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Strategic Professional – Options
Advanced Financial
Management
(AFM)
March/June 2019 – Sample Questions
Time allowed: 3 hours 15 minutes
This question paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – BOTH questions are compulsory and MUST be attempted
Formulae and tables are on pages 8–12.
Do NOT open this question paper until instructed by the supervisor.
This question paper must not be removed from the examination hall.
AFM
The Association of
Chartered Certified
Accountants
AFM ACCA
Section A – This ONE question is compulsory and MUST be attempted
1 Talam Co, a listed company, aims to manufacture innovative engineering products which are environmentally friendly and sustainable. These products have been highly marketable because of their affordability. Talam Co’s mission statement also states its desire to operate to the highest ethical standards. These commitments have meant that Talam Co has a very high reputation and a high share price compared to its competitors. Talam Co is considering a new project, the Uwa Project, to manufacture drones for use in the agricultural industry, which are at least 50% biodegradable, at competitive prices. The drones will enable farmers to increase crop yields and reduce crop damage. Manufacture of drones is a new business area for Talam Co. The project is expected to last for four years. Talam Co will also work on the Jigu Project (a follow-on project to the Uwa Project) to make 95%+ biodegradable drones. It is expected that the Jigu Project will last for a further five years after the Uwa Project has finished. If the Uwa Project is discontinued or sold sooner than four years, the Jigu Project could still be undertaken after four years. Uwa Project The following number of drones are expected to be produced and sold: Year 1 2 3 4 Number of drones produced and sold 4,300 19,200 35,600 25, In the first year, for each drone, it is expected that the selling price will be $1,200 and the variable costs will be $480. The total annual direct fixed costs will be $2,700,000. After the first year, the selling price is expected to increase by 8% annually, the variable costs by 4% annually and the fixed costs by 10% annually, for the next three years. Training costs are expected to be 200% of the variable costs in year 1, 60% in year 2, and 10% in each of years 3 and 4. There is substantial uncertainty about the drones produced and sold, and Talam Co estimates the project to have a standard deviation of 30%. At the start of every year, the Uwa Project will need working capital. In the first year, this will be 20% of sales revenue. In subsequent years, the project will require additional or a reduction in working capital of 10% for every $1 increase or decrease in sales revenue respectively. The working capital is expected to be fully recovered when the Uwa Project ceases. The Uwa Project will need $35,000,000 of machinery to produce the drones at the start of the project. Tax allowable depreciation is available on the machinery at 15% per year on a straight-line basis. The machinery is expected to be sold for $7,000,000 (post-inflation) at the end of the project. Talam Co makes sufficient profits from its other activities to take advantage of any tax loss relief. Tax is paid in the year it falls due. Jigu Project as a real option Talam Co estimates that Jigu Project’s cash flows are highly uncertain and its standard deviation is 50%. It is estimated that $60,000,000 will be required at the start of the project in four years’ time. Using conventional net present value, Talam Co’s best estimate is that net present value of the project will be $10,000,000 at the start of the project. The following figures were estimated for the Jigu Project using the real options method. Asset value (Pa) = $46,100,000 (to nearest 100,000) Exercise price (Pe) = $60,000, Exercise date (t) = 4 years Risk-free rate (r) = 2·30% Volatility (s) = 50% d 1 = 0·329 d 2 = –0·671 N(d 1 ) = 0·6288 N(d 2 ) = 0· Call option value: $15,258, It can be assumed that the call option value is accurate. Talam Co’s finance director wants to know how the asset value of $46,100,000 has been estimated. Honua Co’s offer Honua Co, whose main business is drone production, has approached Talam Co with an offer to buy the Uwa Project in its entirety from Talam Co, for $30,000,000 at the start of the third year of the project’s life.
Section B – BOTH questions are compulsory and MUST be attempted
2 Lurgshall Co is a listed electronics company. Lurgshall Co has recently appointed a new chief executive, who has a number of plans to expand the company. The chief executive also plans to look carefully at the costs of all departments in Lurgshall Co’s head office, including the centralised treasury department. The first major investment which the chief executive will oversee is an investment in facilities to produce applications-specific components. To finance the planned investment, it is likely that Lurgshall Co will have to borrow money. It is now 1 May. At present, it seems that Lurgshall Co will need to borrow $84 million on 1 September, for a period of six months, though both the amount and the period of borrowing are subject to some uncertainty. The treasurer plans to borrow the funds at a variable rate of LIBOR plus 50 basis points. LIBOR is currently 4·5% but is expected to rise by up to 0·6% between now and 1 September. So far, the possibility of hedging a rise in LIBOR of 0·6% using a forward rate agreement or September $ futures has been investigated. The results of the calculations for these instruments were as follows: 4–10 Forward rate agreement from Birdam Bank: 5·38% Three-month traded September $ futures: 5·36% Lurgshall Co’s treasurer also wants to consider using options on futures to hedge loans. Although Lurgshall Co has not previously used swaps for hedging purposes, the treasurer has asked Birdam Bank to find a counterparty for a potential swap arrangement. Relevant information about options and swaps is as follows: Options The current price for three-month $ September futures, $2 million contract size is 95·05. The price is quoted in basis points at 100 – annual % yield. Options on three-month September $ futures, $2 million contract size, option premiums are in annual % September calls Strike price September puts 0·132 95·25 0· It can be assumed that futures and options contracts are settled at the end of each month. Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on monthly time intervals. It can also be assumed that there is no basis risk and there are no margin requirements. Swap Birdam Bank has found a possible counterparty to enter into a swap with Lurgshall Co. The counterparty can borrow at an annual floating rate of LIBOR + 1·5% or a fixed rate of 6·1%. Birdam Bank has quoted Lurgshall Co a notional fixed rate of 5·6% for it to borrow. Birdam Bank would charge a fee of 10 basis points to each party individually to act as the intermediary of the swap. Both parties would share equally the potential gains from the swap contract. Treasury staffing Lurgshall Co’s new chief executive has made the following comments: ‘I understand that the treasury department has a number of day-to-day responsibilities, including investing surplus funds for the short-term liquidity management and hedging against currency and interest rates. However, these tasks could all be carried out by the junior, less experienced, members of the department. I do not see why the department needs to employ experienced, expensive staff, as it does not contribute to the strategic success of the company.’
5 [P.T.O.
Required:
(a) Compare the results of hedging the $84 million, using the options and the swap, with the results already obtained using the forward rate agreement and futures, and comment on the results. Show all relevant calculations, including how the interest rate swap would work. (15 marks)
(b) Discuss the advantages and disadvantages of using swaps as a means of hedging interest rate risk for Lurgshall Co. (5 marks)
(c) Criticise the views of the chief executive about the work carried out by the treasury department and the staff required to do this work. (5 marks)
(25 marks)
7 [P.T.O.
Required:
(a) Discuss the advantages and disadvantages of demerging the sportswear division into a new company. (5 marks)
(b) Calculate:
- The change in the weighted average cost of capital of Newimber Co if the demerger of the sportswear **division takes place;
- The valuation of Poynins Co using free cash flows, based on the information and assumptions given and** briefly discuss your results. (15 marks)
(c) Discuss the factors which may determine the policies Poynins Co should adopt for communication of information to its shareholders and other significant stakeholders. (5 marks)
(25 marks)
Formulae
Modigliani and Miller Proposition 2 (with tax)
The Capital Asset Pricing Model
The asset beta formula
The Growth Model
Gordon’s growth approximation
The weighted average cost of capital
The Fisher formula
Purchasing power parity and interest rate parity
k k T)(k k
V
e e V
i e
i d
d e
E(ri ) = R (^) f +βi (E(r (^) m ) – Rf)
βa e β e d
e
d e d
V
V V T))
V T
V V
1 – – T)) d
β
P
D g) o (r g)
o e
g =bre
WACC
V
V V
k
V
V V
e k e d
e
d e d
= (^) + d
( – 1 TT)
( 1 + i) = ( 1 +r)(1+h)
S S x
(1+h (1+h
F S x
(1+i (^1 0) (
c b
0 0 = ) = c )
++ib )
Present Value Table
Present value of 1 i.e. (1 + r )– n
Where r = discount rate n = number of periods until payment
Discount rate (r)
Periods
11 [P.T.O.
Annuity Table
Present value of an annuity of 1 i.e.
Where r = discount rate n = number of periods
Discount rate (r)
Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1 2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2 3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3 4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4 5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6 7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7 8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8 9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9 10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11 12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12 13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13 14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14 15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1 2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2 3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3 4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4 5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6 7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7 8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8 9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9 10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11 12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12 13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13 14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14 15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
1 – (1 + ————–– r ) – n r
