This rate would be used as Milkyway Co’s cost of capital as it is expecting to have no debt and therefore this rate does not need adjusting for financial risk. Therefore the cost of equity is also the cost of capital. This cost of capital is calculated in Appendix 1 as 11%.

Milkyway Co estimated value

Using the cost of capital of 11%, the value of Milkyway Co is calculated as $564.9 million (see Appendix 2 for full calculation), before considering the proposed Bammi project. The value of the Bammi investment, without considering the tax shield and subsidy benefits from the subsidised government loan, does not exceed the initial investment. When the tax and subsidy benefits are considered, the present value of the Bammi project is $21.5 million (see Appendix 3 for full calculation). This gives a total value for Milkyway Co of just over $586 million. This gives the following potential share prices, based on 100 million shares, including the effect of the suggested 20% share price discount.

Equity-for-debt swap

The unsecured bond is currently estimated to be worth $56.8 million (see Appendix 4 for full calculation). It is proposed that the existing bond holders will be offered a 10% stake in Milkyway Co post-listing, which means that only the value at $5.86 per share would leave the bond holders better off, and therefore would be the only acceptable price. If the lowest price of $4.52 per share is used, then the equity stake would need to be around 12.6% for the bond holders to accept the offer (56.8m/4.52 = 12.566).

The bond value is based on a yield to maturity of 7%, because Milkyway Co can borrow at 7%, so this is therefore its current yield. The yield could be more accurately estimated if it was based on future risk-free rates and the credit spreads for the company.

Assumptions

The main assumptions are over the accuracy of the estimates used in producing the valuation. The value of Milkyway Co is based on estimated future growth rates, profit margins, tax rates and capital investment. The future growth rates and margins are based on past data, which may not be a reliable indicator of future prospects. The Bammi project includes estimated cash flows for 15 years and the reasonableness of these estimates needs to be considered to see if they are realistic.

The cost of capital used for Milkyway Co is based on Zoro Co’s ungeared cost of equity, on the basis that the business risk is the same for both companies as they operate in the same industry. However, it is possible that the business risks are different, for example due to geographical locations, and therefore the cost of capital is not appropriate for Milkyway Co. Accepting the Bammi project could also affect the business risk of Milkyway Co.

The value of the Bammi project is based on the Bammi Government providing the promised subsidised loan. Milkyway Co needs to consider whether the full subsidy will definitely be provided for the full 15 years and whether a change of government may change the position. There may also be other political risks which need to be assessed fully.

Transaction costs for the listing have been ignored as they are assumed to be insignificant. It should be confirmed that this is the case before making a final decision.

Reasons for a public listing

The main reason behind this public listing is to remove the debt from the company. Other reasons for pursuing a public listing include: a gain in prestige for the company by listing on a recognised stock exchange, having greater access to sources of finance and being able to raise funds more quickly as a result, providing shareholders with a value for their equity stake and enabling them to realise their investment if they wish to do so.

Issuing shares at a discount

Since the public will only be issued 20% of the share capital from the initial listing, they will be minority shareholders and have a limited ability to influence the decision making of Milkyway Co. Even if they voted as a bloc, they would not be able to overturn the decision on their own. The discounted share price, would therefore compensate the shareholders for the additional risk of being minority shareholders. The position of the unsecured bond holders should also be considered. On the assumption that they hold 12.6% of the equity (as discussed earlier) they could form a bloc with the new shareholders of 32.6%, which would be enough to influence company decisions. Whether they would form a bloc with new shareholders or are more closely aligned with the interests of the current owners is something that should be looked into.

Shares are often issued at a discount to ensure that they all get sold. This is even more common for a new listing and the price of the shares does usually rise immediately after the listing.

Conclusion

A price range for the listing of between $4.52 and $5.86 per share has been calculated, depending on whether the Bammi project is undertaken and whether the shares are offered at a discount of 20%. It is recommended that Milkyway Co consults the underwriters for the share issue, to carry out book-building to assess the price that potential investors are willing to pay.

If 20% of the shares (20 million shares) are sold to the public at $4.52 per share, the listing will raise just over $90 million. $80 million would then be spent redeeming the secured bond, leaving just in excess of $10 million of funds remaining. Milkyway Co needs to consider whether these funds will be sufficient to carry on its operations. The Bammi investment may result in a change to the desired capital structure of the company, which may also have an impact on the cost of capital.

Becoming a listed company will also result in listing costs and additional annual costs to meet compliance and reporting requirements. These factors will need to be balanced against the benefits of listing before making a decision whether or not to proceed.

(Max 12 marks)

APPENDICES

 Appendix 1: Milkyway cost of capital

Zoro Co market value of debt = 105/100 × 1,700m = $1,785m

Zoro Co market value of equity = 200m × $7 = $1,400m

Zoro Co ungeared cost of equity using k_eg = k_eu + (1 – t) (k_eu – k_d) D/E

16.83% = k_eu + 0.75(k_eu – 4.76%) × 1,785/1,400

16.83% + 4.55% = 1.9563k_eu

k_eu = 10.93% (say 11%)

(Max 7 marks)

Appendix 2: Value of Milkyway Co prior to Bammi project

Past 2 years’ sales growth =  -1= 0. 0625 or 6.25%

Expected growth for 4 years = 1.2 × 6.25% = 7.5%

Operating profit margin (historic)

20X3 58.4/389.1 = 0.150

20X2 54.9/366.3 = 0.150

20X1 51.7/344.7 = 0.150

Operating profit margin is expected to be 15%.

Value of company = $564.9m

* 47.6 × 1.035 = 49.3

** 1/ (0.11 – 0.035) × 0.659 = 8.787

Working

Appendix 3: Value of Bammi project

Base case

10-year annuity discounted for 5 years = 5.889 × 0.593

Annual tax shield benefit = 3% × 150m × 25% = $1.1m

Subsidy benefit = 4% × 150m × 0.75 = $4.5m

Total annual benefit = $5.6m

Annuity factor (7%, 15 years) = 9.108

PV of tax shield and subsidy benefit = 5.6m × 9.108 = $51.0m

APV = ($29.5m) + $51.0m = $21.5m

(14 marks)

Appendix 4: Value of unsecured bond

Annual interest = 13% × 40m = $5.2m

Assume a yield to maturity of 7%. A 10-year annuity factor at 7% is 7.024

Discount factor for redemption of bond (7%, 10 years) is 0.508

Bond value = 5.2m × 7.024 + 40m × 0.508 = $56.8m

(5 marks)

(Professional marks for part (a) report 4 marks)

The activities of Milkyway Co are likely to be of greater interest and be scrutinised more closely once it is listed. The company needs to consider the ethical implications of both situations and whether Milkyway Co is complying with its own ethical code (if it has one).

Regarding the relocation of the farmers, Milkyway Co needs to judge where its responsibility lies. It may decide that this is a matter between the farmers and the Government, and that Milkyway Co is not responsible (either directly or indirectly) for the current situation. If Milkyway Co does not agree to the offer, it seems likely that the mining rights would be given to another company and so the farmers’ situation would not improve by Milkyway Co walking away from the deal. Milkyway may be better off by influencing the Government over this issue by asking it to keep the farmers together and to offer them more fertile land. In addition, Milkyway Co could offer jobs and training to any farmers who choose to remain where they are.

In the case of the Bammi president and Milkyway Co’s CEO, Milkyway Co must ensure that any negotiation was transparent and there was no bribery or other illegal practice involved. If the company and the Government can show that decisions have been made in the best interests of the country and Milkyway Co, and no individuals benefited from the decision, then it should not be seen negatively. Indeed, it is good for business to have strong relationships and this can create a competitive advantage.

Milkyway should consider how it would respond to public scrutiny of these issues, possibly even pre-empting issues by releasing press statements to explain positions.

(Max 8 marks)